Domino effect of a downgrade will be much worse than expected

Don’t be lulled if a Moody’s downgrade doesn’t move markets: There’s more to the matter than what’s priced in

The deteriorating creditworthiness of the sovereign has already done damage to the economy. And the further the country slips down the rating-scale, the more dire the degree.

Just eight years ago, South Africa had a solid investment credit-rating of BBB+. Today, however, two of the three main rating agencies – S&P and Fitch – rate the sovereign’s local currency debt at sub-investment, or speculative, grade (BB+). Moody’s is likely to make this a humbling hat-trick in 2020.

Yet, few in fixed income circles seem to be fretting about this prospect, opining instead that the coming downgrade is already “priced in” by the markets. And it appears so. South Africa’s implied five-year credit-default-risk spread is higher than Brazil’s for example, which is a striking verdict as South Africa, for now at least, still has one remaining investment rating, while Brazil, by contrast, is already BB- rated. Consequently, when Moody’s wields its unaffirming axe, the sell-off in the domestic bond market is set to be short-lived.

Of course, for this scenario to ensue – the subsequent removal of South Africa from the FTSE World Government Bond Index (WGBI) and trigger of forced selling by foreign institutional investors aside – there would need to be some counteracting inflows.

Comforting here is the fact that yield-seeking emerging market investors (with less conservative mandates) have, historically, supported countries that have been excluded from the WGBI. After initial currency weakness and a resultant spike in bond yields caused by forced sellers exiting, it’s therefore possible that South Africa too could benefit from some new inflows from bargain hunters. Such renewed foreign interest might even prompt local fixed income managers to jump in as well, thereby further easing the pressure on yields.

So, all good and well then? D-Day – or M-Day as the case may be – is priced in. And as such, its impact on the bond market, temporary. Not so fast. As reassuring as this benign market outlook might be, it’s no reason to ignore the economic effects of the sovereign’s deteriorating credit quality. These effects have already been harmful – and there is more pain to come, the deeper the country sinks into the sub-investment abyss.  

As the government’s credit-rating has fallen over the years, so its borrowing costs have risen. Coinciding with gaping budget deficits due to South Africa’s economic woes, egged on by State Owned Enterprise (SOE) bailouts, have only meant one thing – a gigantic R110bn jump in the interest bill. From the time of the first rating downgrade in 2012, the figure stands at nearly double that – R200bn today. Accommodating this increase would have left the government facing even larger budget deficits than the 4.5%-5% of GDP in recent years. Growth in non-interest expenditure therefore had to be curtailed, along with further increasing the tax burden on consumers and companies – both policies that knocked the economy.  

But it gets worse. The credit-ratings of critically important SOEs are tied to the sovereign’s (through partial debt guarantees and implicit support). And so, their creditworthiness too has suffered. For the many over-indebted and cash-strapped ones, escalating borrowing costs only made matters direr – again, at the expense of the economy. In several cases, vital infrastructure investment had been jeopardised – while at the same time, growth-inhibiting tariffs hiked. Talk about a double-punch. “Tied to the ratings hip”, even development finance institutions in better financial standing had to pay up to ensure continued access to loan finance, albeit not as much as some infrastructure SOEs.

Then there are the banks. Their direct loan exposure to the sovereign, SOEs and other public entities – as well as their indirect exposure through the government bonds they own (which is a regulatory requirement) – also made them victim to the state’s falling credit-rating. Due to no fault of their own, banks’ funding costs therefore also started to go up. Compounding this effect was the introduction in 2013 of new global Basel III regulations compelling banks to do three things: 1) increasingly shift their sources of funding from less expensive short-term ones to more stable – yet costlier – longer-term ones; 2) raise their capital buffers against the risky assets on their balance sheets; and 3) further increase their holdings of liquid assets, such as the government bonds they already own, which, in recent years, had become riskier. 

The consequences have been predictable. In confronting these challenges in an environment of persistently low economic growth, banks have had to adopt more conservative lending policies. And, where credit has been extended to public-and private-sector debtors, they have had to do so at higher interest rates. In short, several borrowers have had to become accustomed to tighter financial conditions, even though the repo rate has fallen somewhat.

This interconnected web of linkages clearly leaves the country extremely vulnerable. In fact, even if Moody’s decided not to proceed and but both S&P and Fitch acted on their respective negative outlooks, the sovereign’s average credit-rating across the three agencies will fall even deeper into sub-investment terrain.  This will unleash a shock that will domino-effect itself through the detailed transmission channels with consequences most dire.

The thing is that default probabilities jump exponentially, the worse the credit-rating of the sovereign – and every entity linked to it – gets. As such, the additional premium that creditors will want to compensate for the ever-riskier debtors they lend to will leap exponentially too. A broadly-based and particularly further sharp increase in borrowing costs, and the even harsher economic effects it will unleash, may well be the trigger that pushes an already-limping economy over the edge.

South Africa should never have been on its current path of slowing economic growth, deteriorating fiscal ratios and falling credit-ratings. But it is. That’s not to say, however, that it’s too late for forceful and corrective action to turn the ratings tide – and, by implication, the economy’s fortunes – around. It’s not too late. But time is short – and the consequences of inaction sending South Africa spiraling down a path, too catastrophic to contemplate. Over to you Finance Minister Mboweni. We keenly await your budget speech on Wednesday.

Le Roux is chief economist and Ilkova an investment strategist at Rand Merchant Bank