South Africa is ‘junk’ – here’s what that means to you
- Moody's stripped South Africa of its investment grade rating on Friday.
- This means investors across the world will be forced to sell billions of rands of South African government bonds.
- South Africa losing its investment grade is not the end of the world – other countries, like Brazil, have been junk for years.
- But it may push up the cost of government debt, which will be a very bad thing.
- For more stories go to www.BusinessInsider.co.za.
The ratings agency Moody’s has just stripped South Africa of its investment grade rating, downgrading government bonds to “junk”.
A “junk” rating means there's a bigger chance that the government won’t be able to pay back its debts.
Moody’s is worried about South Africa’s ballooning government debt, and its inability to curb its spending (especially on civil servant wages). This will worsen amid the coronavirus crisis. South Africa will lose billions in tax income during the lockdown, and has to pump more money – which it doesn’t have – into a recessionary economy. Moody’s now expects that SA's debt burden will reach 91% of GDP by 2023.
Because SA government bonds were rated investment grade, they were included in the most important group of government bonds, FTSE World Government Bond Index (WGBI). Now they will be kicked out of that index, which doesn’t allow bonds that are junk.
All the many overseas investment funds that track that index and are only allowed to invest in investment grade bonds will be forced to sell their South African government bonds. Some estimates reckon R200 billion in bonds could be sold.
In normal times, this is how a junk rating would impact you
Scaled-down government services and higher taxes
Theoretically, foreigners would now demand a higher interest rate when they lend money to a “junk” South African government. Government would have to pay more in interest, which means less money for services (healthcare, education etc) and investments in infrastructure.
And as government has to pay more in interest on its debt, it would need more money to cover its basic expenses. This can only mean one thing: higher taxes.
A weaker rand – higher petrol, bread and prices (potentially)
Most of the bonds foreigners will be forced to sell are held in rands, which means when they get rid of these rand-based assets, they will sell their rands to take their proceeds out of the country. This should put pressure on the rand.
A weak rand affects everything, starting with fuel prices. Oil is South Africa’s biggest import. If the rand weakens, oil (which is priced in dollars) becomes immediately more expensive. Luckily, the oil price crashed this month, and petrol prices will in April see its biggest decrease in history. So, for now, it shouldn’t have that much of an effect.
But imported electronics and machinery will get pricier if the rand is weak. And South Africa’s maize and wheat prices are also linked to the global dollar prices.
On Sunday night, the rand weakened to a new record low of almost R18.07/$ in reaction to the Moody's announcement and a stronger dollar. By Monday morning, it was at R17.93 - from R17.67 before the downgrade.
Bad news for the banks and their customers (eventually)
The credit ratings of Standard Bank, Absa, Nedbank and FirstRand are all tied up to the rating of South Africa, where they make most of their profit. S&P downgraded seven local banks directly after it cut South Africa to junk. This means that banks have to offer higher interest rates when they borrow money. This could put more pressure on them to get more money from clients, through higher fees and interest rates.
By law, banks are also forced to hold government bonds, which would hurt them in case of a bond sell-off.
But these are not normal times
The impact of the coronavirus crisis will probably completely overshadow the Moody’s downgrade.
Across the world, rich countries have added massively to their own government debt as they announce measures to protect their economies during the crisis. This means that South Africa’s own financial position may not look as bad by comparison. Already, on Saturday, the UK was hit by a downgrade itself (but it remains investment grade).
The rich countries have also cut their interest rates, often to close to 0%. And many government bonds – including the US – now offer negative yields. This means that investors are paying these countries for the privilege of lending them money.
This is great news for South African bonds, which are still offering a fat interest rate, currently above 10%. Once the dust settles after the coronavirus crisis, these bonds could look very attractive to international investors who are desperately looking for yield. This could help soften the Moody’s blow.
In fact, the expected Moody’s downgrade may even work in South Africa’s favour, says Schalk Louw, a portfolio manager at PSG Wealth. While South Africa is now the most risky government bond in the investment grade club, it will be among the most exemplary in the junk category. When international investors start looking for yield again, they will start in the junk group, which offers the best interest rates. And in this group, South Africa is among the safest options.
This is because the majority of South Africa’s government bond debt is in rand – not dollar. So even given the rand’s recent slump, this won’t threaten its ability to settle its debt. Many other emerging markets are not in the same position.
Also, other major economies, like Brazil, have been junk for years.
Many analysts believe that the South African bonds and the rand have been trading at “junk” levels for many months. They reckon that the fall-out won’t be that bad.
Still, Treasury remains concerned.
"Non-residents currently hold approximately 37% (R800 billion) of the total domestic government bonds and the number is expected to substantially decline with the combined impact of Covid-19 and the downgrade. The interest rate for government, households and the broader economy is also expected to increase as a result," Finance Minister Tito Mboweni in a statement on Friday evening.
"Therefore, to say we are not concerned and trembling in our boots about what might be in the coming weeks and months is an understatement."
A bond is basically an IOU, with the borrower agreeing to repay an amount plus interest. If a bond issuer is seen as riskier, investors will demand higher interest rates.
If South African bonds were rated as junk, government would have to pay higher interest rates. This means the state would have to pay billions more in interest, at the cost of investments in local roads, hospitals and services
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