South African Rand: Sell ahead of Wednesday's Budget Announcement say RBC Capital Markets

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- Sell the Rand ahead of Wednesday budget says RBC Capital Markets.

- Moody's downgrade is unlikely but market will still be left disappointed.

- Recession, budget constraints, election challenge Ramaphosa's resolve.

The Rand is likely to suffer over the coming week once the South African government's latest budget plans become know, according to analysts at RBC Capital Markets, who are advocating that clients of the bank sell the currency and buy the beleaguered Turkish Lira instead. 

Newly-minted finance minister Tito Mboweni will announce the government's latest budget plan on Wednesday 24, October in an address to parliament that will be watched closely by financial markets and credit rating agencies alike. 

Credible plans that stem and eventually reduce a still-rising budget deficit are key to whether South Africa will retain the investment grade credit rating Moody's has assigned to its local currency debts. 

A loss of investment grade status would be destructive for the Rand as well as the economy because it would force many institutional investors, particularly those whose portfolios track the Citi World Government Bond index, to jettison South Africa's government bonds.

Foreigners were known by authorities to have held around 40% of South African government bonds back in August so any downgrade would be sure to prompt a significant pickup in capital flight from the country.

"It is well-known that growth disappointed in Q1 and Q2 and the three year public wage deal resulted in unbudgeted costs. But it is not yet known how the government plans to make up for the revenue shortfall. Ramaphosa and his administration are in a difficult spot as they are juggling a challenging fiscal outlook and general elections, potentially before May 2019," says Daria Parkhomenko, an analyst at RBC Capital Markets. 

Former finance minister Malusi Gigaba said in February South Africa would raise an estimated ZAR 36 billion in the current year by adding 1% to the VAT tax rate offering only below-inflation adjustments to payroll tax brackets for workers.

However, since then negotiations between unions representing public sector workers and state owned companies (SOEs) have resulted in a three-year wage agreement that provides for above-inflation increases in pay.

"We think the risk is tilted to the MTBPS disappointing on the fiscal front as the government looks to appease voters ahead of [2019] elections," says Parkhomenko.

South Africa slipped into recession during the second quarter of the year, with the economy contracting -0.7% after posting a -2.6% fall in GDP growth at the start of the year.

President Cyril Ramaphosa has since responded with a stimulus programme that is the probably the best that South Africa's public finances can manage without encouraging a downgrade to the nation's credit rating.

The plan appears light on new funding but it does redirect through "re-prioritisation" around ZAR 50 billion (£2.7 billion) of existing money that will now go toward programmes Ramaphosa says are more likely to boost the economy. Wednesday's budget statement statement will reveal whether it really is neutral for the deficit. 

"Although we do not expect Moody’s to downgrade SA after the MTBPS, the perceived risk of a downgrade will rise if the government does not signal fiscal discipline," Parkhomenko notes. 

The combination of measures announced by Gigaba in February were expected to see South Africa's deficit falls from an estimated 4.3% of GDP in the 2017/18 year, to 3.5% of GDP in the 2020/21 year. This should have stabilised the nation's debt pile stabilize at a level equivalent to 56.2% of GDP by the end of the 2022 year.

That was enough for Moody's to spare South Africa a downgrade to "junk" status in March. However, the public sector wage settlement and 2018 recession mean tax revenues will now be lower than previously thought, while the close proximity of elections due to be held in the first half of 2019 has left Mboweni with little room to manoeuvre.

"With consensus skewed towards a market friendly MTBPS, we like long TRY/ZAR as a tactical trade that is risk-neutral and avoids USD-directionality. For now, the easing in US-TU tensions has diverted the market’s attention away from Turkey’s economic problems. As a result, the market expectations for a rate hike in the next 3 months have fallen and this lowers the hurdle for the CBRT to meet expectations and possibly even over-deliver, benefiting a long TRY/ZAR position," Parkhomenko writes, in a note to clients Friday. 

The TRY/ZAR rate was quoted at 2.5476 just after the London close Friday. The USD/ZAR rate was quoted 0.05% higher at 14.4440 while the Pound-to-Rand rate was 0.24% higher at 18.82.

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