Tomorrow (Friday 1 November 2019), Moody’s is scheduled to publish its latest assessment of South Africa’s sovereign credit rating. This event is of course framed by the fact that S&P and Fitch have already downgraded South Africa’s sovereign credit to sub-investment grade, colloquially known as “junk”.
In the build-up to the event, there has been a flurry of governmental policy announcements, including Pravin Gordhan’s rescue plan for Eskom, Tito Mboweni’s wide-ranging economic strategy document released for public comment on 27 August, as well as the newly revised 2019 Integrated Resource Plan. What seems evident is that government, in anticipation of Moody’s rating review date, is attempting to put its best foot forward.
While it should be acknowledged that these policy statements have been long in the making and somewhat thin on substance, government’s actions at least demonstrate a certain sense of urgency. To put this all into perspective, however, the question as to why this particular date has been chosen for the rating review is pertinent.
On the day of the review, there are a number of scenarios that can play out. Moody’s can potentially upgrade South Africa’s currently “stable” outlook to “positive”, downgrade the outlook to “negative”, or leave the outlook unchanged. If the outlook is changed to “negative”, it signals that the next likely rating will result in a downgrade of the credit rating within the next 12 to 18 months. Before a downgrade occurs, the country will first be placed on a “rating review”, which is typically resolved within 90 days.
But, whatever the outcome, it should be noted that the upcoming review date is not an ad hoc event, but rather a European legal requirement. To be clear, Moody’s does not have the right to change this date.
This is significant because since the 2007/2008 financial crisis, the Dodd-Frank Act has created an Office of Credit Ratings to regulate the conduct of credit rating agencies, and as part of its mandate, it provides fixed dates for the potential release of new rating announcements. Similarly, the European Union created the credit rating agencies’ (CRA) Regulation Framework, which aimed to restore market confidence and investor protection, recognising that in the period leading up to 2008, credit rating agencies played a critical role in the build-up of enormous leverage through providing authoritative stamps of approval on a plethora of risky financial instruments.
The introduction of these regulations was critical, since the actions of the credit rating agencies, specifically with regard to ad hoc credit reviews, had not only contributed to the onset of the crisis, but in some cases had significantly exacerbated its deleterious effects. Moody’s, as an example, upgraded the rating on Iceland’s banks as late as 2007, shortly before the entire Icelandic economy tanked. This occurred despite severe warnings by analysts at Danske Bank in an extensive report published in March 2006 pointing out that Icelandic bank assets were 10 times larger than GDP.
Just a month after Danske Bank released its report, Moody’s published its own report, stating that Iceland – which it had given an Aaa rating – did not have any undue solvency or liquidity risk.
“While we have warned of the risks that may accompany increased leverage in the economy,” said Moody’s in 2006, “Iceland has our top rating with a stable outlook, and we believe these concerns have recently been exaggerated.”
In 2008, all three of the largest banks in Iceland collapsed in short succession. On 29 September 2008, the government was forced to take control of the country’s third-largest bank, Glitnir, after it faced short-term funding problems. A week later, the largest and the second-largest banks, Kaupthing and Landsbankinn, were taken into curatorship.
On the very same day that the last of the three banks collapsed, Moody’s downgraded Iceland’s government bonds three levels on its rating scale, from Aa1 (the second-highest rating) to A1 (the fifth-highest rating). The downgrade substantially exacerbated the Icelandic crisis, driving down the value of the krona and making any rescue plan significantly more difficult to execute.
It was only after the crisis that the true extent to which the global financial system had come to depend on the rating agencies was understood. What investigations – by the Financial Services Subcommittee on Oversight and Investigations, for example – revealed was that because the rating agencies were so deeply embedded in the financial system, there was, in fact, no viable alternative to the status quo. It was for this reason that, if the dependence on these agencies could not be reduced, at a minimum, there needed to be strict regulatory frameworks put in place to limit any undue negative effects that could result from their actions.
If Moody’s were – even for good reason – to issue a negative outlook on 1 November and then later to downgrade South African’s sovereign credit, it would inadvertently be making the country’s situation significantly worse. If a downgrade by Moody’s were to occur, South African bonds would be removed from the FTSE World Government Bond Index. In turn, a portion of large international investors would be forced to remove South African bonds from their portfolios, driving down the value of the currency and pushing up existing government bond yields, and thereby, raising interest rates.
Thus, in making its observation, as Moody’s will do on 1 November, the observation itself, if negative, will accelerate South Africa’s financial and economic future negatively in a sudden and disproportionate manner. Despite the outcome, however, we must keep in mind that the date set for South Africa’s rating review is not a reactionary announcement by Moody’s in response to current economic conditions, but rather that it is simply a mandated event, dictated to the rating agency by its regulators. DM
"Day and night we are watching over your welfare. It is for your sake that we drink that milk and eat those apples. Do you know what would happen if we pigs failed in our duty? Jones would come back! Yes, Jones would come back! Surely comrades." ~ George Orwell