By Jac Laubscher, 7 July 2014
The foreign currency rating was downgraded to BBB , which is one notch away from the classification of this section of South Africa’s government debt as speculative. Rand-denominated debt received a rating of BBB+, which is two notches higher.
As rand-denominated South African government bonds held by foreigners is approximately four times the amount for foreign currency debt, the BBB+ rating is actually of more importance. The difference between the two ratings also indicates that the risks inherent in South Africa’s international financial position are crucial, in other words the relatively high current account deficit, the poor export performance, the dominant role of portfolio investments in capital inflows, the relatively low level of foreign reserves, and the vulnerability of the rand exchange rate.
If one wants to assess the fairness of South Africa’s credit rating, it is important to remember that credit ratings are relative, in other words South Africa is not rated in isolation but in comparison with its peers.
As the South African government itself attaches much importance to South Africa’s membership of the BRICS group of countries, it is fitting to look at how South Africa compares with the other member countries.
What is striking is that four of the five countries that form part of BRICS have a BBB- rating for foreign currency debt, namely South Africa, Brazil, India and Russia (China is the exception with an AA rating). Of these four, South Africa and Brazil’s rating outlook is stable, whereas that of India and Russia is negative. (Other countries with a BBB- rating are Azerbaijan, Bulgaria, Iceland, Montserrat, Morocco, Romania and Uruguay – a very strange mix of countries indeed!)
If one considers government bonds denominated in the respective countries’ own currencies, the picture is a little different, with South Africa and Brazil enjoying a BBB+ rating, followed by Russia with BBB and India with BBB-.
The starting point in any comparison of the rationale behind the rating of the different countries is the state of their government finances. The most important figures appear in the table below.
The table certainly does not paint a uniform picture, which implies that the rating process is not of a mechanistic nature but depends largely on the judgment of the analysts concerned.
Russia appears to be in a much better position than the other countries. This notwithstanding, S&P’s rating outlook for Russia is negative, in other words the next step will probably be a downgrade to speculative status. The problem is that although Russia’s ability to meet its debt obligations is apparently beyond reproach, it is being questioned owing to the country’s political situation, including the application of international sanctions as a result of its meddling in the Ukraine.
India is the other extreme with the highest budget deficit and total debt just slightly less than that of Brazil. All that counts in its favour is that a very small percentage of its government debt is held by foreigners. India’s ability to reduce its budget deficit, among others by cutting subsidies and introducing a goods and services tax to steady government revenue, is being questioned – hence its negative rating outlook.
This puts South Africa and Brazil at the centre of the group and it is therefore not surprising that they have the same credit rating. However, Brazil’s gross government debt as a percentage of GDP is nearly 50% higher than that of South Africa and owing to the fact that Brazil’s interest rates are much higher that its growth rate, its ability to reduce its debt is not as good.
However, the common factor for all four these countries is the need to accelerate economic growth (see graph below) and S&P’s lack of faith in their ability to do so. The credibility of economic policy, as well as the respective governments’ ability to implement the necessary reforms, is in question.
South Africa and Brazil in particular have much in common: deterioration in fiscal policy, a weakening current account of the balance of payments, low economic growth, mixed policy signals and a lack of credibility. Another commonality is that both the South African and Brazilian governments have expressed their dissatisfaction with S&P’s downgrades and claim that their economies are fundamentally sound.
One could, of course, question S&P’s credit ratings as they are to some extent subjective, as mentioned previously – however, at the end of the day this is the harsh reality confronting investors. The only meaningful response would be to prove S&P wrong and for the performance of the economy to exceed the agency’s expectations.