Why the South African Rand Could Rally Following Budget 2020

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The South African Rand could rally in the wake of the February 26 National Budget say analysts at global investment bank Credit Suisse, who say the market is underpricing the prospect of “supportive news” in the budget.

Sentiment towards the South African Rand remains resolutely negative with markets nervously awaiting the February 26 National Budget announcement for indications as to whether or not the Government has the ability and ambition to put the country's finances back on track. 

The Rand has fallen 5.0% against the U.S. Dollar over the course of the past month, while against the Pound it is 3.2% lower and against the Euro it is now 2.23% lower.

Driving the Rand lower over the course of the past month is a combination of soft sentiment towards emerging market currencies due to concerns of a slowdown in the Chinese economy owing to the coronavirus outbreak, but domestic concerns over a potential credit ratings downgrade to South Africa by Moody's are also weighing.

Moody's is the last major ratings agency to hold South Africa's sovereign debt at investment grade status, but should the National Budget at month-end disappoint then a credit rating downgrade in March could well transpire.

“The budget next week represents two-way risk,” says Shahab Jalinoos, head of FX strategy at Credit Suisse. “Although we acknowledge that the risk of under-delivery is high, we also think that current rand pricing (i.e. around 15.00) somewhat under-prices the probability of a market-friendly outcome.”

Moody’s cut the outlook on the government’s last remaining investment grade credit rating from stable to negative after the horror show that was October’s mid-term update and markets have been increasingly attuned of late to the risk of a downgrade to ‘junk’ coming on March 27.

Indeed, the Rand sold off earlier this week after economists at Moody’s downgraded its South African economic forecasts, leading markets to believe this could pave the way for a downgrade. However, a competent budget presentation by Tito Mboweni could well stave off a ratings downgrade and return some positive sentiment into South African financial assests.

“We see two positive “tail” risks that could lead to a sizable drop in USDZAR from current levels, namely (a) a VAT hike; (b) a funding deal for Eskom which is structured in a way that reduces the future need for government funding for the company. We think that both of these are real possibilities,” Jalinoos says.

Jalinoos and the Credit Suisse team say that if given the choice markets would prefer to see the government announcing increases to the VAT sales tax rate in order to reduce its budget deficit, instead of a funding agreement with social partners that reduces the Eskom burden on the public purse.

Eskom has R450bn of debt guaranteed by the government to which it's repeatedly gone cap in hand for help paying bills, while failures of its under-maintained equipment left South African households and companies in the dark. And the risk of fresh bailouts rose when CEO Andrew de Ruyter said in the ‘state of the system’ update that debt refinancings will increase the existing interest bill, which Eskom already struggles to pay, over the coming years.

No Eskom funding plan would be able to ensure South Africa’s lights remain on and the economy’s wheels moving in the short-term even if it would mean less default risk. Meanwhile, a 1% VAT tax raise accompanied by pledges of lower spending on the public sector wages could be a ratings gamechanger.

Above: USD/ZAR rate shown at daily intervals.

Credit Suisse numbers suggest a VAT hike would eliminate 40% of the anticipated revenue shortfall for the next three years and under that scenario, Moody’s might be less inclined toward a downgrade of the rating.

Losing the rating would force the sale of South African government bonds by fund managers who're limited by mandate to holding only 'investment grade' debt, leading to potentially large outflows from the Rand.

“We would expect USDZAR to fall to the 14.40-14.50 area over a span of a few days in these circumstances as investors reduce their FX hedges. This line of thinking leads us to adopt a sell-on-spike bias for USDZAR,” Jalinoos says.

Jalinoos has told Credit Suisse clients to take advantage of any spikes up to 15.19 ahead of the budget by betting on a subsequent decline back to 14.40.

Such levels might materialise ahead of the budget even without any fresh coronavirus-induced souring of sentiment, simply because the Rand has a tendency to do badly out of annual budget statements.