While there is some disagreement around when South Africa’s sovereign debt rating will be cut below investment grade, the market consensus is that it won’t be avoided. In either June or December Standard & Poor’s is likely to be the first agency to announce a downgrade.
Minister Pravin Gordhan and the team around him will continue to work valiantly to avoid this, and they may well succeed in at least improving sentiment. However the honest assessment is that it is probably already too late, and they don’t have the tools on their own to do everything that is necessary to prevent the move.
South Africans should therefore prepare themselves for what happens next.
Many pundits have suggested that the immediate impact of a credit downgrade would be a flight of capital, a spike in bond yields, rapid currency depreciation and a fall in equity markets. However, the head of fixed income at Prudential, David Knee, says that an historical analysis of other emerging markets that have suffered a downgrade from investment to sub-investment grade actually reflects something different.
“Markets are very good at anticipating what’s going to happen, and they price that in,” Knee explains. “They tend to perform poorly in the run up to a downgrade, but actually in the 12 months after that these assets generally perform better.”
He studied a group of emerging markets that had all been downgraded from investment to sub-investment grade, and looked at how their bond yields, currencies and equity markets performed in the 12 months before and after the move. These countries included South Korea, Brazil, Russia, Greece and Uruguay.
The table below shows the changes to ten year bond yields in these countries immediately before and after they were downgraded. The chart is indexed to the downgrade point.
The general trend is clearly that yields expand leading up to a downgrade, but generally recover afterwards.
“In Russia, for example, ten year bond yields were 6% lower a year before the downgrade, and subsequently in the 12 months afterwards they rallied 4%,” Knee points out.
He noted that the exceptions are Greece, where yields continued to rise, and Uruguay, where yields spiked so high that they wouldn’t have fit onto this chart. These were however countries that suffered a series of downgrades over a short period of time.
“In a world where you get even a half-baked policy response, asset prices improve,” Knee says. “And we would say that there is a reasonably good chance that South African assets post the downgrade will perform okay.”
The chart below showing the real effective exchange rates of the currencies of these countries tells a similar story.
“There have been some examples where currencies have done poorly, but overall the average currency on a real effective exchange rate basis has increased relative to where it was at the time of the downgrade,” Knee says. “South Korea’s currency actually went up by 40%.”
South Korea set the standard for how to deal with a downgrade, having managed to regain investment grade status in one year.
“That shows that if you can get your policy response right, things can move very well for you,” says Knee. “But even some of those countries where the policy response hasn’t been fabulous, like Brazil, their currency has actually rallied in real terms.”
Given that the rand has already depreciated by 50% since 2011, Knee believes that there is already a lot of bad news priced into it.
The effect of a downgrade on equity markets in these countries has been more mixed, but as the chart below shows, big losses are rare.
“If you look at the average, equity markets approaching the move to sub-investment grade tend to have modest bear markets and then track sideways for the 12 months afterwards,” Knee says. “There certainly isn’t a catastrophic decline.”
This suggests that a downgrade will probably not be profoundly negative for financial markets in the short term. What will really matter is the longer term policy response and how South Africa goes about getting back to investment grade status.
“There are significant concerns that are very valid about being downgraded, particularly because if you want to get yourself back on track it takes a long period of time and its incredibly painful from a macroeconomic perspective,” Knee says. “But in terms of the financial markets, the interest rate markets have done a lot of the heavy lifting already and the currency too.
“With equities I think it depends an enormous amount on what happens to the US dollar and commodity prices,” he adds. “The South African market in our view does look slightly expensive on a real yield view so the market is vulnerable to bit of a re-pricing to get it back to fair value, but it is certainly not a train smash.”
Almost without exception, countries that are downgraded to sub-investment grade go into recession. It also takes them many years to earn back their credit rating. This is the real challenge that South Africa faces, the policy response will be critical.
“There is a very tough road to tread and none of the policy decisions are going to come easily,” says Knee. “National Treasury and the Reserve Bank are world class institutions, but they’re not really in a position to lift potential growth for South Africa, which is what needs to happen. That needs to come from other government departments and other initiatives.”