Why Zuma’s actions matter by Pierre Heistein (IOL), 17 December 2015

4 January 2016

The writer says that by dismissing Nhlanhla Nene (above), President Jacob Zuma pulled the plug on all South Africans. File picture: Nic Bothma

Why has President Jacob Zuma’s decision to sack Nhlanhla Nene caused such a fuss? Has Zuma crossed an important line or is this only a threat to the wealthy?

Upset in the treasury will naturally have more consequences for investors and traders than were Zuma to cause turmoil in any other ministry. But unfortunately that’s not where it stops and the millions lost on the stock market are inconsequential when compared to how this will affect the lives of every South African. This is not a storm in a teacup.

The dynamics are as follows.

A few days before Nene was sacked government’s credit rating was downgraded by Fitch to one notch above the “junk” status, while S&P cut its outlook on the country. Moody’s yesterday also cut their outlook on South Africa to negative from stable, but affirmed their rating at two levels above junk.

Governments and companies issue bonds to individuals and wealth funds as a way of raising money. A bond is essentially a way for you to lend money to government and then get it back later with an interest earning on top. The amount of interest government has to pay depends on how risky it is to lend to them.

A downgrade means that the South African government is now viewed as a riskier debtor to lend money to and they will have to pay higher interest rates to attract foreign and local funds. Their borrowing costs have increased and there will be less money to fund government spending.

Junk implications

This is true for downgrades at all levels, but one level above junk status comes with its own implications.

Many bonds are not bought by selective investor behaviour, but by automatic algorithms. For example, a large European pension fund may have a mandate to hold 10 percent of their portfolio in emerging market or South African bonds.

In almost all cases, and especially in wealth funds that have to take low risks (such as pension funds), they are banned from investing in bonds with junk status and below. If the government is downgraded to junk these algorithms will kick in and there will be a large sell-off of South African bonds, resulting in money flowing out of the country.

Speculative investors will not wait until the downgrade, but rather get their money out early – as many are doing now. An outflow of money from South Africa decreases the demand for the rand and causes it to depreciate. When Zuma fired Nhlanhla Nene and replaced him with an unknown candidate so soon after a downgrade he signalled to the world that financial stability and fiscal prudence are not important to him.

The next ratings review will only happen in a few months, but there’s little doubt that a further downgrade is inevitable unless Pravin Gordhan can put the house in order. It’s likely that, unless a downgrade is avoided, the rand will depreciate further, inflation will rise and interest rates will increase in response.

The cost of food is the most concerning outcome. Due to the drought, South Africa will be forced to import grain over the next six months when usually it is a net exporter. A 3 percent decrease in the value of the rand, such as we’ve seen since last week, is essentially a 3 percent increase in the cost of imports and this will soon be passed on to the consumer.

It is part of the Reserve Bank’s mandate to keep inflation below 6 percent by increasing the repo rate when necessary. It is likely that they will do so early next year, leading to higher interest rates across the economy and a higher cost of borrowing for everyone.

Pulled the rug

Not only does this decrease spending on goods and services and create less demand for businesses, but it also restricts our ability to invest in new businesses, projects, maintenance or upgrades.

These ebbs and flows are normal in an economy and often unavoidable. But in this case President Zuma pulled the rug from under us with no justification apart from personal gain. It’s not the share traders, asset managers, or forex fanatics who stand to lose the most.

It’s the small business owner, the stay at home parent, the self-funded student, the employee of a shrinking firm – it’s every South African who is struggling to make ends meet.

Source: www.iol.co.za