Why SA should care about Fitch, S&P, & Moody's cuts

Over the last four months, as the world’s Big Three credit ratings agencies have, one by one, downgraded their outlooks for South Africa to negative, reactions have run the gamut from outrage to indifference.

On the one extreme, the South African government and its allies have been vocal in condemning the downgrades. After Moody's downgraded the outlook for five South African banks and the South Africa National Roads Agency (Sanral), for example, finance Minister Pravin Gordhan came out of his corner swinging, calling the ratings agency "schizophrenic" and saying that South Africa has a proven track record of "excellent fiscal management" and that Moody's was making unfair judgements. And last week, after S&P, following Moody's and Fitch, cut its outlook for South African debt to negative, the Treasury loudly criticised the move, saying that S&P was mistaking open political debate for political instability.

In a similar vein, Cosatu denounced the downgrades, saying, "These warnings [about South African economic management] are completely unacceptable attempts by a foreign, unelected capitalist institution to try to dictate to a sovereign, democratic government what policies it should adopt."

On the other end of the spectrum, the reaction among many ordinary South Africans (especially of the kind that comment on Moneyweb), has been to dismiss the downgrades, saying that the ratings agencies revealed their incompetence and irrelevance during the financial crisis and that their opinions don't count for much. Unfortunately, both of these positions - condemnation and dismissal - are wrong. It's wrong to dismiss the opinions of ratings agencies, because these still play a crucial role in financial markets.

Imagine a hypothetical money manager in New York who is allowed to allocate 10% of her investment capital to sovereign bonds. In all likelihood, the rules of her fund dictate that she must keep average risk across her portfolio at a certain level; the rules may even prohibit her from putting any money into sovereign bonds with less than an investment-grade BBB- (S&P and Fitch) or a Baa3 (Moody's) rating. Furthermore, the woman can hardly be expected to be an expert on the political and economic conditions of all the countries of the world, so, when it comes time to decide where to allocate her sovereign bond money, she relies on credit ratings to maintain a suitable level of portfolio risk and to guide her choices. If South Africa were to lose its investment grade rating, it would almost automatically fall off the radar for big investors, especially in these risk-averse times.

And the consequences of a downgrade don't end there. For better or worse, the interest rate that country's pay on their sovereign debt is based, in part, on their credit rating, which serves as a signal about their long-term prospects. That's why even big European economies like France fret when their credit ratings are put on watch for a downgrade - such things act as a powerful signal to investors that things are really going pear-shaped.

Dismissing ratings is not the right attitude. But neither is condemning them as some kind of capitalist plot. The problems that Fitch, Moody's, and S&P have highlighted with respect to the South African economy are very real, and should be taken seriously.

First, SA has been running budget deficits for a few years now, and plans to continue to do so for a few more. Now, the country's debt-to-GDP ratio of around 39% is not at all bad compared to its peers, for whom the mean and median ratios are 44% and 47% respectively. Nevertheless, as the agencies rightly note, the government is under increasing pressure to spend more on social welfare (think the NHI) and on public sector wages, which have been increasing at above-inflation rates for several years. If this spending pressure is not tamped down, optimistic projections of future surpluses will not come to pass, and SA could end up in a real fiscal mess. Whatever the country's history of fiscal prudence, a fiscal disaster is not impossible, especially given the narrowness of the country's tax base and the huge demands for resources coming from populist elements of the tripartite alliance.

Second, the agencies rightly highlight the unsustainably high levels of unemployment that South Africa lives with, and note that this is a very destabilising situation. Again, it's no use whining that the country is being picked on - unemployment is too high, and government policies are actively keeping it that way. Instead of complaining about "unelected capitalist institutions", South Africa's leadership should be trying to address the very real threats that the ratings agencies have highlighted. Shooting the messenger never solves anything.

Three outlook downgrades in four months is a serious thing, and South Africans need to sit up and take note. Unless the issues raised by the ratings agencies are addressed in a level-headed manner, things could take a real turn for the worse.

Author: Felicity Duncan
This article first appeared in Discovery Invest

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