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Ratings Downgrade Looms Following mid-Term Budget, South African Rand Sold as a Result

Gordhan impact on the Rand

December 2nd could now well be the date South Africa is downgraded from investment grade status, and the Rand knows it.

The market reaction to Pravin Gordhan's mid-term budget confirms financial markets are nervous about South Africa's fiscal prospects. 

The Treasury's latest financial forecasts reveal a downgrade to growth estimates and seemingly over-optimistic expections for growth over the next two years.

Those growth forecasts are linked heavily to the assumption that the South African growth will ride the coat-tails of an acceleration in global economic growth rather than from much-needed domestic reforms.

The Pound to Rand exchange rate shot higher by over a percent after the contents of the mid-term budget were revealed.

GBP/ZAR reversed its short-term decline to rally back above 17.00 while the US Dollar to Rand Rate rose to 13.88.

The mid-term budget was deliverd amidst notable unrest on the streets outside South Africa's Parliament where protesting tertiary education students forced police to secure the area and limit the movement of politicians.

This is the latest escalation in country-wide protests that have been going on for months as students press for free tertiary education.

The protests confirm the Treasury is faced with unprecedented pressure to expand spending but it is burdened by a slowing economy and declining tax receipts. 

There exists a lingering, but growing, uncertainty towards South Africa as a stable and long-term investment destination; something that is always reflected in the currency first.

"We continue to believe that there is a better than evens chance that S&P downgrades South Africa to junk at its December review," says Paul Fage, Senior Emerging Markets Strategist at TD Securities in London.

We believe the reaction of the Rand confirms currency markets share this view.

Analyst John Cairns at RMB in Sandton, Johannesburg, says he is also nervous that a downgrade looms:

"Our call has been that S&P will not downgrade us in December but rather hold off until June. The numbers in this budget, the lack of reforms, plus the political climate means that the call is going to be closer than we would like."

For Cairns, December 2nd remains a key day for the local markets.

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Gordhan Fights to Maintain Fiscal Credibility

Finance Minister Gordhan announced that the Treasury had cut their growth estimates for 2016 down from 0.9% to 0.5%.

But, growth is forecast to rise over the next three years with GDP hitting 2.2% growth in 2019.

However, much of that growth is linked to the global economy expanding, which most indepedent economists say is no guarantee.

It would appear that Gordhan has opened his wallet a little wider than markets were expecting with an 18% increase in health spending over three years catching the eye.

An additional R17bn for universities and students over the medium term.

The spending will be partly be met by an increase in taxes to the tune of R13BN, this on top of the R15BN announced in February in the budget.

It was announced that revenue collections for the first half of 2016/17 have fallen sharply below expectations, mostly due to shortfalls in personal income tax.

VAT intake was also below expectation, largely due to weak demand for domestic and imported goods which reflects the GDP downgrade for the year.

Nevertheless, the expenditure ceiling is reduced by R10bn in 2017/18 and R16bn in 2018/19.

The consolidated budget deficit is expected to narrow around 3.4% to 2.5% of GDP in 2017 which confirms fiscal discipline remains a hallmark of Gordhan's tenure. 

"There were positives and negatives in the budget but, on balance, we see it as market and rating negative. The Minister needs to be given credit for putting everything on the table: tax adjustment and expenditure cuts to deal with the budget shortfall. However, in a tight economic environment, he simply could not do enough," says RMB's Cairns.

The analyst argues that ultimately the market will not be able to get away from the lack of underlying economic reform, higher deficits, greater bond issuance, higher debt levels.

Where the forecast peak in the net debt ratio was 46.2% of GDP in FY17/18, it is now 47.9% in FY19/20.

 

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