Rand Debt Downgrade Brought Forward but Is a Buying Opportunity Says UniCredit

The UniCredit team have cut their year-end and 2018 forecasts for the Rand following Wednesday's budget but they also highlight that, after an initial bout of short term volatility, the Rand should see a steady improvement throughout 2018.

South African Rand volatility may spike in the coming weeks but any “blow-out” weakness should be viewed as a buying opportunity according to strategists at UniCredit Bank.

Expectations of volatility come after Wednesday’s medium term budget plan was seen increasing the odds that South Africa’s local currency credit rating is downgraded sooner rather than later.

Treasury said the South African budget deficit will reach 4.3% of GDP in the 2017/18 year, before falling to 3.9% in the 2019/20 year. Economists had expected it to top out at 3.9% in 2017 before falling steadily till 2020.

“We stress that in the weeks ahead, overshooting and highly volatile price action is possible,” says Kiran Kowshik, a foreign exchange strategist at UniCredit Bank. “However, any blow-out weakness could eventually provide a buying opportunity in the months ahead.”

The Rand has fallen by 4% against the US Dollar during the week to Friday and has dropped 5% against the Pound Sterling, with the bulk of the move coming from Wednesday onward.

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A perceived absence of credible budget measures to address the wider deficit jarred markets and prompted strategists to suggest South Africa could lose its investment grade credit rating as soon as November. Previously, this was seen surviving until the mid-point of 2018.

“Should both Moody’s and S&P downgrade the local currency rating to below investment grade (to BB+), South Africa would be excluded from the Citi WGBI local-currency bond index,” says Kowshik.

A cut below investment grade and subsequent exclusion of South Africa from the Citi bond index would see index-tracking funds forced to sell their South African government bond holdings, resulting in an estimated outflow of between $6 billion and $10 billion

“Our long-held view is that such a downgrade – while having a weakening impact – needs to be considered in the context of the improvement in South Africa’s external balances,” says Kowshik. “In the past, improving external balances have been a stronger driver for the exchange rate, over and above the extent of foreign participation in the bond market.

Kowshik and the UniCredit team have cut their year-end and 2018 forecasts for the Rand but they also highlight that, after an initial bout of short term volatility, the Rand should see a steady improvement throughout 2018.

“We now project USD-ZAR at 14.40, 14.10 and 13.80 for 4Q17, 1Q18 and 2Q18, respectively (compared with 13.20, 13.30, and 13.0 previously). For 4Q18, we would pencil in 13.30 (compared with 12.40 previously),” the strategist adds.

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The new forecasts imply a steady rise in the value of the Rand over the course next year when before, strategists had expected a steady depreciation as the threat of downgrade was expected to hang over the currency during the coming quarters.

South Africa's Rand traded at 14.14 against the Dollar, up nearly 1%, during the noon session in London Friday while the Pound-to-Rand rate slipped 0.75% to 18.54.

“Of the 50 cents rise in USD/ZAR over the past two days, 30 cents can be ascribed to the budget and the other 20 cents to the surging dollar. In aggregate, the move is super aggressive and we should eventually expect some recovery,” says John Cairns, a strategist at Rand Merchant Bank.

But Cairns also notes that both pressures will persist in the short term while, in the medium term, the ball is in the hands of politicians to make the choices necessary for the deficit to be reigned in.

Much of the forecast increase to the deficit is the result of falling tax receipts as opposed to increasing government spending. And with the South African government already having penciled in, earlier in 2017, more than ZAR 25 billion of planned spending cuts there is a question mark over how much more it can cut in the short term.

Strategists at Standard Chartered have suggest tax increases could be the way forward. But much rather than simply increasing taxes on pay packets and the bottom lines of companies, they have advocated increases to the VAT rate.

“A VAT hike remains important. Not only is it a less-distortive tax compared with alternatives, but it is also the one measure that is most likely to raise significant revenue,” says Razia Khan, chief Africa economist at Standard Chartered.

VAT is a tax that is paid at the point of sale and is ultimately borne by the end consumers of products. 

“We estimate that a 1ppt increase in the VAT rate could raise as much as ZAR 22 - 23bn of additional revenue,” Khan says. “A 2-3ppt rise – although only expected to take effect from FY19 at the earliest – might compensate for all of the revenue shortfall South Africa has seen in the current fiscal year.”

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