After an initial sell-off following S&P's ratings cut on Friday, South African dollar and rand assets recorded a huge rally. The shift seems counterintuitive. Not only have South African local bonds now been dumped from the Barclays Global Aggregate Index, but the country is just one, highly likely, ratings move away from expulsion from the larger Citi World Government Bond Index (WGBI), which is tracked by funds worth between $2tr and $3tr.
Société Générale estimates that South Africa’s removal from the WGBI could result in passive forced selling amounting to $5bn-$11bn.
Even if all logic suggests that South African bond prices should be lower, to reflect the country’s downward ratings trajectory and the huge economic and fiscal challenges it faces, market evidence hints otherwise. Taking a negative view on South Africa over the past year would have meant losing money, and why would any self-respecting investor do that, as one senior EM trader points out.
It seems entirely wrong that shambolic governance, cronyism and gross mismanagement are rewarded with access to cheaper financing. But in this respect the price action in South African dollar bonds acts as a microcosm of the market as a whole.
“We are completely inured to any type of risk — economic, political, Brexit, Trump," said the EM trader. "Whatever the threat smells and looks like we don’t seem to care. Any wobble has proved to be a buying opportunity, rightly or wrongly.”
While rating agencies often lag the market, and can appear out of step with what is going on, when investors show they don’t care about ratings, why should the borrower?
South Africa still clings to one investment grade rating from Moody’s, which has placed the country on negative watch and will provide an update in February.
It will be tough for South Africa to meet the stipulations laid out by Moody’s. The rating agency will review South Africa’s “willingness and ability to respond to rising pressures through fiscal tightening, structural economic reform and improvements to [state-owned enterprise] governance”.
While the likelihood that any government could make major progress in all of the above in a mere 90 days is laughable, South Africa was once committed to maintaining its investment grade status. Removing an additional incentive to reform quickly and efficiently to preserve that status can only be bad.
If a government believes it can access foreign funding cheaply and easily, why would it introduce potentially punitive and unpopular reforms?
Then what of the knock-on effects on an unwilling reformer when a shock does occur — a rate hike, or political disruption, for example? They will be exacerbated.
Liquidity may be there now, when everyone wants to buy, but it can be gone in an instant. The EM trader likens it to a switch – it’s either on or off. There is no dimmer.
Perhaps Moody's decision will be the tipping point, with the expected full junk status leading to a repricing. But until then, the pressure and necessity to reform is being reduced though the negative reinforcement of bad behaviour, which seems to be rewarded by solid bond prices.
South African dollar bonds may have rallied but the market’s gain is the country’s pain. It may not be logical, but that is the state of the market. It will make the correction more painful when it does come.