Prospects of further rating downgrades for SA remain high

Moody’s Investor Services (Ba2, negative outlook) and S&P Global Ratings (BB-, stable outlook) will release their South Africa rating reviews on 7 May and 21 May, respectively. Fitch Ratings (BB-, negative outlook) does not provide its release dates as its analyst is based outside the European Union, but its review is due at about the same time.

The prospects of further rating downgrades remain high, but the agencies may hold off until the finalisation of wage talks, according to a note issued by Nedbank economists today.

“The three agencies adopted cautious responses to this year’s budget, warning that the National Treasury set a challenging fiscal roadmap. The budget deficit and public debt targets are based primarily on an economic rebound and containing the public sector wage bill. Both these drivers face significant downside risks.”

The rating agencies have cited the independence and credibility of the South African Reserve Bank, exchange rate flexibility and deep local capital markets as credit-positive factors. In addition, the notable improvement of the current account and a low level of external debt support the current ratings.

However, Nedbank economists say, key factors that underpinned the rating downgrades into subinvestment grade are still unfavourable.

Economic growth was already anaemic heading into 2020 (the economic downturn started in December 2013) with real GDP growth slowing to 0.2% in 2019, averaging only 0.8% since 2015. GDP per capita contracted by a 2.3% annual average since 2015, and the official unemployment rate rose to more than 30%. “The outlook for growth remains lacklustre even from the low base set in 2020. The 2020 contraction of 7% was slightly shallower than the market consensus of -7.3% at the time of the November 2020 rating reviews, but forecasts for the next two years have trended broadly sideways.”

The implementation of growth-enhancing measures remains “almost non-existent”, and the economy is forecasted to return to its pre-Covid level only in 2023. This, Nedbank economists say, points to the socio-economic situation not improving rapidly − a rating-negative factor.

Preliminary figures indicate that 2020/21 revenue collections were R37.8 billion more than forecast in Budget 2021 but R175.4 billion (12.3%) short of the original budget estimates. This, against the backdrop of a slightly shallower 2020 contraction, points to a marginally narrower 2020/21 deficit.

“The latest economic data suggest an economic rebound firmer than National Treasury and the market consensus forecasts. However, the deficit will remain wide and further raise the public debt stock over the next three years. Subdued revenue growth will place an even more significant burden on expenditure cuts to narrow the budget shortfall.”

Turning to the public sector wage bill, the research note says that expenditure reduction is anchored on containing the public sector wage bill over the next three fiscal years.

“The government plans to increase the wage bill by an average of only 1.2% per year over 2021/22 to 2023/2024, while the 2020/21 wage freeze is still subject to a Constitutional Court judgement. Public sector unions entered the wage talks with a demand of CPI plus 4%, which has resulted in a deadlock. Based on the 2020/21 public sector wage bill of R574.4 billion, meeting the unions’ demands will add R274.3 billion (15.6%) to the envisaged wage bill over 2021/22 to 2023/2024, assuming a steady public sector workforce and a 4.5% annual CPI rate.

“If the Constitutional Court rules in favour of the unions, R37 billion will be added to the 2020/21 wage bill. Additionally, Eskom has started wage talks with unions demanding a 15% per year hike for three years. If granted, although this is highly unlikely, the high wage increases will exert further fiscal pressure in the form of higher bailouts for the financially constrained electricity utility.”

Nedbank economists point out that the budget shortfall has historically been financed via the issuance of long-term local-currency bonds. However, National Treasury will increase its foreign-currency borrowing over the three years to 2023/24. The public sector borrowing requirement will hover around an elevated 10% of GDP per year over 2021/22 to 2023/24, which could pose financing challenges if global market conditions worsen again.

“In March 2020, the South African Reserve Bank intervened in the secondary bond market to ease liquidity pressures. Bond market liquidity has since normalised, and the Reserve Bank has started to reduce its holdings of government bonds. However, the proportion of bonds held by foreign portfolio investors is still close to recent lows, suggesting that the breadth of external funding for the sovereign has shrunk.”

The trajectory of the public debt ratio presented in Budget 2021 is lower than in the October 2020 Medium Term Budget Policy Statement (MTBPS), the research note points out. “National Treasury projects the ratio to peak at 88.9% in 2025/26 and gradually ease to 86% in 2028/29, which compares favourably with a peak of 95.3% projected in the MTBPS. However, the ratio remains well above the median of BB-rated sovereigns, which Fitch Ratings calculated at 50% in 2020.”

Turning to the debt service cost ratio, Nedbank economists say that the rapid increase of the public debt stock has raised interest payments significantly. “The interest bill rose by 13.7% in 2020/21, and National Treasury projects it to increase by an average of 13.3% per annum over 2020/21 to 22023/23. As such, by 2024 the ratio will breach 21%, with interest payments absorbing 21c of every R1 of revenue collected at the national level. Debt service cost-to-GDP will breach 5%.

The economists conclude that the balance of factors points to imminent rating downgrades deeper into sub-investment grade. “However, the rating agencies are likely to hold off until the public sector and Eskom wage talks have been finalised.”

“S&P Global Ratings and Fitch Ratings will be reluctant to move a country with reasonably solid institutional governance and deep local financial markets below the psychological hurdle of a B rating. This hesitancy is likely to delay further downgrades for at least a year.”

The research note added that Moody’s and Fitch Ratings downgraded their ratings in November 2020, which may persuade them to adopt a ‘wait-and-see’ at least until the 2022 budget.

“However, a deterioration of economic prospects would increase the chances of further downgrades during this year.”

Nedbank economists suggest that to improve the country’s ratings, the government must tackle the longstanding macroeconomic challenges head-on. “First, stabilise government finances. Second, restore the state-owned enterprises to good financial health. This will reduce the burden on the fiscus and the risks posed by the high contingent liabilities. Third, eradicate power shortages by stabilising Eskom and prioritising the licensing of renewable power projects. These three steps will lift confidence, facilitate greater fixed investment by the private sector and ultimately stimulate job creation.”