When, not IF 

 
On Friday March 27th, South Africa (SA) lost its last investment grade rating as Moodys downgraded the country to “junk” status. Even before the Corona crisis, the deterioration of government finances made the downgrade inevitable; it was just a matter of time. Both Fitch and S&P had downgraded SA to junk status as far back as 2017. Moodys followed a more lenient methodology which gave credit to our low level of offshore debt, but with the SA economy set to go into a deep recession, the downgrade was unavoidable.

 
Potential Outflows

The question of the effect of the downgrade has been asked countless times over the last three years. While the Moodys action has been a dark cloud hanging over the market in recent years, the real issue has been the underlying fiscal deterioration. Government has been unable to take any positive steps to get spending under control in order to save the investment grade rating. Without an investment grade rating, SA would be removed from the World Government Bond Index (WGBI) and some outflows would result. The quantum of these flows has been estimated at anywhere between $1bn and $12bn. The majority of offshore investors in the SA market are emerging market (EM) investors who invest in both investment grade and sub-investment grade debt across countries. We believe that the outflow will be towards the lower end of the estimates.
We had previously indicated that the effect of the outflows would very much depend on the global environment. A downgrade last year, when global markets were rallying and risk premiums were low, would have had minimal impact (20-40 basis points). However, the timing of the downgrade now means that the impact is potentially bigger. However, we understand that the rebalancing of the WGBI has been delayed from the end of March to end of April given the global turmoil. This should help in spreading the outflows over a longer period.

 
The SARB Factor

The SARB surprised the market last week Wednesday by announcing that they would start a program of bond purchases in order to add liquidity and stabilise the bond market. It is very rare that an EM central bank is able to do quantitative easing (i.e. monetise debt). It would have previously led to a massive loss in confidence, but with almost all developed market (DM) central banks doing quantitative easing (QE), it looks like EMs will be able to engage in these policies, albeit on a much smaller scale. As long as inflation remains within target, the SARB will argue that they can continue with their purchases. The current SARB team is highly credible, we would expect that the market should respect their authority and give them the benefit of the doubt.
Details on the intervention are minimal thus far. The SARB has left it open-ended to give themselves flexibility. We have no idea the potential size, and at what levels on bond yields, they would look to intervene. We will probably have to wait for disclosure at month-end to see what they have done. We would expect them to absorb a significant amount of the foreign selling to come. However, if they accumulate too many bonds, they will lose credibility.

In the short term, it does give bond holders a bit of confidence that yields will not become unhinged. The risk last week was that bond yields were heading to 15%. Yields rallied 200bp after the announcement and we used the opportunity to trim our bond holdings. Globally, QE has been used to suppress bond yields and to date we haven’t seen anyone pay an economic price. However, the ability to buy your own debt opens Pandora’s box and is a ruinous policy when the wrong people are in charge. On balance, the SARB policy will lead to lower yields and weaker currency over time.

 
The fundamentals are what really matter

 
While we have warned about the fiscal deterioration for some time, the Corona crisis has brought forward SA’s debt crisis from 3-5 years in the future, to the present time. Expectations from economists indicate a contraction of 5% in GDP this year, which will lead to a fiscal deficit of 12%. This is clearly not sustainable, and we now need massive intervention from Treasury, likely in combination with cheap funding and a program from the IMF. The reason for the debt crisis is the inability of the government to control both its own spending and that of SOE’s. Plans for reform have so far achieved nothing. If you can’t reform, the market will force you to it, and it will be more painful. We are at the point where a severe restructuring can’t be avoided. The SARB intervention and some funding from the IMF may buy us some time, but it needs to be used effectively. We do not want the interventions to take the pressure of the government. The wage bill and SOE problems must be confronted now.

 
Portfolio Positioning

 
We must remember that while SA’s fiscal position is dire, the entire world is dealing with the Corona crisis, and deficits and debt are a global problem. Bonds had already de-rated significantly prior to the Corona crisis. Our spread to EM peers had moved up from 2% to around 3% as the market moved to price in the downgrade. The Corona crisis has resulted in the sharpest bond move on record, the only comparable being the Asian crisis of 1998. We currently hold 10% of government bonds in our funds, with a yield of around 12%. This is a substantial risk premium given the SARB recently cut the repo rate to 5,25%. We will maintain this position as we believe that action on the deficit is due, and an IMF program will provide some credibility to the market. However, if we continue to see the lack of follow-through from Treasury and the Cabinet, we will look to mitigate the risk of a debt crisis by reducing bond exposure or increasing FX exposure from its current levels.