A good Article from Alastair Sellick from PSG Asset Management.
Enjoy reading !!
"After the close of the local bond market on Friday the 12th October, bond market participants received the unwelcome news that S&P had cut South Africa’s foreign currency credit rating to “BBB“ from “BBB+” and the local currency credit rating to “A-“ from “A”. Importantly, the ratings outlook was maintained at negative. This was the most concerning aspect of the downgrade, as a negative outlook means that there is a material chance that the credit rating could be subject to further downgrades later.
The move by S&P wasn’t unexpected - on Thursday the 27th September, Moody’s had downgraded South Africa’s foreign currency credit rating to “Baa1” from “A3”, the equivalent of S&P’s “BBB+”. At the time, this brought Moody’s in line with S&P and Fitch. However, S&P’s timing certainly was a surprise. The common wisdom of the market had been that they would give the sovereign the benefit of the doubt and wait until the Medium Term Budget Policy Statement had been delivered by Finance Minister Pravin Gordhan. That the ongoing developments had, in their view, deteriorated so rapidly, is quite telling, and serves to underscore the severity of the implications of the maintained negative outlook.
S&P list the following factors that could lead to further ratings downgrades:
If the South African business and investment climate weakens more than they expect
If the diverging factions within the ANC impede the formulation of a policy framework that is conducive to growth and job creation
If the Mangaung congress sets a policy framework that deviates from the path of fiscal consolidation
Factors that could lead to a downgrade of more than one notch include:
If the government’s fiscal flexibility decreases potentially due to public sector wages or debt service costs increasing more than currently expected.
In order for the rating to be affirmed at current levels, and a revision of the outlook to stable, S&P require that:
The expected increase in public sector debt must be offset by an improvement in investment and economic growth prospects, and
Fiscal consolidation must continue
Ordinarily, it is counter-productive for the downgraded entity to respond to a ratings agency. It is far more telling to react to the reasons that have been cited for the rating action. However, National Treasury’s response to S&P is measured and it emphasizes the positive long term consequences of the infrastructure spending programme. The financial markets certainly took the ratings actions in their stride – bond yields sold off around 15 bp and have since recovered. The Rand had weakened significantly around the strike actions which happened the week or two before, so is broadly stronger than it was at the time of S&P’s announcement.
These ratings downgrades were not a fait accompli. They represent the consequences of allowing an inefficient labour market to impact on the productive capacity of the South African economy over a long period of time. It is no surprise that South Africa features so poorly in the labour categories of the Global Competitiveness Report of the World Economic Forum. As an increasingly emboldened and more powerful member of the tripartite alliance, labour has been flexing its muscles – the annual strike season refers. When strikers are so emboldened that the rule of labour law is no longer respected, the consequences can be disastrous. Labour would be well advised to take note that much of the gain, in terms of being able to increase social spending and develop the country’s infrastructure has depended on positive foreign investor perceptions about South Africa.
Fitch has given the Finance Minister the benefit of the doubt, and has indicated that a pronouncement on the South African sovereign rating will occur early in 2013. However, the manner in which the wildcat strikes expanded, as well as the lost output in various mines and support industries suggests that there could be a reduction in the country’s Q3 / Q4 growth rate, and this has implications for the fiscus. We thus continue with the Sword of Damocles hanging over the bond market.
In the current global environment, there is such a heightened focus on government deficits, austerity and fiscal consolidation. It is important that governments keep their house in order, and fly below the radar. While South Africa initially did so well at the start of the financial crisis, primarily through the sound policies of the South African Reserve Bank and the rigorous regulation of our banks, we have lost the advantage we once had. South Africa has also benefitted from the dual windfalls of global quantitative easing, which has sent large amounts of cheap foreign capital out hunting for yield in the well run, investment grade bond markets, and our inclusion in the Citi World Global Bond Index (the WGBI) on the 1st October 2012. We should be doing our utmost to show the world that South Africa is a capital friendly investment destination, and in the context of the global financial crisis, we should be putting our best face forward. We should be marketing our country as the ideal destination for capital that can be deployed towards the economic development of the African Continent. We need to now convert the hot-money of global bond inflows into long term Foreign Direct Investment (FDI) otherwise we will pay the price if that capital leaves at the speed with which it arrived.
Ratings agencies and the bond markets play an important role in regulating the behaviour of governments. If governments play by the rules and adopt sensible, responsible policies, they will be rewarded by good credit ratings and access to foreign capital. If not, it is the duty of the ratings agencies to point this out to bond investors. In turn, it is the obligation of bond investors to price adequately for the investment risk they are taking. Now that foreign investors hold close to 40% of our nominal local government debt, we are even more vulnerable to the marginal ratings change by ratings agencies.
There is no doubt that the required risk premium for investing in South African government bonds has risen, even though our bond yields have fallen. The question is: will the government be able to deliver on the required improvement in investment, economic growth and social prospects that are now demanded of this country?"
"The PSG Angle is an electronic newsletter of PSG Asset Management"
Kind Regards
Steven
Steven Morris Chartered Accountant (SA)
Mobile :+27 83 943 1858
Facsimile : 0866 712 498
E-mail : steven@global.co.za
Website : www.stevenmorris.co.za
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