Junk downgrade: A self-fulfilling prophecy?

A RATING downgrade of South Africa to junk status may serve as a self-fulfilling prophecy that places the country’s economy at risk and possibly creates the exact economic decline it aims to predict, warn researchers at the University of Pretoria.

According to the researchers, the methodologies used by rating agencies to make their decisions are “black boxes” that are not currently open to independent evaluation and validation.

Dr Conrad Beyers, spokesperson for the group of researchers, has extended an open invitation to credit rating agencies to “open the black box” and make their models available to him and his colleagues, and possibly other researchers as well, for scrutiny.

According to Beyers, any downgrade of South African government bonds, together with the potential economic fallout at a critical time, may be regarded as irresponsible without detailed information on how the decision was arrived at.

South Africa is currently at risk of being downgraded to non-investment grade ratings levels (also known as “junk status”) by several ratings agencies such as Moody’s Investors Services and Standard & Poor’s. Recently (March 2016), Moody's placed South Africa’s Baa2 bond and issuer ratings on review for downgrade.

This paves the way for actual downgrade to junk status where South African bonds will likely be perceived as more risky. As a result, investors typically require higher yields or interest for a given bond. This has a trickle-down effect to the entire economy, making access to capital more difficult (and expensive) and discouraging investment and business enterprise.

A rating downgrade, especially in a highly publicised, controversial and politically loaded case such as South Africa, may have the effect of a self-fulfilling prophecy. In essence, a hypothetical country with strong economic fundamentals may be plunged into a negative spiral after a prominent and controversial rating downgrade.

Knee-jerk reaction by investors

For example, a downgrade (especially to junk status) can lead to a knee-jerk reaction among investors – leading to large-scale disinvestment and a simultaneous slowdown in business activity. Without the rating downgrade, the economy may be growing. But a downgrade can lead to economic uncertainty and distress.

In fact, the researchers argue that the potential downgrade might already have had a negative impact on the South African economy. Markets are forward looking and tend to react to what they think might happen in the future. Since the potential downgrade has been widely publicised, markets already started to reflect a possible downgrade.

As a result, any attempt to assess the true impact of a downgrade should consider movements from the initial signal of a possible downgrade, until well after the downgrade. This then becomes a chicken and egg situation. After the intention to downgrade has been made public markets react, providing “evidence” that the country should be downgraded.

How many of the reasons to downgrade are due to the reaction to a possible downgrade? We simply do not know, because rating agencies only provide a rating and a vague explanation of the “process”. The rest is a black box.

According to Beyers, it should be kept in mind that a ratings downgrade reflects the view of a particular rating agency and is based on their preferred model, subjective assumptions and decisions. These assumptions and decisions should be clearly disclosed to an extent where they can be critically examined by at least South African and other academics.

Transparent disclosure of benchmarks is a must

Credit rating agencies normally publish generic information about their models and assumptions. Such disclosures do not enable independent researchers to test and validate the specific models and rating decisions that are made in respect of a specific country such as South Africa.

Moody’s, Standard & Poor’s or any other credit ratings agency should clearly set out their assumptions as well as modelling decisions – as specifically applied to South Africa.

Assumptions as well as subjective inputs and modelling decisions underlying future scenarios should be clearly stated and open to critical analysis – at a level where it can be assessed by South African and other academics. Any other subjective decisions and assumptions considered part of any downgrade should be declared.

Specific questions that should be asked about credit rating models and decision include:
 - How specifically are global methodologies tailored to the South African environment?
 - On what basis are essentially non-quantitative elements such as the South African government’s policy and strategy, or policymakers’ commitment to financial restraint, evaluated and quantified?
 - What are the assumptions and modelling decisions (e g weightings) used in the models, and how are they determined?
 - Which assumptions and model specifications will be used to evaluate South Africa 's longer-term economic performance?

In general, rating agencies expect the public to simply accept their outlook on the South African economy, based on some unknown assumptions and models. Credit rating decisions affect every single household and business in South Africa. It would be negligent if such decisions are not properly scrutinised to better understand how they were arrived at.

The researchers do not necessarily question the ultimate rating decisions. However, we need to understand how they have been reached - and what is in the black box.