3) Fitch and Moody article

Question 1

Summarise the article posted by Fitch and Moody? (3)

Answer 1

• On the 20th of November 2020, Fitch Credit Rating Agency downgraded South Africa’s long term foreign currency bonds deeper into junk status (from BB to BB-)
• Credit Rating – Fitch and Moody
  o Evaluated SA as in issuer of bonds and made these ratings.
  o Evaluated ability to pay debts, coupons, principal.
  o Default risk as an issuer

Question 2

What effects credit rating? (2)

Answer 2

(Ability to repay debt)
o A function of cost and revenue
o Underlying factors affecting these two things

Question 3

Why did Fitch and Moody downgrade South Africa? (8)

Answer 3

1) Sharp fall in revenue and increased spending (weakening fiscal strength)
2) High and increasing in debt means more interest payments for the government.
3) Low economic growth
4) Unreliable electricity supply
5) An unreliable power supply negatively affects the production of goods and services
6) Poor performance by state owned enterprises (SOEs) become a burden to the fiscus as they may require bail-out from the state
7) High inequality between the rich and the poor
8) Capital Outflows due to the pandemic

Question 4

Explain how weakening of fiscal strength (Increase in spending and decrease in revenue) results in downgrade in credit rating (3)

Answer 4

• The fiscal strength is measured by the amount surplus/deficit (the difference between revenue
  and expenditure).
• Weakening fiscal strength increases the probability of default, it may result in
  South Africa (SA) not being able to service her debts. It is an indication of decreasing revenues
  (mainly tax) and ballooning expenditure.
• So a deterioration of the fiscal strength, in South Africa’s case, means the budget deficit is increasing (the pocket is getting thinner and thinner), which reduces South Africa’s capacity to pay its debts, hence the downgrade.

Question 5

Explain how high and rising government debt, results in downgrade in credit rating (3)

Answer 5

• High and increasing in debt means more interest payments for the government.
• The increased interest payments on the back of shrinking revenues put SA in a very tight financial situation which may lead to default.
• In the worst case scenario, a high debt situation, means the collateral security may not be enough to cover all bond holders if South Africa defaults hence the increased risk of default

Question 6

Explain how unreliable electricity supply, results in downgrade in credit rating (2)

Answer 6

• This problem feeds into weaker economic growth story because the production of goods and services, which are a source of tax revenue for the government, require reliable power supply.
• An unreliable power supply negatively affects the production of goods and services – which means less tax revenue for the government, weakening fiscal position and less money to service debts

Question 7

Explain how low economic growth, results in downgrade in credit rating (2)

Answer 7

• Low economic growth implies less or lower tax revenue for the government, which means the government, will have less money to pay for its debt
• Therefore, lower national production (the lower the GDP growth) means lower tax revenue for the government, which reduces the government pocket and consequently affect its ability to honour its debt obligations

Question 8

Explain how poor performance of SOE’s results in downgrade in credit rating (5)

Answer 8

• Poor performance by state owned enterprises (SOEs) become a burden to the fiscus as they may require bail-out from the state.
• This will further strain the government’s financial position and consequently their ability to meet their debt obligations.
• Furthermore the poor performance by SOEs or their inability to service their debts pose a risk to the government because of contingent
  liabilities.
• The contingent liabilities arise from the guarantees that the state provides to state- owned enterprises when they are borrowing. This is a huge risk because the government has the obligation to step-in if the parastatals fail to honour their obligations to the investors.
• Given the poor performance by SOEs, there is a high likelihood of this happening. This will then become a case of obligations ballooning but without a corresponding increase in the revenue base, which may result in default.

Question 9

Explain how high inequality between rich and poor results in downgrade in credit rating (2)

Answer 9

• A high inequality gap between the rich and the poor is a double edged sword. On one side it
  increases the need for the government to spend more on the poor to uplift them and bridge the inequality gap. The means more funding is directed to the safety net as opposed to servicing debt.
• The more money spend on bridging the inequality gap the less money to service debt, which increase the probability if default. On the other side, it implies lower tax base for the government.

Question 10

What happens due to the downgrade in credit rating which causes the yield for SA bonds to increase? (3)

Answer 10

• The yield for SA bonds may increase, hence the South African government will have to pay higher interest rates if they take on new debt.
• Given the timing of the downgrade being the
  middle of the Covid19 pandemic this possibility was not unlikely.
• The government was desperately looking for funding to increase the safety net and to support the economy that
  was negatively affected lockdown and Covid-19.

Question 11

What did the finance minister describe the downgrade as ‘painful’? (4)

Answer 11

1) The yield for SA bonds may increase; resulting in an increase in interest rates
2) Can drive inflation
3) Increase in repo rate
4) Business and consumer confidence will decline

Question 12

What happens due to the downgrade in credit rating which causes the inflation to increase ? (3) (explain with regards to exchange rate effect)

Answer 12

• A downgrade to junk can drive inflation upwards, through the exchange rate effect and interest rates (refer to the point on capital outflows due to the pandemic above).
• In simple terms, an increase in inflation or high inflation means more people will go to bed hungry, many will be homeless, and more people will live below the poverty datum line.

Question 13

How does the downgrade affect inflation and the exchange rate? (5)

Answer 13

• South Africa is vulnerable to capital outflows.
• With a further downgrade deeper into to junk status it becomes less attractive for investors (specifically those who only invest in investment grade assets) to invest in South African bonds.
• This results in a massive sell-off of South African bonds or investors avoiding SA bonds
• Imported comodities become more expensive like oil and affect general price levels
• Consequently result in the rand depreciating

Question 14

A rand depreciation has ____________ consequences on inflation (imported inflation). ____________ commodities, equipment etc. like oil become more ____________ and that will affect general price levels in the country.

Answer 14

negative
imported
expensive

Question 15

What further impacts inflation and price levels?

Answer 15

Given that the Reserve Bank of South Africa, which follows inflation targeting framework, use interest rates as the main instrument to tame inflation, the repo rate is likely to be hiked which pushes up the general level of interest rates

Question 16

What is the impact of increasing the repo rate for ordianry people?

Answer 16

The impact of increasing the repo rate (alluded to above) is higher borrowing rates for the ordinary people, reduced spending by consumers, less borrowing by companies and consequently reduced economic growth.

Question 17

Business and consumer _____________ will decline, resulting in ______ investments and spending and less employment opportunities.

Answer 17

confidence
lower

Question 18

What are the possible outcomes of the ‘painful’ downgrade? (6)

Answer 18

• high interest rates
• increased government expenditure
• high unemployment
• reduced government revenues were a cause for concern
• it would result in less spending to the poor and vulnerable (less money for schools and clinics, and other services)
• at a time when they needed more assistance – hence it was “painful”

Question 19

A surprise reduction in the repurchase rate (repo rate) can lead to a decline in bond yields.

Explain the mechanism that triggers this shift, detailing the process from the repo rate cut
to the subsequent decrease in bond yields. (5)

Answer 19

• A repo rate cut means related interest rates like deposit and lending rates will also decrease
• A good example is the prime lending rate, which is benchmarked to the repo rate. The decrease in lending and deposit returns make bonds more attractive or more competitive compared to these other interest rate related instruments like lending and fixed deposits.
• This increases the demand for short term bonds; hence their prices will increase. As the bond prices increase, the yields will be decreasing – so a rate cut is likely to result in bond yields decreasing.

Question 20

On the 22nd September 2022, the Reserve Bank of South Africa increased the repo rate
from 5.5% to 6.25%. Bond yields (for both short- and long-term bonds) did not experience
a significant change in response to this rate hike – an indication that it was largely
anticipated by market participants, and it was already priced or incorporated into bond
yields.

Required: Explain in detail how the expectation or anticipation of a rate hike was priced
into short-term bond yields in the days leading up the rate hike decision.

Answer 20

• When investors are anticipating a rate hike they position themselves by selling/avoiding
  short terms bonds
• Hence there will be a less demand and more supply for short term bonds – by doing this, they would be hoping to avoid incurring capital losses from the bond price depreciation when repo rate is hiked (bond prices decrease when interest rates increase)
• The less demand for bonds will be push the bond prices down while pushing the yields up– hence the short-term bond yields will increase before repo rate hike announcement if the market anticipates it.