MMI Holdings’ Sanisha Packirisamy (Economist), and Herman van Papendorp (Head of macro research), give their view on Friday’s Fitch and S&P ratings reviews:
In line with our and the market’s expectations, Fitch ratings agency downgraded South Africa’s long-term sovereign debt rating to BBB- from BBB. On a more optimistic note, they revised the outlook from a negative stance to stable, indicating a lower likelihood of an imminent downgrade to non-investment grade status. We had expected S&P ratings agency to hold off from downgrading SA’s long-term sovereign debt rating, but did not anticipate the outlook change from stable to negative as early as the December 2015 review.
Lower trend growth, less fiscal flexibility and increased vulnerability to a change in risk appetite cited as key concerns
Both Fitch and S&P alluded to the likelihood of lower potential growth going forward, particularly as a lack of policy implementation to address SA’s structural problems continues to inhibit higher potential growth in a muted commodity price environment. Fitch highlighted the extent to which policy uncertainty and investor-unfriendly proposals have weakened business confidence, which has further been reflected in the Bureau of Economic Research’s 4Q15 manufacturing survey which pointed to 71% of manufacturers citing the general political climate as a major deterrent to fixed investment spend in SA.
A more benign structural growth outlook leaves SA’s fiscal authorities with less room to manoeuver, suggesting a significant threat to Treasury’s fiscal consolidation timeline and medium-term debt stabilisation plan. Moreover, both rating agencies have raised concerns over the weak state of the balance sheets of SA’s state-owned enterprises (SOEs). Reneging on government’s expenditure ceiling remains a trigger for further negative ratings action as this would extend fiscal consolidation timelines and prevent a stabilisation of the debt ratio.
In addition, the rating agencies continued to highlight the risks to funding SA’s current account deficit against the backdrop of diminishing global risk appetite, particularly as we near the US Federal Reserve’s (Fed) lift-off in short-term interest rates from ultra-low levels and as emerging market risk remains elevated.
Broad political/institutional stability and macro policy continuity remain among SA’s key strengths
According to Fitch, SA’s ranking on the World Bank Governance Index (measuring the rule of law, government effectiveness and political stability amongst others) remains higher than the BBB median, which has supported SA’s investment grade status in the past. Furthermore, prudent monetary policy and quality fiscal institutions have provided a conducive environment for SA’s floating exchange rate regime. The rand has acted as a safety valve, curbing the need for further (more painful) internal adjustments.
In addition, SA, unlike many other emerging market peers, has a relatively low level of foreign currency-denominated debt, reducing SA’s external vulnerability to currency risk.
Market pricing in further downgrade risk
Both the SA bond and currency markets were little changed notwithstanding S&P’s non-consensus outlook shift to negative. Moreover, SA’s credit default swap (CDS) spread (reflecting the market’s view of the credit risk of a borrower) suggests that the market is already pricing in further credit rating downgrades for South Africa over time.
SA edging closer to sub-investment grade status
Averting a downgrade to junk status is still an attainable goal. If government commits to reducing the bloated public sector wage bill by constraining employment additions, curbing wasteful expenditure through cracking down on corruption and dedicating resources to reduce maladministration in South Africa’s state-owned corporations, the trajectory of structural expenditures will improve. Acting on a number of proposed economic reforms, in the labour and product markets, in particular, will cultivate higher rates of economic growth, allowing SA to grow its way out of a potential debt crisis, even in the absence of another commodity super-cycle. Providing certainty around the direction of economic policy to encourage inward investment would further benefit trend growth and hence revenue collections on a more sustainable basis, alleviating South Africa’s government debt concerns.
However, if the South African government does not react to growing fiscal risks in time, further expected cuts to longer-term capital expenditure in favour of current spend will exacerbate benign domestic growth projections, eventually forcing government debt ratios even higher. Rising interest expenditure, from the current 3.1% of GDP, would further crowd out other forms of more beneficial growth-enhancing spend. A larger debt burden, reduced sovereign creditworthiness and lower inward investment would perpetuate a poor growth environment, fuelling a weak growth-high debt cycle.
Over the shorter-term horizon, economic growth remains under pressure amid a less optimistic global commodity outlook in a domestically energy-constrained environment plagued by labour market instability. Against this challenging revenue backdrop, buckling under socialist demands and endorsing policy measures that could damage the investment climate continue to pose a significant threat to South Africa’s sovereign rating outlook over the next 1 – 2 years.