Rand: Debt Markets Give South Africa the Green Light Ahead of Crunch Rating Decision

The auction comes a week out from a November 24 review, which could see S&P and/or Moody’s cut South Africa’s local-currency rating beneath investment grade.

South Africa received a greenlight from the international debt market this week after Treasury saw strong demand for its bonds at an auction Tuesday, even as financial markets wait with baited breath to hear if the country will lose its local-currency investment-grade credit rating.

Treasury sold ZAR 3.4 billion of bonds Tuesday, with maturities ranging between 2031 and 2044, which hit the market with clearing yields of up to 10.4%.

The auction comes just more than a week out from a November 24 credit rating review, which many say is likely to see S&P and/or Moody’s cut South Africa’s local currency rating beneath the investment grade level - something likely to have profound consequences for the Rand.

“The Treasury tested the market carefully in advance, launching a ZAR bond auction totalling ZAR3.3bn yesterday,” Elisabeth Andreae, an analyst at Commerzbank. “Thanks to the relatively high coupon and weaker rand, it was received well.”

Treasury saw as many as 4.01 bids for every one that it accepted during the auction. It announced another similar sized auction for Wednesday.

“Whether the risk premiums will be worthwhile for investors remains to be seen,” Andreae adds.

Despite the auction success, the Rand saw mixed trading during the Wednesday session, rising against commodity currencies like the Australian and Canadian Dollars while falling to majors like the Swiss Franc, Euro, Japanese Yen, US Dollar and Pound Sterling.

Above: Pound-to-Rand rate shown at hourly intervals.

“The rand is likely to remain volatile and under pressure in coming weeks, not only as a result of the forthcoming rating reviews and imminent party convention in December,” Andreae wrote in a note Wednesday.

Falling tax receipts and elevated government spending had already driven a larger than expected deterioration in the South African budget deficit for 2017.

This led strategists to predict the country will lose its last remaining investment grade rating (local currency debt) in November. Both fiscal and ratings risks to the Rand were aggravated earlier this week when the government released a long-awaited report into the feasibility of providing free higher education.

The report stopped short of recommending an abolition of tuition fees but did advocate a number of measures that could still add heavily to the deficit.

“We continue to believe sovereign rating downgrades are an imminent risk to ZAR and expect further hedging demand and outflows in preparation for the event,” says Paul Meggyesi, head of global FX strategy at JPMorgan.

South Africa’s budget deficit had been expected to top out just beneath the 4% of GDP level in the current year, before falling steadily after, but October’s medium term budget policy statement changed all of this.

Treasury now expects the deficit to go as high as 4.3% of GDP in the current year and is unlikely to come back beneath the 4% threshold until the 2019/20 year.

Above: USD/ZAR rate shown at hourly intervals.

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

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.

“We also continue to believe a market unfriendly outcome is more likely out of the December ANC elective conference,” says JPMorgan’s Meggyesi.

Another factor weighing on the Rand, and looming large ahead of international investors, is the ruling ANC party’s December conference that will see delegates elect a new party leader.

“Expectations are that the leadership in Mpumalanga, a province historically aligned with the traditionalist camp, will meet this weekend, which should shed light on evolving support for key contenders,” says Meggyesi. “

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).

“To date, broadly two-third of branches that have indicated a position reportedly favor Ramaphosa, though results have largely come from urban areas and provinces more closely affiliated with his support base and thus may not reflect the likely December outcome,” Meggyesi adds.

The chosen leader will replace incumbent president Jacob Zuma at the head of the party and fight the 2019 general election on behalf of the ANC, as Zuma is expected to step down at the end of his term.

“Support from Mpumalanga could indicate whether Ramaphosa potentially has gained traction on a unity slate, although that is not our base case. For now, the political situation remains very fluid in what likely will be a close race,” says Meggyesi.

Many strategists have pondered if the ratings agencies will offer South Africa a stay of execution in November.

Above: EUR/ZAR rate shown at hourly intervals.

Ratings agencies might do this in the hope that December’s conference will yield a 2019 presidential candidate willing to eschew corruption, impose better governance on state owned enterprises and ultimately, drive real reform in South Africa.

But even if they don’t wait until then, December’s conference will be a key input into South Africa’s international appeal going forward and so the outcome could still exert influence over the Rand, even if a downgrade has already happened by that time.

The Pound-to-Rand exchange rate was quoted 0.34% higher at 18.96 during noon trading in London Wednesday. The USD/ZAR rate was 0.19% higher at 14.40 while the EUR/ZAR rate was 0.42% higher at 17.06.

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