South African Rand Unimpressed by Eskom Support Package as Market Contemplates Moody's Rating

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- ZAR sees receives little support following Eskom support plan.

- Funding injections set to lift budget deficit significantly this year.  

- As weak growth poses risk to Government tax revenue forecasts.

- Commerzbank says ZAR is "vulnerable" as Moody's watches on.

The Rand is vulnerable to a reversal of its recent gains over the coming weeks and months, according to some analysts, because the government's plan to save the ailing power utility Eskom from insolvency is putting South Africa's top credit rating at risk. 

Finance minister Tito Mboweni introduced in parliament on Tuesday a special appropriations bill that seeks approval for an additional R59bn of cash injections for Eskom over the next two years, which comes on top of R23bn approved for each of the 2019/20 and 2020/21 years back in February. 

It's unclear how much funding Eskom needs in order to survive, although the electricity monopoly has long struggled to keep the lights on for all of South Africa's households and businesses due to years of underinvestment in infrastructure. The company provides 95% of all South Africa's electricity, which means it's 'too big to fail'.

Falling electricity production, nonpayment by customers and a bloated cost base have seen the company repeatedly lean on the taxpayer not only for government guarantees of its large debt pile but also more recently for direct cash injections. This is now a strain on an already-stretched public purse.

"With South Africa’s revenue is projected to fall short by R50.3bn and R84.6bn in 2019/20 and 2020/21 due to a weaker growth outlook, adding in Eskom’s financial assistance raises the budget deficits to 5.9% and 6.0% of GDP, higher than the 2019 Budget Review deficit estimates of 4.5% and 4.3%. This will substantially increase the government’s borrowing requirements," says Mpho Tsebe, an economist at Rand Merchant Bank (RMB). 

Above: USD/ZAR, GBP/ZAR (blue line, left axis) rates at hourly intervals. Limited gains for the Rand. 

South Africa's government said in February its budget deficit would likely come in at 4.5% of GDP for the 2019/20 year, up from its November 2018 estimate of 4.3% and an increase upon the 4% seen in 2018/19. However, now, analysts are saying the deficit could top 6% this year and next. 

Moody's, the last major agency to still have South Africa rated as an 'investment grade' credit prospect, said that budget showed a "further erosion in fiscal strength". It later warned in May that South Africa's rating could soon be cut if the government doesn't get its spending, deficit and debt pile under control.

Finance minister Mboweni warned in parliament Wednesday that tax receipts are also likely to underperform against the government's earlier forecasts, which is another reason for markets to be concerned about the outlook for South Africa's credit rating.

Germany's Commerzbank delivered its verdict on the plan Thursday.

"Fiscal budget deficit and public debt threaten to erode further. In our view, the risks of a rating downgrade have thus increased. The news affected the rand only temporarily, as the tailwind for EM currencies from the Fed's and the ECB's expansive monetary policy still seems to be supporting it. Nevertheless, we recommend caution, as the rand remains vulnerable," says Elisabeth Andreae, an analyst at Commerzbank, in a not to clients. 

Above: Pound-to-Rand rate shown at daily intervals.

Losing the Moody's rating would risk driving the Rand into the ground at least temporarily because it would see many international investors, particularly those who benchmark to the Citi World Government Bond index, automatically forced into selling their government bonds. That would force investors to swap Rand denominated capital back into their domestic currencies. 

President Cyril Ramaphosa and the government are working on a plan to save Eskom that could ultimately see it broken up into three separate operating units, with parts of some of them sold to private investors. However, it's not yet clear whether the plan will be implemented in time, much less sufficient, to spare the public purse from further expense in the name of the struggling company. 

"Confirmation of the funding support for Eskom is a good starting point, but we are no closer to establishing a timeline for Eskom’s restructuring. What is of concern is that, according to the minister, “without major changes to Eskom’s business model, the power utility will not be financially sustainable and may not be able to ensure security of electricity supply beyond the medium term, with significant consequences for the economy,” says RMB's Tsebe.  

The South African Rand has advanced against the Dollar, Pound Sterling and many other currencies this year in response to mounting expectations that developed world central banks will soon begin to cut their interest rates.

 Above: USD/ZAR rate shown at daily intervals.

This has boosted the appeal of South Africa's relatively high bond yields for international investors and acted as a sweetener for the troubled domestic economy because lower rates in the developed world offer the South African Reserve Bank (SARB) scope to cut its own rate too.

The SARB already cut its cash rate last week and could cut rates again if the Federal Reserve actually goes ahead and indulges the U.S. bond market by slashing U.S. borrowing costs on July 31.

Lower borrowing costs would aid any economic recovery seen in South Africa later this year and minimise the extent to which the debt-to-GDP ratio rises in response to Wednesday's funding package for Eskom. 

"Weak domestic economic growth alongside higher SA unemployment pose a material risk to the fiscal matrix. Indeed, the risk of ratings downgrades has slightly risen though we don’t yet foresee a downgrade for the next six months. This sustained economic weakness and elevated risk of a ratings downgrade limit both the rand and SA bonds though both could potentially benefit from monetary policy easing in advanced economies," says Peter Worthington, an economist at Standard Bank. "Still, our year-end R13.80/$ forecast stands." 

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