South African Rand to "Trade Rather Nervously" into Feb. 26 Budget: JP Morgan

- Markets remain nervous of ratings downgrade
- Lacklustre growth of 0.7% forecast for SA in 2020
- But ZAR weakness unlikely to persist say JP Morgan
- Coronavirus provides unsupportive global backdrop

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The South African Rand is likely to remain soft heading into the key February 26 budget, as the Government's tax and spend plans for 2020-2021 could well determine how ratings agencies adjust their guidance on the country.

The world's largest full-service investment bank, J.P. Morgan, expects the Rand to exhibit nerves ahead of February 26, at which point it should become clearer how ratings agencies will react.

"In the near term, ZAR is likely to be vulnerable to a disappointing budget. We have previously found that a reaction to a downgrade decision is more pronounced if it comes at a time when the exchange rate is not pricing the risk particularly well, trading fair or overvalued heading into such an outcome," says Anezka Christovova, an analyst at JP Morgan in London.

The only ratings agency to rate South Africa's sovereign debt at ratings grade level is Moody's, who are due to give their next verdict on March 27, therefore the Rand could even find itself under pressure into this date.

However, further subsequent downgrades from the other ratings agencies could also trigger downside pressures.

The South African Rand is a notable laggard on global foreign exchange markets this week, with the currency being weighed down by global risks in the form of the Coronavirus outbreak in China and rising anxieties ahead of the critical Moody's ratings decision.

"While global market players have shown some risk aversion on worries about the spread of the coronavirus, SA’s increasing risk of a Moody’s downgrade is proving a dead weight for the domestic currency," says Annabel Bishop, an economist at Investec in Johannesburg.

The Pound-to-Rand exchange rate has this week jumped back above the 1.19 level; the exchange rate had been as low as 18.75 on Friday before the latest bout of ZAR selling.

The Dollar-Rand exchange rate continues to trend higher and is currently at 14.63, having been as low as 14.27 last week, meanwhile the Euro-Rand exchange rate is at 16.11 with the exchange have been as low as 15.80 last week.

The South African economy barely grew in 2019, and this is expected to place immense pressure on the country's budget. Economies that aren't growing tend to find their revenue base stalls, which is something a country with unemployment levels such as South Africa can ill afford.

The risk is the government maintains its spending commitments as income declines, meaning its ability to pay back borrowed money is questioned by international investors which in turn creates downside pressure on the Rand.

It is up to ratings agencies, such as Moody's, to signal to the investor community just how safe lending money to South Africa really is. A downgrade to junk status would mean institutions would have to liquidate exposure to South Africa bonds if the rules governing their portfolio allocations do not allow for holding junk-status assets.

JP Morgan economists now project a technical recession with a 0.3% quarter-on-quarter GDP decline in the fourth quarter of 2019, resulting in full-year growth of 0.3% for the year.

Energy supply constraints make 2020 projections hard, but the base case at the investment bank is for only 0.7% growth.

Poor growth performance will result in slippage in the already dismal MTBPS fiscal projections, JP Morgan says the 2019/2020 deficit is likely to end up at 6.2% GDP (vs. 5.9% GDP projected).

For 2020/2021, JP Morgan says the budget deficit would end up at 7.1% GDP (vs. 6.5% GDP projected) if the Treasury does not introduce mitigating measures.

"The extent and credibility of mitigating measures appears to us crucial for the risk of an immediate downgrade," says Christovova. "In the near term, ZAR is likely to be vulnerable to a disappointing budget."

While the Rand could fall on a disappointing budget, and subsequent ratings downgrade, the currency cannot be considered to be down-and-out.

Indeed, the declines could make it attractive from a valuation perspective.

"Overall, we would expect the market to trade rather nervously heading into the key budget event on February 26. While our bias would be negative for the budget/downgrade risk itself, we would not extrapolate the immediate reaction into subsequent months. A downgrade often marks a peak of the sell-off, followed by some opportunities to buy from better levels," says Christovova.

Coronavirus to Weigh

While domestic issues remain a constraint on the Rand, the global picture also remains unsupportive for Emerging Market currencies.

"The ZAR is under pressure amidst emerging market volatility and broader risk-off sentiment," says Bianca Botes, Treasury Partner at Peregrine Treasury Solutions.

The National Health and Health Commission in China has reported they have received 4515 reports of cumulative confirmed cases of Neo Coronavirus in 30 provinces (autonomous regions and municipalities), 976 cases of severe cases, 106 cases of cumulative deaths, and 60 cases of cumulative cured discharge. There are 6,973 suspected cases.

The economic impact of the virus will initially be felt in travel-related and retail industries in China, which should weigh on economic growth.

The Chinese government has already banned all group tours from travelling outside the country, beginning Monday. Tens of millions of Chinese travel abroad during the lunar new year holiday, which began this weekend, and bans such as this will likely knock economic activity.

China is a key destination for South African exports, and therefore any expectation for an economic slowdown in China will ultimately impact South Africa's foreign currency earning power, and by extension the Rand.

"The speed at which the virus is spreading is a likely catalyst for volatility this week, manifesting in equities losses and commodities price swings," says Nema Ramkhelawan-Bhana, analyst at RMB Global Markets.

Under current conditions we would expect the Rand to suffer; however we are also acutely aware that such public health scares are ultimately short-lived and therefore there is scope for markets to recovery rapidly as soon as China can indicate in a convincing manner that it has gained the upper hand on Coronavirus.