. . . economy reels from political risk, low growth
JOHANNESBURG — Although SA avoided a downgrade to non-investment grade, or junk status, in 2016, the country is not yet out of the woods and may be downgraded this year. The reasons for this are ongoing political risk as factional battles in the ANC intensify, policy inconsistencies and low economic growth.
The effects of a sovereign credit rating downgrade would be significant for all South Africans. It would drive up borrowing costs, which in turn would have a negative effect on the government’s finances. It could also lead to foreigners leaving SA’s capital markets, as well as making the rand weaker — and it would, in turn, push interest rates up, which would hurt everyone.
There are, however, some steps the country can still take to avert a downgrade. These include underscoring that Finance Minister Pravin Gordhan is secure in his job, and cutting wasteful expenditure.
Impact on the markets
SA’s public debt stands at 50.1% of the country’s GDP, nearly double what it was in 2006. If the government’s borrowing position is not controlled it runs the risk of running up debts it can not service. An over-borrowed government is also perceived to be risky, which increases the cost of additional borrowing because lenders demand a premium. On top of this, the country’s fiscus is under pressure from low revenue collection as a result of the slowing economy.
A downgrade to junk status is also likely to trigger significant capital flight. This is because sovereign downgrades typically have a direct effect on bonds and other fixed income securities making them less attractive to foreign bond investors. The likely outcome is that they will take their money to markets that offer better returns. This would be bad news for the country as foreign investors hold about R62bn ($4.5bn) in government securities.
A downgrade may not affect equity holders to the same extent as bondholders. Of the 472 companies listed on the JSE, 39 are dual listed. These have primary or secondary listings in SA, London and New York. Companies listed abroad will be less vulnerable because most of their earnings are from abroad and in foreign currencies. But companies listed solely in SA would be affected by the country’s poor economic performance and a weaker currency. This is likely to drive them to internationalise, which would mean a loss to SA. In addition, their valuations would be negatively affected by the higher cost of capital.
As the bond market reacts to the sovereign downgrade, the ripple effect would extend to the rand, causing it to weaken against major currencies. The rand averaged R14/$ at the end of 2016, but a downgrade this year would be likely to push it beyond its low point of about R16.80/$ — and possibly beyond the R20/$ level in the medium term. It plunged to this level in December 2015 after President Jacob Zuma announced he was removing then finance minister Nhlanhla Nene.
According to the World Bank, South Africans are the biggest borrowers in the world. Statistics from the National Credit Regulator indicate that approximately 20% of consumers are three months in arrears.
A downgrade would drive up debt servicing costs. In addition, the fiscus would be under pressure due to higher interest costs on debt repayments coupled with lower economic growth. The government’s response would then be to raise taxes. The choices would be between the politically unpalatable option of raising the VAT rate, which would hit the rural poor and the lower-middle class urban consumers, or increasing personal taxes on the already over-taxed working middle class. As the recent local government elections have shown, this could also have political ramifications for the governing party.
With budget deficits for the past 20 years averaging 3.24%, a rating downgrade would force the government to either embark on injecting new money into the economy or borrowing more. Injecting new money into the economy would fuel inflation and exert pressure on the exchange rate; the central bank would then have to respond by raising interest rates, again hitting consumers.
Further borrowing is also risky as it could lead to a possible debt trap where the government is no longer able to service its debts.
This is a momentous year for the country with the factional battles and ANC contestation gathering momentum, and for the world with the inauguration of president-elect Donald Trump, as well as uncertainties around post-Brexit trade policies. In such an uncertain environment, SA must rectify the four mistakes that have led it to drift to the point of a downgrade.
First, government policy needs to be clear, consistent and growth-oriented. Second, rather than considering further borrowing or increasing taxes, the government must cut nonproductive spending and restructure the nonviable state-owned entities (especially those that rely on bailouts or have become too large to manage). Third, the authorities need to ensure that business confidence doesn’t deteriorate further. It can do this by not issuing conflicting political statements that cause investors to panic. And last, the presidency must quell the uncertainty around the finance minister’s position.
If SA continues to get these wrong, it’s likely that it will be downgraded this year. Since it takes an average of seven years for a country to regain its investment grade, SA would be stuck in a middle-income trap until at least 2024. Under this scenario it would be unable to move out of low-level manufacturing, unemployment levels would remain high and the economy would remain stagnant. — BDLive