CAPE TOWN - How the downgrade of South African credit ratings will affect individual investors depends very much on their personal circumstances. Nevertheless, we can make some broad generalisations, and you can decide whether they apply to you.
Credit ratings can have implications for all South Africans insofar as they affect the rand exchange rate and the yield on capital market instruments.
It is useful to think of the ratings of a country as the equivalent of a credit score from your bank manager. If you keep on spending more than your income, which is what the South African government has been doing since 2009, the manager will tell you that you need to change your behaviour. If you do not change your behaviour, your manager will start charging you more interest, because the bank’s risk of your defaulting on the loan increases.
At some stage, the bank will stop lending to you and start repossessing assets that you bought with the money it loaned to you. If you do not have enough assets to cover the loans, you will be declared insolvent.
In the case of a country, that means it has defaulted on its bonds. These are loans issued with a promise to repay at some future date. The most recent country to default was Argentina in July 2014, while Puerto Rico, which is a dependency of the United States, defaulted on its debt in May 2017. Both Grenada and Mozambique are in “selective default” – they have defaulted on some debt, but not all. That is equivalent to you, as an individual, defaulting on your car loan but not your home loan.
The other point to bear in mind is context. After “Lehman Monday” in September 2008, banks would not lend to anyone, no matter how good their credit score. What’s known as a credit freeze could happen if the US equity market corrects from its lofty valuation and the Chinese shadow banking system implodes. Recall that Moody’s Investors Service in May downgraded China’s sovereign debt by one notch to A1, the rating agency’s fifth-highest grade.
That was the first downgrade since 1989. Moody’s said in June that the downgrade reflected expectations that China’s financial strength would erode somewhat over the coming years, with economy-wide debt continuing to rise as potential growth slows. If a credit freeze did occur, the rand could lose 24 percent of its value, as it did in October 2008. In today’s terms, that would be a move from, say, R12.90 to R16 to the dollar.
Currently, the global context is almost exactly the opposite, because, thanks to quantitative easing by the Bank of Japan and the European Central Bank, there is a surfeit of liquidity, and some countries, such as Germany, Japan and Switzerland, have bonds with negative yields. That means that, instead of the government paying you interest, you have to pay the government to hold some of their bonds.
The result is that emerging markets have experienced an inflow of capital from the developed world. South Africa has been a recipient of these flows, so, despite the ratings downgrade in early April by Fitch and Standard & Poor’s (S&P), net foreign purchases of South African government bonds continued.
ALSO READ:
The Institute of International Finance (IIF) estimated that capital portfolio inflows to emerging markets were US$21 billion in May 2017 and $100 billion in the first quarter of 2017. Its June 2017 forecast was that non-resident inflows into emerging-market debt and equities could jump by 35 percent this year compared with 2016, to some $970 billion, and could pass the $1-trillion mark by 2018 – the highest level since 2014.
Portfolio flows into emerging-market bonds in the first quarter of 2017 were driven mainly by institutional investors, which accounted for about 80 percent of inflows. The IIF said the improving global outlook should be broadly supportive of emerging-market fixed income, as will falling corporate default rates and more robust emerging-market fundamentals, although some risks remain in specific markets.
“Rising non-financial corporate leverage in China and Chile remains a key risk, while political and policy risks are likely to continue to weigh on Brazil, Mexico, Turkey, South Africa and Nigeria,” the IIF said in the June edition of its emerging-market capital flows report.
On June 9, 2017, Moody’s joined the other two major ratings agencies and cut South Africa’s foreign-currency rating to junk status, but, crucially, it kept the rand rating at investment grade. If Moody’s had cut the local currency rating to junk, it could have triggered a forced divestment of some R130 billion, because some institutional investors have a mandate that requires that at least either S&P Global Ratings or Moody’s must rate as investment grade the local currency bond included in Citi’s World Government Bond Index.
So, although South Africa escaped having its local currency rating cut to junk, the government cannot rest. In response to the Moody’s rating, National Treasury said: “The Minister of Finance will ensure that the joint work of government, business, labour and civil society continues at a faster pace. The commitment is on improving investor and consumer confidence through fast-tracking the implementation of structural reforms on economic growth.”
The problem is that this sounds very similar to what Treasury said in 2011, when Moody’s put South Africa on negative ratings watch, and Fitch followed with a similar action in January 2012. At that time, Treasury said a countercyclical fiscal stance remains a strategic intervention tool for South Africa to counter the adverse effects of a structurally integrated global economy.
Within the context of maintaining a good track record despite the underlying uncertain macro-economic environment, South Africa remains committed to the prudent execution of growth and employment supportive economic policies.
The focus for the individual investor is, therefore, more on what happens internationally than domestically, because the structural changes that will return us to investment grade will take years, rather than months, to implement, particularly because we have made little progress since 2012, when the National Development Plan was launched.
If you are an investor or saver, the ratings downgrade may be good news, because the RSA retail bond is priced off the South African government bond market. So if we see foreign capital outflows, capital market yields will rise, as they did in January 2016 in response to “Nenegate”. In February 2016, you would have earned a fixed rate of 10 percent for five years, compared with the current five-year fixed rate of only 8.25 percent.
If, on the other hand, you want to borrow money and/or need to import goods, the ratings downgrade increases your vulnerability to a sudden exodus of foreign capital. This would lead to a weaker rand, higher costs of imports, increased inflation and a rise in interest rates. Not a pretty picture, so you must hope that the IIF’s forecast that capital flows into emerging markets will increase this year and in 2018 proves to be correct.