South Africa has been downgraded again. But what exactly is a “credit rating downgrade”?
Read on as we break it down for you.
1.Governments borrow money by issuing bonds:
The first thing to understand is that governments, like you and me, borrow money to fund shortfalls in their budgets. So if a country is not collecting enough in taxes or has low levels of savings, chances are it will need to borrow money in order to build infrastructure, provide basic services and generally carry out its functions as a government.
Governments do this by issuing what is known as bonds. These are viewed as fairly sound investments because a government is unlikely to be unable to repay its debt. So, investors – including pension funds and asset managers, such as Old Mutual or Allan Gray, buy these bonds, lending governments the extra money that they need to function. In return, governments pay the investors back their money, PLUS interest.
Think about it this way: If you don’t have the income or the savings to afford that awesome pair of jeans at Foschini, you can buy the jeans by borrowing that money from Foschini and then paying Foschini back plus extra (interest). The upside is that you get to buy the jeans and enjoy them today, the downside is that they are going to cost you more than they would have if you didn’t have to borrow the money to buy them.
So, now that we have established that governments commonly borrow money in order to do what they need to do as government, we come to credit ratings.
2. Credit ratings assess risk and therefore determine what those borrowings cost
A credit rating is simply an opinion on the ability and willingness of a country, or a company, to repay its debt. A credit rating assesses the creditworthiness of large borrowers, in the same way that a credit score assesses the creditworthiness of you and me.
So, imagine you walk into Foschini and try to get a store card to buy those jeans on credit. But you have already bought clothes using store cards at Truworths and Jet and run up major bills at those stores, which you haven’t paid off. Foschini will look you up on a central database and will see you’re not great at paying back debt. As a result, Foschini will probably be unwilling to lend you more money in the form of a store card.
In the same way, when investors – like pension funds and asset managers that manage money on behalf of savers like you and me – look to buy government bonds in a country, those investors look at, among a range of factors, the country’s credit rating, which is given to them by a credit rating agency.
So how does the credit rating agency help the investor? To assess the state of a country’s finances, rating agencies look at factors such as economic growth, tax collection, budget, debt repayment history and how much the country is already borrowing from investors to form their credit rating score.
Similarly, Foschini will also consider your income and expenses before making a decision on whether to lend you money, in addition to looking at your personal credit score.
Credit rating agencies also take into account softer factors such as the independence and quality of a country’s institutions, its leadership and its commitment to tackling corruption. This is done by actually meeting with institutions, such as the Treasury and Reserve Bank, to get greater detail on the facts and figures.
(Unfortunately, this isn’t the same for you as an individual. Foschini won’t really consider how smart or ethical you are when deciding whether or not to lend you money.)
Once the credit rating agency have gathered all the information and analysed it, they come up with a credit rating – generally from AAA (kind of like an A++ on your school report card), for the best borrowers, to D, which is a rating given to entities that have already failed to pay back some of their debt (kind of like an F on your school report card).
Now, rating agencies distinguish between a foreign currency and a local currency credit rating. To understand the difference, check out our note below this explainer. For our purposes, we’re going to focus on the more important of the two, which is the local currency credit rating and refers to the debt that it is in rands (rather than say dollars or euros).
Now, there are many ratings in between AAA and D…just like most of us probably weren’t A++ or F students at school, but somewhere in between. These ratings are separated into investment grade and sub-investment grade – also referred to as junk. Generally, the lowest possible rating you can have to still be considered investment grade (but only just) is a BBB -. Once you hit BB+ you’re junk.
In the credit rating game, S&P, Fitch and Moody’s are the three names that matter most because their ratings are what most investors pay attention to.
3. Credit quality matters to investors
And this brings us to why credit ratings matter: because point number 3. is that credit quality matters to investors. And South Africa, for various reasons, including our own low savings rate and low income from taxes, needs foreign capital in order to support economic growth.
Now, a large number of these investors we’ve spoken about, which, as mentioned, are generally investing money on behalf of ordinary people, are not allowed to invest in government debt that does not have an investment-grade credit rating from one (or sometimes two) of the three major credit rating agencies. This is because the investment rules of their funds prevent them from doing so.
In other words, they would be forced to sell the government debt of countries that are downgraded to junk, by Fitch, Moody’s and S&P to other investors that are able to invest in junk bonds – we’ll come to them in a bit.
4. SA stands to lose a lot of money from a junk credit rating
As we’ve explained previously, SA lost a lot of money from our downgrade to junk. Moody’s joined the other two agencies in downgrading us to junk in March 2020. It was a seminal moment.
At that point, our debt was automatically kicked out of the World Government Bond Index, which includes the government debt of more than 20 of the world’s largest economies, all investment grade, and is used by investors all over the world as a criteria to help them decide which bonds to invest in. Going back to our report card example, it would be like choosing to invest in the future of the A, B and maybe the C-grade students at school.
When Moody’s made the decision to downgrade us to junk in March, those investors that held our bonds in funds that permit only investment-grade debt were forced to sell them – likely at a lower price than what they bought them for since those bonds were now considered riskier.
In addition, with each downgrade, South Africa’s borrowing costs rise, which means the government has to spend more of its budget on repaying debt.
For example, let’s say you take out a R250,000 loan over five years to buy a car at an interest rate of 10%. Your monthly repayments on that will be about R5,300 and the car will end up costing you R319,000 over five years. If you were considered a riskier borrower and instead of a 10% interest rate were charged a 15% rate on the same car, your monthly repayments would be more than R5,900 and the car would end up costing you R357,000 over five years – so R38,000 more. That leaves you with a lot less money to spend on, say, fixing up your house. All because of the higher cost of your debt. And, while R250,000 is a lot of money, governments generally borrow in the billions – so a seemingly small change in an interest rate will cost them a lot more.
The more a government has to spend on servicing its debt, the less it has to spend on service delivery, infrastructure and critical areas such as health and education. In the latest government budget, about R200bn was already set aside for debt servicing costs. That’s almost the same size as the health or basic education budgets for a year.
5. Government will have to spend less or tax more to pay for its debt
This brings us to the final point: government will have to spend less or tax more to pay for its debt. Just like when you and I need to plug gaps in our finances, government can really only do two things: spend less or increase its income by raising taxes. Both of these will place a drag on already weak economic growth, leading to job losses, higher rates of unemployment and increased poverty. So yes, credit ratings matter and if we don’t seriously tackle what all the agencies say are our main credit challenges: low growth, steadily rising debt, indebted state-owned enterprises and weakened institutions, things will get worse.
Spelling it out:
Foreign versus local currency credit ratings: what’s the difference?
A foreign currency credit rating takes into account additional risks to the repayment of debt that is in foreign currency, such as dollars. These could include the likelihood of exchange controls being imposed (i.e. restrictions on the amount of money you can take out the country) or other restrictions on the repayment of foreign currency debt.
A local currency credit rating is an opinion of the country’s overall capacity to meet its financial obligations in its own currency (in our case Rand) and is the more important of the two. In SA’s case, the majority of our debt is in Rands, which is a good thing as it means it is not subject to fluctuations in the exchange rate.
How exactly did we lose money when we were downgraded to junk?
Those investors that held our bonds in funds that permit only investment-grade debt were forced to sell them – likely at a lower price than what they bought them for since those bonds were now considered riskier. This had a negative effect on the returns of the fund, which in turn has a negative effect on the investment returns of the individuals and companies whose savings are held in those funds.
Research by Hanna Zaidy