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SA CREDIT RATINGS OVERVIEW

MAY 2016

Mohammed Yaseen Nalla, CFA

Head: Strategic Research – Global Markets

South Africa

+2711 295 5430

Mohammedn@Nedbank.co.za

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The much awaited ratings review from Standard and Poor’s will be announced on Friday 3 June, most likely after SA trading hours. At its

conference in April, S&P indicated a series of risk flags, but the most pertinent according to our assessment were the following:

– Any material deterioration in fiscal flexibility. This would largely hinge on growth forecasts which we currently project at 0.2% for 2016

and 0.9% for 2017. This is significantly below the 0.8% expected by S&P (which we would expect to be revised lower). The SARB has also

recently revised its 2016 growth forecasts to 0.6%. As such, unless we see tax buoyancy levels providing a material offset to the growth

drag, coupled with significant fiscal prudence, a deterioration in fiscal flexibility can be expected.

– S&P, while relatively comfortable with the institutional and governance effectiveness at a sovereign level, cited specific concerns around

reform at SOEs - or lack thereof. Any failure to overhaul SOE management, corporate governance and/or balance sheet structure would

be seen to have a knock on effect on the contingent liabilities of the sovereign, and would imply a greater debt burden on the sovereign.

Given that SOE reform was promised at the 2016/2017 National Budget tabled in February, we would see it as premature to assess the

progress on reform after a 3-4 month window, and as such would believe that the review at the end of the year would offer better ‘line

of sight’.

Moody’s have recently affirmed their rating of South Africa at Baa2 (BBB equivalent), albeit with a negative outlook. As such, they remain

out of kilter with S&P and Fitch who have us 1 notch lower.

The incidence of ‘split ratings’ has increased materially in recent times. Of a sample of 145 countries, 87 (60.0%) have the same rating, 46

(31.7%) have a one notch difference, 7 (4.8%) have a two notch difference, and 5 (3.4%) have a three notch difference.

RATINGS REVIEW CONTEXT

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RATINGS SCALE COMPARISON – SA SOVEREIGN

Source: Nedbank, Fitch Ratings, Standard and Poor's, Moody’s

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The rule of thumb is that approximately 18 months is a reasonable length of time from an outlook change to an actual downgrade.

However any material adverse development may catalyse a more aggressive downgrade cycle, or in extreme circumstances, an out of cycle

change which can occur at anytime outside the normal review dates provided.

An example of these timeframes would be Brazil which was downgraded to BBB- in March 2014 and thereafter downgraded to sub-

investment grade BB+ in September of 2015 (18 months). Thereafter, a further downgrade to BB was announced in February 2016 (6

months) as negative growth dynamics were compounded by significant increases in political risk.

It has been around 24 months since the previous S&P downgrade to BBB- (June 2014) and 6 months since the outlook changed to negative.

There has been a significant deterioration in growth rates which can be partially attributed to cyclical as well as structural factors. The latter

is of more material consequence to a sovereign’s ability to repay its debt.

Most recent SA ratings activity:

– S&P downgrades outlook to negative from stable (December 2015)

– Fitch downgrades credit rating to BBB- from BBB (December 2015) and changes outlook to stable

– Moody's downgrades November 2014 to Baa2 and affirm negative outlook in May 2016

RATINGS REVIEW CONTEXT

Source: S&P, Moody’s, Fitch, Nedbank

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SA SOVEREIGN CREDIT RATING – COMPARISON TO SELECTED PEER MARKETS

Fitch Ratings S&P Moody’s Ratings

South Africa

BBB- (downgrade Dec ‘15)

Stable outlook – Dec ‘15

BBB- (downgrade June’14)

Negative outlook – Dec ‘15

Baa2 (downgrade Nov ‘14)

Negative outlook – May ‘16

Brazil BB (downgrade May ‘16) BB (downgrade Feb ‘16) Ba1 (downgrade Feb ‘16)

Russia BBB- (downgrade Jan’15) BB+ (downgrade Jan ‘15) Ba1 (downgrade Feb ‘15)

Mexico BBB+ (upgrade May ‘13) BBB+ A3 (upgrade Feb ‘14)

Colombia BBB (upgrade Dec ‘13) BBB (upgrade Apr ‘13) Baa2 (upgrade July ‘14)

Turkey BBB- BB+ (upgrade Mar ‘13) Baa3 (upgrade May ’13)

Source: Bloomberg, Fitch, Moody’s, S&P

After a lull in ratings activity since 2013/2014, ratings agencies appear to be on the march again with many EM countries

ratings’ at risk, as global growth dynamics have weighed on domestic growth metrics coupled with significant currency

weakness.

The latter has a lower impact on South Africa as compared to peers such as Brazil given our lower weighting of foreign

currency denominated debt, which remains a relative strength.

While foreign participation in rand denominated debt is high at around 34% currently, this is largely benchmarked to

the local currency rating which is currently 2 notches higher.

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SA SOVEREIGN CREDIT RATING – DOWNGRADE TIMEFRAME AND POLICY MOVES

Source: Bloomberg, S&P, Nedbank

Since the start of the current ‘hiking cycle’ in Ems, South Africa has been relatively more muted in only having

experienced 200bps of hikes. This indicates that monetary policy, while observing the ideals of inflation targeting and

price stability, has not been overly restrictive.

This compares favourable to Russia and Brazil, both with over 450bps of hikes, which has exacerbated the growth

downturns in those economies.

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SA SOVEREIGN CREDIT RATING – SELECTED EM PEERS CDS SPREADS

Source: Bloomberg, Nedbank

South Africa’s CDS spreads have correlated with the weaker EM spreads over the last 18 months, although recent

political developments have pushed CDS spreads closer to Brazilian spreads than the EM basket as a whole.

The commonalities in these elevated spreads are closely tied to building political risks, as sovereigns with similar or

worse economic fundamentals are currently trading at lower CDS spreads.

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SA SOVEREIGN CREDIT RATING – SELECTED EM PEERS CDS SPREADS

Source: Bloomberg, Nedbank

While the implied political risk premium is high, South Africa’s relative deterioration to other EM peers predates the

political developments in December last year. This is indicated in the relative spreads of SOAF CDS to other EM CDS. SA

moved into a premium to other EMs early in 2015, and more specifically to Turkey by October 2015.

This suggests that while some of the deterioration in CDS spreads can be attributed to political risk, that the macro-

fundamental backdrop remains a key driver on a relative basis.

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SA SOVEREIGN CREDIT RATING – SELECTED EM PEERS CDS SPREADS

Source: Bloomberg, Nedbank, S&P

Country S&P Credit Rating Outlook CDS Spread FX % chg 1 Yr

Chile AA- STABLE 113 -11.93%

Thailand BBB+ STABLE 124 -6.08%

China AA- NEG 126 -5.39%

Hungary BB+ STABLE 140 -0.82%

India BBB-u STABLE 160 -6.02%

Malaysia A- STABLE 164 -12.29%

Mexico BBB+ STABLE 182 -17.50%

Indonesia BB+ POS 195 -3.31%

Colombia BBB NEG 241 -18.65%

Russia BB+ NEG 272 -25.11%

Turkey BB+u STABLE 280 -12.16%

South Africa BBB- NEG 320 -23.92%

Brazil BB NEG 362 -13.31%

EM Ratings - ranked by 5 yr CDS SpreadS&P Moody's Fitch Probability of

default

AAA Aaa AAA 0.010%

AA+ Aa1 AA+ 0.014%

AA Aa2 AA 0.020%

AA- Aa3 AA- 0.029%

A+ A1 A+ 0.043%

A A2 A 0.066%

A- A3 A- 0.100%

BBB+ Baa1 BBB+ 0.160%

BBB Baa2 BBB 0.260%

BBB- Baa3 BBB- 0.420%

BB+ Ba1 BB+ 0.710%

BB Ba2 BB 1.210%

BB- Ba3 BB- 2.120%

B+ B1 B+ 3.760%

B B2 B 6.820%

B- B3 B- 12.610%

CCC Caa CCC 23.800%

CC Ca CC 23.800%

C C C 23.800%

D D D 100.000%

EXTERNAL RATINGS

SA CDS spreads trade significantly wider than some lower rated peers such as Turkey, Russia,

Indonesia and Hungary. This suggests that the downgrade is largely priced into credit markets

and notwithstanding volatility around the actual event, may well settle to lower levels once the

uncertainty abates.

The importance of an investment grade rating are highlighted in the table to the right which

indicates the probability of default in the first year given a specific credit rating. Our assertion is

that SA already trades in line with BB+ peers.

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ZAR AND BONDS CORRELATION WITH CDS

Source: Nedbank, Bloomberg

The correlation between the performance on the USDZAR and the performance of SA CDS spreads is currently at similar

highs to the December ‘blow out’ phase of around 80%. This is significantly above the long term average of around 53%. A

similar view is evidenced when looking at SA govi bonds (not shown).

Premised on our belief that the downgrade is largely priced into the CDS and bond markets, a similar assertion is held

for the rand at levels above R15.50/$. We remain bearish on the fundamental outlook for the rand over the longer term,

premised on another wave of global dollar strength.

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SOUTH AFRICA – RATINGS HISTORY

Source: Nedbank, Fitch Ratings, Standard and Poor's, Moody’s

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The ‘Negative’ outlook by S&P predisposes us to a high risk of a downgrade this year, given the macro-fundamental backdrop. The ‘Stable’

outlook by Fitch may delay a move toward sub-investment grade from this rating agency. We maintain a view that a December downgrade

from S&P holds a higher probability than a June downgrade. We could see Fitch changing their outlook to negative in the near term.

The ‘average’ rating of the big three ratings agencies shifted from ‘BBB ‘to ‘BBB-’. The incidence of ‘split ratings’ has increased materially in

recent times. While foreign participation in rand denominated debt is high at around 34% currently, this is largely benchmarked to the local

currency rating which is currently two notches higher.

The material deterioration in the growth profile remains a key risk in the near term, coupled with any lack of momentum in reviewing

and implementing reform at SOEs. Monetary policy, while observing the ideals of inflation targeting and price stability, has not been overly

restrictive. While some of the deterioration in CDS spreads can be attributed to political risk, that the macro-fundamental backdrop remains

a key driver on a relative basis.

Notwithstanding initial volatility in any actual announcement, over the longer term, we feel that the downgrade is largely priced into

credit markets as SA already trades in line with BB+ peers. Premised on our belief that the downgrade is largely priced into the CDS and

bond markets a similar assertion is held for the rand at levels above R15.50/$ given the current status quo. We maintain a bearish longer

term view on the rand premised on fundamentals and global risk factors.

SYNOPSIS

Source: Nedbank

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THANK YOU

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