Since the outbreak of COVID-19, the South African rand has continually plumbed record lows after breaching the 18.00 handle six days ago.
A stagnant economy, riddled with labour market rigidities and a lack of reform to government liabilities, has been the story of the rand since Ramaphosa’s re-election back in May 2019. However, the introduction of COVID-19 has exacerbated the economic contraction as South Africa, along with many developed markets, enters an extended containment period which shuts down both manufacturing and social consumption. To add to the rand’s woes, Moody’s downgraded its sovereign credit rating on March 27th, rendering South African government debt sub-investment grade. This prompted an outflow in foreign demand for SAGBs as they were no longer eligible for global bond indices, increasing the impact of the risk-off environment on South Africa bonds.
Currently, the percentage of SAGB’s held by non-residents sits at a 4-year low, but more concerning is the rate in which foreign agents diversified their bond portfolios away from higher-yielding South African debt compared to 2015.
While this move from foreign players wasn’t focused solely on South African debt, with many EM bond indices also falling to levels not seen since 2008, the fact South Africa’s economy was already experiencing economic difficulties just adds to the blowout in bond markets.
Chart 1: Portfolio flows show 2008 style exodus from EM assets as foreign bond ownership of SA debt hits 4-year low
Chart 2: % of SAGB’s held by foreign investors dropped to a 4-year low
Bond issuance, yields and CDS pricing have all exploded recently, and are set to continue until the global risk appetite subsides and global growth conditions improve. While an improved risk climate will help attract foreign demand back due to the relatively high yielding nature of SAGB’s, issuance will remain high as the government seeks to meet its previous stimulus plans despite revenues falling. A projected 2-4% contraction in the economy according to the SARB’s latest Monetary Policy Report or 3.7% as measured by Fitch, highlights the erosion of the Treasury’s tax base which will only put increasing pressure on SAGB issuance to finance previous pledges towards growth stimulus.
The fiscal shortfall was already estimated at 6.8% this fiscal year in February’s medium-term budget, but the impacts of coronavirus on growth prompted rating agency Fitch forecast the fiscal deficit surging to 11.5%.
This prompted the rating agency to follow Moody’s decision last week and cut South Africa’s sovereign credit profile to two notches below investment grade at BB. However, a glimmer of hope is left by the fact that South Africa’s debt tends to be denominated in the local currency, reducing the costs of servicing such debt due to FX movements, and it’s relatively long averaged duration – around 15 years. Increased bond issuance will only keep SAGB yields elevated over the medium-term. The yield on 10-year debt reached a high of 12.38% last month and currently sit just above 11% today.
In the short-run, the rand is likely to be under pressure from risk aversion in global markets and containment policies intensifying the economic contraction in 20H1. The latter concern will draw attention to the virulence statistics seen in South Africa.
On Sunday evening, the Minister of Health, Zweli Mkhize, announced a further increase in the number of confirmed virus cases in South Africa. While the total figures are still relatively low (1,655 cases and 11 deaths as of yesterday), officials warned of a quick escalation as the virus arrived in more crowded urban areas. With health and social infrastructure underdeveloped in South Africa compared to that seen in China, for instance, the suppression of the virus may take longer. This will only increase the economic impact, which is already projected to be large and maintain pressure on the rand despite its higher-yielding status of late.
Due to malfunctions in bond markets, the South African Reserve Bank started the purchase of SAGBs just over a week ago to inject liquidity and promote good functioning of domestic financial markets. The question now for the rand on a longer-term basis is the depth of the economic contraction, spurred on by the impact of coronavirus, and whether monetary stimulus can fill the government’s shortcomings yet again due to the restrained fiscal space.
Despite today’s negative news stemming from both SARB’s monetary policy report and Fitch downgrade, the rand is trading on the front foot still. A tentative risk-on reaction in global markets that is befitting with the current trend in FX markets allowed for the currency to reverse the earlier decline, reaching daily highs against the euro and USD.
Chart 3: the South African rand rebounds after hitting a record low against USD
Chart 4: 3-week containment policy expected to shave 2.6% from growth in 2020
Simon Harvey, FX Market Analyst
Ima Sammani, Junior FX Market Analyst