09 May The combined impact of the Coronavirus pandemic and the sovereign ratings downgrade by Moody’s Investors Services
The South African economy is reeling from the combined impact of the Coronavirus pandemic and the sovereign ratings downgrade by Moody’s Investors Service resulting in a loss of the country’s last investment grade rating.
For all entities reporting under IFRS, these two events are likely to have a significant impact on the Expected Credit Losses (ECL’s) required by IFRS 9. While most of accounting records historic transactions, IFRS 9 is forward looking, which causes an immediate impact on financial results. Virtually all ECL calculations will be impacted and for many the increase will be material. For organisations with 2020 year-ends, the timing of changes relative to year end date is important. The sovereign risk downgrade is a precise event that took place on 27 March 2020. i9 Partners uses Moody’s ratings where available so there will be an immediate impact. The Coronavirus started spreading out of China in January. By February there was a common acceptance that it would have an economic impact. However, it is only during March that the impact of the pandemic was understood and financial markets reacted. It is probably fair to assume that pandemic scenarios economic forecasts only began to appear in March. There is a strong case to be made for February year ends not to include these but for all March year ends forecasts must reflect the forecast impact of the pandemic.
For the sovereign downgrade, the immediate impact is on all assets that carry an SA sovereign rating. All amounts owed by central or provincial government are included in this as are amounts guaranteed by government including SOE debt subject to a guarantee. There are also a great number of entities whose ratings are significantly influenced by the sovereign rating. This includes major banks, municipalities, SOE’s and corporates whose rating is the same as the sovereign rating and potentially impacted by a sovereign ceiling. The impact on all other South African assets will be less immediate but will be felt in coming months. The sovereign risk reflects the general level of credit risk in the country in many ways.
Coronavirus is having a significant impact on our economy. With the country in lock-down there is a significant lack of liquidity and spike in unemployment. There are anecdotal reports of many business failures. The SARB has lowered interest rates and is injecting liquidity into the economy and government has introduced measures for SME’s to delay paying over payroll taxes collected in certain circumstances. These are hoped to ameliorate the impact on the economy with there being no expectation that they can fully reverse them. Macroeconomic forecasts under IFRS 9 must inevitably reflect the new economic reality. Economists talk about V, U and W shaped recessions. The best case for the country at the moment is a V shaped recovery which reflects a sharp downturn followed by an immediate upturn. Once-off events can have this impact. A U shaped recovery reflects a sharp downturn followed by an extended period of reduced economic activity before a recovery. A W shaped recovery appears like a V shaped recession but the recovery is followed by another downturn.
i9 Partners has the tools and knowledge to quantify the impact of these changes. Through our partnership with Moody’s Analytics we have access to updated to economic forecast scenarios taking into account the impact of the pandemic. Moody’s Analytics are continuously updating forecasts as new information is becoming available. There have been 4 updates during the month of March already. This is not the only source of forecasts of the impact of Coronavirus but it applies a consistent methodology that is part of the same framework of all our previous forecasts. Moody’s Analytics has a vast pool of economic research resources and has put considerable efforts in studying previous economic crises. All forecasters are in new territory and are reticent to speak about the confidence of their accuracy but we do know that these forecasts we are using are backed by a sound methodology and are credible.
In addition to new forecasts for the impact of COVID-19, Moody’s Analytics are recommending a change of weightings of scenarios. We have previously generally applied a Baseline (S0), S1 and S3 set of forecast scenarios weighted 40%, 30%, 30%. The recommendation is now to apply a Baseline, COVID-19 and S3 Scenario. This is a much more conservative outlook. We are also changing our weightings to reflects Moody’s Analytics new recommendations. These recommendations are not based on the same degree of research that the previous set was and which lead to the 40%, 30%, 30% weightings being so widely used but is a current best estimate that takes into account all their previous research and current examination of previous financial crises.
For our clients with year ends (or interim reporting periods where we are reviewing or re-measuring) from March onwards, these forecasts will automatically be included. For other clients, we can recalculate ECL’s under the new reality to see the impact. This will be a billable service as it requires time and use of proprietary information that we purchase. We are not trying to benefit from the Coronavirus crisis and will only charge a fee to provide a reasonable recovery of our costs. For non-clients, we can perform an impact assessment to determine the possible impact on existing ECL’s.