What a ratings downgrade would mean
12 October 2016
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On mobile, on digital, on demand, this is Old Mutual Live, Money Coach. Hello and welcome, my name is Chris Gibbons. In early December a ratings agency called Standard & Poor’s will deliver its verdict on South Africa and the prospects for our economy. If it’s a negative view, we’re going to be facing a ratings downgrade which many of the experts say could be very serious.
Let’s unpick this thing, if it happens. What would it mean for ordinary South Africans? In other words, why should we care? We’re joined now by Anchor Capital Fund Manager, Nolan Wapenaar. Nolan, let’s start right at the very beginning, what is a ratings agency and what exactly do they do?
What is a ratings agency?
Nolan Wapenaar: A rating agency is an independent company/agency that essentially goes and evaluates the ability of a borrower of money to actually repay that money at a future date. Really, what they do is they go and look at the ability of South Africa to repay its debt and the quality of South Africa as a borrower. They then rank these borrowers according to a set scale that they’ve been using for many decades. To give lenders like ourselves, like international investors an ability to very quickly assess the nature and the quality of the people to whom they are lending money.
CG: There are three of them, Standard & Poor’s, Moody’s and Fitch. They all report on South Africa, why are we so concerned about S&P.
NW: There are three major rating agencies, as you say. Between them they represent about 90% of the ratings that are out there. Standard & Poor’s as one of the Big Three is very important to us. Because at the moment they are rating us as BBB- (triple B minus). That means is we are an investment grade country still.
The issue with S&P is they have put us on negative watch. Which means that potentially they think that our credit quality has deteriorated and they will reduce the quality assessments that they have of SA. Unfortunately, being on BBB- means that we’re on the precipice of being knocked out of the investment grade community and being pushed down into the junk bond or junk investor, junk borrower category.
This could have some quite severe implications for South Africa. Specifically, we note that S&P has put us on a ratings watch negative and under EU regulations they have two years to actually either move us to a lower rating or otherwise affirm our current rating. In December we will have been on negative watch for the year and that starts to put pressure on S&P to actually make a move.
What will determine the ratings decision?
CG: What are the things they look at when considering this rating?
NW: On a sovereign basis they really look at, well, the country as a whole, if you want. So the first aspect of it is how much debt do we have as a country and how easily are we servicing our interest bill in terms of collecting taxes to then pay interest and are we growing into our debt.
In other words, if South Africa is growing its revenue, its economy at 4-5% per annum, but our debt base is only growing at 1%. As long as your income is growing faster than your debt, you’re in a very good position. Unfortunately, that’s not the case with SA. That’s not the only thing they’ll look at.
Against this they will also be looking at things like the quality of our institutions. For instance, we have a very strong Reserve Bank, we have got a very strong FSB and we’ve got a very strong financial system. Our judiciary has been tested this year and it’s actually come through pretty well. There are a lot of positives in South Africa as well that counterbalance some of the negatives that we’ve been seeing and talking about of late.
CG: It’s actually government debt that they rate in this instance?
NW: They will rate in this particular instance the specific debt that the government issues. Each time the South African government goes to issue debt to foreigners, they will assign a rating to that particular debt instrument, to that particular loan.
How can we still influence the decision?
CG: What then Nolan, can government and big business here do to influence this decision?
NW: The challenges that Standard & Poor are facing in terms of their rating model, they’ve been very transparent with us. Their primary concern is that South Africa’s growth rate is very low, expected to grow at just over zero percent this year. Maybe 1% if we’re lucky in terms of growth rates next year. That’s just not enough.
Really, it’s about finding ways to improve the South African economic growth rate. There are a lot of structural impediments to our growth, we’re very familiar with these. We can see them in the press all the time and ultimately it’s about collaboration between business and government. It’s about removing some of these impediments, some of the red tape to smooth or pave the way for a better growth rate for our economy.
CG: Let’s imagine the verdict in December goes against us. What will happen immediately and what long term are the implications of that?
What will the impact of a downgrade be?
NW: Assuming it’s just Standard & Poor’s that downgrades us and that the other two rating agencies don’t follow suit. There’s a good argument to be made that South Africa has already adjusted in terms of international pricing of our debt towards junk bonds or towards junk status.
What I mean by that is recently we saw Turkey being downgraded from investment grade to junk. We’ve seen that happen to Brazil a year or two ago. If I look at our pricing of international debt right now, it’s actually very much in line with those two countries. From that point of view a lot of the pain might have been taken. If we remember the rand was at R17 maybe nine months ago to the dollar, it’s already come back a little bit. One could argue that a lot of the shock and a lot of the financial pain has been felt already.
In the near term, I’m certain that there will be a knee jerk reaction in the market, I’m certain it will not be positive. But one might say that it’s likely to stabilise around current levels. Unfortunately, the problem with the rating agencies in the long term is, as they downgrade the quality of our debt. What happens is the amount of interest that our government has to pay goes up because as a lower quality borrower, foreigners expect us to pay more interest for the additional risk. In order to service that debt, the SA government is going to need to come to the tax payers and take it out of taxes.
The government has really then got two choices. Either it needs to raise taxes, which is very difficult in the current environment. Frankly we just don’t have enough high net worth individuals that will be able to stomach that bill on top of everything else that they’re paying right now.
The alternative is then to either raise taxes on the middle class, which means the middle class will feel the brunt of the pain or alternatively we find ourselves in a situation where the government needs to start diverting money from universities where they divert money from service delivery towards servicing their interest bill. In the long term this is actually very bad for inequality because it starts to put pressure on your lower and middle classes again, whereas your upper class actually finds itself more isolated or protected from the events.
If it’s not all bad?
CG: How would you assess then the direct impact on ordinary South Africans?
NW: On ordinary South Africans, you are probably going to see your imported goods increase in price. We’re going to probably see greater inflation. You’re probably going to see more pressure on the government to reduce the services that we are currently receiving.
CG: If the verdict goes in our favour, let’s hope it does, what happens then?
NW: I think that would be a fantastic outcome for everybody because I would expect to see a significant increase in share prices. I’d expect our bond market to really celebrate with significant gain and what it really means is that South Africa is in a position to continue with stable, sustainable growth which in the long run is just better for everybody. There’s more cash available for the government to spend on things that we need like universities.
CG: You’re listening to Old Mutual Live, the Money Coach edition, on demand, visit dogreatthings.co.za. Nolan, once a country has been downgraded, is it easy to recover, to move back upwards in other words?
NW: Theoretically it is. The rating agencies would certainly look at improvements that we make and if they are sufficient to justify moving back to investment grade, they will make the change. In practice it has actually proven very difficult for other countries to do this. On average it’s taken them up to seven years to right the wrongs that got them downgraded originally and to regain their status as an investment grade country. There’s no short term fix for this if it happens, but certainly over the next decade it’s something that we could see correct itself.
CG: Final question Nolan, what’s your guess, what do you think the decision will be?
NW: I like to be an optimist, I like to think that I’m seeing a lot of good things being done by government. I’m hoping that they’re enough and I’m hoping that the rating agencies will give us another six months.
CG: There we’ll leave it. This has been another edition of Old Mutual Live Money Coach, my name is Chris Gibbons. I’ve been talking to Nolan Wapenaar of Anchor Capital. Nolan, thank you for your time, it is appreciated.
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