While CDS markets had largely priced in a downgrade (with levels approaching those of Brazl), FX markets seemed surprised when moments ago S&P downgraded South Africa to junk, cutting it from BBB- to BB+, in the aftermath of last week's sacking of finance minister Gordhan by president Zuma. The stated downgrade catalyst: "in our opinion, the executive changes initiated by President Zuma have put at risk fiscal and growth outcomes. We assess that contingent liabilities to the state are rising."
As UBS warned on Friday, a junking of South Africa could cause up to $10 billion in outflows, UBS said on Friday. Investment outflows at that level would effectively double South Africa's current account gap, UBS said. President Jacob Zuma's midnight ouster of finance minister Pravin Gordhan deepened a financial market selloff caused by political uncertainty that had been brewing all week.
The departure of Gordhan threatens to tip South Africa's higher profile foreign currency credit rating, currently one notch above so-called junk at BBB-/Baa2, into non-investment grade. Moody's is scheduled to review the rating next Friday.
UBS said however that a bigger danger lay in local currency debt. Rated two notches into investment grade, South Africa is one of the few emerging economies whose local currency bonds are eligible for Citi's World Government Bond Index (WGBI), a global benchmark tracked by over $3 trillion worldwide.
A two-notch cut to local ratings would exclude the country from the index, UBS noted, estimating WGBI-indexed South African bond holdings at $10 billion - just above the country's 2016 current account deficit of $9.5 billion, or 22 percent of total foreign holdings of South African debt. WGBI membership hinges on investment grade ratings on local debt from both Moody's and Standard & Poor's.
"South Africa's continued inclusion in WGBI rests on a local currency investment grading rating from S&P and Moody's – presently two notches away," UBS analysts told clients. "Any unwind of these positions could effectively double the expected current account deficit."
Fitch said on Friday that the cabinet shake-up heightened political risk and signalled policy change, and could result in a review of its ratings on South Africa.
And while CDS had largely anticipated the move...
... it came as a surprise to the rand which tumbled to 3 month lows on the news.
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South Africa Long-Term Foreign Currency Rating Cut To 'BB+' On Political And Institutional Uncertainty; Outlook Negative
- In our opinion, the executive changes initiated by President Zuma have put at risk fiscal and growth outcomes.
- We assess that contingent liabilities to the state are rising.
- We are therefore lowering our long-term foreign currency sovereign credit rating on the Republic of South Africa to 'BB+' from 'BBB-' and the long-term local currency rating to 'BBB-' from 'BBB'.
- The negative outlook reflects our view that political risks will remain elevated this year, and that policy shifts are likely, which could undermine fiscal and economic growth outcomes more than we currently project.
On April 3, 2017, S&P Global Ratings lowered the long-term foreign currency sovereign credit rating on the Republic of South Africa to 'BB+' from 'BBB-' and the long-term local currency rating to 'BBB-' from 'BBB'.
We also lowered the short-term foreign currency rating to 'B' from 'A-3' and the short-term local currency rating to 'A-3' from 'A-2'. The outlook on all the long-term ratings is negative.
In addition, we lowered the long-term South Africa national scale rating to 'zaAA-' from 'zaAAA'. We affirmed the short-term national scale rating at 'zaA-1'.
As a "sovereign rating" (as defined in EU CRA Regulation 1060/2009 "EU CRA Regulation"), the ratings on the Republic of South Africa are subject to certain publication restrictions set out in Art 8a of the EU CRA Regulation, including publication in accordance with a pre-established calendar. Under the EU CRA Regulation, deviations from the announced calendar are allowed only in limited circumstances and must be accompanied by a detailed explanation of the reasons for the deviation.
In this case, the reasons for the deviation are the heightened political and institutional uncertainties that have arisen from the recent changes in executive leadership. The next scheduled rating publication on the sovereign rating on the Republic of South Africa will be on June 2, 2017.
The downgrade reflects our view that the divisions in the ANC-led government that have led to changes in the executive leadership, including the finance minister, have put policy continuity at risk. This has increased the likelihood that economic growth and fiscal outcomes could suffer. The rating action also reflects our view that contingent liabilities to the state, particularly in the energy sector, are on the rise, and that previous plans to improve the underlying financial position of Eskom may not be implemented in a comprehensive and timely manner. In our view, higher risks of budgetary slippage will also put upward pressure on South Africa's cost of capital, further dampening already-modest growth.
Internal government and party divisions could, we believe, delay fiscal and structural reforms, and potentially erode the trust that had been established between business leaders and labor representatives (including in the critical mining sector). An additional risk is that businesses may now choose to withhold investment decisions that would otherwise have supported economic growth. We think that ongoing tensions and the potential for further event risk could weigh on investor confidence and exchange rates, and potentially drive increases in real interest rates.
We have also reassessed South Africa's contingent liabilities. This reflects the increased risk that nonfinancial public enterprises will need further extraordinary government support. We expect guarantee utilizations will reach South African rand (ZAR) 500 billion in 2020, or 10% of 2017 GDP. The utilizations are dominated mainly by Eskom (BB-/Negative/--), which benefits from a government guarantee framework of ZAR350 billion (US$25 billion)--about 7% of 2017 GDP. We estimate Eskom will have used up to ZAR300 billion of this framework by 2020.
South Africa's energy regulator has capped Eskom's permitted 2017/2018 tariff increase at 2.2%--with negative implications for its financial performance. Eskom will fund the resulting revenue gap via borrowings of up to ZAR70 billion, of which up to half may utilize government guarantees. Other state-owned entities that we think still pose a risk to the country's fiscal outlook include national road agency Sanral (not rated), which is reported to have revenue collection challenges with its Gauteng tolling system, and South African Airways (not rated), which may be unable to obtain financing without additional government support. While governance reforms have proceeded at the airline, Eskom still has to complete its board appointments and appoint a permanent CEO. Broader reforms to state-owned enterprises are still being discussed and we do not foresee implementation in the near term.
South Africa continues to depend on resident and nonresident purchases of rand-denominated local currency debt to finance its fiscal and external deficits. We estimate that the change in general government debt will average 4.2% of GDP over 2017-2020. On a stock basis, general government debt net of liquid assets increased to about 48% of GDP in 2017 from about 30% in 2010, and we expect it will stabilize at just below 50% of GDP in the next three years. Although less than one-tenth of the government's debt stock is denominated in foreign currency, nonresidents hold about 35% of the government's rand-denominated debt, which could make financing costs vulnerable to foreign investor sentiment, exchange rate fluctuations, and rises in developed market interest rates. We project interest expense will remain at about 11% of government revenues this year.
South Africa's pace of economic growth remains a ratings weakness. It continues to be negative on a per capita GDP basis. While the government has identified important reforms and supply bottlenecks in South Africa's highly concentrated economy, delivery has been piecemeal in our opinion. The country's longstanding skills shortage and adverse terms of trade also explainpoor growth outcomes, as does the corporate sector's current preference to delay private investment, despite high margins and large cash positions.
South Africa's gross external financing needs are large, averaging over 100% of current account receipts (CARs) plus usable reserves. However, they are declining because the current account deficit is narrowing. The trade deficit (surplus in 2016) has seen contraction, but given the small recovery in oil prices (oil constitutes about one-fifth of South Africa's imports) we could see the trade balance weakening again. We could also see weaker domestic demand and a notable increase in exports from the mining and manufacturing sectors, along with a slower pace of increase in imports.
We believe sustained real exports growth is likely to be slow over 2017-2020 because of persistent supply-side constraints to production. Import growth will be compressed amid currency weakness and the subdued domestic economy. Therefore, we estimate current account deficits will average close to 4% of GDP over 2017-2020. However, South Africa funds part of its current account deficits with portfolio and other investment flows, which could be volatile. This volatility could stem from global changes in risk appetite; foreign investors reappraising prospective returns in the event of growth or policy slippage in South Africa; or rising interest rates in developed markets.
We consider South Africa's monetary policy flexibility, and its track record in achieving price stability, to be important credit strengths. South Africa continues to pursue a floating exchange rate regime. The South African ReserveBank (SARB; the central bank) does not have exchange rate targets and does notdefend any particular exchange rate level. We assess the SARB as being operationally independent, with transparent and credible policies. The repurchase rate is the bank's most important monetary policy instrument. Absent large currency depreciations, we expect that inflation will fall back below 6% this year and remain in the target range of 3%-6% over our three-yearforecast horizon.
The negative outlook reflects our view that political risks will remain elevated this year, and that policy shifts are likely which could undermine fiscal and growth outcomes more than we currently project.
If fiscal and macroeconomic performance deteriorates substantially from our baseline forecasts, we could consider lowering the ratings.
We could revise the outlook to stable if we see political risks reduce and economic growth and/or fiscal outcomes strengthen compared to our baseline projections.