On Wednesday last week, Standard & Poor’s (S&P) downgraded Brazil from BBB- to BB+ with a negative outlook, giving Brazil’s bonds the feared ‘junk status’. Why did this happen and what does it mean for South Africa?
The three main rating agencies – S&P, Fitch and Moody’s – each have a scale by which it rates the risk of government and company bonds – that is, the ability of the bondholder to pay them back. Their scales are a combination of letters, symbols and numbers, but for simplicity’s sake note that A is better than B and more Bs are better than less, with a positive or negative sign marking the difference between each scale. In this way BBB- is better than BB+ but bond ratings are divided into two broad categories: investment grade (BBB- and better) and junk grade (BB+ and worse).
Many of the largest international investors in bonds are funds looking for safe places to store their money including sovereign wealth, pension contributions and insurance installments. Their policies state they are not allowed to invest in junk grade bonds and when a rating agency downgrades a country’s bonds below this line, the demand for these bonds drops.
Brazil entered into this situation due to weak economic growth, a growing fiscal deficit, high government debt and rising borrowing costs. Government bonds are the government’s way of borrowing money from the public and the yield on the bond is the interest rate they have to pay the lender. The interest rates at the initial sale are therefore the cost of borrowing.
These interest rates are set by demand and supply – the higher the demand for the bond, the lower the yield that needs to be offered to attract buyers, and vice versa. But due to low demand the yields on Brazil’s 10-year government bond have soared from 12.5 percent in July to over 15 percent in September.
Any new bond issues will have to be offered at the higher rates making it more difficult for Brazil to pay its debts. The drop in demand due to the downgrade further increases Brazil’s borrowing costs – just after the S&P announcement, the yield on the 10-year government bond increased from 14.91 percent to 15.29 percent.
The downgrade in Brazil has sparked speculation that other emerging markets may be downgraded to junk, especially Turkey, Malaysia and South Africa. In June this year, S&P maintained their rating of BBB- with a stable outlook for South Africa, saying that this was unlikely to change in the next two years.
South Africa is facing many of the same risks that led Brazil to its junk status, but it is doing better. Brazil’s budget deficit in 2014 was only 0.6 percent of gross domestic product (GDP) to South Africa’s 3.8 percent. But where the Treasury has made solid commitments to decrease spending and slightly raise taxes, Brazil has been slack in coming up with a plan. Their deficit is expected to increase to 8 percent of GDP in 2015 and 2016.
South Africa’s economy is growing slowly – forecast to be around 1.7 percent for 2015 – but Brazil is in a recession with annual GDP growth at negative 2.6 percent. South Africa’s government debt to GDP ratio of 39 percent is healthier than Brazil’s 59 percent, and while Brazilian 10-year bonds yields have exceeded 15 percent, South Africa’s are still around 8.5 percent.
A downgrade for South Africa would not be welcome but as yet, we’re not following in Brazil’s footsteps.
* Pierre Heistein is the convener of UCT’s Applied Economics for Smart Decision Making course. Follow him on Twitter @PierreHeistein
** The views expressed here do not necessarily represent those of Independent Media.
BUSINESS REPORT