Already facing a second recession in four years and grappling with a nationwide lockdown to curb the spread of the novel coronavirus, South Africa was dealt a huge blow on Friday night after Moody’s, the only major credit rating agency that still rates the country’s bonds as investment-grade, cut them to “junk” status.

Moody’s cited a deterioration in the country’s fiscal strength and “structurally very weak growth” for its decision to lower the rating from Baa3 to Ba1, one level below investment grade. In addition to the downgrade, the outlook on the rating remains negative.

“Unreliable electricity supply, persistent weak business confidence and investment as well as long-standing structural labour market rigidities continue to constrain South Africa’s economic growth,” Moody’s said. “As a result, South Africa is entering a period of much lower global growth in an economically vulnerable position.”

Without an investment-grade rating for the first time in 25 years, South Africa will be excluded from the FTSE World Government Bond Index. Participation in the index requires a country to have at least one investment-grade rating by one of the credit-rating agencies – the other two, Standard & Poor’s and Fitch, both cut their ratings to junk nearly three years ago. 

The downgrade by Moody’s could “not have come at a worse time” for South Africa, National Treasury said in a reaction, as it would add to the prevailing financial market stress with the country battling to contain the spread of the coronavirus. It is entering a 21-day lockdown period in an effort to slow the pandemic. 

Leaving the WGBI could prompt significant capital outflows as fund managers with investment-grade mandates will be forced to sell South African government bonds. “Non-residents currently hold approximately 37 percent (R800 billion) of the total domestic government bonds and the number is expected to substantially decline with the combined impact of Covid-19 and the downgrade,” Treasury said.

A natural result of this is a rise in borrowing costs, complicating the government’s efforts to narrow the budget deficit. “Sub-investment grade from all three rating agencies will undoubtedly raise the cost of capital or funding in South Africa,” Hugo Pienaar, an economist at the Bureau for Economic Research, said.

As revenue declines this year, the country’s fiscal deficit will widen in fiscal 2020 to around 8.5 percent of gross domestic product, according to Moody’s estimates. The debt burden will reach 91 percent of GDP by fiscal 2023, inclusive of the guarantees to state-owned enterprises from 69 percent at the end of fiscal 2019.

“Therefore, to say we are not concerned and trembling in our boots about what might be in the coming weeks and months is an understatement,” Finance Minister Tito Mboweni said on Friday evening.

While the decision by Moody’s was widely expected by analysts, some believe it will not have a major impact on the economy as South African assets have been trading as though they are junk-rated in recent years.

The Moody’s downgrade itself has for some time been discounted by financial markets and “guided by global examples in this regard, it is possible that the bulk of the repricing has already occurred,” said Elna Moolman, an economist at Standard Bank. But it remains uncertain exactly what impact the subsequent global bond index expulsion will have, she adds.

Some market participants may argue that the impact of a sovereign downgrade has already been priced in, but it is difficult to “stipulate with certainty the extent,” Treasury said. But in the immediate period, South Africans are “rallying together to fight Covid-19 and ensure South Africa emerges triumphant from the pandemic,” the Finance Minister said.

“Over the short to medium term, (the) government remains committed to implementing structural economic reforms to address the weak economic growth, constrained fiscus and the ailing state-owned companies,” Mboweni added.

But progress on structural reforms has been limited, and no initiatives that constitute a “step-change” for the economy had progressed, Moody’s said, adding that the restoration of full capacity to South Africa’s electricity system will take “some years to complete,” which also contributed to its decision.