Can South Africa escape a downgrade?

The big three ratings agencies (Standard & Poor’s, Moody’s and Fitch) granted South Africa a reprieve earlier this year as they all chose not to downgrade the country towards or into “junk” status. However, this reprieve may be short-lived as political issues seek to overshadow the recent fiscal and economic progress that the country has made.

The ratings agencies consider a combination of qualitative and quantitative factors when assessing a country. The political environment is of vital importance and the agencies will evaluate the government and how the policy-making environment can assist the economy. The government and its institutions need to be accountable and have a degree of transparency. The economic landscape is also of importance as these factors are often seen as the drivers within an economy. Ratings agencies will look at the sources of growth and income, the level of diversity within the economic environment and whether the economy is stable. They also look at how a country stacks up in a global context in terms of debt levels, transactions and liquidity. The sustainability of a sovereign’s debt burden and deficit is also explored, and the agencies scrutinise monetary and other policy decisions to assess how these may impact the strength of capital markets and the financial system. The rating that a country achieves will closely reflect the status of each of these factors and ratings are frequently considered by investors when evaluating the risks and opportunities of investing within or into a country.

The current political situation within South Africa has placed the country in a difficult position. As the graph below shows, government debt to GDP reached 50.1% in 2015, the highest level ever recorded over the period 2000 – 2015. Despite having relatively peaceful elections in August, the results of which exposed a significant waning of support for the ruling party and healthy opposition party prominence, government debt levels may remain under pressure if the ruling party fails to deliver on its GDP growth and fiscal targets or worse, acts irrationally in an attempt to maintain its position.

Source: Trading Economics

The political landscape has once again been thrown into a state of disarray as a consequence of the public exchange of communication between the finance minister and the South African Police Service’s investigative unit, the Hawks. Added to this are lingering concerns of widespread corruption and allegations of state capture, now the subject of Thuli Madonsela’s final report before she vacates the office of Public Protector. The ratings agencies have warned that continued political squabbles may push the government off the path to fiscal consolidation.

On the economic front and under the reign of the current finance minister, steps have been taken to curb excessive spending. There have also been some positive economic data releases including better-than-expected mining and manufacturing numbers, positive retail sales numbers, higher trade surplus figures and a relatively stronger currency. This has helped lift second quarter GDP levels to 3.3% on a quarter-on-quarter basis, as shown in the graph below. However, political woes may dampen growth prospects for the remainder of 2016. The immediate reaction to the situation regarding the Hawks and the finance minister was a sell-off in South African bonds and equities. During August 2016, South Africa saw net foreign outflows totalling R3.4 billion. If the finance minister is replaced before the end of his term by what is perceived as an inadequate replacement, this could have dire economic consequences for the country.

Source: Statistics South Africa

The issues surrounding the finance minister also appear to have dulled consumer and business sentiment which were already sitting at low levels. The rand was battered towards the end of 2015 and in the early parts of 2016; however, the volatile currency has recovered over the last few months, reaching a high of R13.19 against the US dollar. With the finance minister debacle and the possibility of higher interest rates in the US the rand has softened once again, with many analysts forecasting a further blow-out of the currency if the political squabbling persists.

Whilst South African equity has historically produced significant returns for investors, returns in recent periods have been more range bound. On a global scale, many developed equity markets are considered to be expensive and/or not offering sufficiently compelling opportunity. Within the last few months emerging markets, including South Africa, have looked relatively attractive and benefited from the global search for yield. Hawkish comments from the US Federal Reserve slowed the emerging market rally for a period of time, although markets welcomed the Fed’s news of keeping interest rates unchanged for the time being.

With economic growth stuttering, volatility rearing its ugly head and the political environment potentially seeking to create havoc, the question remains how best to protect and grow your capital? From a South African point of view and given the risks inherent in our market, portfolio diversification across asset classes and global markets remains a key element of downside protection in the face of heightened volatility.

Moody’s analysts recently created a slightly positive recalibration of downgrade expectations as they noted their own expectation of downgrade probability to be about one third, although also cautioning that a rating cut was likely if GDP growth this year falls below their 0.2% estimate. Analysts from Standard & Poor’s on the other hand, have cautioned that political issues “may be detrimental to economic growth and investor confidence.” It is in South Africa’s best interest for politicians to get their house in order, or face a rating downgrade and an uncertain economic future. All eyes will be focussed on the ratings agencies due to review the country’s rating in December.

Nitisha Singh is an Investment Analyst at Maitland. Maitland is a global advisory and fund administration firm.

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