What does it all mean… junk status? How is the economic fate of our country decided by three rating agencies and whether or not they’ll decide to throw us into the landfill? Is there life after junk status?
Pikitup workers are doing their bit to avoid junk status by embarking on another strike, hoping that if we don’t pick up with rubbish we can negate a downgrade to junk. Unfortunately that won’t work fellas, but we appreciate the efforts.
Moody’s, Standard & Poor’s (S&P) and Fitch are the rating agencies who place a rating on each country’s credit rating. In simple terms, how risky is it to invest in that country? More specifically, it refers to the riskiness around that country’s debt. But why debt in particular, you might ask? Well South Africa is forced to take out debt with the rest of the world to foot our budget deficit – similar to how we would go to the bank to request a loan.
Let’s break down why we have a budget deficit. Every year the Minister of Finance prepares a budget for the country. He or she allocates money to each facet of the country, which requires funding. These include items such as healthcare, infrastructure development, education and so on. The funding for all of this expenditure is supplemented by the money that Sars collects in the form of taxes. Most years, however, the amount collected from Sars is just not enough and so the government needs to go out to the rest of the world to raise more funds. This is a budget deficit.
The South African government raises these additional funds by issuing government bonds. To get people to buy these bonds, we have to pay interest on the bond. That interest is determined by the credit spread in the market, which is where the rating agencies come in. If the rating agencies rate our debt as risky, we would need to pay a lot more interest on that bond to attract investors. The illustration below explains the process in a simplified manner.
So what’s the big deal then? The first problem is that the South African economy is slowing with some expecting it to head towards recession. Current growth forecasts are estimated under 1%. Think of all the lay-offs we’ve had in the mining sector alone. When less income is generated by companies and ordinary South Africans, a smaller amount of tax is collected. A decision has to be made then as to whether we go out to borrow more money to foot the budget deficit or do we cut the budget spending? This time however, with a credit downgrade, we would need to spend more money on just paying interest and less on important items such as healthcare and education. As you can see it is a vicious cycle. The way to avoid this is to cut spending and focus on growing the economy, that way we are less dependent on debt and we are more self-sufficient. Easier said than done. I recently saw articles of Mr Ramaphosa and Mr Gordhan taking domestic flights around the country in economy class. This might be a step in the right direction but far from the type of cost cutting that we need to see from government.
Another important point is that foreign investors have mandates, most of which prohibit the investment in countries with a junk status credit rating. Once that happens you can bet that we’ll have a bit of a run on the stock market and the currency market as people exit with haste.
To give context to this situation, we are currently rated at one level above junk status by Fitch and S&P. Moody’s has us one level above the rating of Fitch and S&P, but not for long. Moody’s announced last week that it would review South Africa for a further downgrade meaning that all rating agencies will rate South Africa one level above junk.
Brazil has been downgraded to junk status recently. I thought it might be worth considering some unwanted similarities we have with Brazil, which has led to its downgrade:
- Brazilian president Dilma Rousseff is currently embroiled in a corruption investigation. Opposition parties and legal teams are seeking her impeachment;
- Inflation has swollen to a range outside the norms, currently at 10%;
- Weak economic growth;
- Unemployment level is at its highest levels in decades;
- State-owned entities, specifically Petrobras (semi-public), are reporting massive losses due to corruption and mismanagement. Dilma Rousseff ran the company for several years during which the corruption took place. Have a look at what Petro SA delivered in their last financial year Petro SA’s massive loss;
- Brazil’s high respected finance minister Joaquim Levy resigns in December 2015. Brazil’s worrying change of finance ministers.
It seems as we are slowly meandering towards junk status. With rising unemployment, slow growth and potentially diminishing tax revenue…it might be time to hedge those ZARs.