KEY TAKEOUTS

• With Morocco currently the highest rated Eurobond issuer in Africa, coming in two notches above South Africa’s B-rating with a BB+ rating, the GNU could learn something about economic reform from Morocco’s more stable credit rating.
• An improvement in SA’s investment grade would provide a reduction of around 100 basis points or 1% in the cost of dollar borrowing, which is a meaningful improvement given the scale of our funding needs.
• South Africa’s BB- rating by Fitch is driven by its weak growth prospects based on deeply entrenched structural problems and continued uncertainty about its ability to stabilise debt-to-GDP due to high unemployment and inequality.
• Morocco’s BB+ rating by Fitch, on the other hand, is based on sound policy framework underpinning macroeconomic stability and supported resilience to shocks, despite the deterioration in GDP growth volatility and high inflation.
• Morocco has also maintained a relatively prudent fiscal policy, allowing the government to manage its debt levels effectively.

When Moody’s downgraded South Africa’s credit rating to junk status in 2020, it became one of the last Eurobond issuing countries to lose its investment grade across the continent. Most countries across the continent are currently B-rated, with Morocco the highest rated Eurobond issuer in Africa and South Africa two notches below Morocco, having a B- rating. Botswana and Mauritius are rated investment grade, but do not issue Eurobonds.

While a sub-investment grade rating does mean a higher degree of risk, it does not mean that one should not invest in these markets as more risk could mean more opportunity. Investors need to adjust their portfolio accordingly for this increased risk when gaining exposure to these markets.

However, Morocco’s cost of borrowing is the lowest among African countries, at only 5.66%, while South Africa’s borrowing costs are at 6.7%. This raises questions about what South Africa’s Government of National Unity (GNU) can learn from the reform of other African economies such as Morocco, and what this would mean for our debt markets.

Diversified funding sources

When it comes to sovereign debt, it is normal for governments to borrow money – in fact, it is rare to find a country without debt.  To optimise the funding mix, a country's debt management office typically develops a comprehensive strategy based on criteria. African governments have historically relied on a mix of bilateral and multilateral creditors, private creditors such as local and international banks, and local debt capital markets to drive funding. Recently, there has been a shift towards tapping into international debt capital markets, notably through the issuance of Eurobonds, typically issued in foreign currencies, such as the US dollar or euro.

South African government has also issued Eurobonds to diversify its funding sources and establish a presence in this market. Developing an investor base in the Eurobond market ensures that, should the need arise in the future, the government will not have to start from scratch in relying on this funding option.

The charts below show the Eurobond yields for different countries ranked by credit rating. We use Eurobond yields since this is a better means to compare apples with apples since the bonds are all US dollar denominated so we don’t have to control for different exchange rates. The main driver of Eurobond yields is the general level of interest rates and the credit worthiness of the issuer.

Advantages of a stable credit rating

Credit rating agencies provide ratings to indicate the degree of credit risk while bond spreads (the difference between the bond yield and that of a risk-free (or AAA rated) bond of similar duration) provide a quantitative measure of additional cost incurred by having a lower credit rating.

Official credit ratings from the rating agencies are only updated twice a year but are often viewed as more of a lagging indicator with markets responding much faster to higher frequency data or new developments. Interestingly, both South Africa and Morocco used to have higher credit ratings, with South Africa rated investment grade as recently as 2020 by Moody’s – although both S&P and Fitch had previously downgraded SA to below investment grade in 2017. Morocco’s rating has been more stable over the last decade, hovering just below investment grade, but not quite making the grade.  

As can be seen from the charts, there is a strong but not perfect correlation between bond yields and credit ratings, with the reason for the difference in the market’s “live” view of credit risk (and also other factors).

Based on current market conditions, an improvement in SA’s investment grade would provide a reduction of around 100 basis points or 1% in the cost of local borrowing. While this does not seem like that much, considering the sheer scale of funding needed, it is quite a meaningful reduction in the cost of borrowing.

Given that across Africa, only Morocco is higher rated than South Africa, it would be useful to understand what they are doing better, and what South Africa can do to improve its credit rating.

Deep structural challenges versus sound policy framework

To understand how a rating is assigned it is instructive to peer under the hood of the ratings process. We will use one of the big three ratings agencies as an example. Fitch’s sovereign rating model incorporates both a quantitative (SRM) and qualitative (QQ) component. The quantitative component is based on a regression model that includes both structural and macro-financial characteristics of an economy. The model becomes more forward-looking with the so-called qualitative overlay, which is where the analyst can apply an override—up or down—to the calculated rating, based on additional factors not fully captured in the SRM.

For South Africa, the SRM score is BB+, but Fitch applies a negative qualitative overlay, resulting in a two-notch downgrade to a BB- rating. The reasons for this include:

• Macroeconomic Outlook: South Africa's weak growth prospects relative to the 'BB' category median and population growth, are driven by deeply entrenched structural problems that have significant implications for public finances.
• Public Finances: Continued uncertainty about the government's ability to stabilise debt-to-GDP in the context of high unemployment and inequality, as well as the weak finances of state-owned enterprises that could lead to the materialisation of contingent liabilities.

In contrast, Morocco's SRM score is BB, but Fitch applies a positive qualitative overlay, leading to a one-notch upgrade to a BB+ rating. The reasons for this include:

• Macroeconomic Outlook: Fitch acknowledges Morocco's sound policy framework that has underpinned macroeconomic stability and supported resilience to shocks, despite the deterioration in GDP growth volatility driven by the Covid-19 pandemic and high inflation stemming from the war in Ukraine.
• Public Finances: Morocco has maintained a relatively prudent fiscal policy, and the government has been able to manage its debt levels effectively. The favourable debt structure, with a significant portion denominated in local currency and held by domestic investors, also supports the positive adjustment.

Economic growth is important in credit assessment as it serves as the engine that enables a government to generate the revenue needed to service existing debt and provide a larger base for sustainable borrowing. In contrast, borrowing without corresponding economic growth leads to an increasing debt-to-GDP ratio, which is unsustainable over the long term. This situation can strain a government's finances, reduce investor confidence, and potentially lead to a debt crisis. Sustainable borrowing relies on the ability of the economy to grow and generate sufficient revenue to meet its debt obligations.

The following two charts illustrate these dynamics – the first chart shows how Morocco has been able to grow almost twice as fast as South Africa, while the second chart illustrates how Morocco has been able to keep its interest costs under control compared to South Africa’s debt servicing cost, which has doubled.

The SA opportunity for progress

Considering that South Africa’s rating could be much higher if it was not for the concerns around economic growth and public finances raises the crucial question of the practical steps to address these concerns. In this regard, there is reason for optimism. South Africa’s energy crisis has been a major restraint on growth (both in terms of disruptions and the negative impact on business confidence), so the progress that has been made to date in resolving this is very positive. Recent developments indicate significant improvements in the energy sector. Eskom has achieved over 127 days of no load-shedding since March 2024, with a notable increase in available capacity and a reduction in unplanned outages.

These improvements are supported by the return of major generating units to service and a substantial increase in the Energy Availability Factor (EAF) to 70% as of late July 2024. This progress suggests a potential end to daily power cuts by late 2024, boosting business confidence and economic activity. The government is also investing in new transmission lines and supporting solar power initiatives, which will enhance energy security and reduce reliance on load shedding.

On the fiscal front, the new GNU could also have a positive impact. With multiple political parties involved in the government, there is a higher level of accountability. Each party brings different perspectives and oversight, which can reduce instances of corruption and mismanagement. Improved governance can lead to better management of public finances and more responsible spending, which could enhance business confidence and attract investments.

To some extent, markets have priced in a lot of the good news, or at least are giving the GNU the benefit of the doubt, because credit spreads are now at or around five-year lows. For it to compress further we would need global macro tailwinds in the form of the US Federal Reserve starting to cut rates, while the GNU will have to exceed initial expectations.

While the outlook for South Africa’s investment grade rating remains important, markets are forward-looking and do not wait for credit rating agencies to make decisions. The reversal of the uncertainty premium following the SA elections suggests that markets were previously pricing in the risks and uncertainties associated with the electoral outcomes. Once the elections concluded and the GNU was formed, much of that uncertainty was resolved, leading to a reversion to earlier levels. This reversion reflects restored confidence and a reduction in perceived risks, aligning with broader optimism over political stability and economic reform under the new government structure.  

By taking the high road on reform, South Africa could yet overtake Morocco to become Africa’s highest rated debt issuer.