File picture: Mike Segar/Reuters File picture: Mike Segar/Reuters
On Friday, Moody’s will release its credit rating review on the South African government. S&P Global Ratings will follow with theirs on December 2 and Fitch is expected to release their review later in December.
But what does it all mean? In the bombardment of news articles, radio conversations and analysis from braais to boardrooms, it is easy to lose track of the basics. This article intends to give context and foundation to the flow of information that will follow in the weeks to come.
Despite the power they yield, ratings agencies are not neutral organisations that conduct objective studies - they are private companies that make a profit by selling a product. The service they provide is to conduct rigorous analysis on behalf of investors - they rate the risk of investment. Their opinions are entirely subjective and investors can choose to believe their outlook or not.
In the case of South Africa’s “sovereign credit rating”, the rating agencies are reviewing how risky it is to invest in the government’s debt - that is, how risky it is to buy government bonds.
Bonds are issued by governments or companies in order to raise funds. They’re essentially IOUs - if you buy a R1 000, 10-year bond at 9 percent, you are lending the government R1 000 for 10 years and will receive 9 percent interest per year until the 10-year period is complete. But in doing so you are taking a risk that after 10 years the government won’t be able to pay you back. This is the risk that ratings agencies review.
While I’ve phrased this in terms of our own personal purchases of bonds, the bond market is dominated by enormous investment conglomerates - pension funds, hedge funds and sovereign wealth funds, for example - who trade billions of rands in bonds. These are the people who get jumpy when a rating is changed.
Each rating agency has its own scale according to which it states the riskiness of an investment, but typically they assign a letter code (A being better than B) and an outlook (positive, stable or negative).
There are many individual notches on the scale, but the most important change is when the rating moves from investment grade to sub-investment grade (otherwise known as “junk”). It’s an arbitrary line in the sand - for Moody’s, it is when the rating passes below Baa3, for S&P and Fitch, it is below BBB-.
But it’s an arbitrary line that has great impact.
More risk
Normally when a government’s debt is downgraded a notch, not a lot happens. A few investors may pull out or the interest rate may go up to encourage investors to put up with a little bit more risk, but it’s a subtle adjustment.
However, when a one-notch downgrade means that the rating dips into the sub-investment range, the outflow of investment is far greater.
Many large investment funds have an inbuilt rule that they are not allowed to invest in sub-investment grade bonds. If their current investments get downgraded below this line, they have to sell them and pull their money out of that investment and the country. This causes a larger than normal outflow of cash, a depreciation of the domestic currency and an increase in interest rates.
The South African government would face even higher costs of borrowing, making their debt even riskier to invest in.
A sovereign credit rating is not a judgment of the health of the country - it is simply a rating of the government’s ability to pay back its debt.
So when we discuss and analyse whether South Africa will be downgraded or not, it’s only useful to consider things that impact the government’s budget balance. We need to focus on the money, not the politics - and only on the politics if it affects the money. This is why scandals around Pravin Gordhan as Minister of Finance create far more impact than scandals around Zuma as president.
The main factors analysed by the rating agencies will be South Africa’s growth prospects (as growth converts to tax revenue for government), fiscal consolidation (reducing spending and increasing revenue) and the stability of fiscal leadership.
* Pierre Heistein is the instructor of UCT’s Applied Economics for Smart Decision Making course. Follow him on Twitter @PierreHeistein.
* The views expressed here do not necessarily reflect those of Independent Media.
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