It’s easy to get caught up in the hysteria of news headlines about South Africa’s credit downgrade. But we should all take a step back and ask what impacts us more directly than junk status, write Ricardo Teixeira and Andries Kotzee.
As the Budget Speech 2020 looms, there will be a lot of emotion around South Africa’s potential credit ratings downgrade from Moody’s. There’ll be headlines warning us about the implications of junk status and why we should be moving our assets and investments offshore. But we must be careful not to over-react. The fact is South Africa is already priced as sub-investment grade (aka “junk”) by Fitch, S&P Global and, most importantly, by the market. The sky hasn’t fallen, investors are still making returns, and despite our weak GDP growth there is no reason to abandon ship. We’re not saying credit ratings don’t matter. They do. But the repo rate is a better indicator of what affects consumers in their everyday spending and savings cycle than our credit rating.
What is a credit rating?
A country’s credit rating assesses government’s ability to repay its debts. Loans to government can come in many forms: foreign aid, global investment funds, even a country’s own citizens. A credit rating agency decides how risky these loans are. Moody’s isn’t being “kinder” to us than Fitch and S&P because they haven’t junked us yet. Each rating agency uses their own criteria.
When credit rating agencies first started, they were just investment research firms who would publish their findings on various bonds in the market and then sell that information to investors and fund managers. The problem was that some research firms started selling high ratings to the highest bidders and awarded lower ratings to those who wouldn’t pay for the privilege. To combat this, the US Securities and Exchange Commission decided to recognise only Fitch, S&P and Moody’s. And because much of the world depends on the US market to raise capital, the opinions of these three agencies eventually become the global yardstick.
Why do credit ratings matter?
Credit ratings are a qualitative assessment of a debtor’s ability to repay its debt. They’re used by institutional investors to make decisions about where to put the money under their custodianship.
Do these ratings matter? Absolutely. Most of the world’s money is managed by funds with built-in restrictions. A large pension fund, for example, can’t just make any investment – they often must put their money in investment-grade securities, not speculative ones (ie: not “junk” ones). Like any investment, you can put some of your portfolio in higher risk baskets. But for long-term performance, you’ll want to put a majority of it low to moderate-risk investments. If South Africa is rated “speculative grade”, we’ll be that higher-risk investment: fine to put a bit of money in, but rarely a principal investment. And when investors do lend to government, they’ll want higher interest rates because of the higher associated risk.
As an aside, one of the main reasons that analysts are so focused on Moody’s next rating is that a downgrade would mean South African bonds are excluded from the FTSE World Government Bond Index. Any funds that passively track this index would have to sell, leading to more capital outflows from the country.
The market has already decided we’re not investment grade. What does that mean for you?
Unlike formal ratings from the big three, market evaluations of sovereign debt occur in real time in the form of trading flows. These are quantitative assessments by the market, and you can see it in the price of South African credit default swaps (CDS).
A CDS is an insurance policy (a protection) taken out by bond owners in case their debtor defaults. They’re all about transferring risk – for a fee. Just like for a monthly fee your insurance company will replace your car if it gets stolen (thus absorbing your risk), a CDS will cover you if your debtor can’t repay their loan. And the riskier it is to lend a country money, the higher the premium on a CDS.
If Moody’s downgrades South Africa, they will simply be aligning their qualitative assessment with the market’s existing quantitative one. South Africa is not investment grade, yet government is still able to raise R4.5 billion of debt each week to fund the fiscus, 40% of which is bought by global investors. That means the risk appetite is still there and bond yields are still attractive.
Again: our credit rating does matter. But do you know what affects consumers more directly? The repo rate, ie the rate at which the SARB lends money to banks. The repo rate directly affects the interest you pay on borrowing money, and the interest you earn on saving money. The SARB will adjust the rate depending on where inflation is going: if they see inflation is rising too quickly, they’ll raise the cost of borrowing money to reduce spending and vice versa. This is far more impactful on one’s personal financial wellbeing than what the country’s credit rating is.
The SARB’s Monetary Policy Committee (MPC) will track things like local GDP growth, local and international inflation rates, business confidence, consumer confidence, and the movement of foreign currency when making a repo rate decision. That’s because they know that market movements are rarely about a single factor. Similarly, a credit ratings downgrade by Moody’s won’t singularly make or break South Africa, so don’t get caught up too much in the headlines. Whatever the Finance Minister says later this month is not going to a national panacea. But it will hopefully be a step in the right direction.
Andries Kotzee is the Chief Investment Officer at Celerity Investments.
Ricardo Teixeira is the Chief Operating Officer at BDO Wealth Advisers.
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