close menu

South Africa’s sovereign debt downgrade – the effect on the private sector, public sector and ultimately South African citizens

by Mike Abbott | Apr 13, 2017
  • South Africa finds itself in the grip of a full-blown political crisis. In times like this, cool heads prevail and well-considered plan Bs are put into action.
    light-house-stormy-weather-ocean-night

    In South Africa’s case, the downgrade of its sovereign credit rating by ratings agencies Fitch and S&P is not a downgrade like the UK suffered after Brexit. Instead, it’s a downgrade from investment grade to sub-investment grade (i.e. junk status). We cannot understate the significance of this event on the business climate, South African corporates and the treasury.

    Bond fund managers and pension funds around the world have investment mandates that prohibit them from investing in sub-investment grade debt. Therefore, such a downgrade triggers the forced selling of large volumes of South African government debt. Forced selling in turn lowers the price of current bonds in issue and raises the interest rate that must be offered by the South African Government and South African corporates on any future debt that it needs to raise.

    Essentially, a downgrade makes it significantly more expensive for the government to borrow and for businesses to finance their operations and expansions.

    This is particularly unfortunate when you consider that international investors often prefer to use debt as the investment mechanism in high-risk/high-return regions, like Africa, for the simple reason that debt is secured on assets whereas equity is not.  

    In 2014, authors Almeida, Cunha, Ferreira and Restrop published a paper entitled The Real Effect of Sovereign Debt Downgrades. The paper helps us understand the interconnected and mutually re-enforcing effects of a sovereign debt downgrade on a country and its business environment. The paper sets out the causal links and key effects of such a downgrade.

    Firstly, it raises the cost of new debt issues by the treasury. Fitch was the first ratings agency to include both Rand denominated and external foreign currency denominated debt in the downgrade. These events are usually accompanied by a devaluation in the currency, which in turn raises the cost of servicing the existing debt that is denominated in foreign currencies. All emerging markets are forced to some extent to raise debt in foreign currencies.  South Africa’s Gross External Debt as at 30 December 2016 is USD 142 billion.

    Secondly, due to an effect known as “the sovereign ceiling”, corporates’ credit ratings cannot exceed the sovereign rating of their domicile country. Hence, we see corporate debt downgrades that then affect the financing costs of these corporates, which then has a flow-through effect on their liquidity and their investment levels. It’s difficult for business to expand or grow under these conditions.

    Thirdly, long term supply and financial contracts are normally backed by guarantees which in turn are affected by credit ratings. A sovereign downgrade causes corporate downgrades, which in turn affects these contracts. Mergers and acquisitions are often conditional on these guarantees, which are backed by corporate credit ratings.

    Finally, as mentioned above, a downgrade of this nature creates a series of mutually reinforcing trigger events. The downgrade caused South African debt to fall out of the Citibank World Government Bond index. In 2007, the flows of funds into passive index ETFs and mutual funds was around USD 100 billion per annum. At the end of 2016, that number was around USD 1.4 trillion.

    Being removed from the index is going to mean a considerable volume of South African debt is sold as passive investors re-align portfolios with the index. JP Morgan estimates sales of South African bonds will amount to USD 2.4 billion in the months following the downgrade. Furthermore, demand will be weak for the approximately USD 2 billion of debt South Africa typically issues each year. The effects of these events on the Rand and the treasury will become clear in time.

    While none of the above is good news, it does offer a lesson for investors. Countries like South Africa are high-risk emerging markets. Investment holdings in these markets should be balanced within a global portfolio so that the above effects don’t damage the overall portfolio performance. A globally diversified portfolio will likely pick up the windfall available to investors in the country set to be included in the World Bond index as South African loses this coveted place.


    Mike Abbott Sable International’s the Director of Wealth. Find out more about our wealth team by visiting this page. You can also email our wealth team if you have any queries related to the issues in this article.

    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.

    • Home Model
      4 things first-time homebuyers should do
      Aug 20, 2019  |  by Neil Ambrose
    • Property with price tage
      It’s a great time to buy your first UK property – here’s why
      Jun 03, 2019  |  by Marlon Borez
    • Handing over house keys
      Contractor mortgages: What you need to know for a successful application
      May 31, 2019  |  by Ian Henning
    • House rent protection
      Rental guarantees: What lenders think about rent protection schemes
      Apr 24, 2019  |  by Bill Monty
    • blended-families
      How “yours, mine and ours” complicates the estate planning process: Advice for blended families
      Apr 17, 2019  |  by Sherron Alexander-Bedingfield
    • Mortgage Concept
      The perfect time to secure a better interest rate on your remortgage
      Apr 03, 2019  |  by Ian Henning
    • growing tree
      The boom behind ESG investing – what’s actually driving the demand
      Mar 26, 2019  |  by Mike Abbott
    • Lightbulb working
      South Africa’s Retail Distribution Review – slow but important changes for investors and advisors
      Mar 05, 2019  |  by Mike Abbott
    • English-house
      Common mistakes that first-time homebuyers make
      Dec 06, 2018  |  by Ian Henning
    • Man-on-a-rocket
      Are you a UK contractor? Maximise tax-efficiency by using your pension
      Sep 25, 2018  |  by Bill Monty
     
     

    South Africa

    Cape Town

    Regent Square
    Doncaster Road
    Kenilworth 7708 +27 (0) 21 657 2120

    Durban

    25 Richefond Circle
    Ridgeside
    Umhlanga 4320 +27 (0) 31 536 8843

    United Kingdom

    Croydon

    One Croydon
    12-16 Addiscombe Road
    Croydon CR0 0XT +44 (0) 20 7759 7514

    Australia

    Melbourne

    9 Yarra Street
    South Yarra
    VIC 3141 +613 (0) 8651 4500

    Sable International is a trading name of 1st Contact Money Limited (company number 07070528), registered in England and Wales. We are authorised and regulated by the Financial Conduct Authority in the UK (FCA no. 517570), the Financial Services Conduct Authority in South Africa (1st Contact Money [PTY] Ltd - FSP no. 41900) and hold an Australian Financial Services Licence issued by ASIC to deal in foreign exchange (1st Contact Group - AFS Licence number 335 126).

    We use cookies to provide the best website experience for you. Using this website means that you agree to this. How we use cookies.