S&P downgrade: remember the rand debt is two notches above junk

Arthur Kamp, investment economist at Sanlam Investments

Says Arthur Kamp, investment economist at Sanlam Investments, as fixated as we are with the possibility of a downgrade to sub-investment grade by ratings agency Standard and Poor’s (S&P), all may not be as gloomy as predicted. One has to be careful to distinguish between our foreign currency debt and our local currency debt in determining the true extent of the debt burden, says Kamp.

The possibility of a downgrade to sub-investment grade by S&P on South Africa’s long-term foreign currency debt, which it currently rates as BBB- (negative outlook), detracts from the materially better rating the agency attaches to South Africa’s long-term local currency debt (BBB+), albeit with a negative outlook. The local currency rating is therefore two notches higher than the foreign currency rating. This distinction is not trivial.

Around 90% of government’s debt is denominated in SA rands, says Kamp, and the rating that S&P assigns to this debt suggests that it has no qualms, at present, about South Africa’s ability to repay debt issued in its own currency.

This does not mean that the foreign currency debt rating is not important, however. A downgrade to junk in this rating on 2 December 2016 would send a pitiful message about our macro-economic performance and raise questions about our future performance.

In assigning the foreign currency rating, S&P pays attention to factors such as South Africa’s external accounts in addition to “domestic” factors such as GDP growth and the level of GDP per capita. This highlights the importance of the adequacy of South Africa’s foreign exchange reserves, the size of the current account deficit and the underlying trend in this deficit.

Sufficient foreign exchange reserves – just

The encouraging news is that the Reserve Bank notes South Africa’s augmented Guidotti ratio (the level of South Africa’s foreign exchange reserves relative to its short-term foreign debt plus the current account deficit), which improved from 0.89 to 1.01 between the first and second quarters of this year, suggesting our foreign exchange reserves were sufficient to cover our total external financing needs as at the second quarter of 2016 – just. The Bank noted this was the best level for the ratio since 2010. Also, although the current account deficit probably widened in the third quarter, it has been on an improving trend – just not in a straight line.

Still, despite this, our reserves position is not comfortable and numerous factors continue to weigh on the foreign currency (and local currency) rating. For example, it is disconcerting that government’s debt ratio is projected to increase further despite the announcement of additional expenditure cuts and tax hikes in the 2016 Medium Term Budget Policy Statement. This suggests the underperformance of the economy is making fiscal consolidation difficult, despite the National Treasury’s exemplary track record on spending in recent years and its clear intent to implement the policy changes needed to promote long-term fiscal sustainability.

 “Fifty-fifty” for foreign and local currency ratings

Hence the decision this week remains a close call – “fifty-fifty” in my opinion for both the foreign currency and the local currency ratings, says Kamp. Interestingly, unlike S&P, the Moody’s and Fitch ratings agencies currently do not assign different ratings to government’s local currency and foreign currency debt. This begs the question of whether or not S&P will possibly downgrade its local currency debt to BBB, while leaving its foreign currency debt rating unchanged, thus narrowing the gap between the two ratings.

Distinction between local and foreign debt is key

We should check which debt the agency is referring to in the event of any downgrade announcement on Friday. A downgrade to junk on our foreign currency debt would probably invoke an adverse market reaction in the near term. A downgrade in our local currency debt would, for now, get less attention unless it is more than one notch.

That said, any downgrade is not a good thing and it should not excuse us from the structural economic reform required to get our economy going again. Recent announcements involving government, labour and the private sector give cause for optimism, but they are not yet game changers. No matter what the outcome of the S&P review this week, failure to act decisively would still leave us on a long-term path to likely further downgrades.

Ultimately, the current level of real GDP growth is too low, given the current level of real interest rates (and the heightened demands on government spending) to guarantee long-term fiscal sustainability.

#Growth must lift.