Downgrade fallout could still get worse, economist warns

Johannesburg – The credit downgrade has had a psychological impact on investors, and there is a possibility that there may be capital disinvestment going forward, said Dr Azar Jammine, director and chief economist at Econometrix.

Jammine was speaking at a junk status seminar in Sandton on Thursday. He indicated that the effects of the downgrade to junk status by two rating agencies have not been as bad as expected. However, things can still get worse in the case of further downgrades.

“It’s not all doom and gloom, we have not yet reached a worst case scenario. But there is a worst case scenario,” said Jammine.

Currently, Standard & Poor’s (S&P) local currency rating is still at investment grade. Fitch has downgrade both local and foreign currency debt to junk status. Rating agency Moody’s, which is expected to release its rating for the country in the beginning of July, has both local and foreign currency debt two notches above junk status.

READ: S&P downgrades SA to junk status

“The most important rating agencies for foreign investors are S&P and Moody’s,” Jammine explained.

The biggest concern of a downgrade of local currency debt is that South African government bonds could fall out of the World Government Bond Index, of which it accounts for 12%. “This will force holders of funds to sell out South African government bonds.” This is $10bn or R135bn, and will cause the rand to tumble, he explained.

There were no major outflows after the S&P and Fitch downgrades because only 10% of debt is dominated in foreign currency. Investors have in fact been buying more because they would rather earn 8.7% interest from South African bonds, compared to 0% returns on German or Japanese bonds and similarly low yields from the US, said Jammine.

This contrasts with the initial fears held about the downgrade. Firstly, it was expected that there would be a massive sell-out of government bonds, a collapse in the rand, rising interest rates and a decline in consumption and investment, he explained.

Secondly, there were expectations that government would have to borrow money at higher interest rates. This means government would have to spend more to service its debt, crowding out its ability to spend on other priorities such as infrastructure and social development.

“Neither of these factors have been material,” said Jammine. Since former finance minister Pravin Gordhan was sacked, the rand effectively only dropped 2%. “The Reserve Bank won’t raise rates, inflationary pressures are declining.” The collapse of the rand has not been massive, nor has it caused interest rates to soar.

However, the uncertainty about further downgrades, including political uncertainty, is damaging business confidence levels. “It has a psychological impact on the business community and the desire to invest is weighed down,” said Jammine. This in turn impacts consumer spending patterns.

ALSO READ: S&P downgrades SA banks to junk status

Lastly, the sovereign downgrade has had an impact on corporate debt ratings, such as the big four banks. Even though South African banks are ranked the second most stable globally, there will be a switch of credit away from them to foreign banks, said Jammine.

This reflects low confidence levels, regardless of the fact that interest rates have not risen. The downgrade of banks will contribute to the capital disinvestment.

What rating agencies are looking at

To avoid a further downgrade, rating agencies are concerned about government’s ability to stick to fiscal consolidation, said Jammine. “So far so good, we have been sticking to budgets well, and the new finance minister [Malusi Gigaba] said there would be no change and [government] will stick to the parameters going forward.”

However, Jammine said the market's concern is that if Gigaba really is not going to steer away from the current fiscal consolidation plan, it raises questions over why Gordhan was removed in the first place if both ministers are to follow the same fiscal policy.

The second prerequisite of rating agencies is improving the running of state-owned enterprises. If government has to continue bailing them out, it will cause public debt to rise further.

READ: White businesses must champion transformation - Gigaba

Rating agencies will also look at any improvement in economic growth. Higher growth will result in greater tax revenue collections and put government in a position to borrow less, bringing down public debt. The National Development Plan outlines ways to achieve better economic growth. However, the concern is if radical economic transformation policies take away from the growth plan.

Possible scenarios

Jammine highlighted possible scenarios for the future.

Firstly, if Gigaba sticks to the path laid out by Gordhan, the currency would see a modest depreciation over the coming years and could reach R15/$ by 2020. However, if the credit rating gets downgraded to junk status across the board, the rand could reach R20/$ over the same period.

In the base case scenario, inflation should drop to 5.5%, but a downgrade would cause inflation to shoot up to 8.5%. The prime rate may rise from 10.5% to 12%.

Last year capital investment declined 4%. if there are continued downgrades, the psychological effect on investors will see capital investment drop between 4% and 5% over the coming years.