The downgrade by Moody’s Investors Service has struck a further blow to the punch-drunk SA economy, which was already reeling from the apocalyptic impact of the coronavirus pandemic. Not since 1994 have SA’s local currency ratings been this low. All the progress achieved over the past 25 years — during which SA’s ratings peaked in 2006 at A+ with S&P Global Ratings — has now been wiped out.
This is reflected in the rand, which traded at its weakest level yet against the dollar, at R18.05/$ early on Monday morning, before pulling back slightly. In January it was trading at R14/$ before the pandemic caused a seismic retraction in global risk appetite.
Given the scale of the Covid-19 outbreak, some have dismissed the Moody’s downgrade as a mere sideshow. But it would be a mistake for SA to ignore the two big messages implicit in Moody’s ratings action.
First, all three of the major ratings agencies now think SA has lost the battle — that the government is unlikely to be able to implement meaningful economic and fiscal reforms to halt its downward slide.
Second, the steep deterioration in SA’s economic and fiscal strength is not the result of external shocks, such as the coronavirus pandemic, but the government’s continued failure to change its approach to managing the economy.
"SA now finds itself in the dangerous situation where the threat of a doom loop [a negative downward spiral] lurks large," says Rand Merchant Bank (RMB) chief economist Ettienne le Roux.
"Made worse by the Covid-19 disaster, a period of deep recession and fast-deteriorating fiscal ratios could easily feed into further credit-rating downgrades, even sharper increases in debt servicing costs and so on," he says. "In such a scenario, the government would find it increasingly difficult to fund a gaping budget deficit through traditional channels."
The next big hurdle from a ratings perspective will be S&P’s review on May 29, with Fitch Ratings expected to move around the same time. Both agencies junked SA’s ratings in 2017 in response to former president Jacob Zuma’s axing of his finance minister, Pravin Gordhan.
S&P currently rates SA’s foreign currency debt two notches deep into junk territory on "BB", but Fitch has it only one notch down, on "BB+".
Both agencies placed SA’s ratings on a "negative" outlook last year in response to its failure to respond convincingly to its deteriorating growth and fiscal prospects. With Moody’s having retained SA’s "negative" outlook, in addition to its one-notch downgrade, SA is now rated junk with negative outlooks across all three agencies.
"This is risky territory," says Citibank economist Gina Schoeman. She has been more concerned about downgrades deeper into junk from S&P and Fitch than the "inevitability" that Moody’s would finally catch up to their position.
The problem is that investors distinguish between countries on the top rung of the subinvestment grade (junk) ladder and those deeper within it.
"A country firmly established at the top on a stable outlook across all agencies can become an investment opportunity should it adhere to reforms and fiscal discipline," Schoeman explains. "But a country two or three notches in requires a significant amount of often-unpopular measures to get back to investment grade."
Peter Attard Montalto, who heads capital markets research at Intellidex, thinks South Africans underestimate what comes next.
SA is not now "magically free of its shackles", he says, regardless of the "don’t-care attitude" of some politicians towards the downgrade. On the contrary, he says, Moody’s action will reduce the long-term growth potential of the SA economy through higher funding costs, higher volatility and less-liquid markets.
The immediate impact is expected to be capital outflows of between $2bn and $6bn, as the downgrade will cause SA’s automatic ejection from the FTSE Russell world government bond index. This will force passive index-tracking fund managers to exit the SA bond market from the end of April.
However, given the significant market sell-off over the past month, combined with the fact that the Moody’s downgrade has been long anticipated, the actual outflow could be smaller.
The initial market reaction seems to confirm the view that the downgrade had already been priced in. Though the yield on the R186 spiked by about 80 basis points to 11.28% initially, it has since fallen back to pre-downgrade levels.
Even so, the decision by Moody’s "could not have come at a worse time," says finance minister Tito Mboweni. "The sovereign downgrade will further add to the prevailing financial market stress.
"These two events [the downgrade and the coronavirus] will truly test SA financial markets … Therefore, to say we are not concerned and trembling in our boots about what might be in the coming weeks and months is an understatement."
Moody’s loses faith
Moody’s key reason for downgrading SA is the continuing deterioration in the country’s fiscal position, combined with structurally very weak growth. But, more than that, it is because Moody’s "does not expect current policy settings to address [these issues] effectively".
Put simply, the ratings agency no longer believes enough structural and budget reform will occur to raise SA’s growth rate and stabilise its galloping debt trajectory. In short, having given President Cyril Ramaphosa’s government two years to effect policy reforms, Moody’s has finally lost faith in its ability to turn things around.
This rationale unites all three ratings agencies. SA’s short-term fiscal performance has never been the main issue. Rather, their concern has been about its longer-term fiscal and debt sustainability, given the inability of the economy to grow at the levels required to create meaningful employment.
Essentially, the ratings agencies and SA’s citizens have all been asking for the same thing: evidence that SA is putting in place the building blocks for a sustainable recovery in growth and a return to fiscal sustainability.
Crucially, SA has not been downgraded because of the anticipated impact of the coronavirus. That gets scant mention in Moody’s statement. Quite simply, it is because of the government’s failure to make meaningful progress in lifting the binding constraints to growth and reining in debt.
S&P was the first to realise that the SA government lacked the wherewithal to implement the structural reforms and business-friendly policies needed to revive confidence and fixed investment. Over the past decade, it has led the other agencies in downgrading SA. Its bearishness has been vindicated by subsequent events.
Now, three years after S&P junked SA’s ratings, Moody’s has finally been forced to acknowledge that SA has made "very limited" progress with structural reform. It concedes that labour-market rigidities and uncertainty over property rights, generated by the ANC’s land-reform proposals, remain unaddressed.
Eskom’s inability to stabilise electricity production earns SA another black mark. Moody’s assumes that while SA’s power supply will slowly become more reliable, the restoration of full capacity will take years to complete. So even after the coronavirus pandemic subsides, SA’s growth will remain very low.
Moody’s has downgraded its 2020 real GDP forecast for SA to -2.5% (from 1% previously). This puts it at the conservative end of forecasts, as many local economists are expecting growth to shrink by 3% or more.
In the absence of growth, SA’s fiscal picture looks dire.
Moody’s estimates that SA’s debt burden will reach 91% of GDP by fiscal 2023, inclusive of the guarantees to state-owned enterprises (SOEs). That would be up from 69% at the end of fiscal 2019.
The estimate is based on its assumption that Mboweni’s plans to restrain wage growth will not be fully implemented.
The actual outcome could be worse — hence Moody’s decision to retain SA’s ratings on a "negative" outlook. But it’s not just the potential for the coronavirus pandemic to worsen SA’s economic and fiscal challenges that has Moody’s worried.
It raises the longer-term possibility that "negative economic sentiment becomes further entrenched as policymakers and stakeholders continue to struggle to reach consensus on the structural reforms that would sustainably stimulate growth and employment".
Given these downside risks, Moody’s fears that government debt could stabilise even later and at a higher level than it currently expects. It warns that a steeper increase in debt would weaken debt affordability, potentially challenging the government’s currently strong access to funding at manageable costs.
If this happens, Moody’s says it would probably downgrade SA again. The "negative" outlook suggests this could be within the next 18 months.
Dodging the ‘doom loop’
How can SA avoid a "doom loop" and get off the path to further downgrades?
Moody’s says it will depend on the government’s ability to contain the impact of the coming virus-related global recession on the SA economy; implement structural reforms to strengthen the economy, including by instituting a framework for reliable electricity supply; and undertake fiscal reforms to contain expenditure and enhance revenues.
If the real risk of getting caught in a doom loop doesn’t motivate the government once and for all to go all out in implementing pro-growth policies ... nothing will
— Ettienne le Roux
Attard Montalto expects the government to fail to overcome all these challenges, given its track record in each area. Consequently, he expects Moody’s to downgrade SA again in the coming year. He thinks S&P and Fitch are also likely to downgrade SA in the coming months on the coronavirus impact.
"We see virtually zero probability that SA will regain investment grade status in the three-year forecast horizon," he adds.
Absa economist Peter Worthington believes another downgrade from Moody’s is "not inevitable, but on balance probable", especially since the coronavirus could deliver a sharper-than-expected blow to the economy than is factored into Moody’s credit-scoring model.
He also thinks S&P and Fitch are "more likely than not" to downgrade SA at their upcoming reviews, given the country’s weak growth, ballooning fiscal deficits, slow structural reform, and now Covid-19.
S&P has already downgraded five emerging markets this year. This week it cut SA’s 2020 real GDP growth rate to -2.7%, while warning that the risks remain sharply to the downside across all emerging markets.
According to S&P’s "heat map", which provides a comparative risk profile of 16 emerging markets, only Argentina is currently flashing more red lights than SA.
On a scale of one to six, where one is the strongest score and six the weakest, SA scores two sixes for its fiscal deficit and debt trajectory and a dismal five for its economic profile. Only Argentina and India’s fiscal profiles score as poorly as SA’s, though when it comes to assessing the economy, Russia, Brazil, Mexico and Argentina also score fives.
Turning the ship
Ramaphosa, in a last-minute throw of the dice, has given Mboweni permission to move more boldly with structural reforms. To this end Mboweni will be establishing a special unit in the finance ministry to drive structural reforms throughout the government to address weak economic growth, the constrained fiscus and ailing SOEs.
It’s possible that by threatening SA’s very economic survival, the shock of Covid-19, combined with the Moody’s downgrade, will break the ideological logjam that frustrates policy reform.
All three major ratings agencies think the government is unlikely to implement the economic and fiscal reforms needed to halt SA’s downward slide
— What it means:
But it is also possible that it will ignite a battle royal over economic policy between the National Treasury and the rest of the government, the ANC and its left-leaning allies.
The Left is already demanding, regardless of SA’s acute fiscal and funding constraints, that the government hugely scale up its fiscal response to the coronavirus (including, says Cosatu, by implementing the original inflation-plus 2020 wage agreement) in line with the stimulus being unleashed by well-funded developed countries.
Yet many on the Left will probably resist Mboweni’s plan to approach the International Monetary Fund (IMF) or World Bank about accessing special funding to support the health sector in the fight against the virus.
A wider IMF bailout is not on the cards. Even so, Mboweni clearly expects pushback, as he has stressed that he takes "no ideological position in approaching the IMF and World Bank" — it’s simply a matter of taking advantage of facilities that another 80 countries are grabbing to relieve pressure on their public finances.
"Something fundamentally has to break first for the politics to shift to reform," concludes Attard Montalto. "Maybe the deep scars left by coronavirus on the economy and a permanent step-up in unemployment … will be it; maybe failed [government bond] auctions or going to the IMF will be it."
Whatever it is that tips the balance, SA has finally come to its moment of truth.
As RMB’s Le Roux sees it: "If the real risk of getting caught in a doom loop doesn’t motivate the government once and for all to go all-out in implementing pro-growth policies … nothing will."
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