Implications Of S&P Junk Status For South African Investors
South Africa’s foreign currency debt rating has been downgraded to non-investment grade by Standard & Poor’s Global Ratings following last week’s Cabinet reshuffle which saw Finance Minister Pravin Gordhan fired.
The downgrade was announced late Monday following an emergency S&P meeting over the weekend, Independent Online reported. Political uncertainty was one of the reasons for the downgrade, the rating agency said.
When countries get downgraded to non-investment grade, these are some of the things that can happen, depending on how authorities respond, according to Lesiba Mothata, chief economist at Sandton-based Investment Solutions:
Cost of funding increases, a recession ensues, currency depreciation induces inflation, which leads to monetary tightening. The short- to medium-term impacts could prove painful.
It is in times like these that investors need to hold on to a diversified and long-term investment strategy, Mothata said in a guest column in The South African. Even as a political storm is once again battering South Africa, history has shown that, in the long-term, markets have the ability to return to fundamentals even when short-term noise, especially from the political sphere, creates much angst.
President Jacob Zuma fired Gordhan and his deputy Mcebisi Jonas last week, replacing Gordhan with former Home Affairs Minister Malusi Gigaba, a rookie when it comes to finance and business, Bloomberg reported.
As part of a broader cabinet reshuffle, Zuma replaced cabinet members with loyalists, drawing public criticism from top party officials including Deputy President Cyril Ramaphosa, and calls to step down from former President Kgalema Motlanthe.
Rating agencies have warned of political risks in South Africa. S&P’s results were expected on June 2, making Monday’s announcement appear to be two months premature.
South Africa’s banking index fell to its lowest in six months after S&P cut the sovereign’s foreign-currency debt rating to junk, making it more likely that lenders will face lower returns and increased bad debts in the coming year, Bloomberg reported:
South Africa’s six-member banks index, which includes Standard Bank Group Ltd. and Barclays Africa Group Ltd., has plummeted more than 8 percent since Zuma fired Gordhan, making it the country’s worst-performing stocks gauge this year. Barclays Africa, still waiting for its London-based parent company to sell down its holdings, has been hit the hardest, sliding 16 percent in 2017. The rand has also weakened against major currencies while yields on benchmark government bonds have soared.
The S&P downgrade “is bad for banks’ net return on assets and return on equity, not just via lower performance on existing assets, but also via a higher incidence of non-performing loans,” said Adrian Saville, chief strategist at Citadel Wealth Management, in an email to Bloomberg Tuesday. “The real issue is the impact on economic growth, industrial performance and employment. There is an unambiguous negative relationship between economic growth and bank assets.”
South Africa’s banks have proved that they can weather the storm. When former Finance Minister Nhlanhla Nene was fired in December 2015, it wiped $11.2 billion off the index’s market value in two days. This time, Gordhan’s firing has cost the banks $4.5 billion so far.
South Africa escaped a downgrade in late 2016 after the ratings agencies did their final review for the year.
S&P is the first agency to downgrade South Africa’s sovereign debt to non-investment grade. Fitch is expected to do the same soon. This will be challenging for South Africa given that the local dominated debt (90 percent of total outstanding stock) is likely to go to non-investment by Fitch, Mothata said.
“The Moody’s outcome, even if it holds a more favorable outlook on South African debt relative to the other two agencies, could contribute negatively to the downward trajectory of South Africa’s ratings,” Mothata said in The South African:
Ratings agencies have different approaches to assessing the debt issued by the National Treasury in domestic and local currency. To fund government expenditure, Treasury borrows in local currency (90 percent of total outstanding stock) or in foreign currency (10 percent) in international markets. In other words, the so-called junk status relates to 10 percent of total debt issued by the Treasury.
Moody’s and Fitch ratings do not differentiate between the currencies used when debt is issued. The credit quality assigned to South Africa’s total debt is similar for both local and international currency issuances. In contrast, Standard & Poor’s (S&P) provides a rating on local and foreign debt. In its latest action on South Africa, the foreign currency component of debt issued (10 percent of the total) has been downgraded to non-investment grade BB+ (see the figure below) and local-currency denominated debt (90 percent) has been pushed one notch down to BBB-, which is still investment grade.
Before the S&P downgrade, bad-loan charges were at a multi-year low, the economic outlook was improving and South Africa’s bigger banks were considering easing lending criteria for the first time in five years, Bloomberg reported:
While the banks’ debt will have to be downgraded alongside the sovereign cut, that’s unlikely to lead to a banking crisis, according to Peter Attard Montalto, a London-based economist at Nomura International, who spoke on Bloomberg Television. The political crisis isn’t going to threaten financial stability, he said, because the banks are well capitalized.
Even with the downgrade, banks’ average return on equity remained above 16 percent in 2016, according to Ernst & Young LLP research. South African banks may continue to beat the ratios of their peers in Europe and the U.S.
“We have 50 percent more capital than in the global financial crisis and all South African banks came through that event fine,” said Mike Brown, CEO of Nedbank Group Ltd. “Banks are well prepared for this event and have conducted numerous stress tests — I’m confident all will remain stable in the months ahead.”
S&P’s decision does not impact the country’s eligibility in global bond indices as yet, Mothata said.
South Africa’s benchmark 10-year government bond had become the fourth most heavily traded sovereign bond in Europe according to Trax. March was a record month for trading volume in South African bonds — 15 billion euros ($16 billion US), the largest number on record and 52 percent higher than the average monthly volume since July 2013.
The Citigroup World Government Bond Index is a widely-used global bond benchmark. According to its exit requirements, a country will be removed from the index for the following reasons:
- Market capitalisation of outstanding debt falls below half entry level (US$25 billion) for three consecutive months.
- A country gets downgraded into non-investment grade by both Moody’s and S&P on its long-term domestic credit.
- Authorities deliberately introduce policies that materially change the ability of investors to replicate the returns of that country’s portion of the index.
The three exit requirements are not yet triggered, and all rating agencies still have South African credit quality rated in investment grade, Mothata said. However, more ratings downgrades and increased trading volumes could impact South Africa’s ability to raise funds and affect the flow of capital into South African bonds.