South African Rand Nerves Ahead Imminent Rating Review

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ZAR is at risk of a hefty sell-off on Friday if two ratings agencies downgrade the country's credit rating, however no action could result in the currency jumping. 

Tomorrow sees the two largest credit rating agencies, Moodys and Standard & Poors publish their latest assessments of South Africa.

The Rand is reflecting nerves ahead of the key event coming in about 0.4% lower against the majors: the GBP/ZAR exchange rate is down at 18.47, the EUR/ZAR is at 16.44 and the USD/ZAR is at 13.88.

The key risk is that bonds issued by South Africa's Government in order to borrow money are judged to be increasingly risky for investors to hold.

The particular bonds that will be in focus are those bonds issued by South Africa in Rand - this accounts for about 80% of all South African bonds in circulation, eclipsing those bonds that are issued in foreign currency.

We have already seen foreign currency bonds downgraded to junk by one agency, but clearly the risk is the massive tranche of ZAR-denominated bonds are also downgraded.

If both Moodys and S&P both decide to downgrade South Africa's credit rating it could be a torrid day for the Rand.

Such a move would likely see South African sovereign bonds removed from the holdings of most major funds; Governor of the SARB's Lesetja Kganyago recently noted 40% of rand-denominated sovereign bonds are now in foreign ownership. He has warned that further rating downgrades could trigger bond sell-offs of index-oriented funds with a volume of 100 to 180 billion rand.

Such a fire-sale would understandably place immense pressure on the Rand.

South Africa's Rand-denominated bonds are a downgrade away from 'junk status' -  a term used for sub-investment grade debt; most funds will only hold assets from country's with an investment grade rating, so SA bonds, stocks, shares, and other hard assets will become non grata.

It also means SA bonds will be removed from Citi's World Government Bond Index (WGBI) which has become the standard goto 'league table' for government bonds internationally.

To fall out of the index and be classed as sub-investment grade both agencies need to downgrade SA tomorrow, when they publish at 18.30 (S&P) and 23.30 (Moodys), (SA time which is 2hrs ahead of GMT).

Three Scenarios for the Rand

There are three possible outcomes of the S&P and Moody's rating review:

1. No change, deferral of rating reviews;
2. One of the two rating agencies downgrades South Africa’s rating;
3. Both rating agencies downgrade South African sovereign bonds to junk status.

"We assume that quite a few market players are already banking on the first or second scenario ahead of the ruling ANC’s National Conference in December. Nevertheless, if the first scenario is realised, we believe the market would probably initially react with relief and that the rand would appreciate sharply, at least temporarily," says Elisabeth Andreae at Commerzbank.

Rand Merchant Bank FX analyst John Cairns puts the probabilities at 'possible' rather than 'probable'.

"We put the probabilities of a local currency rating downgrade on Friday evening at 40% for S&P and 10% for Moody’s. Fitch, which does not release its review dates, might also make an announcement this week but this is far less of an issue," says Cairns.

A survey of analysts shows that a majority expect the second scenario to be played out. "If this happens, we would also expect the USD-ZAR to initially fall, albeit to a lesser extent than under the first scenario," says Andreae.

According to analysts at ING, the Rand's current level reflects broad market expectations of a downgrade by only one of the agencies, but this still leaves risks.

"We think the risks of the ZAR being removed from the (WGBI) bond index are quite high, thus would not be tempted to chase the ZAR recovery – and see risks to 15.00 (USD/ZAR) on a downgrade by both rating agencies tomorrow," says ING's Head of FX Strategy Chris Turner.

If the third scenario plays out and both Standard & Poor’s and Moody’s downgrade ZAR-denominated bonds to junk status, Commerzbank forecast the Rand to fall sharply.

"The extent could be similar to after the April rating downgrade," says Andreae.

An eleventh-hour attempt to allay the possibility of a downgrade, by SA's Finance Minister Malusi Gigaba in parliament on Wednesday, was dismissed as having little impact on Friday's rating decisions.

Gigaba announced that the government would be cutting spending by R25bn and raising revenue by R15bn in its next budget, in order to balance the books, however, Cairns sees this as too little too late, commenting:

"This won’t meaningfully impact the decisions of the rating agencies."

SARB Rate Meeting

Another potentially significant event for the Rand is the South African Reserve Bank's (SARB) interest rate decision, released (today) on Thursday, November 23.

Yet with inflation in the middle of their target zone, RMB's Cairns sees little chance of SARB  changing interest rates, although a slightly less 'hawkish tone', which means indicative of lower, growth, inflation and interest rates, could weigh on the Rand slightly.

"Today’s SARB MPC meeting is the only notable event on the calendar. We expect rates to remain unchanged. While the decision should not have a meaningful bearing on the currency, the tone can be slightly less hawkish than what markets are currently pricing," said Cairns.

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