SA escaped the three main credit ratings agencies’ May reviews relatively unscathed, thanks mainly to a supportive trade environment that has provided a cyclical uplift to the country’s revenue and growth prospects, making the economy appear healthier on the surface.
However, it is the job of ratings agencies to take a penetrating look under the hood — and their prognosis is that SA’s public finances remain structurally weak.
As Moody’s puts it: "SA’s credit profile is increasingly constrained by strong, widespread fiscal pressures, including rising borrowing costs and persistently low growth."
The agencies’ combined message is that the pace of structural reform (and therefore growth) is still too slow and the cost of borrowing too high for debt stability to be achieved in the next five years as the government has promised. This means that unless there is a significant game-changer — a positive growth shock, for example — further downgrades are likely.
Moody’s rates SA’s foreign-denominated debt Ba2, two notches into junk territory, with a "negative" outlook. Fitch Ratings has SA pegged three notches down, on BB-, also with a "negative" outlook, while S&P Global Ratings has SA on the same rung as Fitch but with a "stable" outlook.
Of the three recent ratings reports, Moody’s is sounding the most bearish and S&P’s the most sanguine.
S&P has decided to maintain its stable outlook "since SA’s credit strengths — particularly a credible central bank, a flexible exchange rate … and deep capital markets — should help counterbalance relatively low economic growth and fiscal pressures".
Moody’s, on the other hand, sounds as if it is itching to pull the trigger for another downgrade, warning that its negative outlook reflects downside risks to both growth and fiscal consolidation, including that interest rates could climb or that weak state-owned enterprises (SOEs) could make further financial demands on the government. (The latter concern was echoed by finance minister Tito Mboweni in parliament last week.)
"If these risks were to materialise, the rise in the government debt burden would become increasingly difficult to slow down, let alone reverse," says Moody’s.
There are three main reasons why it expects SA government debt to keep climbing — and it’s hard to argue against them.
First, interest payments are taking up an increasingly large part of the budget. Second, medium-term growth will likely continue to remain below the expected interest rate on debt. And, finally, fiscal pressures (especially arising from SOEs and the wage bill) will continue to cause SA to run primary deficits.
The National Treasury responded to the ratings reviews by saying its fiscal consolidation strategy remains on track "to achieve a sufficiently large primary surplus to stabilise debt". Over time, the plan is that "debt stabilisation will reduce borrowing costs and the cost of capital, attracting investment that can support the economy".
Only, none of the agencies believes that the government will achieve the cornerstone of its consolidation plan: freezing the public sector wage bill for the next three years.
And even if the government were to pull off this extraordinary feat, S&P warns that it won’t be enough to offset the rise in interest payments that are coming down the track. So there will be little progress with narrowing SA’s large deficits or the debt ratio, even if the government cuts spending to the extent it has promised.
There are two main routes by which SA could escape a looming debt trap and further ratings downgrades: a structural raising of the growth rate and a significant lowering of the cost of borrowing. Unfortunately, neither holds much promise on current trends.
All three agencies expect structural impediments — particularly Eskom’s unreliability, SA’s weak levels of investment and its inflexible labour market — to continue to weigh on the country’s growth rate. All conclude that the pace of economic reform remains too slow.
"We are not factoring in a large impact from the government’s reforms, which seem limited in scale and slow in implementation," says Fitch. The agency expects medium-term growth to remain below 2%, which it cites as "a key rating constraint complicating fiscal consolidation".
Much depends on the government’s ability to secure a stringent pay deal with public sector workers, craft liability solutions for troubled stateowned companies and accelerate reforms
— Peter Worthington
Moody’s is even more bearish, forecasting that after rebounding to 4% this year, growth will drop back to just 1.2% in 2022 and remain slightly above 1% over the medium term.
The chief reason, it says, is because structural issues, including labour market rigidities, remain largely unaddressed and will continue to weigh on the economy’s growth potential.
While Moody’s acknowledges that there has been some progress, "we do not believe these reforms will be sufficient to lift long-term growth substantially in the coming years", it concludes.
S&P makes much the same finding, stating that "structural constraints, a weak pace of economic reforms and low vaccination rates will continue to constrain medium-term economic growth and limit the government’s ability to contain the debt-to-GDP ratio".
A key question is what is going to happen to interest rates, given that there has been a clear deterioration in SA’s debt affordability in line with the rise in fiscal risk. SA’s marginal cost of debt, that is the year-to-date cost of borrowing, has been 9.5%.
Nazmeera Moola, co-head of fixed investment at asset manager Ninety One, believes SA’s risk premium is "overdone" as it suggests that a debt default is being considered within a five-year time horizon. However, she doesn’t expect much to improve until SA demonstrates progress on structural growth.
"I had thought that control on expenditure from the Treasury would be enough to see some solid progress," she said on a recent Moody’s webinar. "It has helped. But I think we need to see growth move higher for that differential to close materially."
Though Moody’s expects the average cost of SA’s debt to remain about 7% (similar to India’s, but above Brazil’s), S&P has run a series of stress tests to estimate how badly countries’ public finances could be affected if rates shoot up.
While S&P’s view is that global inflation fears are overblown, it is mindful that global yields have started to climb on concerns that central banks may be falling behind the curve in their mission to contain inflation. The risk is that by the end of this year or early in the next they will need to hike rates more than they would have had they started to tighten earlier.
S&P’s survey finds that nearly all developed countries and emerging markets (EMs) should be able to digest the first-round effects of even a 300 basis point (BPS) rise in refinancing rates.
Among the outliers, only four of the 20 EMs surveyed would experience a rise in their debt servicing costs of as much as one percentage point of GDP by 2023 if rates were to rise by 300 BPS, it says. However, for the three worst-placed countries — SA, Egypt and Ghana — interest costs would rise by double that (see graph).
Part of the problem is that SA is already spending a huge 5% of GDP on interest payments and is refinancing at rates above its average cost of debt. Its rollover ratio is also extremely high, at 20.6% of GDP. (The rollover ratio is the total debt a government is due to refinance in a year, plus the portion of medium-and long-term debt that is maturing in that year, divided by GDP.) Only Egypt’s rollover ratio at 38% and Kenya’s at 26.3% are higher among the 20 EMs surveyed.
But what ultimately matters for countries and their credit ratings is why rates rise in the first place.
"If [the increases reflect] recovering growth and normalising monetary policy amid accelerating productivity, they will represent little threat to public finances," says S&P’s sovereign credit analyst Frank Gill.
This is because the higher cost of debt servicing will likely be offset by improving state revenue, allowing faster fiscal consolidation.
On the other hand, if rate hikes are aimed at choking off runaway inflation but productivity is stagnating, the fiscal and ratings fallout could be even worse than the stress tests suggest.
"Against a backdrop of weaker GDP performance, pulled lower by stagnating productivity, consolidating very large government deficits would be extremely challenging for sovereigns," says Gill.
The bottom line for SA is that if growth doesn’t recover more convincingly and government doesn’t get the debt ratio to stabilise inside of 100% of GDP as it said it would, the country will likely be downgraded again.
The next scheduled ratings reviews are in November. SA is now on the cusp of falling into the "highly speculative" category of single "B" countries, which includes Bosnia, Iran and Ecuador.
"This is not company SA would like to keep, but it is exactly where it is headed — unless there are some game-changing reforms from the government.
"We remain of the view that further credit rating downgrades are more likely than not, though the risk of an early downward move has abated somewhat thanks to the recent better-than-expected tax collections and the surprisingly strong pick-up in economic activity," says Absa economist Peter Worthington.
"Much depends on the government’s ability to secure a stringent pay deal with public sector workers, craft liability solutions for troubled state-owned companies and accelerate reforms."
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