There has been much talk about an imminent ratings downgrade for South Africa. But what does this really mean, and will it impact local investors? Let’s unpack this…
Standard & Poor’s (S&P), Moody’s and Fitch are rating agencies that rate a country’s credit rating.
Essentially, the credit rating given by a ratings agency for a country is no different to the credit rating a bank manager gives to an individual – in that an assessment is made about the ability to repay debt.
When the SA Finance Minister prepares a budget for the country, he allocates money to areas that need funding (e.g. education, health care, infrastructure etc.). The funding for this expenditure is obtained from taxes collected from SARS.
Often, this money is not enough – and the government needs to go to the global markets to raise more funds. The SA government raises these additional funds by issuing government bonds. To encourage people to buy these bonds, the government has to pay interest on these bonds.
If the ratings agencies downgrade SA to junk bond status, then more interest on the bond will be required to attract investors. In other words, where there is some risk of default, the interest rate that lenders will lend money at, rises.
So what’s the issue?
This is a problem for SA as current growth forecasts for 2016 are estimated at 0.9% or lower. This, in turn, means that a smaller amount of tax will be collected.
The effect of speculation about a downgrade has already meant that SA’s cost of borrowing has gone up. A downgrading to junk status would mean spending more money (just paying interest!) and less on items such as healthcare and education. The question is, if SA goes to junk, will the excess return investors want for taking on SA credit risk, rise further?
Investors are already demanding a higher return to take on SA debt so, to some extent, junk status has already been priced into our yields.
Now, all eyes are on government – can it follow through with its public efficiency drive and on South Africa’s economic performance? SA remains in a precarious position. Any more policy blunders or shocks to the fragile economy will relegate SA to junk status.
Source: Prescient Investment Management