A result of the downgrade is that South Africa, which constitutes 0.45% of the FTSE World Investment Grade Bond Index (WGBI), will no longer form part of the index from 1 May 2020. Passive strategy investors following the WGBI will have to sell their rand bond holdings to avoid breaching their investment mandate. South Africa has a 0.45% weighting in the WGBI that represents $3 trillion of investments, which suggest that there could be as much as $14 billion of investment outflows.
The announcement by Moody’s confirmed the first downgrade into speculative status since an investment grade rating was awarded to South Africa 25 years ago. This downgrade by the last of the trio of recognised rating agencies was the result of years of flawed government policy, weak governance, corruption and state capture. The legacy of the Zuma presidency has left South Africa in a vulnerable state from a financial and economic perspective. The post Zuma government under Mr Ramaphosa has been struggling to make any meaningful inroads in fixing the structural deficiencies of the South African economy. Internal party politics, ideological differences and low levels of trust between government, the private sector and labour resulted in a lack of focus and action to start addressing the growing socio-economic challenges. The outbreak of the COVID-19 pandemic has now also left the country exposed and in a fragile state from a humanitarian perspective.
The build up to the Moody’s latest downgrade started as far back as 9 December 2015 with “Nenegate” when President Zuma, as part of a politically driven agenda, decided to remove the then Minister of Finance, Mr Nhlanhla Nene. Since then South Africa’s benchmark fixed interest instruments traded at yields of emerging market peers that have already been relegated to the sub investment grade league. Fragmented and slow decision making by government, pedestrian economic growth, faltering state owned enterprises, the Eskom energy crisis and rapidly rising government debt were raised repeatedly by Moody’s as the main factors they were concerned about before deciding to change their credit rating outlook from Stable to Negative on 01 November last year.
Every dark cloud has a silver lining and with the Moody’s downgrade also comes several positives. Firstly, some uncertainty has now been removed that was hanging over the local bond market and our currency in recent years. Secondly, South Africa is now ranked as one of the most attractive investment options in the sub-investment grade league and offers yields that are higher than some emerging market peers with lower credit ratings. Thirdly, the downgrade comes as a clear wakeup call for government to stop putting the interest of the ANC before that of the country and to start prioritising the critical actions required to get the local economy growing again. In addition, the COVID-19 crisis and subsequent “lock down” has pushed the agenda of the fourth industrial revolution from a digitalisation and remote working perspective. Very importantly it also helped the President to find his voice in order to unite the country in an effort to manage the crisis and to protect the lives of its people.
Given the additional pressure that COVID-19 will place on the local economy and the fiscus, South Africa might be left with no choice but to approach the World Bank, the New Development Bank (aka the Brics bank) or the International Monetary Fund for financial assistance. The highly emotive topic of “prescribed assets” can be expected to raise its head again as an alternative to knocking on the door of the World Bank or the IMF. Further credit rating downgrades by the three credit rating agencies during the remainder of 2020 remains a real possibility with all the agencies maintaining a negative credit rating outlook. In addition, the Budget announced on 26 February has become obsolete in the space of three weeks as the assumptions on which it was based is not valid anymore.
Despite these challenges the South African economic and financial landscape still has various positive features to nurture and protect. The country has a relatively large and diversified economy which allows for low volatility in GDP growth. The South African Reserve still enjoys independence in setting the monetary policy. The local financial services industry and banking system are well regulated and has the necessary depth and financial strength to navigate the current storms. Most of South Africa’s government debt is denominated in local currency, which still has a AAA status from a local ratings perspective and is long term in nature.
Building on these pillars of strength, South Africa needs to work its way back up the ratings scale by focussing on a few key ingredients. The first and most critical is fiscal consolidation over the medium-term in order to bring it broadly in line with the central expectations of the ratings agencies. Secondly, the aim should be to create an environment for a steady but sustainable improvement in economic growth. This will allow for a gradual reduction in primary deficits in the next few years and increase the likelihood of government debt remaining below 90% of GDP.
The world currently has many of its own challenges to deal with and South Africa should use this opportunity to quietly but purposefully go about turning around its economic, fiscal and credit rating fortunes. While we do not have the luxury of unleashing large fiscal stimulus packages like the US or the UK, the South African Reserve Bank still has room to further reduce interest rates to stimulate the economy. In the short-term debt relief and tax holidays for households and small to medium business will create some breathing space and limit further structural damage to the local economy.
The President should capitalise on the current sense of national unity and mobilise government, the private sector and labour to collectively find solutions to creating long-term growth and save the economy. Government’s view was that the Moody’s downgrade could not have come at a worse time given SA’s existing fiscal challenges. However, there never is a good time to receive a downgrade for a country that has a weak economy and limited financial resources to protect itself. The worst time to have received our credit rating downgrade might also be exactly what we as a country needed to create the necessary sense of urgency and take control of our own destiny.
We remain positive on BTI given its ongoing profitability enhancement through active operational optimisation, its continued robust pricing power in combustibles, coupled with a broad reduced risk portfolio, supported by the US regulatory environment