The South African Rand Weakens after Budget Disappointment Sees Threat of a Ratings Downgrade Return

Image © Government of South Africa

- ZAR turns lower after budget shows deficit targets to be missed.

- Deficit projections mean risk of a Moody's downgrade has risen.

- ZAR inflation pressures mount, SARB to hike rates says Investec.

The Rand weakened on Wednesday after the South African government's latest budget revealed it will miss deficit targets that are intended to preserve its last remaining investment-grade credit rating.

South Africa's government projects that it will see a R27.2bn (£1.4 billion) tax revenue shortfall in 2018 and a R24.7 billion black hole in 2019 that rises to R33 billion the following year. 

This is estimated to put the budget deficit at 4% in 2018 and 4.2% in 2019, before the mismatch between government income and spending stabilises at 4% in subsequent years. 

That is a significant deterioration from the projections reported back in February when the government said its budget deficit would fall from a 4.3% in 2017, to 3.6% in 2018 and that it would stabilisie at 3.5% in 2020. 

A backlog of VAT refunds and an earlier underestimation of refunds due to be paid was responsible for much of the deterioration, although slower economic growth and higher-than-expected public sector wage settlements have also left government revenue lower and costs higher than previously envisaged. 

"We are at a crossroads. This Policy Statement highlights the difficult economic and fiscal choices confronting us over the medium term. We must choose a path that takes us to faster and more inclusive economic growth and strengthens private and public sector investment. We must choose a path that stabilises and reduces the national debt. We cannot continue to borrow at this rate," says Tito Mboweni, South Africa's Finance Minister, in an address to parliament. 

Then-finance minister Malusi Gigaba said in February the government would stabilise its deficit at 3.5% in 2020 through an increased VAT tax rate and below-inflation adjustments to public sector wages.

That plan persuaded Moody's to leave South Africa's last remaining local-currency credit rating unchanged at the investment grade level in March.

However, the budget situation has deteriorated quite apparently since then, aided in part by South Africa's slide into recession during the second quarter. Moody's is expected to update its assesment of the rating this week.

"While the political environment has improved from last year, the fiscal arithmetic remains concerning, with Treasury’s figures again showing a marked deterioration in the country’s finances," says Dennis Dykes, chief economist at Nedbank. "The fiscal trajectory is considerably worse than they have been anticipating and there is therefore a greater risk of a downgrade or a change to a negative outlook in the short term. The hope is that they wait for the main budget next February as well as the elections expected in May."

A loss of investment grade status would be destructive for the Rand and the economy because it would force institutional investors whose portfolios track the Citi World Government Bond index to jettison South Africa's 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 and fresh pain for the Rand.

The USD/ZAR rate was quoted 1.27% higher at 14.40 following the statement, denoting a stronger Dollar and weaker Rand, while the Pound-to-Rand rate was 0.80% higher at 18.61.

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Mboweni takes Aim at State-owned Companies

South Africa's state-owned companies have long been a burden on the public purse because poor governance and insufficient cash flows mean private lenders have been reluctant to finance them without the government guaranteeing their debts. 

As a result the government is on the hook for R1.6 trillion of borrowings taken out by the double-digit assortment of companies that are owned by the South African taxpayer. Some R350 billion of that liability is the result of guarantees issued on behalf of just one company, the troubled power utility Eskom. 

"Madam Speaker, our state-owned companies can spend our money better. Many of these state-owned companies need to be reconfigured," Mboweni told parliament. "There should be no holy cows!"

Mboweni appeared to hint at the possibility that some of these companies, or parts of them, could be sold over coming years in order to lessen the burden on the public finances.

This is something that would be sure to improve the country's chances of retaining an investment grade credit rating because Moody's has cited debt guarantees and poor government at state-owned companies as a key concern on multiple occasions. 

"Reconfiguring our state-owned companies requires us to take a hard look at how they operate. Our current challenges with state-owned companies present an opportunity to demolish the walls that exist between the private and public sectors," Mboweni says. 

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Inflation Pressures set to Mount; SARB in Focus

South African inflation rose at an annualised pace of 4.9% during September, which was unchanged from August but ahead of the consensus for a modest decline to 4.8%. 

Core inflation, which is seen as more representative of domestically generated price pressures because it excludes energy and food items from the goods basket, also held steady at 4.2%.

"Following the respite in August and September from the transport component, we see inflationary pressures building from October into 2019," says Lara Hodes, an economist at Investec Bank. "We are of the view that the SARB will implement a 25bp hike at their November MPC meeting, given the upward trajectory in US interest rates and the eroding differential with SA interest rates, which has contributed to rand weakness." 

Markets care about inflation because it has direct implications for interest rates, which are themselves the predominant driver of exchange rates. 

Changes in interest rates are only made in response to movements in inflation but impact currencies because of the push and pull influence they have on international capital flows and their allure for short-term speculators.

"Rising US interest rates, a stronger dollar and concerns over mounting US-China trade tensions have increased market volatility and reduced appetite for investment in developing economies," Mboweni says. 

South Africa's central bank held its interest rate steady at 6.5% in September, citing a deteriorating inflation outlook that is not yet sufficiently severe in order to justify an interest rate rise.

Governor Lesetja Kganyago said risks to the inflation outlook are on upside but at the same time, risks to the economic growth outlook are to the downside given the nation's slide into recession. 

A double-digit increase in the price of oil this year, as well as a similarly sized decline in the Rand, have had many economists fearing a sudden increase in inflation that forces the South African central bank into action.

With the economy still weak, another rate hike could merely add to South Africa's woes. But Investec's Hodes says that one is most likely on the way in November. 

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