Moody's rating downgrade pushes rand to historic levels

Ratings Downgrade

Moody’s Investor Relations has finally downgraded South Africa’s local currency debt to sub-investment grade (junk). The sub-investment grade rating aligns with major ratings agencies S&P Global and Fitch Solutions.

What does a rating downgrade mean?

The Moody’s downgrade means that South African Government Bonds will be removed from the FTSE Russell’s World Government Bond Index (WGBI) as the WGBI cannot use speculative Bond Indices in its constituent weightings. This will result in net selling of SA bonds (estimated at around $10 billion). However, the FTSE Russell’s WGBI is delaying the reweighting of the index until the COVID-19 effects on liquidity and spreads start to dissipate. This will delay the physical selling of SA bonds to reweight the WGBI index.

For the South African economy, the downgrade suggests an increase in the cost of raising capital, which pressures an already delicate local budget. The COVID-19 pandemic is expected to significantly disrupt a local economy already in recession, making revenue collections softer, which makes meeting the country’s expenditure commitments even more challenging. This will raise the budget deficit and necessitate increased capital raising through more expensive debt issuances.

Too large a proportion of the South African budget is already allocated towards debt and interest obligations. The increasing cost of capital allows less room for economic growth initiatives such as infrastructure development. This also makes funding and implementing much needed structural reforms (in State Owned Entities) and socio-economic reforms increasingly more difficult for government.

Brazil, Russia, India, China & South Africa (BRICS) currencies vs US dollar

We are now seeing a short-term underperformance in The Rand (ZAR) aligning its depreciation for the year to date, with that of the Brazilian Real and Russian Ruble. Both Brazil and Russia also carry sub investment grade ratings by major agencies Moody’s, S&P and Fitch. Russia is currently battling sanctions and decade lows in oil prices (primary commodity export). Brazil has only recently emerged out of a recession which is likely to renew with COVID-19, political disruption and the regions high unemployment. While India remains one of the fastest growing economies in the world its currency has been resilient by comparison, while the Chinese Yuan remains stable on account of currency pegging by the Peoples Bank of China.

USD/ZAR

The USD/ZAR has now traded through the all-time high of R18/$, as highlighted by the monthly chart below, of the currency pair. The short-term capitulation can be attributed to the rating downgrade, although the general weakening trend for the ZAR has been largely attributable to sympathy with softer emerging market assets in the wake of a risk off environment.

The long-term trend remains up for the USD/ZAR. The short-term trend, while also up, appears to be overbought at current levels and could be capitulating at present. With a lot of negative headwinds now priced into the ZAR, we do think that short-term strength could take the USD/ZAR back below the R17/$ mark, possibly closer towards R16.50/$. Short-term strength could be catalysed by further carry trade opportunities while bond local yields remain attractive on a global comparative basis.

While the USD/ZAR could retrace from overbought territory, the longer-term trend does suggest that weakness will then resume after a short-term correction.

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