What the latest downgrade means for the rand and the future of SA

This article was originally published on The South African

What does junk status mean?

Credit ratings for countries are like credit ratings for people. A poor credit score means you are considered a risky debt prospect. If a country is more likely to default on debt, lenders charge a higher interest rate for borrowing. Junk status means that a country is considered sub-investment grade. This means that international investment guides (and even laws in some territories) prevent investment in the country.

Two out of the three credit rating agencies, Standard and Poor’s and Fitch, downgraded South Africa into junk status in 2017, following a Zuma cabinet reshuffle. The third, Moody’s, held off right up until the day South Africa went into lockdown in March 2020. This downgrade was as a result of a medium-term budget policy that announced an Eskom bailout. 

Now, only eight months later, Moody’s has issued another downgrade, alongside Fitch. This puts South Africa three notches below junk status. Generally, when countries start receiving further downgrades at such a rapid pace, it means that they are seen as going down an unsustainable path. 

The effect of the downgrade on the economy

The Rand’s muted reaction to the recent downgrade fails to communicate the severity of what it means. This can be partly attributed to the Covid effect – every economy has been affected and even first-world, developed economies are facing downgrade threats. 

However, the downgrade is going to have a material effect given our already-tight fiscal position. The government will collect less tax this year and will then need to either increase taxes or borrow money to make up the difference. The downgrade means that the cost of borrowing that money will be higher than it was. Either way, it’s going to come at a massive cost to the economy, and, from a risk perspective, we will see the Rand sink in response. 

South Africa imports much of what we consume – from fuel to food to clothing – and now all that will cost more. Even locally-produced products will likely rise in price because of the cost of equipment and transportation. This means that the general cost of living will go up. Usually the government would increase interest rates to offset this devaluation, but this would be a difficult strategy to implement in the post-Covid economy.

South Africa's future outlook

When Finance Minister Tito Mboweni spoke about South Africa’s situation in June, he outlined the impact of spiralling debt, the weakening Rand and the flight of capital from the country. He presented a path forward that involved government stabilising debt, increasing revenue collection and stimulating business. 

However, the downgrade shows us that the ratings agencies hold the view of, “We’ll believe it when we see it.” Implementation has historically been a problem for the South African government and, even with the steps that Mboweni mentioned, South Africa is still facing a slew of issues that won’t be going away any time soon, such as:

• Increased expenditure on government salaries and government debt servicing costs
• The decrease in tax revenues for both Covid-related reasons and the flight of taxpayers from South Africa
• A public sector wage bill that is still way too high
• A lack of initiatives to attract foreign investment
• The high crime rate
• Ongoing corruption

The most pressing issue is one of fiscal discipline and the ability of the government to control spending. If you compare the government sector to the private sector in South Africa over the last year, much of the private sector took salary cuts and many were laid off for periods of time. That didn’t happen in government, but in order to move forward the government has no option but to start cutting costs because the reality is that South Africa is running out of money. 

The country can still recover, but it’s not a quick fix. Some big structural reforms need to happen first.

The future of the Rand

The Rand reacted to South Africa’s downgrade to junk status in March, but the impact was largely masked by the effect of Covid and the lockdown. Generally, when a country is determined to be sub-investment grade, there’s a structural resetting of the baseline for the currency and that’s what we saw. Since this is the second set of downgrades this year, the immediate reaction is more muted.

It is possible that we will still see a major sell-off and a big devaluation in reaction to the downgrade, but the Rand is likely to bounce back from it in the short term. More concerning is the long-term impact. Looking at the long-term fundamentals that typically affect the value of the Rand relative to a mixed basket of hard currencies, we can probably expect a steady 7-8% decline per annum against the harder currencies going forward.

The Rand is already a heavily undervalued currency with weak buying power and the future currently looks grim. However, as an emerging market currency the Rand is subject to many different fundamentals and if the government manages to make the large-scale reforms needed to improve South Africa’s economy, the future might be brighter. 

If Covid has shown us anything, it’s that when it comes to currency and the world economy, no one can predict the future. It’s never a good idea to let panic and short-term uncertainty guide your financial decisions. 

We always recommend that South Africans look at diversifying their investments using the relative stability of developed economies to balance the risks posed by living, working and investing in an emerging market like South Africa. 

We are a fully regulated and registered financial services provider in South Africa, the UK, Europe and Australia. If you'd like to transfer money out of South Africa, we can help. Get in touch by sending us an email at fx@sableinternational.com or giving us a call on +27 (0)21 657 2120.