South African Credit Downgrades: Damage Could be Limited from Here

The South African Rand is looking firmer in mid-week trade as bargain-hunters step into foreign exchange markets to pick up a bargain.

It has been a tumultuous period for the currency with an adverse political shake-up in the Government prompting a sharp drop in the value of the currency.

The big driver of the fall was the anticipation that South Africa’s debt would be downgraded. Indeed, S&P made the call to downgrade on Monday, April 5 and the others are likely to follow.

But, the Rand’s current recovery suggests the damage could be relatively limited.

“Although the decision by S&P to downgrade South Africa’s credit rating on Monday saw the country lose its investment-grade status from the agency for the first time since 2000, we think the move makes little difference to the outlook for its dollar bonds,” says Oliver Jones at Capital Economics.

Admittedly, the developments which triggered the downgrade have had an effect.

Once it became clear last week that Finance Minister Pravin Gordhan – seen as a voice of fiscal discipline – would be sacked, the spread of South Africa’s Dollar bonds jumped.

“However, while the spread rose a bit further following S&P’s decision, most of the overall increase appears to have been caused by the political turmoil rather than the downgrade itself,” says Harvey.

What’s more, Harvey notes investors were already factoring in the possibility that South Africa might lose its investment-grade status:

“Even before rumours surfaced that President Zuma would sack Gordhan, the spread of South Africa’s dollar bonds was already higher than that of several emerging market borrowers with speculative-grade credit ratings.”

Capital Economics had previously argued a downgrade always looked likely eventually.

“Accordingly, even if, as seems likely, other agencies also revise down their credit ratings for South Africa, we doubt that this will have any meaningful impact on the country’s spread,” says Harvey.

Brazil’s experience over the past couple of years lends further support to the idea that credit ratings agencies tend to lag rather than lead the markets.

Aside from credit ratings, there are fundamental reasons to think that the spread of South Africa’s dollar bonds won’t rise too much further in the near term.

“The country’s balance sheet problems are actually fairly limited at present (see our forthcoming Africa Economics Update), and we expect the economy to fare better than most are anticipating this year,” says Harvey.

Therefore further damage to the Rand might be limited.

More Damage to the Rand Lies Ahead

Not all share Capital Economics’ view that the worst might now have passed on the ratings front and the Rand could therefore be exposed to further downside.

While the ongoing relief rally will be welcomed we are warned that the declines might not yet be over as the market will now turn its attention to Moody’s rating decision scheduled for this Friday.

Moody’s currently rates South Africa at Baa2 (the lowest investment grade status).

“Thus a one notch downgrade from Moody’s would raise concerns about the eligibility of South African debt in investment grade bond indices,” says Petr Krpata at ING in London.

Foreigners have bought around US$1.2bn worth of South African bonds since the 15 March Fed decision and Krpata says they will now be underwater on both FX and the bond trade.

“The ZAR has one of the highest EM traded volatility prices for good reason. USD/ZAR to 14.00 before Friday,” says Krpata.

Analysts at UniCredit Bank AG agree that 14.00 is achievable near-term.

"We see upside risks to spot and it should trade with an upward bias within a 13.65-14.05 range in the near term," say UniCredit in a note to clients dated April 4.

Moody’s will likely downgrade the sovereign to Baa3 (the lowest IG rating) at their review on Friday, but this will likely have less of an impact than the surprise of the S&P move and the gravity of any potential action at Fitch.

"Instead, a downgrade by Fitch (which has the rating at BBB-) would be significant, as it would see two of the three main agencies with a sub-IG rating on the country, meaning that South Africa would come out of some of the IG bond benchmarks, resulting in selling by passive benchmark investors," say UniCredit.

Analysts at HSBC calculate that if S&P downgrade South Africa's rating it could trigger $9-10bn of outflows from the local bond market as the country would be removed from the widely followed World Government Bond Index.