South African Rand: Moody's Downgrade in the Price

Image © Natanael Ginting, Adobe Stock

The South African Rand could be relatively immune to a downgrade from Moody's later on Friday, as the event has been well signposted to market participants and is therefore likely already absorbed by ZAR valuations.

The South African Rand has suffered alongside other emerging market currencies in 2020 as the global spread of the coronavirus update delivers a severe impact to global trade and investor sentiment. Therefore, it also becomes questionable as to how much a Moody's downgrade actually matters given the scale of the external headwinds facing South Africa's economy and its currency.

"We think the external backdrop is likely to remain the main driver of ZAR in the foreseeable future, overshadowing most domestic events," says Daria Parkhomenko, FX Strategy Associate at RBC Capital Markets.

"If Moody’s gives South Africa a “pass” today, any boost to ZAR is likely to be temporary without a continuation of the recent USD selloff, a sustainable improvement in the risk backdrop, or significant progress in fiscal consolidation that removes the risk of a future downgrade altogether," says Parkhomenko.

Moody's will give its verdict at some point after U.S. markets close for the weekend.

Ahead of the decision, the Pound-to-Rand exchange rate is trading a full percent and a half higher at 21.43, its highest since June 2016. The Dollar-Rand exchange rate is at 17.51 while the Euro-Rand exchange rate is at 19.29.

Parkhomenko says if Moody’s downgrades South Africa, the hurdle for "new" negative news is high given consensus is expecting a downgrade to happen at some point this year. As such, the negative impact of a downgrade could be muted, as we have reflected in an earlier article here.

RBC Capital's research modelling shows the market is already very heavily positioned against the Rand, when this occurs it becomes more difficult for a trade to extend. To put it simply, if the market is betting heavily in one direction it becomes harder to find more and more traders to engage in the bet, hence the pace of the Rand's decline would lessen if the market is already heavily positioned against it.

RBC Capital also say foreigners have been lowering their exposure to South Africa’s local-currency government bonds since March 2018, and it is likely that at least the US-based investors have been hedging their FX exposure, which would limit the negative impact of forced selling of LC government bonds on ZAR due to a downgrade.

Moody's is the last major agency to still have South Africa as an investment grade borrower and crucially, it is one of two that must rate South Africa as such a high quality borrower for the country to remain in the FTSE World Government Bond Index, once known as the Citi World Government Bond Index. And without inclusion in that index international fund managers who benchmark to it would be compelled to sell their South African government bonds, potentially inciting large outflows from the currency.

Foreign holdings of South African government debt were R316bn (£15 bn) in 2019 according to the statistical annexe included by Treasury in the February budget update and it was always thought that a large portion of that debt would end up being sold on the open market following a downgrade. However, foreign outflows from South Africa have picked up sharply in the last month since the budget and so much so the Rand may already have paid part of the price of a Moody's downgrade. Jalinoos says there's been around $4bn (£3.3bn) of outflows since February 20, which is equal to around 20% of foreign holdings.

"Moody’s will publish its rating decision after local markets close on Friday. When Moody’s conducts its coming review, South Africa government’s debt dynamics will look much worse than it did a few weeks ago," says Shahab Jalinoos, head of FX strategy at Credit Suisse. "A downgrade will lead to an initial spike in USDZAR perhaps taking USDZAR 3%-4% higher initially (i.e. above 18.00 from current levels). Low liquidity in Asian trading hours on Monday could exacerbate the initial move."