South Africa will learn soon whether Cyril Ramaphosa’s first month as president has saved the country’s last remaining investment grade rating, but even if it hasn’t, a broader rise in optimism should limit the damage.
Moody’s, with a downgrade review on South Africa since last November, is to make a decision by March 23.
A cut to junk – following downgrades by S&P and Fitch – will see the country ejected from Citi’s influential World Government Bond Index (WGBI), triggering up to 100 billion rand ($8.5 billion) in selling by foreign investors.
It is a prospect that sends a chill down the spine of the country’s officials, who know the odds aren’t in their favour.
“It is very difficult to read the body language of the rating agencies,” new Finance Minister Nhlanhla Nene said in London this week, having just meet with Moody’s. “If there was a downgrade that would have a negative effect”.
Moody’s rarely spares those it puts on a downgrade warning. Only seven of the dozens of countries it has had on review over the last two years have been reprieved its data shows. South Africa was one of those. None have been saved twice.
As a result, markets seem to be going with the form book.
Zsolt Papp, an emerging market debt portfolio manager at JPMorgan Asset Management points to the ‘spread’, or premium, investors demand to buy South African government bonds rather than U.S. ones.
That spread is now 245 basis points, which is right in line with the average for ‘BB’ bracket ‘junk’-rated countries like Macedonia and Guatemala or heavyweights like Turkey and Brazil.
“The market is already pricing South Africa as a BB credit,” Papp said, although he said he was not sure which way the decision will go.
For a government, losing ‘investment grade’ status causes pain because it means certain types of investors — usually big pension funds or Exchange Traded Funds — are mandated only to buy high-grade debt. They are forced to sell any bonds which are downgraded to junk.
A 2016 World Bank study, which was co-authored by South Africa’s own central bank, found that being cut to ‘junk’ by at least two of the major ratings agencies increases a country’s treasury bill rate by almost 200 basis points on average.
South Africa intends to borrow a much smaller-than-usual 4.2 billion rand ($350 million) in T-bills in 2018/19 but any rise in costs won’t help a debt level which has already more than doubled as a share of GDP over the last nine years.
THE MOODY’S BLUES
But there are some factors that could make South Africa’s experience different.
The World Bank’s analysis looked mainly at foreign currency debt downgrades, but Moody’s decision is related to the country’s domestic rand-denominated debt.
It is far more important because roughly 90 percent of all South Africa’s debt is local currency S&P estimates. Around 40 percent of it is held by foreigners who can be quick to flee when the outlook sours.
The World Bank didn’t detect any statistically significant impact from local currency downgrades. But it did find that the main impact – over two-thirds of it – came when the first rating agency downgraded a credit to junk.
Market reaction to subsequent downgrades is usually far smaller, it noted bit.ly/2tTzm44
Another potentially damage-limiting factor is widely held optimism that Ramaphosa and his new team will be able repair at least some of the damage done during Jacob Zuma’s tenure.
South African stocks, bonds and currency have all rallied hard since late last year when Ramaphosa seemed set to become the new party leader. The cost of insuring against a default has plunged more than 25 percent..
Morgan Stanley analysts point out that South African bonds are currently international investors’ top ‘overweight’ in portfolios linked to another influential bond index, JPMorgan’s GBI-Emerging Markets.
A downgrade would have no impact on South Africa’s membership of the $220 billion GBI-EM index, so funds tracking it could make up for some of forced selling by Citi WGBI investors.
One of the reasons South Africa is still so attractive is that ‘real’ yields, which are the rate of interest its bond offers minus the country’s inflation rate, are among the highest in emerging markets.
There are also those who reckon a downgrade is no longer on the cards, given the change in leadership and crucial measures unveiled in the recent budget. This included raising the VAT rate for the first time 25 years.
At least 10 big fund managers that Reuters interviewed for this story see a downgrade now as unlikely.
“We don’t expect Moody’s to take any action given the adjustment that we are expecting from the deficit and VAT measures proposed in the budget,” said Standard Life Aberdeen portfolio manager Kevin Daly.
The budget was welcomed by the S&P and Fitch agencies but Moody’s has stayed quiet. Finance Minister Nene hopes, however, the agency has been persuaded, adding: “I think it is a credible story we are telling.”