What does junk status mean for your SME?

11 May, 2017

In recent weeks, rating agencies Standard and Poor’s and Fitch have both downgraded South Africa’s foreign credit rating. While a lot of effort has gone into explaining and reporting what impact that will have on the average man on the street, it (obviously) also has a big effect on business and especially Small and Medium Enterprises (SMEs) which has largely been ignored by the general media.

While very much aligned to personal impact, there are some subtle differences for businesses, especially SME’s. These show that the credit rating goes deeper than the general mantra that higher risk for external investment due to political, economic and other factors may not be too attractive – even though the potential reward is greater.

Debt
As we’ve seen with the share prices of big financial institutions after the downgrades, banks are first to feel the pinch. They are directly impacted by the sub-investment grade status, and have themselves subsequently also been downgraded to junk status.

This is where SMEs will feel the first effects of the downgrades. The increase in borrowing costs for the banks puts pressure on their own returns, which affects shareholder returns. To combat the deterioration of profits, banks will be forced to reduce expenses and increase the cost of funds. This affects the total cost of credit, proportionally more for smaller enterprises. It makes it more difficult to obtain loans in the first place – largely due to regulation and affordability – but also makes current loans more expensive to maintain.

According to most business leaders, it will take years to recover from this additional cost of servicing the obligatory debt most small businesses need to grow.

The Rand
Alas, the effect is only compounded through the supply chain. The Rand has of course taken its predicted dive – linked to the downgrades – though thankfully less so than post Nene-gate.

Do not mistake the relative strength of the Rand for the robustness of our economy. This is mostly due to instability and volatility in foreign markets, not our own outlook. We can expect the Rand to depreciate further if things work themselves out overseas.

The weakening Rand impacts our economy as a whole, as we’re a net importer of goods and services. It means we need to obtain more commodities, foods, general goods and professional services from outside our borders than we can supply locally. This has a direct impact on our inflation rates. Even for SMEs that don’t attain goods or services from outside our borders, the cost of trading increases, regardless of industry. It exacerbates costs more than would otherwise be the case, while shrinking margins.

Sentiment
The biggest differentiator from individual negatives of the downgrade that has largely been ignored for most SMEs is not strictly an economic issue. Like it or not, emotion comes into trading decisions all the time. We see it on the stock markets, and we see it in a more general sense in economies all over the world.

While an individual will feel the pinch due to the inflationary impact on living costs, most SMEs will feel the pinch due to the individual’s negative economic sentiment. If the perception by individuals (collectively) is that they have less money to spend or need to cut back on expenses – simply due to the sentiment that we’re in trouble and heading for recession – then SMEs are often the first part of the economy that feels these attitudes (as reflected on their bottom line).

People still need food (which is owned by the large supermarkets), a roof over their heads (rent or their mortgage payments), education for their children and a nice SAB beer after a stressful week at work. What they don’t necessarily need is a lavish meal out at your small establishment, a niche handbag you can’t find anywhere other than your outlet, a ‘spoil’ getaway to your Airbnb or B&B, or your homemade pasta sauce, slightly more expensive than the generic brand.

These factors are often very self-prophesising – unfortunately – insofar as one feeds the other. Higher cost of serving debt leads to lower margins, which leads to inflation of prices of your services, which leads to lower spending by the public, which leads to businesses closing and people losing jobs, which leads to recession and higher rates and inflation and so on.

While generalised and not true for all businesses, this should shed some light on the economic landscape to prepare ourselves for over the coming months and years. It’s up to all of us in South Africa to remain vigilant through the transitions we face.

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