South Africa’s shaky economy – the power of rating agencies demonstrated

Oliver Dyson

South Africa’s economic outlook looks dire for the coming months. On October 25th, Malusi Gigaba -South Africa’s Finance Minister – revised GDP growth estimates down from 1.3% to 0.7% in the Medium-Term Budget Policy Statement (MTBPS), firmly placing the nation as the third worst-growing economy, behind Brazil and Switzerland. This is not a developing market issue; South Africa is not following the current trend rate of growth in emerging markets, currently standing at around 3.4%. Unemployment rates of 28% also pose an issue on how to improve government finances in a situation where next year’s budget deficit is forecast to stand at 4.3% of GDP. More troubling are the recent S&P downgrades of Rand-denominated bonds to ‘junk’ grades which has worsened the options for South Africa going forward.

Slack demand for the country’s exports, along with political turmoil have culminated in an economic recession over the past few quarters, ending in September of this year. Investor confidence has remained low in the nation, spurred by several scandals involving President Jacob Zuma. The first family’s close involvement with the Gupta family, a cohort of rich Delhi-born businessmen, has created anti-corruption outcry with many suggesting that the family has been using their influence to achieve policy changes. Indeed, the anti-corruption minded former Finance minister Pravin Gordhan was one of the largest critics of the family, stating that the Guptas had bee involved in ‘suspicious’ transactions worth some $490m. Several downgrades by rating agencies were unsurprisingly made when pro-reform Gordhan was ousted by the ruling party. Zuma’s African National Congress (ANC) party has been under increasingly close scrutiny going forward; investor trust has suffered as a result.

Zuma’s economic policies going forward are also giving cause for concern in markets. The President told his Presidential Fiscal Committee to reduce spending by 25 billion rand ($1.8 billion) in next year’s budget and to find ways to add 15 billion rand to the nation’s revenue. This is likely to lead to tax increases, which may dampen economic expansion for a country that just exited its second recession in a decade. Ratings agencies have severely downgraded their outlook for the economy as well; S&P stated last week that “South Africa’s economy has stagnated and external competitiveness has eroded”. The institution downgraded Rand-denominated debt to one-level below investment grade at BB-, with Fitch following suit. This move has contributed to the nation’s economic woes by ensuring that SA bonds have been expelled from the Barclays Capital Global Aggregate Bond Index (which only trades S&P investment-grade bonds). With access to $2tn of capital now cut off, the government’s borrowing costs are set to rise, as a rise in issued debt is expected in the near future to plug the deficit gap. As evidence of this issue, yields on 10-year bonds have increased from 8.4% to 9.4% since October, reflecting investors’ waning confidence in the economic performance of the nation. The rand also fell by 2% after the announcement.

However, the rating agency Moody’s has decided to keep local-currency bonds on its rating of Baa3 (the lowest investment-grade rung above ‘junk’) for the next 90-days as it revises its decisions. This decision has enabled SA bonds to remain in the Citi World Government Bond Index (with access to a much larger $8tn of foreign capital), while Citigroup economist Gina Schoeman has estimated outflows of 100 billion rand ($7 billion) from the bonds if they are allowed to fall to ‘junk’ grade. Clearly, the government has been thrown a lifeline from Moody’s decision, which has given it the opportunity to turn the economy around in the next 90 days. Indeed, this took the rand’s year-to-date carry return against the dollar to 5.7 percent (up from a negative rate in early November), meaning more investors performed carry trades (borrowing in rand to buy more dollars) following this announcement. Reinforcing the gravity of this decision, previous Finance Minister Gordhan stated that if Moody’s downgrades the country to sub-investment grade, it could take up to 10 years to recover.

Going forward, both ratings agencies and investors will be looking at the ANC party conference in December, which will pick Zuma’s successor. Many argue that the role is only truly contested between Zuma’s ex-wife Nkosazana Dlamini-Zuma, who argues for a more equitable distribution of wealth in the economy, and Cyril Ramaphosa arguing for reigniting growth and restoring investor confidence. Investors may have several opportunities present with this conference. Firstly, prices of options for dollar-rand volatility remain around the highest in a year for one-month contracts. That suggests that traders are anticipating big market swings when the ANC decides who will replace Zuma as party leader. Moreover, Toronto-based bank Toronto-Dominion says the Rand may rally by almost 10 percent to 12.55 next year if Ramaphosa or another candidate outside Zuma’s faction wins the vote, especially if they push the president to resign from his role of as head of state before the end of his term in 2019. This would be a great improvement for the economic outlook of South Africa, as growth-based policies would be put in place once more. This party conference on 16th -20th December should therefore be watched closely by FOREX traders.

Yet it is hard not to forget about the fundamentals of the economy. The same issues of low growth, large inequalities, high unemployment and low investment still remain and it is unlikely that these will be resolved soon. Low growth and poor credit/bond ratings may be here to stay for Africa’s largest economy, which is why a favourable Moody’s rating on rand-bonds in the next few months is vital to lifting the economy out of a low-confidence malaise.

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