Our third Fireside Chat took place between with Nthulleng Mphahlele, Research Analyst, and Jones Gondo, Senior Research Analyst discuss the credit outlook for the sovereign, state-owned companies and credit trends. Jones is one of the powerhouse analysts behind the credit research that is published by CIB. He is a Senior Credit Research Analyst within the research team.
Jones touched on four main topics: the Sovereign credit outlook now that South Africa is in junk status, the overall credit for state-owned enterprises, the outlook and future of Eskom and an overall view on the general credit climate.
What is next for the Sovereign now that South Africa is in junk status?
South Africa was downgraded to junk status across all three rating agencies, and this may be the tipping point needed to accelerate reforms in the country. But what comes next for the Sovereign credit rating now? While South Africa is sub-investment grade or speculative grade, which we can see in the bond prices. We had long-end bonds reaching north of 10% on the tenure. It is a high yield that we have to fight for.
We need every bit of foreign savings to get growth going again, mainly because we aren’t investing and we aren’t growing right now. We do not have a domestic savings pool and the long-term warning from the rating agencies were there telling South Africa to begin the process of getting affairs in order. The downgrade is a definite catalyst to begin structural reforms.
While we continue to talk about getting the house in order, South Africa is not quite there as yet. What this downgrade has really done is shorten the time in which the political environment needs to come to a resolution on reforms. It is a very difficult terrain to navigate and you need to look at three main factors. There are technocrats within the government who want to have programmes in places to ensure things get done but the political will from the principle seems to be divided. This leaves us with outcomes that are sub-optimal in terms of just the costs to the economy. We will await the reform plans which will be revealed at the MTBPS in October 2020.
Do the politics matter when looking at the Sovereign credit rating?
The politics matter when it comes to the Sovereign credit rating and the rating agencies flagged political risks consistently. The political risk comes out in the ESG matrices saying that the governance and politics of state-owned institutions municipalities have the prospect of government interference. This interferes with the process that they need to go through to implement their own reforms, results in a blockage on its own. There’s a lot that depends on political principles. Does SAA get a 10 million bailout, as it has asked for, or can Eskom actually start to separate the businesses that will right-size their business? Decision-making still lies predominately with politicians rather than the boards, and this is how it comes across.
What could be the probability the sovereign defaulting on the IMF loan they received?
The probability is still quite low, the sovereign does a lot more when it is under pressure. They have a lot, and they can do a lot more. We won’t like a lot of the things they intend on doing such as prescribing assets or marshalling assets out of the economy and enforcing taxes.
There is a lot of things that can be manoeuvred to avert a downgrade and that’s within the Sovereign’s rights to do so. The tipping point for the Sovereign that will continue to be a blindsiding issue is the fact that they are not moving nearly fast enough for some of these systemically important SOEs.
The outlook of a contentious topic, that being prescribed assets. With the sovereign funding SOEs, is there cause for concern for the government to start using prescribed assets?
While it would not be the first time for South Africa to use prescribed assets, the government finds itself in a different position now compared to when they first used them. We have already seen the government crowding the private sector from accessing credit and they’ve increased their auction size.
Prescribing is very distortionary, the quid pro quo of reform movement and opportunity that can get to growth in forced exchange of investment is the first issue. The second issue for South Africa, if you are looking at other emerging markets, is that we’ve got very deep capital markets. This has been a case in post-democracy in South Africa. This wasn’t always the case, a shortage of access to money in big infrastructure projects was really preparing the projects for investment.
With the budget and the size of our GDP, we’re failing to find the resources to do growth-promoting fixed capital formation. It has to do with the capacity of the state to manage such things. The other side of prescription is the current state of SOEs and that will not change the outcomes of their future, by pouring money into them. Ultimately this outpouring of funding into it, is how they got to their point of failure. IF this is not addressed, we will see the same outcomes.
With over 700 state-owned companies, a lot of people are questioning whether or not SOEs are still relevant. Are SOEs still relevant in the current economic landscape in South Africa?
SOEs are still needed as there are certain services that the private sector cannot provide, adequately. It is more a case of a development philosophy that really determines if they are important or not. If an economy believes in centralised planning, big projects and using state-owned enterprise to catalyse a different kind of development path. Then they have a very relevant role to play especially on the supply side. In most of the world when you mention SOEs, people tend to think about banks, huge development banks. This is seen when one thinks of vendors in Brazil, and there is a lot of literature around the relevance in creating credit or access to credit.
South Africa has these licensed monopolies in transportation and energy on the main. Network industries are where our SOEs are and it’s very unique.
A look at state-owned enterprises’ credit.
SOEs are credit negative, and we have seen two things in these entities, aside from their operational challenges. There is an unwillingness to get a harmonised policy framework. That would get accountability and transparency in their governance, which makes people lose confidence. If you look at SOEs as normal companies when regular companies are in trouble, you would change the board, put in new management but the core of the entity is still running on old technologies. A very high-cost basis and lack of critical skills that are desperately needed to do any type of turnaround.
Land Bank was previously considered one of the better SOEs but has since defaulted on its loan. With something like this happening, should we be worried about SOEs in the short-term?
We should be worrying about SOEs in the near future. Unfortunately, a dual mandate doesn’t work. On the developmental mandate, an SOE like Land Bank has the commercial side of what it does, what we can call the credit side of it, it can be replaced. However, in other countries you see banks being given grants on lending into specific spaces, so it’s almost like directed lending. No one refutes Land Bank’s developmental mandate for smallholder farmers but when you start seeing the corporate mandate or what keeps it viable being directed toward obscure goals In the name of outcomes they are not viable.
Legally they haven’t failed because they have certain deliverable but holistically they have failed. Until we know exactly their specific purpose and the role in the development and in government’s policy is, we can then measure that accurately. They can be thought of as zombie firms because the kind of structural change that’s needed. Some of the big SOEs problems are not operational revenue and cost type issues – it’s their debts.
It does crystallise, and it will crystallise on the Sovereign which that means we divert money towards that debt instead of growth and promoting things or alleviating things.
An SOE that has been in trouble for as long as anyone can remember has been Eskom. What can be expected from Eskom in the next 12 to 18 months?
They got given the biggest bailout of 230 billion over 10 years. It was front-loaded 69 billion and a billion upfront over the next three years, and that made everyone relax a bit on their ability to pay for their debt.
Governance wise they’ve got new management but there are still some issues to iron out from a board point of view. The positive thing that I’ve seen is that they’re pressing on with their legal rights. They are going to municipalities and setting a legal precedent to say they are owed money under the law of contract. Which means under the law of contract they can collect and garnish their debtors’ accounts because they have a right and powers to do it.
They’re not relying on the will of political principles to press on with these matters because they have a legal right to pursue it. That is something to highlight and emphasise. From treasury point of view, they’ve got an incredible amount of work to do to stabilise the minds of the investors.
Will we start to see some form of value out of Eskom?
If you’re holding debt that mature within the next three to five years, you’ve got some certainty that you’re going get the principal back. But if you’re holding debts that are a lot longer and is not guaranteed, then you should worry about that. The value in the entity is in what they’ve put in it, in terms of being the system operator and trying to bring the efficiencies out of that.
If that can be done, there are pockets of opportunities in the generation and in distribution. As a vertically integrated entity, there’s little value and that’s it is like a zombie firm – it’s inefficient and will eat up all of that value within it. But in a breakout situation, there could be pockets of value contingent on the rest of the economy being structurally reformed to capture that value in the growth of the economy. Ultimately at the end of the day, we don’t want to produce electricity that no one is demanding.
What are some of the positive notes for the other sectors?
I am most positive about banks because they have been on a journey using innovation and technology to really compete and bring down their costs. They were well capitalised and their earning buffers were fairly strong, going into this crisis. Before you start looking at how shaky Basel III capital is, they have enough earnings buffers by reducing or eliminating dividends to capture some of the potential losses. It’s a sector that has been designed for these kinds of events.
Covid-19 was not a fleeting shock, its persisting and when things persist for a while as a long tail you need those efficiencies and costs. The banks that had invested in bringing down costs and innovation and are continuing to do so will fare better. At the end of the day if you can’t engage your customer and continue having that kind of contact you’ll lose business. You have to be as close as possible to your source of revenue and support it.
We can be confident in entities that are entrenched in keeping up with the consumer on a technology side because of the low-cost base. We really can’t run with high-cost basis into the next decade.
The opinions expressed in this article are solely those of the analysts and do not reflect Nedbank’s views or policies.