Global Sukuk Markets Sovereign Credit Brief South Africa

2 June 2016

Global Sukuk Markets Sovereign Credit Brief

South Africa

Sovereign IG-Status At Risk

Key Credit Considerations

¨   We expect the eventual downgrade of the sovereign of South Africa.  We believe the confluence of weakened political institutions, domestic political uncertainty and sluggishness in necessary policies and reform, in an environment of weaker global growth, reduced demand for South Africa’s exports, long drought and increasing weakness in the unemployment, investment and business sentiment would be a risk on the rating of the South Africa sovereign. The currency has begun to fall since the beginning of May and the 5-year CDS levels already begin to suggest downgrades closer to a BB rated sovereign. South Africa, with its position in the cusp of the IG space, would have a higher risk of further selloffs and increased volatility in currency and bonds.

¨   Structural weaknesses continue to hinder growth and development. The country’s real GDP moderated to 1.3% in 2015 from 1.5% in 2014, much lower than its 2010-2014 average of 2.4%. IMF estimates that South Africa’s GDP will weaken further to 0.6% in 2016, lower than the National Treasury’s February 2016 forecast of 0.9%.

¨   Weak political institutions, policy flip flop, continue to impact investment and sentiment. We believe that lack of clarity in policy direction, legislative delays and the government’s sluggishness in addressing structural impediments to growth especially reforms in its mining, trade and labor policies have had significant impact on growth and investment.

¨   Inflation is close to SARB’s upper end of the target range of 3%-6%; CPI expected to average 6.6% in 2016 and 6.4% in 2017. SARB has gradually been tightening monetary policy by hiking interest rates 200bps since Jan-2014 to 7% currently (last rate hike was on 18 March 2016 by 25bps) as inflation breaches upper limit of SARB’s target.

¨   Government debt-to-GDP ratio ballooned from 26.6% in FY2008 to 50.1% in 2015, and it is expected to widen further to 51.4% in 2017 according to IMF estimates. Fiscal deficits continue to widen to 3.3% in 2015 from 3.2% in 2014.

¨   The depth and structure of the capital market limits market risk. 90% of government debt is in local currency, with an average maturity of c.14 years. This reflects the government’s capacity to finance itself in ZAR from its powers of taxation, control of the domestic money supply through an independent monetary policy and a deep local bond market.

¨   Banking system is stable, supported by regulatory forces. The banks predominantly derive funding from domestic short-term deposits. The dollarization ratio, a measure of domestic investors who use foreign currency, is at 4.6% of bank deposits - much lower than the peer average of 32.2%.