Down but Not Out

the global rating agencies have seemingly run out of patience， downgrading south Africa to what is colloquially known as “junk”status. More specifically， standards and Poors （s&P） recently lowered south Africas long-term foreign currency credit rating to BB+ from BBB- and the local currency rating to BBB- from BBB. s&P also lowered the short-term foreign currency rating to B from A-3 and the short-term local currency rating to A-3 from A-2. A few days later， Fitch changed its outlook for south Africa to stable from negative and downgraded south Africa to BB+ from BBB- on both foreign and local currency debts. Jeremy Stevens， an economist with the standard Bank Group， believes that south Africas credit rating downgrade means both uncertainty and opportunity. his views follow：

AFTer the two rating agencies downgrading South Africa， the question now is how this downgrade is likely to impact the economy. This matters as South Africa is one of Africas largest economies， accounting for one fifth of Sub-Saharan Africas GDP. In addition， more than one fifth of Africas total FDI stock is in South Africa. South Africa is Chinas largest trading partner， as well as the largest market for goods in Africa， purchasing 15 percent of all of Chinas exports to the continent in 2016.

Downgrade influence The downgrade decision followed the cabinet reshuffle on March 31 by South African President Jacob Zuma -changes were made to 10 of the countrys 35 ministries， including energy， police and tourism； five ministers lost their jobs while five others have been given new portfolios. The canary in the coal mine was the removal of Finance Minister Pravin Gordhan， replaced by Malusi Gigaba. Gordhan was viewed as a safe pair of hands and a spearhead for implementing the necessary economic policy to unlock South Africas structural constraints to growth.

At the very least， the downgrade suggests that S&P， for instance， believes that the likelihood of progress in dealing with a checklist of items including the finalization of labor and mining reforms， the adoption of more aggressive fiscal consolidation measures expected to stabilize government debt faster， and maintaining broad political institutional stability and macroeconomic policy continuity， amongst others， has been reduced.

At a maximum， the downgrade boldly assumes that the cabinet reshuffle will not be reversed and that the new treasury appointees will allow fiscal slippage， especially with respect to providing increased support for state-owned enterprises in general and Eskom in particular， without any improvement in their governance. It also assumes that fiscal policy will be increasingly negative for growth.

To be fair， the downgrade itself has been coming for some time. Indeed， by S&Ps methodology， South Africas economy was already in noninvestment grade in 2016， based on growth and growth projections alone. Investment grade requires per-capita GDP growth of 1 percent - which means with South African population growth of 1.6 percent， growth must be 2.6 percent. Instead South Africa has seen growth slip to an average of just 1.7 percent annually in the past three years and an utterly paltry 0.12 percent last year. That is materially lower than the 10-year average trend growth through 2013 of 3.5 percent. Worryingly， the years prior to the 2008 global financial crisis when South Africa was expanding by 5-6 percent certainly seem a long time ago.

However， the rating agencies clearly understood that a downgrade would make positive results even less likely， and so as long as they believed that South Africa was heading in the right direction， and would see growth of 2.6 percent by 2020， the message they were communicating was that they would wait before they pulled the trigger. Therein lies the rub： policy continuity was what mattered most. The decision therefore frames the cabinet reshuffle as an attack on the treasury and raises the specter of an internal erosion of the African National Congress hegemony in South Africas political landscape.

It is fair to say that the future consequences of the presidents move may be serious： the independence and stability of the National Treasury will be a mounting concern， with lasting fiscal and economic implications； and， should the African National Congress fail to resolve the profound tensions that the presidents move has elicited， it will almost certainly split， and lose its national majority. The rating agencies first raised its concerns with respect to politics distracting policy makers from implementing the necessary economic policy to unlock South Africas structural constraints to growth back in June 2016， and S&Ps December review increased its emphasis on politics.

Impact on economy Downgrades to junk from the two agencies will see South Africa drop out of some widely used global bond indexes and force international funds which track them， or which are prohibited from holding sub-investment grade securities， to sell. The move will certainly lead to a rise in government debt-servicing costs， which will mean less money for critical services such as housing， education and sanitation， which could incite even more protests over service delivery that have already rocked towns across the country.

So getting back to the question of how this downgrade is likely to impact the economy. Looking at others that have been downgraded in the past decade - Brazil， Bulgaria， Croatia， Hungary， Romania， and Russia - the behavior of key economic and market variables before and after a move from investment to non-investment grade may shed light as to what to expect in these uncertain times.

History confirms suspicions that the path ahead will be difficult. A year after the downgrade， the group averaged growth of -2.33 percent as all of them -with the exception of Bulgaria - were in recession. Even before the downgrade， the International Monetary Fund forecast that the South African economy would expand by just 0.7 percent in 2017 and average around 2 percent over the following three years. Now， South Africa is surely set to experience a recession.

Promisingly， a rebound typically happens relatively swiftly： two years later most started to see positive growth， and within three years the group experienced growth of just above 2 percent， which it maintained for the following three years. The problem， however， is that none of these economies has been able to get anywhere near their pre-downgrade trend growth rates. Thus， whilst the worst may be behind South Africa by 2019， the kind of growth that South Africa needs to erode poverty and unemployment is going to prove very difficult to attain.

History also suggests that the market is actually quite efficient in pricing a downgrade to non-investment grade before the fact. Interestingly， sovereign credit risk peaks around the time of the downgrade， and then starts to improve. Given that there remains uncertainty around South Africas fiscal policy stance and internal political climate， it is reasonable to believe that credit risk is likely to move higher， by around 50 basis points， meaning credit default swaps spreads are around 250-300 basis points.

On average， currency weakness is substantial leading into a downgrade. The U.S. dollar-South African rand has followed that path， slipping from 7.50 to a low of 16.85 in January 2016. Granted， it has recovered territory since then， strengthening all the way back to 12.46 in March 2017 on the back of relatively robust global risk appetite. Of course， after the announcement of the downgrade， the rand weakened. Now， even though traditionally there is stability in the currency after the downgrade we expect more weakness， largely because of potential selling by foreigners of local bonds （and potentially equities）. Indeed， JP Morgan has recently removed South Africa from index. Thus， one must expect the currency to test weaker， possibly 14.50. Fortunately， the downgrade has occurred at a time when global conditions remain more supportive for emerging market currencies in general. The weaker currency means that inflation is likely to rise. This means that domestic interest rates are probably going to increase and， as real rates rise， domestic demand is likely to be damaged at a time when the economy cannot necessarily afford it. Meanwhile， confidence and sentiment are also going to be battered， preventing cyclical recovery and adding another headwind to growth.

ray of hope With so many uncertainties peaking at the same time， it is little wonder market sentiment toward South Africa has turned sour. However， as Chinese President Xi Jinping said at Davos earlier this year， “We should not develop a habit of retreating to the harbor whenever we encounter a storm， for this will never get us to the other side of the ocean.” Indeed， we take solace in our conversations with Chinese corporates， investors and entrepreneurs， who have built up strong local relationships， developed detailed local knowledge and have proven to be incredibly agile. While others have continued to think of Africa in terms of clichés and generalizations， China has been quietly building solid diplomatic and commercial relationships with African countries since the turn of the century. Much like elsewhere in Africa， Chinese investment and trade have played a crucial role in supporting economic growth and infrastructure development in South Africa. Out of this uncertainty will come opportunities， and we expect Chinese businesses will be ready to participate.endprint