I recently subscribed to the ZAR podcast on itunes. I am enjoying it thoroughly, and highly recommend a listen if you’re here in South Africa and/or interested in the South African economy.
One of the big areas of concern in the current conversation on SA is the looming likelihood of more credit rating downgrades. And, I guess, there is more specific concern around Fitch’s recent decision to discontinue its credit rating licence with the Financial Services Board and depart South Africa’s shores.
From what I can tell, “credit rating downgrades” is one of those topics that seems far too abstract. If anything, it’ll just be a cause for further braai-side declamation against the ANC. But there are some real world consequences to a rating downgrade – and in particular the next one.
First, Some Background
To start, the ratings agencies:
Then, the table of ratings that they can dish out:
And because I’m about to mention it – note that while you’re casting your eyes down the rating grades, there is a second (larger) differential – the drop down from Investment Grade to Speculative Grade.
Finally, to illustrate what can happen when there is a typical ratings downgrade:
So even though it didn’t really happen to the US when its credit rating was downgraded, here is a summary of the general consequences of a ratings downgrade on a government/sovereign:
- The rate of interest that government needs to pay on new debt goes up.
- There is a general sell-off across all domestic markets (stocks, corporate bonds, etc) – in anticipation of the negative impact from a higher government borrowing rates on the economy*.
*Basically, government is a massive economic agent – for example, the SA government spends 20% of the total GDP each year. So every extra Rand that gets spent on interest is a Rand that doesn’t get spent on whatever else the government would like to do with their money.
- Almost as a rule, sovereign credit rating downgrades pull down the credit ratings of all the banks and corporates in that country.
- The increase in interest rates at a government-debt level puts pressure on all interest rates to rise, which comes with its own set of implications for household spending.
Then, there is also this potential problem:
- If the government is downgraded because it’s struggling financially;
- Then the cost of its financing goes up;
- Which means that it will struggle even more financially;
- Which is likely to lead to a further ratings downgrade;
- And so on until:
All of which are bad things.
When your credit rating downgrade also takes you from being “investment grade” to being “speculative grade” – then that has some very awkward implications.
Have a glance at this chart from the 2013/2014 Debt Management Report from the National Treasury:
37.2% of our bonds are held by non-residents. And then everyone else.
But consider how these bonds are held by “non-residents”:
- Some are held by institutions and hedge funds who are mandated to invest in emerging market sovereign bonds;
- Some are held by mutual funds who are investing in SA bonds based on SA’s weighting in the Emerging Market bond index.
Shall we take bets on how many of those investment mandates specifically state that all bonds must be “investment grade”?
Or how many of the indices being tracked require that the underlying securities are “investment grade”, or else they’re dropped from the index?
The slip from investment grade down to speculative grade may force a sell-off in SA government debt simply by virtue of the mandate that non-resident fund managers are bound by.
So: government debt sell-off, Rand sell-off as the 37% of the debt burden exits the building, more Rand sell-off as the rest of the corporates also get sold off, interest rates skyrocketing… I mean, it’s like a ready-mix recipe for recession.
The general theory out there is that Fitch withdrew its licence as a kind of compromise. It told government that it would be downgrading South Africa’s government debt down to speculative grade come next ratings review – and instead of doing that and forcing a minor calamity, they decided to close up shop.
I mean – it’s unlikely to be as bad as it sounds, if only because these things always seem worse as a prospect than they are as reality. But still – it’ll be more destabilising than any previous downgrades.