Last Friday SA failed its fiscal fitness test. Hopes were dashed that all the ratings agencies would hold off further downgrades until the outcome of the ANC’s December elective conference. SA is considered a rubbish bet by S&P Global Ratings and Fitch, and Moody’s is a hair trigger away from concluding the same.
Since 2012, SA’s credit-rating descent has been steep, mirroring the erosion of the country’s economic performance, key institutions and public finances. Having peaked four notches above junk in 2009, SA’s international ratings are now roughly back in the same position as they were in the early 1990s, all fiscal progress having been wiped out.
The heart of the problem is that SA’s growth rate has been too low for too long. The country’s economic growth performance remains among the weakest of the 20 major emerging market countries, having posted negative per capita income growth for several years. Only Qatar and Venezuela are likely to show slower per capita growth this year.
All three agencies want to see evidence that SA is putting in place the building blocks for a sustainable growth and fiscal recovery
Further downgrades from S&P last Friday night, just eight months after it junked SA’s foreign-currency rating on former finance minister Pravin Gordhan’s dismissal, take this rating even deeper into junk territory (BB) and its local-currency rating into junk territory for the first time (BB+). The outlook is stable.
Fitch stood pat last week, keeping both SA’s international and local ratings on the top rung of the junk ladder, but Moody’s, which has SA’s ratings on the last rung of investment-grade, put SA under review for a downgrade. It has given SA just three months to show why it shouldn’t also junk its ratings.
This implies that further cuts are highly likely unless the ANC elects a new administration in December that is able to change tack decisively.
"We have a very short window to change the outlook for the economy, and decisive action is required to prevent further downgrades next year," says Nedbank Group CEO Mike Brown. "We urgently need to accelerate economic growth, which will require policy clarity, structural reforms and restored faith in governance in order to lead a recovery of consumer and business confidence."
Though SA’s growth prospects and fiscal position have deteriorated markedly since the agencies’ previous reviews, the negative ratings action still rattled economists and the markets, if only briefly in the case of the latter.
The rand lost 27c initially against the US dollar, from R13.88/$ before the downgrades to R14.15/$ on Saturday, but then confounded analysts by climbing to a five-week high of R13.77/$ by Tuesday morning. Dollar weakness and rand short covering explain some of the rand’s moves.
Over the past eight months there have been two cabinet reshuffles, confusion over the nuclear programme and mining charter, a steep deterioration in the debt trajectory and growth outlook, further evidence of state capture, and continued policy paralysis.
All these developments have sent a message to the ratings agencies of SA’s deepening descent.
Moody’s lead sovereign analyst for SA, Zuzana Brixiova, summed it up well: "Unclear and shifting policy objectives, political manoeuvring, frequent changes of leadership in key ministries and concerns over the pressures on the key policy-making institutions such as the Reserve Bank and national treasury have weakened SA’s economy, finances and institutions."
Moody’s review will allow it to assess the SA authorities’ ability to turn the situation around.
It wants to see evidence that SA is putting in place the building blocks towards a sustainable growth and fiscal recovery.
In essence this is what all three agencies want. Their concern isn’t over SA’s short-term fiscal performance but its longer-term fiscal and debt sustainability, given the inability of the economy to grow at the levels required to create meaningful employment.
At nearly 28%, unemployment has reached the highest level recorded since 2003, and poverty has been climbing since 2011. The private sector isn’t even investing enough to maintain its existing capital stock.
"The downgrades reflect declining confidence in the management of our economy, the quality of our institutions and the choices we are making as a society," says Business Leadership SA.
"Deficiencies in these areas are making the possibility of a prosperous SA less and less plausible."
The latest round of downgrades will deliver another blow to the fragile economy, but they do not sound its death knell.
"There is life after investment grade," says Rand Merchant Bank chief economist Ettienne le Roux. "But it does mean as South Africans our lives have just become one layer more uncertain and complicated.
"Life will go on, but it will be more costly for all of us."
The immediate effect will be an increase in the cost of borrowing. It will become more expensive for government, state-owned enterprises and the private sector to raise funding. Foreign investor demand for SA debt will also weaken, narrowing the country’s access to capital and removing support for the rand.
Rand weakness, if sustained, will increase inflation, inviting the Reserve Bank to respond with higher interest rates.
Business and investor confidence is already at a 30-year low. The latest ratings actions will deepen it, negatively affecting spending and investment. Growth will slow further and unemployment will rise, deepening SA’s economic stagnation and raising fiscal and social pressures.
"No single downgrade on its own is a catastrophe but every downgrade matters," according to Stellenbosch University’s Stan du Plessis.
This is because every downgrade pushes bond yields higher, raises the state’s interest bill, cannibalises funding for economic and social programmes and makes it even harder to get the debt ratio to stabilise.
"You can get there only if you can overcome the force of the interest bill, and every time you get knocked by a ratings agency this becomes a steeper hill to climb," he explains.
The situation would be dire in the best of times but in the current political climate budgeting has become impossible. The governing ANC is riven with factionalism and completely preoccupied with the looming ANC conference.
SA counted the cost of this in the medium-term budget policy statement in October, which projected a R50bn revenue shortfall for the current fiscal year. Worse, it revealed that cabinet had been unable to approve any evasive action (like hiking Vat or freezing public servants’ wages) to prevent debt from rocketing to 60% of GDP in three years.
Finance minister Malusi Gigaba’s subsequent assurances, bolstered by a directive from President Jacob Zuma, that cabinet is close to finalising a R40bn package of tax hikes and expenditure cuts, have failed to inspire much confidence.
Presumably if cabinet really were anywhere close to reaching agreement, the measures would have been relayed to the ratings agencies to prevent further downgrades.
Instead, there is every reason to believe that national treasury’s centrality in the budget-making process is under threat. This is clear from the recent resignation of Michael Sachs, the head of the budget office, over Zuma’s attempt to ram a R40bn free-university plan down treasury’s throat without regard for policy or budget processes.
With Sachs went the last vestige of credibility of SA’s fiscal framework.
So Gigaba sounded like a tin drum when he asserted on the weekend that "there can be no doubt about government’s strong commitment to addressing the structural constraints to growing the economy and improving public finances" and that treasury’s role "has in no way been undermined".
Gigaba did, however, back-track on the idea of free university education for all, revealing that Zuma had directed that measures to improve higher education access "be implemented in a fiscally sustainable manner". This necessarily implies "a phased approach focusing on the neediest students", Gigaba explained.
It chimes with his frequent assertion that the nuclear deal "will be pursued at a pace and scale the country can afford".
But even if Gigaba’s assurances could be taken at face value, SA has run out of road fiscally. Growth and confidence are now so fragile that additional tax and expenditure measures to reduce the deficit could be self-defeating if they cause growth (and therefore tax revenue) to slow further.
S&P flags this problem in its statement, noting that while it expects government to attempt to introduce offsetting budgetary measures, "these may not be strong enough to stabilise public finances, and may weaken economic growth further in the near term".
In short, SA’s fiscal position is unsustainable, and numerous fiscal policy indicators are pointing directly towards a debt trap.
According to Sanlam Investment economist Arthur Kamp, these include: SA’s persistent difficulty in stabilising the debt ratio, the inadequate adjustments being made to the primary budget balance, the high real interest rate on newly issued debt relative to GDP growth, the increasing share of interest payments relative to government revenue and the inability of the state to protect its balance sheet.
These trends will take some turning around.
"Treasury will have to come up with a very good plan in the February 2018 budget," says Kamp. "Moody’s seems bound to lower SA to subinvestment grade unless the budget is something really special. It’s high noon. I hope SA can find some ammunition somewhere."
Continuing to increase taxes and cut spending will no longer be sufficient. Not only must the overall level of expenditure decrease, but the liquidity problems at state-owned enterprises will have to be addressed without recourse to the taxpayer. Asset sales are becoming unavoidable.
All three agencies flag the risk that many state-owned enterprises are becoming increasingly reliant on public funding and are likely to require further extraordinary government support.
If so, it could lead to even faster debt accumulation than envisaged.
S&P estimates that public debt — including that of central and local government and public sector companies — has already surpassed 70% of GDP. It foresees that more funding may be required over the next six months to shore up Eskom’s weak financial position even though it already benefits from R350bn in government guarantees, nearly 8% of GDP.
"The situation at some of the biggest state-owned enterprises has deteriorated," says the CEO Initiative’s Jabu Mabuza. "Even though new leadership has been appointed in some cases, key entities such as Eskom — which has an unsustainable capital structure and reliance on government guarantees — still pose a material risk to the country’s financial position.
"This is of huge concern to any investor in SA."
Gigaba has said that strengthening governance at Eskom, with the appointment of a highly trusted and capable board as a first step, is "an urgent priority".
Moody’s review will allow it to assess the effectiveness of government’s response to these rising fiscal challenges, especially the reform of state-owned enterprises. If SA’s economic, institutional and fiscal strengths continue to weaken, it is likely that the country will be downgraded further.
On the other hand, all three agencies concede that the situation could improve if the ANC elects a credible new leadership in December.
S&P says the "stable outlook" it has attached to SA’s ratings reflects the possibility that a new ANC leader could unleash confidence and speed up the implementation of key reforms, noting that "who that leader is and the pace of policy implementation he or she pursues could determine SA’s future economic performance".
Similarly, Fitch says that while several developments have pointed to a weaker fiscal outlook, the outcome of the ANC conference could prompt fiscal consolidation measures and, if confidence were re-ignited, GDP growth could rebound more strongly than expected.
So there is still the hope that SA’s ratings outlook could turn positive, should the new ANC leadership start to implement reforms that raise competitiveness and growth.
But the ratings agencies’ lack of conviction is palpable.
Fitch, in particular, is sceptical that the situation will improve immediately after the conference, even if the anti-Zuma faction is victorious.
"Issues to be resolved include the reality that both the main candidates [for the party presidency] will need to form complex alliances to win; that a split of the party chairmanship and the national presidency could lead to inefficiencies; and that disruptive in-fighting between factions is likely to continue," it concludes.
In some ways Fitch’s statement is the most bearish of those of the three agencies, since it sees little prospect that a country with SA’s deep-seated structural flaws will get growth going fast enough to reduce inequality and quell pressures for growth-sapping, redistributive policies, no matter who is in charge.
S&P also emphasises that SA has an underlying growth and competitiveness problem, caused by structural constraints, including an "inadequate" education system and an "inflexible" labour market. It finds little evidence that government supports ambitious reforms in these areas.
In short, SA’s performance and fundamentals have deteriorated steeply over many years, and the ratings agencies are running out of hope that the situation can be turned around any time soon.
The ANC elective conference provides SA’s last chance to prevent all three agencies from junking its ratings.
If it fails to inspire confidence, SA will have earned its place on the ratings rubbish heap.
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