Disease and downgrades: Diary of a bad year for SA
Adrian Saville, Chief Executive, Cannon Asset Managers
30 March 2020: Moody’s finally dropped the sword on South Africa on Friday evening, following in the steps of fellow ratings agencies S&P and Fitch in downgrading the country’s sovereign credit rating to sub-investment grade or “junk status”. And the COVID-19 crisis and current lockdown mean that even before factoring in the impact of Moody’s decision, the economic outlook for SA in 2020 is harrowing.
Financial modelling reveals that the economy could shrink as much as 5% in real terms this year – a figure that is unprecedented in recent times. By comparison, the economy shrunk by around 2% as a result of past crises in 1983, 1992 and 2009.
Additionally, while revenue from personal income tax (PIT) may remain relatively resilient in the near term, it is likely to fall throughout the rest of the fiscal year. VAT intakes will likewise dive off a cliff in March and April, with the possibility of a reasonable recovery thereafter, while corporate income tax (CIT) levels will step down dramatically in line with economic growth.
This COVID-19 fiscal gap means that the budget deficit will come under severe pressure this year. We had already penned in a deficit of 6.8% of gross domestic product (GDP) at the reading of the National Budget in February. Just four weeks later, it looks like that figure could blow out into double digits.
The Moody’s downgrade is then set to place further pressure on SA’s fiscal situation, with even more pain in store for government, businesses and households as the lower credit rating will translate into a higher cost of borrowing and higher interest charges.
On this note, many analysts and commentators have suggested that the downgrade is already reflected in our market prices, and if that is true, then the agency will have finally called what markets have been saying for a long time. But in good economics, there is always a “however”. In this case, the “however” is that we will only know whether this is true when capital market participants begin responding to the rating assessment.
For investors whose mandates prevent them from investing in sub-investment grade bonds (such as foreign pension funds), the downgrade will only oblige them to sell out of SA government bonds when the decision takes effect at the end of April. This means that we may not see the full impact of the downgrade until May.
If that is the case, and if the downgrade isn’t already in priced in, then the sell-off in government bonds and subsequent conversion of rand sales into dollars, will translate into weaker government bond prices and a weaker rand. In turn, weaker government bonds will lead to higher interest rates and higher borrowing costs for government, as well as for businesses and households with company debt, mortgages and vehicle loans.
Meanwhile, a weaker rand will have an inflationary effect, because as much as one-third of the South African economy is made up of imported inputs or imported final goods. It could take as long as nine months for this imported inflation to pass through into the economy, but its effects will be damaging.
Why now for Moody’s?
The timing of Moody’s decision was unfortunate, but hardly unanticipated. At the recent reading of the National Budget, government made all the right noises about addressing the rating agencies’ concerns after Moody’s last rating review in November, but ultimately failed to give any evidence to its good intentions.
Moody’s has given the country the benefit of the doubt for not just months, but years. And the repeated failure to act means that any handwringing over the timing of the announcement, or criticism of the agency for not being more accommodating given the additional challenges of the coronavirus crisis and national lockdown, are disingenuous.
After all, it’s the job of rating agencies to call it as they see it. The reality is that South Africa’s fiscal metrics have moved from troubled to deeply distressed during the time that we should have been demonstrating the steady improvements that would follow from determined policy action.
We have made very little progress in addressing the key structural issues strangling the economy, namely: the growing size of our budget deficit; ballooning government debt levels; continuing uncertainty over land ownership and property rights; feeble economic growth; the dire operational and financial situation at the State-Owned Enterprises (SOEs); the country’s overwhelming unemployment levels; and entrenched inequality.
In light of the above, the decision to downgrade the country was likely made even before the announcement that South Africa would be implementing a national lockdown, as the facts that informed the rating agency’s decision had little to do with the coronavirus crisis.
As such, we have been positioning our clients’ investments for a downgrade for some time already, encouraging clients to place greater emphasis on diversification and a higher exposure to global assets.
The road back for SA
South Korea holds the record for the time taken to regain its investment-grade rating after being downgraded to “junk”, achieving a turnaround within a year. This is after the South Korean government stepped in with swift and bold policy directives that were supported by national cohesion and a call to action. One example of this is South Korea’s 1998 gold-collecting campaign that saw 3.5 million people collect about 227 tons of gold worth some $2.1 billion to help the country repay its debt to the International Monetary Fund.
Unfortunately, our local government doesn’t hold quite the same record with implementing policy, and our society’s financial means are far more limited.
For South Africa to regain investment-grade status, we must evidence progress on the elements that Moody’s and the other rating agencies keep emphasising – and have been emphasising for years. These include: the restoration of sustained economic growth levels above population growth; fiscal prudence and the realignment of budgetary spending from current to capital expenditure; addressing the problem of unemployment, and particularly youth unemployment; restoring the balance sheets and operational capabilities of the SOEs; providing clarity regarding property rights; the prosecution of corrupt officials; and the redressing of grossly skewed inequalities.
Each of these is a serious task that requires commitment and determination. Notably, the policies to achieve this are already in place, meaning that it is merely a question of action and implementation.
However, we reached this point through years of poor spending behaviour and allowing state capture to run rampant while the SOEs fell into alarming states of financial and operational disarray.
So, while the prospects of us regaining our investment-grade rating are good, the probability of us replicating South Korea’s heroic effort is poor. Unfortunately, without firm and decisive action, the overwhelming likelihood is that South Africa will follow Argentina’s path, which has also been laid with good intentions and a lack of evidence for these intentions since it went through a series of ratings downgrades in the early 2000s. Despite ongoing policy promises, Argentina is yet to regain the credit ratings that the country had almost 20 years ago.
As the famous line from the comic strip “Pogo” goes, “We have met the enemy, and he is us.” We already know what the issues are that we need to address. So, whilst we find ourselves in socially stressful and economically demanding times, government needs to stop talking, and start doing.
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