What happens if SA reaches junk status?

Following the World Bank downgrading South Africa’s growth forecast for 2016, we have asked the question, what happens if the country reaches junk status?

In December 2015, a number of international ratings agencies revised their outlooks for South Africa to –BBB, this is one notch above junk status. If a country reaches a junk status credit rating it means that certain investors will not be able to invest in the country.

While no agency has revised our outlook to junk status, the World Bank has noted that the country could be on the verge of a recession.

Junk status explained

Adriaan Pask, chief investment officer (CIO) of PSG Wealth, defines junk status as “the perceived probability of defaulting on the capital loan repayment is higher than that of investment grade bonds. In return of taking additional risk, investors will demand greater compensation i.e. higher yields. This cost will be directly borne by government and corporates, but ultimately passed on to consumers and shareholders.”

Lesiba Mothata, chief economist at Investment Solutions, elaborates non-investment grade, or junk status, places a country at a higher risk of not being able to honour its debt commitments.

“Most countries in non-investment grade pay higher interest rates when they borrow in international markets. Usually, investors use a dollar based interest rate benchmark such as LIBOR a starting point in computing the risk premium with a few percentage points added in order to reflect the required compensation for higher risk taken (LIBOR plus a few percentage points),” reveals Mothata.

What happens when SA reaches junk status?

Christopher Gilmour, investment analyst and marketer at Absa Wealth and Investment Management, highlights that if the country’s credit rating is downgraded to junk status, borrowing costs would rise rapidly. “In other words, the yield on our government bonds, which is a proxy for all other interest rates in SA, would increase rapidly and significantly. The costs of borrowing for everyone -governments, companies, individuals-would rise.”

Pask adds that following a junk status downgrade, the government may struggle to acquire funding for projects.

Mothata suggests examining what has happened in other countries that were downgraded to junk status. He points out that Investment Solutions has analysed other emerging market countries which have similar economic constructs to South Africa.

Gilmour agrees that looking at other countries in junk status will give an indication as to what consumers can expect, particularly with regards to possible future interest rates. For example some countries that have been awareded junk status have interest rates of between 13 and 16%.

“I’m not saying we’re going to get there naturally, or even quickly, but I think those are the kind of interest rates we could reasonably be expecting to reach if we reach that. And much depends on the actions of government,” says Gilmour.

For example, Gilmour highlights that the decision of President Jacob Zuma to replace Nhlanhla Nene as Finance Minister has resulted in incalculable damage being inflicted upon the economy and society.

“It took Colombia 12 years to return from junk into investment grade: Romania six years and South Korea only 12 months (1 year). The response of asset markets are dependent on the duration it takes for a country to come out of a junk status. Equity markets fall significantly during longer stay in non-investment grade. Shorter stay in junk is better for the currency and equity markets as it was witnessed in South Korea,” highlights Mothata.

Gilmour states that if South Africa is downgraded to junk status, he believes that it will be well signalled by the various ratings agencies. “Locally I think you will start seeing people readying themselves for a potential downgrade.”

How does this affect consumers?

Pask, Gilmour and Mothata agree that a junk status downgrade will affect consumers. One of the major effects that consumers will see is the cost of borrowing increasing.

Gilmour emphasises that interest rates will rise, with Mothata explaining: “Consumers will certainly pay higher on their home loans, credit cards and any form of debt.”

According to Gilmour, it is not possible to predict what the interest rates will be. These will be determined by the market at the time. However, he says that if South Africa does reach junk status, the interest rate levels will rise significantly from where they are now.

Furthermore, Pask highlights that government’s cost of capital will rise, which will place added pressure on the national budget, and in turn on taxes. There may also be increased pressure on economic growth.

Who can invest in a junk economy?

Despite what some reports claim, anyone can invest in a country with a junk status rating. However, that does not mean that investors won’t have limitations on where they will invest.

Pask explains: “The country remains open for investment to anyone who is unaffected by investment mandate constraints. Some mandates of pension funds or unit trust portfolios are required to invest in investment grade instruments only. If there is a down grade, these investment vehicles will no longer be able to invest in these bonds, and finance will have to be obtained through other investors with more liberal mandates.”

Mothata believes that if South Africa reaches junk status, it might be attractive to some investors. “Given the deep liquid markets SA enjoys, some investors could find SA credit attractive (cheap) after falling out of investment grade.”

The country will attract investors who are looking for higher risk and are willing to take on additional sovereign risk for additional compensation, reveals Pask.

Gilmour agrees noting that hedge funds and other investment companies outside of pension funds would still consider investing in South Africa, together with foreign individuals.

Is it the end if we reach junk status?

Despite the effect that reaching junk status could have on the country and economy, Justmoney asks if it is really the end of the world?

The experts agree that while junk status is bad, it is not the be all and end all. However, Pask says: “It has serious implications for both investors and consumers. It poses a massive challenge to all South Africans and we cannot afford to be complacent regarding the impact, nor lacklustre in our efforts to turn things around.”

Mothata adds that the agility of authorities in responding to a crisis is critical. In other words, if the country were to receive a credit downgrade, government would have to act swiftly.

Furthermore, Gilmour points out that if junk status is awarded, the country may enter a recession. According to Gilmour, the current economic situation that the country is facing could have been avoided if President Zuma had not replaced Nene. “If this hadn’t happened we wouldn’t be staring down the barrel of junk status right now.”

However, Gilmour states that replacing David van Rooyen after only a few days with previous finance minster Pravin Gordhan was a good move.

“Trying to re-establish our reputation in global financial markets is going to be a long and laborious process, but Pravin is the man, undoubtedly [to get us there],” added Gilmour.