Earlier this year, we managed to avoid a sovereign credit rating downgrade from Standard & Poor’s (S&P) credit rating agency. Credit to our finance minister, Pravin Gordhan, who played a major role in avoiding the downgrade. However, in December, South Africa once again runs the risk of being downgraded to ‘junk’ status. After the municipal elections, things were looking much better. The rand strengthened significantly against the US dollar and a credit rating downgrade in December seemed unlikely. Until recently that is…
Criminal charges are currently being laid against our finance minister. This is bizarre. I am not going to waste my or your time writing about these charges because in reality, these charges are a façade in order to conceal the real motive as to why there is an attempt to remove him from office. Pravin Gordhan refused to sign two treasury guarantees – one for a R1 trillion nuclear project and another for a R5 billion South African Airways loan. If he had signed, it would have been detrimental to our economy while benefiting a few select individuals.
If Pravin Gordhan is removed from office and replaced with another finance minister, South Africa’s sovereign credit rating will certainly be downgraded to ‘junk’ status. And South Africans will feel the impact on a personal level. So today, I would like to answer three questions:
- What exactly is ‘South Africa’s sovereign credit rating’?
- What are the consequences of a credit rating downgrade to ‘junk’ status?
- From a financial planning point of view, how can South Africans prepare for it?
What exactly is South Africa's sovereign credit rating?
When an individual requires money, they go to the bank to take out a loan/bond. When the South African government requires money, the government issues bonds for the public (foreigners and locals) to invest in. So the public is playing the role of the bank and the government is the ‘individual’ receiving the loan. A pre-determined interest is applied to these bonds and the government pays back the money, with interest, over a period of time. This process is common practice in many countries.
Now think of a high-income professional approaching a bank for a loan. More than likely, this individual will get charged a low interest rate from the bank simply because there is a lower chance that the individual will default on the loan. However, if a low-income individual approaches the bank for a loan, this individual will probably be charged a higher interest rate because there is a higher chance that the individual will default on the loan.
South Africa, at present, can be considered a ‘middle-income individual’. When I say that South Africa’s credit rating could be downgraded to ‘junk’ status, it means that the credit rating agency may conclude that South Africa can no longer be considered ‘middle-income’ due to the risks associated with our political and economical landscape and will downgrade the country to ‘low-income’, i.e. ‘junk’ status.
What are the consequences?
- If South Africa’s credit rating gets downgraded, the government will have to pay higher interest on their bonds. Since many of the bond-holders are foreigners, a significantly higher amount of money will be leaving the country in interest payments. This results in less funds available for the South African public. There is already a substantial deficit in South Africa’s current account so a downgrade may require an increase in taxes in order to combat this deficit.
- A downgrade will also result in cash outflows from our financial markets. Many foreign investment companies invest their funds into South Africa. However, many of these investment companies are not allowed to invest into a country that has ‘junk’ status and will be forced to withdraw their investments. This will result in a decline in the financial markets, i.e. your investments will lose value.
- The cash outflows will also result in the rand weakening which in turn will result in an increase in inflation. This means the cost of goods and services will increase, i.e. our day-to-day expenses increase.
- The South African Reserve Bank will probably have to increase interest rates.
Essentially, South Africans will become poorer (or less wealthy).
How to prepare for a credit rating downgrade
Unfortunately, I don’t have much to say here that will enable you to escape the consequences listed above. There is one suggestion I will make however, that will somewhat minimize the impact that a sovereign credit rating downgrade will have on your financial position:
ENSURE THAT YOUR INVESTMENTS HAVE GLOBAL EXPOSURE.
When investing globally, the investor in effect, owns foreign currency. So when the rand weakens, the investor benefits since the foreign currency is now worth more rands. I highly recommend this investment strategy as it is one of the most effective methods in protecting your wealth against a credit rating downgrade. If you are not sure how to go about this, pop me a message. I will be glad to assist.