Rand Hit as Fears Over Government's Free Education Policy Weigh and Capital Outflows Accelerate

The threat to South Africa's credit rating was raised Monday, heaping further pressure onto the Rand, government bonds and pushing GBP/ZAR to new highs.

South Africa’s Rand was pummelled during Monday trading after President Jacob Zumas’ office released a long-awaited report into the feasibility of providing free higher education and said a decision will come after ministers have had chance to digest the recommendations inside.

The Rand has been under pressure in recent weeks as traders increase bearish bets on the currency ahead of key credit-rating decisions by S&P and Moody’s, due on November 24th

Falling tax receipts and elevated government spending have driven a larger than expected deterioration in the budget deficit during the year to date, leading strategists to predict South Africa will lose the investment grade rating currently assigned to its local currency debt as soon as this month.

“The Inter-Ministerial Committee on Higher Education Funding led by the Minister in the Presidency Mr Jeff Radebe, and the Presidential Fiscal Committee whose lead Minister is the Minister of Finance, Mr Malusi Gigaba, are processing the report,” says President Jacob Zuma. “I will make a pronouncement on the Report once the Ministers have concluded their work.

South Africa has already lost the investment grade rating attached to its foreign currency denominated bonds, which account for only a small fraction of its overall debt.

A cut below investment grade (to junk) for local currency (Rand) debt could force an exodus of international investors from the bond market and place severe downward pressure on the Rand.

Above: Pound-to-Rand shown at half-hour intervals. Captures Monday trading session.

“All South African markets are feeling the pressure. The sovereign CDS, in particular, has come under pressure and is now trading at levels that fully price another rating downgrade,” says John Cairns, an analyst at Rand Merchant Bank.

If the country wasn’t already sure to lose the investment grade rating before, any decision to move ahead with the rollout of free higher education would be sure to push the ratings agencies over the edge and into a downgrade.

“If the president does plan to announce free higher education, then it would make sense to do this after the 24 November rating reviews but before the ANC National Conference, implying late November or early December is a major period of risk. Rumours will continue in the interim,” Cairns adds.

Above: USD/ZAR shown at half-hour intervals. Captures Monday trading session.

How long the various South African ministers take to review and digest the report remains to be seen. However, in a tell-tale sign of what may yet be to come, Michaels Sachs, the deputy director general of South Africa’s Treasury, resigned from office Monday morning.

South African media reported earlier in November that President Zuma had planned to announce the the rollout of fee-free education before now but that he had been prevented by the Treasury from committing to the measure, drawing a rebuke from the President’s office on Sunday. 

“The media also continues to repeat the rumours that Deputy President Ramaphosa is set to be fired. We put less faith in these as most political experts think this would be a bad strategic move by the president,” says Cairns.

Recent events, and November’s ratings decision, come at a pivotal time for South Africa. With the political establishment and the president’s office mired in allegations of corruption and economic mismanagement, the ruling ANC party is set to elect a new leader at December’s annual conference.

Delegates at the conference will choose between a new leader who eschews the corruption of the past (Cyril Ramaphosa), a continuation of the status quo (Nkosazana Dlamini-Zuma) or a middle-ground-compromise-candidate (Zweli Mkhize).

“There is still speculation that Deputy President Ramaphosa could be facing the axe, which could upset markets should this rumour turn out to be true,” says the research team at Treasury One, a South African company specialising in cross border payments and FX hedging. “Another spin of this rumour mill is some noise that Gwede Mantashe could also be in the firing line.”

The winner of the December ANC vote will replace President Zuma as party leader and fight the 2019 general election, replacing Zuma in the president’s office if elected. Jacob Zuma is expected to remain president until the next election.

Above: Pound-to-Rand shown at weekly intervals. Captures five-year price trend.

“Given the above, the market is going to struggle to trade in an orderly way as we go into year end. In many ways this is understandable, but still leaves one frustrated at the lack of progress being made to recoup the post MTBPS losses,” says RMB's Cairns.

Panic over the rollout of free higher education comes closely on the heels of the medium term budget policy statement, which saw the Treasury predict South Africa’s budget deficit will reach 4.3% of GDP in the current year.

Markets had been expecting the deficit to top out beneath the 4% threshold in the current year, and the ratings outlook was already negative then.

“The market is too optimistic that downgrades would be postponed and/or on the outcome of the ANC’s December elective conference,” says Anezka Christovova, a foreign exchange strategist at JPMorgan, in an early November note. “We share neither of these hopes.”

Above: USD/ZAR shown at weekly intervals. Captures five-year price trend.

If South Africa loses its local currency investment grade rating then the nation’s bonds will be excluded from the Citi WGBI local-currency bond index. This would see index tracking funds and investment grade credit funds forced to sell off their holdings.

“Foreign ownership of the local bond market is very high at 40% following close to $5bn of inflows this year,” Christovova adds. “We estimate that sovereign rating downgrades by both S&P and Moody’s would trigger about $5bn-$7bn of forced outflows.”

South African government bonds saw steep losses during Monday trading, which pushed the 10-year yield up by 14 basis points to 9.495%, suggesting capital outflows may be accelerating ahead of November's ratings decisions. 

The JPMorgan team have recommended to clients that they sell the Rand short against an equally weighted basket of Euros and US Dollars.

USD/ZAR was quoted 1.12% higher at 14.5185 during noon trading on Monday, after having reached a new one-year high of 14.5732 earlier in the session.

The beleaguered Pound Sterling also eked out a gain over the South African currency, with the Pound-to-Rand rate trading 0.63% higher at 19.0150 a short time ahead of the London close. This pair also set a new one-year high Monday when it was quoted at 19.0780.

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