Junk status: A self-fulfilling prophesy?

Is South Africa's credit rating about to become junk? © Eduardo Huelin 123RF.com

Black boxes

According to the researchers, the methodologies used by rating agencies to make decisions are black boxes that are not currently open to independent evaluation and validation.

Dr Beyers says any downgrade of South African government bonds, together with the potential economic fallout at a critical time, without detailed information on how the decision was arrived at, may be regarded as irresponsible.

South Africa is currently at risk of being downgraded to non-investment grade ratings levels (also known as “junk status”) by several ratings agencies such as Moody’s Investors Services and Standard & Poor’s. Recently (March 2016), Moody's Investors Service has placed South Africa’s Baa2 bond and issuer ratings on review for downgrade.

Bonds more risky

This paves the way for actual downgrade to junk status where South African bonds will likely be perceived as more risky. As a results, investors typically require higher yields for a given bond. This has a trickle-down effect to the entire economy, making access to capital more difficult (and expensive) and discouraging investment and business enterprise.

Knee-jerk reaction

In essence, a hypothetical country with strong economic fundamentals may be plunged into a negative spiral after a prominent and controversial ratings downgrade. For example, a downgrade (especially to junk status) can lead to a knee-jerk reaction amongst investors – leading to large-scale disinvestment and a simultaneous slowdown in business activity. Without the ratings downgrade, the economy may be growing. But a downgrade can lead to economic uncertainty and distress.

Backlash already felt

In fact, the researchers argue that the potential downgrade might already have had a negative impact on the South African economy. Markets are forward looking and tend to react to what they think might happen in the future. Since the potential downgrade has been widely publicised, markets already started to reflect a possible downgrade.

Chicken and egg situation

As a result, any attempt to assess the true impact of a downgrade should consider movements from the initial signal of a possible downgrade, until well after the downgrade. This then becomes a chicken and egg situation. After the intention to downgrade has been made public, markets react, providing evidence that the country should be downgraded.

Vague descriptions

So, how many of the reasons to downgrade are due to the reaction to a possible downgrade? We simply do not know, because ratings agencies only provide a rating and a vague explanation of the process.

It should be kept in mind that a ratings downgrade reflects the view of a particular ratings agency and is based on their preferred model, subjective assumptions and decisions. These assumptions and decisions should be clearly disclosed to an extent where it can be critically examined, at least, by South African and other academics, says Dr Beyers.

Credit rating agencies normally publish generic information about their models and assumptions. Such disclosures do not allow independent researchers to test and validate the specific models and rating decisions that are made in respect of a specific country such as South Africa.

Questions that need to be asked

However, specific questions that should be asked about credit rating models and decision include:

• How specifically are global methodologies tailored to the South African environment?

• On what basis are essentially non-quantitative elements such as the South African government’s policy and strategy, or policymakers’ commitment to financial restraint evaluated and quantified?

• What are the assumptions and modelling decisions (e.g. weightings) that are used in the models and how are they determined?

• What are the assumptions and model specifications according to which longer term economic performance for South Africa is evaluated?

In general, ratings agencies expect the public to simply accept their outlook on the South African economy, based on some unknown assumptions and models. Credit rating decisions affects every single household and business in South Africa.

It would be negligent if such decisions are not properly scrutinised to better understand how this decision was arrived at. The researchers do not necessarily question the ultimate rating decisions. However, we need to understand how the decision has been made and what is in the black box.