By Magnus Heystek – Director and Investment Strategist
SOUTH AFRICA FACES 5 TO 10 YEAR OF RECESSION UNLESS THE COUNTRY CAN GET RID OF THE DISASTROUS RULE OF PRESIDENT JACOB ZUMA AND THE ANC.
The downgrading of the country’s international credit rating to so-called “junk” status last week will have profound long term economic and political effects and can only be described as the largest single financial disaster to hit this country since 1994.
On Monday 3rd April, the largest international credit ratings agency in the world S&P Global Ratings—which was only due to report in June this year—announced that it has downgraded SA’s global credit rating to the sub-investment grade of BB-, also referred to as junk in the financial world.
This move was prompted by to a decision made by Pres. Zuma the week before, to fire 10 cabinet ministers and deputies, which included but not limited to Pravin Gordhan as Minister of Finance, who has been replaced by Malusi Gigaba, a career politician with a very questionable track record at two key portfolios, state enterprises and home affairs.
This was followed by credit ratings agency Fitch which also dropped SA’s foreign AND local credit rating to below investment grade. This was the first credit ratings agency that reduced SA’s local credit to sub-investment grade.
Moody’s, the other large credit ratings agency, was set to make a statement on SA’s credit rating by the 7th April, but has since announced that it needs between 30-90 days to conduct a thorough assessment of SA’s rating.
Moody’s has been more positive about SA’s out-look and currently has the country at two notches above speculative or junk rating.
A downgrade to junk status by at least two of the three big agencies will be a devastating blow to SA’s financial prospects, far worse than the effects of the Great Financial Crisis of 2008.
Historical data shows that it takes approximately 6 years for downgraded countries to have their credit ratings reinstated, provided they take the necessary steps to make their economies attractive for foreign investors once again. This will include bringing down government spending, fiscal consolidation and taking steps to reintroduce economic growth in their respective countries.
The result of a downgrade in a country will automatically lead to a downgrade of that country’s parastatals, banks and other global companies. Whilst international credit is still available, it will cost the lending party substantially more in terms of interest costs.
For a state, this therefore, reduces the amount of money that it can spend on infrastructure while companies normally pass these higher costs on to their clients, thereby reducing economic activity.
Small to medium sized companies are particularly vulnerable to a slow-down in bank lending and it is expected that many under-capitalized companies will not survive a prolonged economic slump. This does not bode well for the unemployment rate, which is already in excess of 35%, according to latest figures.
Countries that have been downgraded in recent times include Brazil and Russia. Brazil is currently still gripped by a sharp economic recession and has experienced a sharp drop in its currency, rising bond yields and a volatile stocks market.
HOW SERIOUS IS THE DOWNGRADE?
Ratings downgrades are a clear signal to policymakers, investors, businesses and society, that things are not on track. Although S&P’s decision to downgrade South Africa was only announced on Monday night after President Jacob Zuma’s disastrous cabinet reshuffle, it’s probably fair to argue that the decision was already in the price and that it has been there for some time.
To substantiate this claim, South African govern-ment bond yields have been priced similarly to the likes of Brazil and Russia for the best part of a year. Indeed, based on economic growth projections alone, South Africa has been failing S&P’s acid test for investment grade status for some time.
If anything, then, the decision to downgrade South Africa was overdue. In the same breath, even though S&P has expressed its growing concerns about politics getting in the way of policy, strength in institutional fabric and policy consistency has given the country a stay of execution. All of this was put paid to by Zuma’s night of the long knives.
The ratings downgrade is confirmation of what’s been suspected for some time – that South Africa has lost its way from an economic perspective and that the country has also entered the political wil-derness. It’s also worth suggesting that there’s a good possibility that S&P’s decision will spur the other two ratings agencies into taking a firmer – and less forgiving – stance on South Africa.
London based analyst Peter Attard-Montalto from Nomura Securities, has already downgraded SA’s growth forecast from 1,7% to 0,2% this year and next year from 1,8% to 0,7%, indicating that a recession is on the rise.
WHAT IS THE REAL IMPACT GOING TO BE ON ORDINARY SOUTH AFRICANS, PARTICULARLY POOR PEOPLE?
IN THE SHORT AND MEDIUM TERM
Arguably the immediate impact will be negligible. The sell-off in the rand, government bonds and banks are felt and seen in capital markets before they spill into the real economy.
But within a month the weaker currency could translate into higher fuel prices at the pump and this will quickly affect household budgets and business margins.
The impact will start to be felt more dramatically in about six months’ time. Exports and imports make up about a third of South Africa’s economic output. Its imports are price inelastic, meaning that we take the prices that are given to us. Consequently, about one third of the economy will be subject to the effects of fairly rigid import price inflation, and will take about six months to pass into the economy. A back of the envelope calculation points to consumer price inflation being raised by as much as three percentage points, from a base of, say, 5% to as high as 8% (this is calculated by a rand decline of 10% multiplied by 30% of South African prices being imported).
In the same breath, we could also see a perverse near-term boost to some economic segments, especially export-oriented sectors, such as commodity producers and tourism. In time, though, the South African Reserve Bank will be obliged to raise interest rates to deal with higher consumer price inflation.
WHAT OTHER NEGATIVE ECONOMIC CONSEQUENCES CAN THE COUNTRY EXPECT?
From these sequence of events, it follows that, in time, the ratings downgrade is followed by slower economic growth, higher consumer price inflation and higher interest rates. The combination of these factors is called stagflation. This environment is a poor outcome that will hold back economic progress and social transformation.
Of course, it would be naive to argue that this is entirely due to the ratings agencies’ call.
However, this poor economic outcome was already on the cards. To explain, it’s important to recognize that the ratings agencies don’t have access to more or better information than the market at large and their calls don’t drive market movements. Rather, their decisions tend to lag rather than lead the markets, and in this way, generally confirm what we already know.
SA’S FOREIGN CURRENCY DEBT NOW HAS SUB-INVESTMENT GRADE STATUS, BUT NOT ITS DOMESTIC CURRENCY DEBT IS THIS SIGNIFICANT?
At least two rating agencies must agree on sub-investment grade status and the rating must apply to local currency debt for a country to be ejected from the key global government bond index.
The sub-investment status attributed to South Africa immediately after the S&P call means that only one agency has rated the country sub-investment grade and is in respect to foreign currency debt.
This is not to say that the other shoe won’t fall. As things stand, it seems that is only a matter of time before the other agencies join S&P and that the call also extends to include local currency debt.
WHAT REMEDIES COULD GOVERNMENT APPLY NOW IF IT WANTED TO?
By some measures, South Africa has been off the pace but not in bad shape. The fiscal deficit stands at about 3.5% of gross domestic product (GDP) and general government debt is just over 50% of GDP. Neither of these numbers are alarming. Even if we extend the debt net to include all “off balance sheet” obligations – especially via state-owned enterprises – South Africa’s state balance sheet and income statement are still in fair shape.
The real issues at hand are the missing economic growth, entrenched unemployment, hopelessly skewed income distribution and urgently needed industrial invigoration. Under a debt downgrade the ability to repair each of these will be compromised. Which means that the challenge rests not just in reestablishing robust policy, but also translating this into practice.
This will require the country to address the veil of uncertainty that shrouds political leadership and that’s left a jaundiced view on decisions that are key to the country’s well being. On this score, evidence shows that countries that “get the message and get to work” can regain investment grade status fairly quickly – on average about three years.
Those that hesitate will take three times as long – the best part of a decade – to regain investment grade status. Since 2010 Brazil, Croatia, Cyprus, Greece, Hungary, Portugal, Tunisia and Russia have been downgraded to sub-investment grade and none have yet recovered investment grade status.
Critically, a point that should not be lost, is that as much as the ratings call is by an external agency, the repair required is domestic, and includes public and private sector facets. For instance, in all cases where countries have regained investment grade status quickly, they have displayed two common attributes: The first is high private sector savings rates fueling high domestic investment levels. The second is sound monetary policy that has been effective in managing the risk of consumer price inflation running away during the recovery.
THE IMPACT ON INVESTMENT PORTFOLIOS
A long drawn-out recession would be devastating for certain asset classes, including banks and financial shares, residential property and potentially listed property with a domestic bias.
A downgrade to the SA’s domestic credit rating will, however, be far worse than a downgrade of the country’s foreign credit rating. Such a down-grade would be devastating to local bonds and is a risk that will need continuous monitoring.
Brenthurst Wealth’s investment portfolios have long been reflecting a more aggressive exposure to offshore assets combined with a conservative approach toward local asset classes.
Brenthurst’s financial planners, who understand the long-term investment objectives of clients intimately, will be assessing portfolios on an individual basis and will, if within the risk-profile of clients, make strategic adjustments in order to reduce domestic risk and obtain larger exposure to offshore asset classes.