Opinionista Nazmeera Moola 13 April 2017

A guide to ignoring the ratings agencies

A friend of mine was once asked about his thoughts on the ratings agencies following the global financial crisis. He responded that he would rate them somewhere between “standard” and “poor”. After Standard & Poor’s downgraded South Africa’s hard currency rating to “junk” and Fitch downgraded both the hard currency and rand denominated debt to junk, there have been quite a few comments saying that ratings agencies should be ignored. There’s a way to do that – but it’s easier said than done.

There is a simple way that South Africa can ignore the ratings agencies: Stop running budget deficits and start running budget surpluses. In order to do this, government would need to either increase revenues or cut expenditure enough to induce a surplus. In the February 2017 Budget Review, South Africa planned to issue R220-billion of debt in the financial year starting 1 April 2017. Of that, R167-billion would be to fund the deficit and the remaining R54-billion would be to roll over debt that matures in the current financial year.

Let’s start with raising revenues. In order to increase revenue by at least R167-billion per annum, the following rate increases would be required if the entire amount were to come from one tax source:

  • Corporate taxes – an increase in the corporate tax rate from 28% to 50% would be required;
  • Personal income taxes – an average 12% increase in the average personal income tax rate; and
  • VAT – an increase in the VAT rate from 14% to 22%.

Higher corporate taxes may sound very attractive to those attacking “white monopoly capital”; however, with most countries in the world cutting corporate tax rates to attract investment, South Africa is left with relatively high corporate tax rates. A further increase would result in slower growth and even fewer jobs. Personal income taxes have already been hiked in this year’s Budget. There is not much scope to do more. And the new 45% tax bracket for those earning over R1.5-million per annum only added an extra R4.3-billion to the fiscus. The bulk of the revenue increase came from the limited inflation adjustment provided to those earning as little R250,000 per annum.

That leaves us with VAT. There is virtually no chance the government will be able to convince the general public that they should stomach a VAT hike. In fact, I’d guess that there is likely to be public unrest if a VAT hike were proposed in the current climate.

The best way to raise revenues is to boost GDP growth. After all, higher growth results in higher tax collections across the board. Unfortunately the Cabinet reshuffle will probably result in far lower growth in 2017 than expected. Prior to the move, I had an optimistic forecast of 1.6% growth in 2017. Simply by accounting for a likely corporate investment strike and lower durable goods spending on cars and furniture mainly, this forecast falls to 1%. It could easily be less.

Having run out of options to raise revenue, we turn to expenditure cuts. Cutting R167-billion from government’s R1.56-trillion budget amounts to a whopping 11% cut in expenditure. The biggest expenditure items were basic education (R243-billion), healthcare (R187-billion) and social welfare grants (R180-billion). Could we halve the R14-billion that will be spent on the executive and legislative organs of the state? Or the R52-billion that will be spent on defence?

The truth is that there is virtually no willingness by the South African government to cut expenditure from current levels.

Without obvious revenue-raising measures and limited stomach to cut expenditure, South Africa is unfortunately left relying on the bond markets to finance our budget deficit. That means that every week, the National Treasury has to borrow another R3.8-billion from the local rand-denominated bond markets. Every week. Therefore we cannot ignore the rating agencies – because we borrow weekly from investors who care what they think.

Fortunately, less than 10% of South Africa’s government debt is denominated in a currency other than the rand. Therefore S&P’s move of the hard currency rating to sub-investment grade or “junk” causes little forced selling and has a far larger impact on sentiment towards the country.

The much bigger concern is the local currency rating. Total rand-denominated government bonds total R1.3-trillion. Foreigners own 38% of this. Of this, about one quarter of the foreign-owned component tracks the Citibank World Investment Grade Bond Index. The local currency rating is now at the lowest investment grade level of BBB- from S&P. Moody’s is one notch higher at the equivalent of BBB – with a high risk of a downgrade to BBB- in the coming weeks. If both S&P and Moody’s keep the current outlook on negative and subsequently move the local currency rating to sub-investment grade in the next 6-9 months, that would then result in forced selling of South African bonds of about R120-billion. In short, that would have catastrophic consequences.

Such forced selling would dramatically raise South African government borrowing costs – leaving even less money for critical services. And it would weaken the rand, resulting in higher inflation, particularly in food and petrol. We may not like what the rating agencies say, but we cannot ignore them until we stop needing to borrow money every week from foreign and local investors who care about credit rating. Unless the pension funds of Brazil, Russia, India and China will start buying South African government debt, a BRICS rating agency will not change this. DM

Nazmeera Moola is Co-Head of SA & Africa Fixed Income at Investec Asset Management


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