August 2016 · Number 15 South Africa and the Ghost of a Rating Downgrade to Sub-Investment Grade Marek Hanusch, Shakill Hassan, Yashvir Algu, and Luchelle Soobyah1 Introduction a country panel to the specific case of South South Africa is under threat of a downgrade to its Africa.3 sovereign credit rating since Standard and Poors This application comes with a number of (S&P) lowered its foreign-currency long-term important caveats. First, there have in fact only credit rating from BBB to BBB- in June 2014, with been relatively few events of sovereign Fitch following suit in December 2015. Moody’s, downgrades to sub-IG and many of them the third major global rating agency, maintained occurred in the recent past. The analysis applied South Africa’s credit rating one notch above S&P in this Note thus builds on insights from a and Fitch, or two notches above sub-IG. With relatively limited number of countries, resulting in economic growth continuing to slow and potentially large margins of error. Second, South perceptions of high policy uncertainty2, some African public debt is predominantly denominated observers expected S&P or Fitch to remove in local currency (88%4) and the effects of a South Africa’s high-prized investment grade downgrade of the foreign-currency rating may be credit rating during the rating review that ended in less pronounced in this case than in the other June 2016. Instead, both raters (including countries that the analysis derives its estimates Moody’s) confirmed their previous assessments. from (South Africa’s local currency credit rating by While the ghost of a downgrade has been S&P remains two notches above the foreign banished for now it will continue to haunt South currency one). Africa until the next rating decision of S&P and Fitch in December 2016. Third, data coverage restricted the country panel to interest maturities of less than one year: This Note explores what would likely have Treasury-bills (or T-bills). Risk premia are more happened if South Africa had been downgraded pronounced in longer-maturity debt instruments, to sub-IG by S&P or Fitch (or both) in June 2016, so the study is likely to underestimate the effects focusing on short-term government borrowing of rating downgrades to the extent that a costs. To this end it applies the findings of the government relies on longer-term bonds to authors’ recent analysis of rating downgra des in finance its obligations 5. In South Africa’s 2016 1 This MFM Practice Note was cleared by Mark Thomas, Practice Manager (GMFDR). 2 SeeIMF Article IV 2016, Annual Country Report on South Africa, Report No. 16/217. 3 Hanusch, M., Hassan, S., Algu, Y, Soobyah, L., and Kranz, A. (2016) ‘The Ghost of a Rating Downgrade: What Happens to Borrowing Costs when a Government Loses its Investment Grade Credit Rating? MFM Discussion Paper No 13, World Bank Group. 4 This is the average estimate for 2016; data is sourced from Haver Analytics. 5 According to the South African Reserve Bank’s Monetary Policy Review April 2016 (page: 4), the increase in long yields is estimated to be at least 24 basis points larger than that for short yields. Budget, T-bills only account for 16% of the 2015/16 (in net terms). The government first government’s borrowing requirements for the declared its commitment to stabilize the public- fiscal year 2016/17. debt to GDP ratio in its 2014 Medium-Term Budget Policy Statement, yet given continued Given these caveats, the results presented in this downward revisions to growth, the stabilization Note should be considered with caution: there level has continuously been shifted upward until remains considerable uncertainty as to what the most recent Budget Review of February 2016. would happen if South Africa was downgraded to sub-IG. Cognizant of the need to control the public debt ratio, the 2016 Budget Review took measures to move debt stabilization forward to 2017/18 (and Economic Context 2018/19 in gross terms). Two thirds of these measures are to be shouldered by the revenue Similar to many other commodity-exporters, side. South Africa has been hit by two crises in recent years: first the global financial crisis of 2007/8 and For a while, the credit rating agencies had been the following global economic slow-down; and expressing concern about weak growth, second the end of the commodity super-cycle, significant fiscal and external deficits, and policy heralded by tumbling oil prices in late 2014 and uncertainty, amongst others. This led some other commodity prices such as iron ore and observers to believe that South Africa would be platinum which are significant export downgraded during the latest rating review by commodities in South Africa. The consequences S&P and Fitch in June 2016. Yet the have been significant for South Africa. Growth government’s fiscal consolidation effort slowed from an average 4.3% between 2000 and contributed to all three raters affirming their 2007 to 1.9% between 2008 and 2015. The World ratings: S&P and Fitch continue to rate South Bank estimates growth to slow further in 2016, at Africa’s foreign-currency long-term denominated 0.6% - well below the growth of the population. debt one notch above sub-IG (S&P maintained a The particularly weak growth performance in negative outlook). S&P rates South Africa’s local 2016 is largely due to the pronounced slow-down currency denominated debt three notches above in mining as well as manufacturing and sub-IG; whereas Fitch has this rating on par with agriculture due to an El-Niño related drought. the foreign currency rating at one notch above Investment has been declining since 2014, partly sub-IG. Moody’s rates South Africa’s public debt as the commodity bust depresses mining, but and foreign-currency debt two notches above also due to high uncertainty and structural sub-IG. bottlenecks (e.g., in industrial relations, electricity constraints) deterring private investment. As the economy cooled, the fiscal accounts Downgrades and Public Borrowing Costs deteriorated markedly. South Africa ran a primary Governments want to prevent a rating downgrade surplus since 19956, before slipping into the red because it is associated with higher borrowing in 2008. In 2015/16, South Africa’s overall budget costs. It may also cost them an election as a deficit stood at 3.9% of GDP and the World Bank downgrade reflects as much a deterioration of sees it at 3.6% for 2016. national solvency conditions as the government’s inability to avert it.7 A downgrade to sub-IG (i.e., Running primary surpluses in the early 2000s had into speculative debt territory) is particularly allowed the South African government to painful: it triggers forced sales by investors whose considerably bring down its public debt, nearly bond holdings are restricted to investment grade halving it between 2000 and 2008; the trend then paper, and results in a narrower demand base for reversed and public debt in South Africa more the sovereign’s bonds.8 Thus, the downgrade to than doubled again, reaching 44.3% of GDP in sub-IG is a special case and its effects on 6Source: SARB 8A particularly strong concern if downgrades of local- 7Hanusch, M. and Vaaler P. (2015) ‘Credit Ratings and Fiscal currency debt follow. Responsibility’ MFM Discussion Paper No 4, World Bank Group. August 2016 · Number 15 · 2 borrowing costs are likely to be larger than Equation 2: downgrades at other points along the rating scale. , = 0 + 1 ,−1 + 2 , + 3 , Technically, markets (most notably funds with + 4 (1 ), investment grade requirements) only consider a + 5 (2 ), country’s debt sub-IG when at least two credit + 6 , + + + , rating agencies issue a sub-IG rating. Yet the study applied in this Note finds that the first downgrade to sub-IG has the largest effect on T- bill rates. Using a sample of 20 countries between Both the predicted and unpredicted rating are 1998 and 2015 the analysis suggests that a used as key independent variables in equation 2 downgrade to sub-IG by one major rating agency to estimate annual T-bill rates (the policy rate is increased Treasury bill yields by 138 basis points also included as a control since it strongly on average. Should a second rater follow suit, influences short-term rates). Treasury bill rates increased by another 56 basis Finally, to account for discontinuities arising from points (although this effect is not statistically the threshold effect of downgrades to sub-IG significant). status, dummy variables are included for the first To arrive at this result, the study aims to tease out and second downgrade to sub-IG status. the extent to which credit ratings reflect economic fundamentals and to which extent they represent rater-specific information that may be news to Application to South Africa markets. This latter component can be expected Applying the results of the analysis to the South not to be priced in by the time the rating decision African case, T-bill rates for the year 2016 are is made. predicted at 6% if markets and rating agencies The study thus estimates two equations. would have been aligned in their assessment that Equation 1 estimates a predicted rating from a downgrade to sub-IG was not warranted (Figure fundamentals (last year’s rating, GDP growth, the 1). If rating agencies had been considerably more budget balance, government debt, and inflation): (less) optimistic than markets in their this is what markets would expect as assessment—two standard deviations below fundamentals that can be observed. The residual (above) their average assessment—rates are of the regression is the average of the three rating predicted at 5.7% and 6.2% respectively9. agencies assessment that is independent of Yet in the first half of 2016, average T-bill rates these fundamentals. (91 days) stood at 7%, and at 7.2% in June. This Equation1: is much closer to estimates for the case where one rating agency downgraded South Africa to , sub-IG—with T-bill rates estimated in the range of = 0 + 1 ,−1 + 2 ℎ, 7.1% to 7.6%. This suggests that markets already + 3 (% ), price in a downgrade. + 4 (% ) , + 5 , + + + , 9 These estimates were done prior to the most recent repo rate increase. August 2016 · Number 15 · 3 Figure 1: Estimated T-bill yields for South Africa 2016/17. One rating downgrade to sub-IG would under different scenarios accordingly have resulted in ZAR 100 million in additional costs for 2016 alone. This is likely to 9 have only been the lower bound as the bulk of 8 South African liabilities are long-term (82.3% or R141 billion). 7 6 Following S&P’s and Fitch’s affirmation of South Africa’s credit rating, T-bill rates have barely 5 changed (although the rand instantly appreciated 4 by 3.3% following the announcement by S&P). This suggests that markets continue to expect a 3 downgrade to sub-IG. The ghost of a downgrade 2 appears to continue haunting South Africa. 1 0 This note series is intended to summarize good practices and +2 Std. Dev +2 Std. Dev +2 Std. Dev Median Median Median -2 Std. Dev -1 Std. Dev -2 Std. Dev -1 Std. Dev -2 Std. Dev -1 Std. Dev +1 Std. Dev. +1 Std. Dev. +1 Std. Dev. key policy findings on MFM-related topics. The views expressed in the notes are those of the authors and do not necessarily reflect those of the World Bank, its board or its member countries. Copies of these notes are available on the No downgrade 1 downgrade to 2 downgrades MFM Web site (http://worldbank.org/macroeconomics) sub-IG to sub-IG About the authors: If one agency had downgraded South Africa to sub-IG in June 2016, average 2016 T-bill rates Marek Hanusch, Senior Economist, World should have been at 7.4% in line with market Bank’s Macroeconomics & Fiscal expectations. This would have required an Management Global Practice (GMFDR), mhanusch@worldbank.org increase in T-bill rates of about 80 basis points10 compared to the average of the first half of 2016, Shakill Hassan, Lead Economist, Economic Research & or by 60 basis points compared to June 2016 Statistics Department, South African Reserve Bank levels. If a second rater had followed, the shakill.hassan@resbank.co.za increase would have been starker. Yashvir Algu, Research Analyst, World According to the 2016 budget, South Africa Bank’s Macroeconomics & Fiscal intends to borrow ZAR 25 billion in T-bills in Management Global Practice (GMFDR), yalgu@worldbank.org Luchelle Soobyah, Associate Economist, Economic Research & Statistics Department, South African Reserve Bank luchelle.soobyah@resbank.co.za 10 Thiscorresponds to findings in Hassan, S. and Soobyah L. Economic Note 2016-1 (in SARB’s Monetary Policy Review, (2016) ‘Sovereign credit ratings and cost of funding’ SARB April 2016). August 2016 · Number 15 · 4