Fitch decided to downgrade South Africa's credit rating to BBB-, one notch above "junk"

Fitch Ratings decided to downgrade South Africa’s international credit rating from BBB to BBB-, but changed its ratings outlook from negative to stable. This rating is now only one notch above “junk” status and in-line with S&P’s rating, although S&P have a negative outlook on the rating, Fitch have a stable outlook. Fitch last downgraded South Africa’s credit rating in January 2013, but revised the ratings outlook to negative in June 2014. The change in rating by Fitch was in-line with market expectations. According to Fitch, the decision to downgrade South Africa was primarily due to the fact that GDP growth performance have weakened further, while various government policies have weakened business confidence.

In making the latest decision to revise the ratings outlook down, Fitch Ratings highlighted the following key factors:

Growth:

  • GDP growth performance and estimates of growth potential have weakened further
  • There have been additional delays to the availability of new electricity generation capacity, which will likely constrain growth for another two years
  • Various policies have weakened business confidence and South Africa's position in the World Bank's Doing Business rankings has fallen to 73rd from 69th. The NDP has not delivered a rapid or material improvement in the business environment
  • Government policies such as visa restrictions (since abolished), delays to the mineral resource law and prospective plans for land reform and a national minimum wage are not always conducive to economic growth
  • Major industrial action has been avoided so far in 2015, but this has been achieved in part through accommodative wage agreements
  • Fitch's GDP growth forecast for South Africa has been lowered to 1.4% for 2015 (from 2.1% in the previous review in June 2015) and to 1.7% for 2016 (from 2.3%)
  • While growth is expected to accelerate to 2.4% in 2017, it will remain well below the country's growth trend before 2008 of around 4% and the NDP target of 5%
  • Unemployment remains stubbornly high, at 25.5%, and the share of the working age population in employment is only 43.8%

Current account:

  • South Africa has a persistent current account deficit despite weak domestic demand and the sharp depreciation of the rand
  • The current account has contributed to deterioration in the country's net external debt/GDP ratio to an estimated 16.1% at end-2015 and exposes it to shifts in global liquidity and risk appetite
  • Subdued commodity prices, a lack of capacity to produce goods currently imported and the tendency for gains in competitiveness to be absorbed by higher wage growth will limit the structural improvement in South Africa’s current account
  • Fitch forecasts the current account deficit at 4.3% of GDP in 2015, 4.1% in 2016 and 3.9% in 2017, below its average of 5.4% from 2012-14

Government finances:

  • The Treasury has stuck to its nominal non-interest expenditure ceiling since 2012, providing a fiscal anchor. Both the headline and primary budget deficits are forecast to decline
  • The above-planned public wage settlement has used up most of the contingency reserve, reducing the capacity of the budget to absorb further shocks
  • Fitch forecasts gross general government debt (which includes local government) to increase to 51% of GDP at end 2015/16. This is up from 26% of GDP in 2008/09 and above the 'BBB' range median of 43%
  • Fitch projects government debt/GDP to rise to 52.4% in 2017
  • The government has contingent liabilities equivalent to 11.5% of GDP, mainly in the form of potential guarantees to state-owned enterprises including Eskom, the state electricity utility which it had to recapitalise this year, although issued guarantees are only 5.6% of GDP
  • The structure of government debt is highly favourable, with only 8.5% denominated in foreign-currency debt and an average maturity of marketable bonds at 13.8 years. This provides the public finances some insulation against exchange rate shocks and rollover risk

Other key points highlighted by Fitch:

  • South Africa’s banking system is strong
  • South Africa has deep and partially captive local capital markets with assets under management around twice GDP, which increases the government and economy's financing flexibility
  • South Africa scores better than the 'BBB' range median on the World Bank's governance indicators
  • The quality of monetary and fiscal institutions is a strength
  • The South African Reserve Bank retains credibility and demonstrated its independence by raising interest rates again in July and November, despite subdued economic growth
  • Fitch assumes that the government will stick to its expenditure ceilings set out in the October 2015 Medium-Term Budget Policy Statement
  • Fitch assumes that the South African Reserve Bank remains committed to maintaining inflation within its 3%-6% inflation target

According to Fitch, South Africa could be downgraded further if fiscal discipline was not maintained, such as upward revision to expenditure ceilings, leading to a failure to stabilise the ratio of government debt/GDP. It would also be a problem if there was a further marked weakening in trend GDP growth, for example due to a lack of policy changes to improve the investment climate and if the rising net external debt to levels increased the potential for serious financing strains.

More positively, Fitch indicated that the rating could be upgraded if South Africa established a track record of improved growth performance, for example bolstered by the successful implementation of growth-enhancing structural reforms. It would also be welcome if there was a marked narrowing in the budget deficit and a reduction in the ratio of government debt/GDP as well as if there was a narrowing in the current account deficit and improvement in the country's net external debt/GDP ratio.

The decision by Fitch to revise down South Africa’s credit rating outlook was not a surprise given that the rating agency had placed South Africa on a negative ratings outlook 18 months ago and the economic and policy environment has clearly deteriorated since then. While it can be argued that because Fitch has changed the ratings outlook to stable, the country has a window of opportunity to improve the broad economic parameters. HOWEVER, yesterday’s decision by S&P to revise South Africa’s ratings outlook to negative means the government needs to urgently address the growth, policy and public sector debt concerns.

It can also be argued that the latest ratings decisions by S&P and Fitch are largely priced-into South Africa’s financial markets. HOWEVER, the country remains highly reliant on attracting foreign portfolio investment to fund the our perpetual savings shortfall. This means the currency, inflation rate, interest rates, debt levels and growth rate are all extremely vulnerable to sudden halt in foreign capital inflows, or worse, a significant rise in foreign capital outflows. As Henk highlighted recently in the morning meeting, many foreign investors will see the decision by S&P to revise our credit rating to negative as a precursor to a full ratings downgrade to “junk” status and could start to position their investment for that eventuality rather than wait for the actual downgrade.

Interestingly, Moody’s Investor Services still has South Africa’s credit rating at two notches above “junk” status, and with a stable outlook. There must be a real risk that Moody’s also decides to move South Africa’s credit rating lower during the first half of 2016.

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