Downgrade to junk may not mean disaster - yet

09 April 2017 - 02:00 By ASHA SPECKMAN
Demonstrators take part in a protest calling for the removal of President Jacob Zuma in Durban on Friday after the sacking of finance minister Pravin Gordhan. Similar protests were held in other cities.
Demonstrators take part in a protest calling for the removal of President Jacob Zuma in Durban on Friday after the sacking of finance minister Pravin Gordhan. Similar protests were held in other cities.
Image: REUTERS

The outlook for South Africa may not be all doom and gloom even as it followed Brazil and Russia into junk status this week, thrusting the case for emerging markets and their growth prospects into murky territory.

In 19 years, S&P Global Ratings has downgraded 21 countries, and on Monday it lowered South Africa's creditworthiness to sub-investment grade for the first time since 2000 as it feared last week's cabinet reshuffle would put fiscal and growth outcomes at risk.

In nearly two decades only six nations - Hungary, Slovakia, South Korea, Colombia, Latvia and Uruguay - have regained investment grade status after being downgraded to junk. Generally, according to KPMG and ratings agencies, it takes about seven years to regain investment grade.

Following South Africa's downgrade, three of the Brics countries (Brazil, Russia, India, China and South Africa) now operate at sub-investment grade.

Research by KPMG shows that over the past three decades 15 countries - including Colombia, Indonesia, Turkey and Uruguay - had seen their investment grade ratings revoked by S&P, Moody's and Fitch, the three largest ratings agencies.

KPMG economist Christie Viljoen said: "South Africa is most closely associated with the countries experiencing economic deterioration and possibly those having unsustainable macroeconomic imbalances."

New Finance Minister Malusi Gigaba, in an attempt to calm the markets, said there would not be policy changes following the appointment of new ministers, but his emphasis on radical economic transformation created some uncertainty in the financial markets.

Credit downgrades are expected to result in capital flight as asset managers that are not allowed to invest in sub-investment grade assets by the rules of the funds they manageare expected to sell. Currency depreciation, rising inflation, high interest rates and economic hardship could follow if there is a significant outflow of funds.

John Ashbourne, Africa economist at London-based Capital Economics, said the outlook for South Africa was not yet dire as the country was supported by slightly stronger economic fundamentals. Even though South Africa's current account deficit was the largest of any emerging market, averaging 4.8% of GDP over the past five years, it had improved to 1.7% of GDP in the fourth quarter of 2016.

"We expect that a combination of higher commodity prices and weak domestic demand will result in a deficit of about 3% of GDP in 2017, which is hardly worrying by emerging market standards," said Ashbourne.

The downgrade had focused attention on the country's budget deficit, which also lagged other emerging market standards, he said. However, he added, a significant change in fiscal policy - for example a nuclear power deal - could result in the situation deteriorating quickly. "For now, at least, South Africa's borrowing levels aren't an immediate worry."

Government debt now exceeds R2-trillion.

"But this is still comparable to that of other large emerging markets and far lower than that of Brazil, a country to which South Africa is unfairly compared," Ashbourne said.

South Africa, unlike other emerging markets, has an advantage in that its debt is denominated in local currency. Government debt that is denominated in foreign currency held by foreigners was equivalent to 2.2% of GDP in 2015.

He said the currency depreciation - the rand has fallen from March 24 by 11% against the dollar to levels of around R13.82 on Friday - would not significantly raise debt repayment costs. However, he added, the "longer-term outlook is, admittedly, less clear".

Other emerging market currencies and stocks fell on Thursday as US monetary policy authorities decided that the Federal Reserve should start trimming its $4.5-billion balance sheet earlier than expected this year.

The MSCI benchmark equities index dropped 0.6%, which tracked losses in developed markets with exchanges across Asia and emerging Europe selling off.

Phillip Pearce, a dealer at TreasuryOne, said foreigners continued to find value in South African bonds despite political tension. "As the local issues start to settle, we could catch further onto the coat-tails of the global winds and a move lower is on the cards."

Kokkie Kooyman, portfolio manager at Denker Capital, said that as an asset class emerging markets had outperformed developed markets last year. China holds about 25% as a category weight in emerging markets, but its economic output is projected to slow down further from 6.7% recorded in 2016, its slowest in 26 years, according to Trading Economics.

"In 2016 and 2017 there are emerging markets that are struggling and emerging markets that are doing very well. India is growing at 7% to 8% and Indonesia is growing at 5%, whereas Turkey, South Africa and Brazil are still growing at 1%," Kooyman said.

Data from Capital Economics showed that portfolio inflows into emerging markets remained strong in March. Total capital outflows from emerging markets slowed to $6-billion in February from $34-billion in January.

This was the smallest net outflow since April 2014.

Inflows lifted to $142-billion in the three months to February 2017 from $117-billion in the three months to January.

Capital flows play a major role in many emerging markets as they help to finance spending and can affect financial market performance.

South Africa will now have to convince ratings agencies that political risk is under control and the risks to fiscal policy or economic growth are negated.

Moody's Investor Services said in a statement this week that it would undertake a review over 30 to 90 days to determine whether it will also downgrade government debt. Moody's ranks South Africa two notches above junk.

Fitch Ratings, which rated South Africa one notch above junk, downgraded the country on Friday.

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