Globally, there are three main credit rating agencies – Moody’s, Standard & Poor’s, and Fitch. These agencies independently evaluate and publish research on all bonds issued by corporations and governments. These agencies have a long market history. Moody’s Investor Services was established in 1909, Standard & Poor’s in 1860, and Fitch’s in 1914. All three agencies are based in the US.
Note that once these rating agencies downgrades a country to a sub-investment or non-investment status, this is a sign to investors that the risk of that country’s debt has increased. Simply put, it means that the government may not have enough money to pay back what it has borrowed.
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What is a Junk Status
A ‘non-investment grade speculative’ is called ‘junk status’ in investment shorthand. Coupled with their investment grade, a ratings agency can also publish what they think the future looks like for a country’s debt. The outlook can be negative or positive. Essentially, a sovereign credit rating is aimed at providing a relative ranking of a country’s overall credit worthiness.
In 2020, Standard & Poor’s Global Ratings (S&P) lowered South Africa’s sovereign credit rating further into non-investment grade, otherwise known as junk status, stating the effects of COVID-19 on South Africa’s public finances and economic growth as one of the reasons for its ratings action.
The rating agency downgraded South Africa’s long-term foreign currency credit rating from BB to BB-, being three notches below investment-grade and its long-term local currency credit rating from BB+ to BB, being two notches below investment-grade.
S&P in its reports further stated that South Africa’s cost of servicing public debt will climb to about 6.5 percent of GDP by 2023. S&P also expect that South Africa’s GDP will shrink by 4.5 percent this year – better than the South African Reserve Bank’s forecast of 6.1 percent.
Even with S&P’s decision to downgrade the country’s sovereign credit rating during these challenging times, the country’s government welcomes S&P’s revised outlook from “negative” to “stable”, and in the very least considers this as an indication that the rating agency “recognizes some of government’s fiscal and monetary policy measures as strong points”.
Foreign currency denominated debt is characterized as debt that is issued in a currency other than the sovereign’s own currency (i.e. South African issued government bonds in US$, yen or Euros), while local currency debt is debt that is issued in local currency (i.e. ZAR).
In addition, it is important to note that it is South Africa’s foreign currency denominated debt rating that is in the firing line in terms of a possible downgrade to ‘junk status’. The bottom line is that if South Africa were to be downgraded to ‘junk status’ in terms of its foreign currency debt, then it will cost South Africa more to borrow money in global markets.
Presently, South Africa has a budget deficit, implying that the government spends more than it earns, whereby the deficit is funded via loans from large international bodies through issuance of South African government bonds. In addition, South African consumers are highly indebted and continue to finance their lifestyles through debt and the cost of servicing this debt will become more expensive.
Generally, as seen in past sovereign downgrades, the direct impact is usually felt in the bond and fixed income markets through rising interest rates. A secondary shock will more or less be felt in the sovereign’s currency, as it weakens against other major currencies. This could also have a negative impact on the equity market as investors deem the sovereign’s assets to be more risky.
5 Major Impact of Being Downgraded to Junk Status for South Africa
A sovereign credit rating expresses the risk that a country will be unable to meet its financial commitments, in terms of repaying interest payments and the debt principal on a timely basis. Moreover, it is important to note that institutions that offer credit in a specific country cannot have a higher sovereign credit rating than the sovereign itself, and this simply means that banks and corporate will be downgraded along with its respective sovereign.
Below are the key impacts on the economy – and South Africans – if all three ratings agencies downgrade the country to junk status.
Cost of Borrowing Rises
Note that people without a regular income may find that they cannot borrow money from banks. These individuals are forced to borrow from loan companies or loan sharks, who charge much higher interest rates. These loan companies understand that the increased number of default loans they make will be offset by their increased profits from charging high interest rates.
International bankers work on a similar principle. A country that is in junk status is seen as high risk, and added risk comes at an added cost. Over the years, South Africa continually has to borrow money abroad to pay for large infrastructure projects or to service previous debt.
If South Africa’s ability to repay loans is seen as risky, the cost of borrowing will increase, resulting in a greater cost of debt to the Treasury. And every additional rand that the Treasury pays in interest payments is a rand that cannot be used for social services.
Once the Treasury finds itself squeezed, it is forced to implement measures to grow the amount of money available to service its debts. If fewer people are employed, it receives fewer taxes. The Treasury could eventually find itself forced to increase tax rates in order to draw more money into the fiscus.
Note that this once again leaves the consumer poorer, resulting in fewer goods being purchased. Tax increases also lead highly skilled professionals, who typically earn the most and are most affected by these increases, to question whether they would do better financially abroad.
Note that if a significant number of professionals leave the country, this has a further impact on the economy as the loss of skills results in greater inefficiency in industries where less-qualified people take over their jobs, there are lower profit margins, and once again a threat to jobs.
The Rand Weakens and Goods Cost More
Under junk status, the rand comes under additional pressure. A lot of factors start working together to undermine the currency. Businesses, both retailers and manufacturers, find the cost of sourcing goods higher. This forces them to raise prices and potentially cut staffing or limit salary increase in order to pay for the more expensive goods.
Note that all of these measures result in less disposable money being available in society as fewer people are working and those with jobs earn less. The knock-on effect is that people buy less, adding more pressure on businesses and resulting in more companies being forced to close. As the rand suffers so the petrol price increases as it takes more money to purchase a barrel of petrol.
The Treasury is expected to repay its debt. If it defaults on debt, the ability to borrow is totally undermined and the country faces the threat of collapse. If the Treasury is not receiving enough money to service its now much more expensive debt repayments, it may be forced to cut social grants in order to free up money to pay its debts.
Also note that this would have a huge impact on the poorest of the poor and translate into increased poverty and many more people going hungry. Medical and other facilities catering to the poor would also find their budgets cut, and, as always, the poor would be the ones to suffer the greatest hardship.
International Funds Take Money Out of South Africa
So many international bond funds are forced by their own rules of conduct to divest from countries that enter junk status. This is to protect their shareholders from excessive risk. This will also result in a significant amount of capital leaving the country, exacerbating the difficulties it is already facing.
Being a net importer of goods (the country spend more on imports than we receive from goods we export), South Africa needs liquidity in order to be able to finance its purchases. Once this liquidity dries up, it is forced to borrow more money to finance its purchases, once again at a higher cost of borrowing.
South Africa’s downgrade last year has been priced into the market, which means that SA’s dollar-denominated debt still trades relatively well when compared to other emerging countries that have poor investment-grade status. Howbeit, a downgrade to junk status is a serious setback for the country. It may weaken the rand and increase the price of fuel. And once the petrol price increases, so does the cost of living.
Nonetheless, it is difficult to say what impact a knee-jerk reaction by investors will have on the bond and fixed income markets. Lower bond yields internationally imply that South African bonds will still remain attractive for investors on a relative basis.
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