By Marc Jones
LONDON (Reuters) – Wednesday budget should decide the fate of South Africa’s solitary remaining investment grade credit rating, but with many in the country already resigned to its loss the bigger question might be how low could it go.
The fiscal plan envisages trimming a swollen deficit via a mix of spending cuts, setting the scene for a showdown that could further hobble an already ailing economy.
A cut to junk by Moody’s – following downgrades by S&P and Fitch in 2017 – would see the country ejected from FTSE’s World Government Bond Index (WGBI), triggering up to $11 billion (168 billion rand) of selling by foreign investors, analysts estimate.
Moody’s has already halved its 2020 growth forecast this month to 0.7% and the Treasury said on Wednesday its budget deficit is likely to reach 6.8% of GDP this fiscal year, the highest in 18 years.
South Africa’s debt is already pushing 60% of annual economic output. In a pessimistic scenario of a long and painful recession it could reach as high as 95%, said Elina Ribakova, Deputy Chief Economist at Institute of International Finance.
Moody’s next reviews of the country’s ratings are on March 27 and November 20.
“I think we are likely to get the downgrade (from Moody’s) this year,” Ribakova added.
“What is worrying me even more though is the reaction of the other rating agencies as they could downgrade further.”
(Graphic: South Africa’s stalling economy – https://fingfx.thomsonreuters.com/gfx/mkt/13/2561/2529/Pasted%20Image.jpg)
S&P and Fitch both already have ‘negative’ outlooks – effectively downgrade warnings – on their junk-grade BB+ local currency ratings, important in South Africa where roughly 90% of its debt is in rand.
Credit default swap (CDS) that bond holders buy to insure themselves already look to be pricing those cuts.
There aren’t specific swaps for local FX debt, but S&P’s Capital IQ model shows the main CDS markets are treating South Africa as a BB-, a notch under S&P’s BB lower foreign currency rating and two notches below Moody’s investment grade score.
The premium investors demand to hold its dollar debt shows a similar picture at around 360 basis points – in line with ‘B’ rating-bracket countries like Pakistan, Jamaica and Mongolia, and far higher than other EM heavyweights Turkey and Brazil.
“South Africa trades relatively wide (at elevated CDS levels) because people are expecting downgrades,” said Peter Kisler a portfolio manager at North Asset Management. “The view is it is on a downward trajectory”.
(Graphic: South Africa’s debt is rising fast – https://fingfx.thomsonreuters.com/gfx/mkt/13/2562/2530/Pasted%20Image.jpg)
For a government, losing investment grade status causes pain because certain types of investors mandated only to buy high-grade debt — usually big pension funds or ‘passive’ Exchange Traded Funds — are then forced to sell.
A 2016 World Bank study co-authored by South Africa’s own central bank found being cut to ‘junk’ by at least two of the major ratings agencies increased a country’s treasury bill interest rate by almost 200 basis points on average.
South Africa expects to increase its stock of T-bills to 380 billion rand ($25 billion) in the next fiscal year, and any rise in costs won’t help a debt level which has already more than doubled as a share of GDP over the last decade.
“We are not there yet, but in the extreme you can very quickly get unsustainable dynamics,” said the IIF’s Ribakova.
“If your debt-to-GDP is 100% and the real rates you pay on that debt are higher than your real growth, then you have explosive debt dynamics.”
And if the permutations of Wednesday’s budget in a country where unemployment is already at a 17-year high of nearly 30% aren’t enough, there is technical curveball coming too.
JPMorgan is set to cut South Africa’s weight in its widely-tracked, $200 billion GBI-EM local currency index by 0.6 percentage points to 8.5% on Friday to make way for another chunk of China’s debt.
State Street Global Advisors’ lead EM portfolio manager Abhishek Kumar estimates that, if all money managers were assumed to be neutral on South Africa and cut their own holdings to reflect the JPM changes, it could see a $1.2 billion sell-off.
“There is a potentially a big gap between what they have said they will do and what can be implemented,” Kumar said after the budget plans triggered a modest rally in South Africa’s bonds. “So we will see what happens.”
(Graphic: South Africa ‘real’ interest rates are high – https://fingfx.thomsonreuters.com/gfx/mkt/13/2560/2528/Pasted%20Image.jpg)
(Graphic: South Africa unemployment at 17-year high – https://fingfx.thomsonreuters.com/gfx/mkt/13/2563/2531/Pasted%20Image.jpg)
(This story restores dropped word ‘trimming’ in paragraph 2)
(Additional reporting by Alex Winning in Johannesburg; editing by John Stonestreet)