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Here’s what will happen if South Africa is downgraded to junk status

by Anton Van Teylingen | Feb 09, 2017
  • South Africa’s sovereign credit rating is on the brink of being downgraded with all three major credit ratings agencies assigning our rating a negative outlook. In these torrid times a question I’m often asked is: What happens if South Africa gets downgraded? What follows below is what the effect of a downgrade would be on South Africa.
    south africa junk status

    In 2016, South Africans far and wide were kept on the edge of their seats by the constant threat of a “looming ratings downgrade”. Thanks to the efforts of Pravin Gordhan and the National Treasury, we escaped the fateful event. However, murmurs of a possible downgrade are starting to surface once again.

    What happens if South Africa gets downgraded to junk?

    The first and most visible reaction will be reflected in currencies and bond yields. Since these are directed by market sentiment in the short term, they are most vulnerable. The Rand will weaken considerably. The extent of the weakness depends largely on whether the chance of a downgrade has been “priced” in to the rate. To determine this, we need to look at whether the Rand is over- or under-valued. Currently, market analysts feel that the Rand is close to being correctly valued after taking economic theory into account.

    How the Rand will behave

    Looking back from 1994 to now, we have used two popular measures to assist us with a forecast. Purchase Power Parity (PPP) and Interest Rate Parity (IRP) are economic models that are often used when looking to determine future currency performance in the medium to long term.

    Although the formulas are fundamentally sound, we know too well that economic theory and real world application are two different things. They seem to provide us with a decent outlook as to where the Rand should be trading, roughly.

    PPP - IRP graph 760

    Red: PPP rate | Yellow: IRP rate | Gray: Actual rate | Green: IRP & PPP combined

    At the time of writing, the Rand was trading at 13.36 to the dollar. According to the above graph this placed the Rand slightly higher than the 12.87 the combined IRP & PPP predicts. This is to say that the Rand is still somewhat undervalued to the USD and there may be some residual “risk premium” priced in. Unfortunately, for emerging markets, this premium is present more often than not, due to the nature of their sovereign, political and economic risks.

    Learning from Brazil’s Real

    From August 2014 until February 2016 Brazil was downgraded three times each by S&P, Moody’s and Fitch. Over the course of that period we saw the Brazilian Real weaken by 76%, from 2.27 to 4 against the USD.

    This effect was largely overstated and I am pleased to report that the BRL has since recovered by 28% from its lowest point. This confirms that in the period leading up to the expected downgrade, markets could overstate the expected effect due to fear of the unknown.

    What happens to South Africa’s government debt?

    In the event of a downgrade currencies often take a hammering, but while this happens bond yields will rise. This may sound like a good thing but it’s not, as yields are inversely correlated to price. Foreign investors will be offloading local bonds partly to avoid any possible risk and to prevent possible exchange rate losses.

    Ultimately this means our government’s debt (bonds) lose their coveted “investment” grade status. Many global bond Indices will remove South African bonds from their tracking. This then prompts global investors, both institutional & individual to sell South African bonds (if they are using Indexes to manage their funds).

    Currently, we are included in the Bloomberg USD Investment Grade Emerging Market Bond Index and the World Government Bond Index. Should both two of the three agencies downgrade South Africa, we could find ourselves falling off these Indexes.

    In addition to this one also has to take into account that many Global pension funds are prohibited from investing in “junk” debt. This will all contribute to a massive flow of money out of the Republic.

    How will the SARB intervene?

    In the days following the downgrade, the market will look to the Reserve Bank for a response. The most expected reaction will be for them to raise interest rates. This should encourage capital inflow that is expected to bring exchange rates back under control.

    Inflation should have a lagged effect. Economic theory suggests inflation should move opposite to interest rates, however looking back, this does not always appear to be the case. Brazil experienced a similar correlation in the months following their downgrade, so in theory we should expect the same.

    inflation v interest rate 760

    Blue: Inflation rate | Red: Interest rate

    What will become of South Africa’s GDP?

    GDP growth will be the next important factor to consider. With lower levels of foreign direct investment, productivity begins to take strain. This in turn hampers GDP growth, which in South Africa, is a cause for concern.

    With GDP growth levels last reported at 0.2%, the effect of a slowdown could ultimately lead South Africa into a recession. This in turn would put strain on the labour market and would likely increase the chances of social and political upheaval.

    Turning this ship around

    Now that we have taken a sobering look at the possible repercussions of a credit downgrade, let’s look at what can be done to turn things around.

    South Korea is a great example for us to use as reference. In December of the 1997 Asian financial Crisis, South Korea had its credit rating slashed to junk by all three ratings agencies. The reaction by government was largely to thank for their quick turnaround.

    They accepted that some conglomerates could go bankrupt and it provided very little help in the way of bailouts. One of the chief proponents to its success was its adjustment to a dynamic and flexible labour market.

    In Feb 1999, just over a year, it once again regained investment grade status.

    That being said, South Africa’s economic and social construct is largely different to South Korea’s. The important point to take away from this is the important role that government plays. On the other side of the spectrum, Romania, for example, took six years to turn itself around from non-investment status.

    Final thoughts

    In closing, the above does not consider all the possible ramifications a downgrade could have, and we haven’t even begun to look at the tax and austerity measures that could come into the equation.

    The important thing to observe, is that when a downgrade is on the cards the reaction leading up to the event is largely overstated - mainly to panic. In the end, many nations have been down this road before and come back stronger. Let’s just hope our resilience is not put to the test anytime soon.

    Anton van Teylingen is the Operations Manager of our forex team in Cape Town.

    We are a professional services company that specialises in cross-border financial and immigration advice and solutions.

    Our teams in the UK, South Africa and Australia can ensure that when you decide to move overseas, invest offshore or expand your business internationally, you’ll do so with the backing of experienced local experts.

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