Keynote address by Lesetja Kganyago,
Governor of the South African Reserve Bank,
at SAICA's Courageous Conversation Session
Nelson Mandela Centre of Memory, Johannesburg
26 September 2017
Sovereign rating downgrades and their impact on the poor
Good evening, ladies and gentlemen.
The sovereign ratings of South Africa, which are the key theme of my
speech this evening, have been a prominent concern for policymakers
and investors alike in recent years, and will again feature heavily in policy
discussions as the year-end approaches. Following the gradual and
regular improvement in our country's sovereign ratings from the advent of
democracy to the mid-2000s, which saw South Africa regain investment-
grade status, South Africa's credit standing has again deteriorated in
recent years.
Both Standard & Poor's and Moody's rating agencies started downgrading
South Africa in 2012; this process culminated in the loss of investment-
grade status (for foreign-currency debt) in 2016 with two of the three major
rating agencies. Further reviews of South Africa's ratings are due before
year-end. Our growth and fiscal performance, in particular, are therefore
under a high degree of international scrutiny at present.
The financial market and policy implications of rating downgrades are well
documented, ranging from difficulties in getting non-resident investors to
finance the current account deficit, through a greater volatility of financial
markets, to higher costs of borrowing for the sovereign. What many
people are less familiar with are the implications for the public at large, for
incomes and inequality, and in particular for the lower-income segment of
the population. These are the points that I would like to discuss this
evening.
The general public, in particular the poorer households, may wonder how
a rating downgrade can directly affect their daily lives. After all, poor
people do not borrow overseas; they do not run businesses that are
dependent on financing by foreign investors; they rarely travel overseas;
they do not directly hold shares in listed companies.
Some voices, indeed, may go further and say that South Africa's
government should not pay excessive attention to the decisions of foreign-
based rating agencies. These voices may argue that the decisions of
rating agencies mostly affect wealthy individuals and have limited
bearings on the economic well-being of the poorer majority. Let me
explain why such thoughts are misguided.
Irrespective of its direct implications, a sovereign rating downgrade does
have indirect impacts on all the citizens of the country. These can be felt
harder by the poorer households who, unlike the wealthier ones, do not
have the possibility of 'hedging themselves' from the consequences of a
downgrade by diversifying their assets. There are five major channels
through which the recent rating downgrades can undermine the well-being
of poorer households, which I will discuss more in detail.
The ratings of a listed entity (be it a government or a corporation) are
meant to reflect its 'credit quality'. Hence, they are used by international
investors to gauge the risk of buying the bonds issued by that entity. In
theory, therefore, these investors will - subsequent to a downgrade -
require a premium in the form of a higher interest rate, or they will shun
these bonds altogether. South Africa requires foreign investors to finance
its external deficit (as its imports regularly exceed its exports). A rating
downgrade therefore means that financial markets will move to a new
equilibrium where the interest rates on bonds are higher and the exchange
rate of the rand is weaker than before the downgrade.
Obviously, the recent empirical evidence is clouded by the fact that many
other factors, bar sovereign ratings, influence the price of South African
financial assets. Nonetheless, a standard measure of sovereign credit risk
for South Africa, namely the credit default swap (CDS) spread, has
underperformed compared to its emerging-market peers in recent years,
and is now trading at similar levels to non-investment-grade countries.
This is clear evidence that investors are requiring a higher risk premium,
if only in relative terms, on South African government debt. The increase
in the yield on inflation-linked bonds issued by National Treasury, over the
past two to three years, is another such indication. Even after being fully
protected against inflation, bond investors require a higher return - even
as global economic factors have continued to depress risk-free, real
interest rates all over the world.
These higher yields on South African bonds will, over time, negatively
affect the poor. As the South African government faces a higher cost of
borrowing, it will have to devote a larger share of its (finite) resources to
servicing debt. Already, estimates by National Treasury indicate that
government debt-servicing costs are expected to represent 10.4% of total
budget spending (and 3.5% of GDP1) in 2017/18, up from a low of 7.0%
in 2009/10. This stands in contrast to the years prior to the global financial
crisis, when the improvement to South Africa's credit rating coincided with
a gradual decline in the share of public spending devoted to servicing
debt.
In turn, when debt-servicing costs rise faster than the overall budget, the
amount of money available for other missions - especially those of utmost
importance to the poor, like public health, education, infrastructure, and
social services - is reduced. Across the world, countries with the lowest
creditworthiness and with the most difficult access to international market
financing are generally those with the poorest Human Development
Indices. To a large extent, poor households 'pay' for the low credit quality
of their sovereign.
Some may argue that, faced with higher debt-servicing costs, there are
policy alternatives to curbing redistributive government expenditure, such
as increasing public borrowing or raising taxes on higher-income
households. However, these alternatives are probably not sustainable in
the long run. Simply adding to borrowing would most likely, over time,
prompt further downgrades, raise interest rates, and threaten a financial
crisis. From 26% of GDP just before the global financial crisis, South
Africa's debt-to-GDP ratio is expected to rise to 52% in the current
financial year, even without including contingent liabilities. (This is,
effectively, a doubling of the ratio in less than 10 years.) From what was
a relatively low level by emerging-market standards in the 2000s, South
Africa's debt-to-GDP ratio has moved to a relatively high position, which
could - if continued - reduce our country's relative attractiveness to global
investors.
Equally, raising taxes on higher-income households and corporations, in
a country where the tax system is already fairly progressive (and the tax
burden, at least by emerging-market standards, relatively high), could
undermine the already anaemic pace of economic growth or trigger capital
outflows. For the state to effectively help the poor, it needs maximum fiscal
space, and that means (among other things) well-managed public
finances and sustainable debt burdens. This also has key repercussions
for monetary policy's ability to best contribute to sustainable long-term
economic growth. In the event that public finances keep deteriorating, a
country can experience 'fiscal dominance' - when the central bank's
interest rate policy is primarily dictated by the need to ensure adequate
financing of the budget deficit at the expense of other, real, economic
considerations. It is easy to see how this can be a suboptimal outcome
from the point of view of economic development.
Fortunately, these difficult trade-offs have to be made by duly elected
representatives of the people of South Africa. As the South African
Reserve Bank, we only look at what the implications of these are for
monetary policy.
Furthermore, a rating downgrade will not only affect the price of
government debt; it will also affect what is paid by all the other bond
issuers in the country - raising, for instance, the cost of issuing and
servicing debt for banks and state-owned utilities. To maintain profitability,
it is likely that banks will pass on these higher costs to their customers, in
the form of higher rates on loans or higher bank fees or lower interest
rates paid on deposits. In fact, higher funding costs for banks may be one
of the reasons why the spreads between bank lending rates and the
repurchase rate as well as deposit rates have widened since the global
financial crisis. With many low-income households relying on cash loans
for meeting their subsistence needs (often at already-high rates) or using
bank deposits as a major form of savings, one can easily see how higher
borrowing costs of banks can penalise them. Equally, if a state-owned
utility like Eskom is forced to pay higher interest rates on its debt, such
costs are likely to ultimately be passed through to their customers - in the
form of higher electricity tariffs, including for poorer households.
Separately, South Africa's domestic savings are insufficient to meet its
investment needs. Offshore borrowing is therefore required to fund growth
and development. So, any downgrade in sovereign ratings is bound,
sooner or later, to have negative consequences for the exchange rate of
the rand. This, too, can potentially harm the poorer households.
Historically, because of the openness of the South African economy, a
depreciation of the exchange rate has tended to raise inflation. In turn, a
higher rate of inflation hits the most vulnerable harder, especially people
who depend on basic grants which only get adjusted once a year at most.
In particular, food prices and transportation costs rise on the back of rand
depreciation. This reflects one of two things: either the need to import
some of these goods (for instance petrol, which will over time affect the
prices of public and collective transport) or linkages between the prices of
foodstuffs and those of agricultural commodities on the global market.
These items account for a larger part of total expenses for the poorer
households. For example, according to calculations by Statistics South
Africa, food and non-alcoholic beverages account for 48% of consumption
expenses for the 10% poorest households, compared with a weight of only
17% for the whole population.
The impact of a rating downgrade on financial markets may also have
more direct implications for the poor than generally assumed. As
mentioned earlier, poor households do not directly hold share portfolios,
but some - in particular, older people who worked for a while in the public
or private sector - rely on payments from pension or provident funds as
their main, if not sole, source of income. If the value of financial assets
declines, the money available in these pension and provident pools will
shrink accordingly. Separately, research shows that some of the savings
vehicles typically used by poor people, such as stokvels, are gradually
being invested in financial assets to create wealth rather than being used
solely for short-term purposes (such as, for instance, to cover funeral
costs).2 Again, any drop in the value of these financial assets would
undermine the efforts aimed at creating wealth through such savings
vehicles.
Finally, rating downgrades cast general doubts on the long-term economic
and financial health of a country. This is because downgrades typically
weigh on business confidence, undermining companies' willingness to
invest in new productive capacities and boost the size of their workforce.
At worst, businesses fearing a worsening economic future may shed jobs,
resulting in an overall decline in the number of employment opportunities
throughout the country. In South Africa, unemployment exceeds 27% of
the workforce, while the ability to find a job often provides the main chance
to escape poverty for an individual and his or her family. Declining job
opportunities would therefore risk aggravating the incidence of such
poverty.
Arguably, many of the channels described above operate through investor
sentiment and financial asset prices, including the exchange rate of the
rand. One can therefore argue that so far, in particular since the latest
rating downgrades, the reaction of financial markets has been rather
benign. For instance, the yield on the 10-year South African government
bond is still close to the average of the past five years, and the 5-year
CDS spread on South African sovereign debt is around its lowest since
late 2014. As for the rand, it has recovered by about 20% on a trade-
weighted basis from the lows it had reached in early 2016.
Yet this relative stability is fragile, dependent on developments that may
reverse in the not-too-distant future. The lack of a strong sell-off in either
the rand or local bonds has more to do with a conjunction of favourable
international factors than with investors downplaying the possible
negative consequences of a downgrade. In particular, the factors referred
to are the improvements in global economic developments, the absence
of inflationary pressures in the advanced economies, and a still-
accommodative stance by the world's major central banks. These factors
have ensured that capital continues to flow to the emerging world, even
to countries which have experienced a deterioration in their
creditworthiness. But these flows could easily reverse. And amid tighter
global financial conditions, investors would be more likely to differentiate
between stronger and weaker sovereign credits. Should South Africa face
another global shock, like it did during the 2008-09 global recession, its
recent rating downgrades could well make it more vulnerable to that
shock.
Admittedly, some commentators claim that further downgrades to South
Africa's sovereign ratings would not starve the country of foreign capital,
as other investors - specifically, funds of a more speculative nature -
would still buy domestic financial assets. However, apart from the fact that
these investors would require a higher return on South African assets than
recent historical norms, their investments would be more short-term in
nature, most likely resulting in a higher volatility of market prices. This, in
turn, would increase the climate of uncertainty facing domestic
businesses, with negative consequences for fixed investment, job
creation, and therefore poverty and inequality.
In conclusion, let me say that a sovereign rating is not a policy goal per
se. Rather, it is a reflection of a broad range of economic, social, and
political factors that constitute the creditworthiness of a country. Key
among these factors is the strength of our institutions, including the
Chapter 9 institutions, the judiciary, and the South African Reserve Bank.
These institutions underpin our democracy and our creditworthiness. It is
this creditworthiness that policymakers should strive to improve, for goals
that include development and poverty reduction. As international
experience shows, it is failure to generate sufficient economic growth and
to maintain healthy fiscal and external balances that keeps large portions
of a country's population in poverty. For South Africa's economy to
become stronger and more resilient, and to make inroads into poverty, we
need not only to avoid further downgrades; we should also ensure that the
recent downgrades are eventually reversed.
Thank you.