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Rating South Africa’s creditworthiness: Nothing but the facts?

Apr 19 2017 19:21
Dr Stephen Labson

THE recent downgrade of South Africa’s sovereign credit rating by both Standard & Poor’s and Fitch Ratings was hardly surprising, except in regard to the timing. Both rating agencies moved forward rating reviews planned for mid-2017 in response to the replacement of Pravin Gordhan as South Africa’s finance minister. Within days of the Cabinet reshuffle, the two agencies downgraded South Africa’s issuer default ratings to sub-investment grade levels.

With the creditworthiness of any government closely tied to its policies, a downgrade of the sovereign rating was bound to become politicised. S&P and Fitch’s focus on political events did not escape comment, raising questions of credibility and bias in ratings.

How credible are the rating agencies?

Putting politics aside, the major rating agencies track record warrants a healthy level of scepticism. Over the past two decades the major rating agencies have been associated with devastating corporate defaults such as that of Enron, which held investment grade ratings only days before declaring bankruptcy; and the US sub-prime mortgage meltdown, partly fuelled by overly generous credit ratings on collateralised debt obligations. Defaults on those debts of some half a trillion US dollars led to failures in the US banking sector, and precipitated the global financial crisis.

Various court actions and regulatory responses have since been undertaken to rebuild creditors’ confidence in ratings, and the rating agencies have taken steps to improve their performance. Whether these actions have had the desired effect is perhaps still an open question.

But to be fair to the rating agencies, their job is not an easy one. In rating sovereign debt they have to untangle a complex interaction between external trends in the general economy and fiscal policies; while anticipating the sovereign’s policy stance into the future.  

So how are the ratings determined?

In assessing a county's credit worthiness, ratings agencies typically rely on a combination of computer driven models and scoring methods - comprised of an alphabet soup of financial acronyms and risk factors -  and a fair amount of professional judgement.

The use of quantitative and subjective analysis is described in detail by Fitch. The quantitative part of Fitch’s rating analysis centres around their Sovereign Credit Rating Model. At the risk of over simplification, credit scores are calculated for issuers relative to global comparator ratings, with 18 measures of credit risk forming key inputs to the calculation. As an example, government debt as a proportion of annual GDP enters the calculation as an often cited measure of sovereign credit risk. In South Africa’s case, at roughly 53% of annual GDP this sits well below countries such as the US, France, UK and Japan, all of which have investment grade ratings. But as just one of eighteen measures tracked, other quantitative risk factors, such as GDP and exchange rates movements would have off-set this value in calculation of the credit score.

Added to this, Fitch explains that the results of the quantitative model are then overlayed with qualitative analysis. It is here that South Africa apparently lost its investment grade rating.

In looking at the details of Fitch’s rating announcement one sees that that the credit score determined by the quantitative modelling on its own was two notches above sub-investment grade. However, that result was lowered by one notch due to Fitch’s expectation of further weakening in the economy, and another notch reflecting ‘the expected deterioration in governance standards, particularly related to SOEs’. Were it not for these two assumptions, South Africa would have retained its investment grade rating.

The implications for South Africa

That the downgrade was not so much based on where things currently sit, so much as what is expected for the foreseeable future has important implications.

First, many of the technical metrics of public finance are not yet at critical levels if compared globally. If S&P and Fitch had seen a flat, or better yet upwards trend in these key risk factors (and if we can take their explanations literally) the downgrade would not have occurred.

The matter of perception has not been lost on the new Minister of Finance, having made clear his intent to engage with the ratings agencies. This is a needed first step - but there is more that can be done.

As an example, SOE governance and regulation is cited by the ratings agencies as a key risk factor, with government guarantees supporting SOEs expected to grow to some R500bn, by the end of the decade. But the lion’s share of these guarantees are in energy and air transport. Companies in these sectors should be able to operate on a profitable basis and able invest in new capacity without government support.

To put a finer point to this example, Eskom, and Airports Company South Africa could be providing dividends to the state as shareholder were it not for deficiencies in the regulatory environments they operate in. This is now being borne out in the courts, where regulators are facing challenges speaking to the legality of the way in which tariffs have been set.

The ratings agencies are well aware of these matters. Having recently reviewed corporate credit ratings of these SOE’s, they have highlighted deficiencies in tariff setting processes and outcomes. To change their view of SOE credit risk, the ratings agencies will need to see regulated tariffs set on a logical, transparent and consistent basis - and in accordance with relevant legislation.

Building a proven track record will take time. But to start, Treasury should take a detailed plan of regulatory reform with them on the next global roadshow. That would need to be followed by periodic reporting on implementation and outcomes - demonstrating the soundness of reformed regulatory processes, and adherence to principles of administrative decision making.

If the ratings agencies can be taken at their word, simple actions like this would go a long way in returning South Africa’s sovereign debt rating to investment grade levels.

*Dr Stephen Labson is managing director of Trans African Consulting Group and senior research fellow at the University of Johannesburg.

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