Government borrowing will surge after the Covid-19 pandemic, placing immense strain on SA’s public finances. If the state is unable to raise growth and reduce the deficit, SA could be headed for an eventual investor rebellion.
The SA Revenue Service estimates the country will experience a revenue shortfall of R280bn in 2020/2021. This would raise debt issuance by about 92% this fiscal year, if funded entirely out of the local bond market. It would push up SA’s bond yields even further, raising the government’s debt service costs. Already 15c out of every rand is spent on servicing debt.
Several economists have questioned whether, in the wake of the pandemic, SA will be able to continue raising sufficient capital on the local bond market at sustainable rates.
"As tax revenue falls and the government’s borrowing needs increase, the burden of interest payments can quickly become chronic," says Wits University adjunct professor Michael Sachs.
"The loss of investor confidence can become self-fulfilling: the increased cost of debt to the fiscus will lead to a fiscal crisis more quickly than the fiscus can adjust … This possibility, and the damage it portends, needs serious and urgent attention."
In the short term, however, there is little cause for alarm. SA’s exit from the world government bond index (WGBI) on April 30 was a damp squib — foreigners had withdrawn early, dumping R55bn of SA bonds in March and a further R15.9bn in April.
Their departure was a reaction to emerging markets’ weak growth prospects generally as well as SA’s specific shortcomings, including low business confidence and an alarming debt trajectory, says Prescient Investment Management portfolio manager Reza Ismail.
However, since the start of May the bond market has rallied — yields have fallen by 76 basis points on the R2030 to 9.52% over the past week — and demand at government bond auctions, mainly from locals, has been strong across the curve. This is probably because local asset managers lightened their holdings before the WGBI exit and are now scrambling for paper.
It is too soon to say whether the rally will be sustained, but with real returns of about 5% and inflation in retreat, the asset class looks "extremely compelling", says Ismail, easily as attractive as equities. He thinks the market will have little trouble absorbing an increase in issuance this and next year, especially as the increase in supply will push clearing yields higher.
But what about long-term funding cost pressures for the government? Will these cheery bond investors still be holding SA debt five or 10 years from now? And what must the state do to reduce the risk of an investor rebellion materialising?
Ismail sees little possibility of an outright default, as a government issuing bonds in its own currency can always print money to service debt. Not that Prescient is comfortable with that idea, or with SA’s mounting debt profile, given that high-debt environments hamstring growth.
"If real economic activity does not reset towards a healthier flight path, you have the real prospect of a debt spiral in which the government needs to issue debt merely to service existing debt," says Ismail. "That situation would be really worrying for sovereign bond holders."
Given SA’s persistently large budget deficits, and the prospect of an exponential increase in issuance, RMB chief economist Ettienne le Roux believes "the likelihood of an eventual investor rebellion is certainly rising".
The only way to forestall it, he says, is to combine spending restraint with a long-overdue growth-boosting reform programme that permanently lifts SA’s tax- generating capacity.
In a recent National Treasury document, finance minister Tito Mboweni warns that the cost of servicing debt will exceed SA’s peace and security budget by 2021/2022 and, over time, crowd out expenditure on everything else.
"This highlights the urgency of returning to a path of fiscal consolidation and substantially raising economic growth," he says.
An implementation plan will be set out in the special adjustments budget and the 2020 medium-term budget policy statement. But that could be months away.
"Investors know that even if you implement the best policy tomorrow, it will take two to three years to boost growth," says Le Roux. "But they need to see SA take the steps to get growth going. Then they will feel so much more comfortable buying bonds in the long term, because it reduces the risk of not being paid."
Given how critical the interest rate on sovereign borrowing will be in the years ahead, several economists, including former Treasury official Andrew Donaldson, now a senior research associate at the University of Cape Town, have suggested that the Reserve Bank implement "real" quantitative easing.
Donaldson proposes a huge bond-buying programme of R10bn-R20bn a week, limited to the secondary market, with the express aim of exerting downward pressure on long-term bond yields to ensure SA’s ongoing fiscal sustainability.
So far, the Bank has made limited purchases in the secondary market (of R1.1bn in March and R11.4bn in April), and purely for liquidity reasons, not with the intention of influencing yields or changing investor confidence and expectations. While this has stabilised the market, yields remain high compared with capital market rates elsewhere.
Reserve Bank governor Lesetja Kganyago explained to the FM, before the monetary policy committee’s closed period, that SA’s persistently high long-term borrowing costs "reflect the assessment of most of the buyers of our debt worldwide that the level is getting too high relative to our capacity to pay it back — our real growth rate".
He says the Bank will step in more regularly to buy bonds if pricing dislocation becomes common, with the ongoing inability of buyers and sellers of bonds to agree on pricing. However, to do so otherwise "would distort the market, creating signals to other normal buyers of bonds that the price is artificially high and dissuading them from also buying in the short term".
These negative effects would be worsened by the Bank buying bonds at subsidised interest rates, or monetisation, he explains, as this "would prompt investors to dump bonds before they lost further value, increasing the borrowing cost problem immediately".
He says: "With advanced-economy central banks increasing liquidity at unprecedented levels, investor demand for emerging-market assets will remain. In that context, it seems more sensible to take advantage of global liquidity and to adjust to market signals sooner rather than later, achieving a sustainable debt level and ensuring that savers can invest safely and confidently in government borrowing."
The best justification for large-scale asset purchases, in his view, would be to prevent a deflation-depression-type scenario, but this is not currently the Bank’s baseline expectation.
With the Bank reluctant to undertake quasi-fiscal measures, the only other significant option, should the cost of borrowing become unsustainable, is to approach the International Monetary Fund (IMF) for a stand-by arrangement (SBA) or the New Development Bank (NDB) under its contingency reserve arrangement.
Speaking on a Deloitte webinar last week, NDB vice-president Leslie Maasdorp said the bank is finalising a $1.5bn loan to SA. But for the country to borrow more, it has to have a plan to show its debt is sustainable because, in the absence of growth, it would have "great difficulty" servicing its debt. In short, SA has "no option" but to implement reforms to resuscitate growth, he said.
So far, Mboweni is seeking only Covid-19 financing of R95bn from international lenders. That comes with little to no conditionality. Under a full SBA, SA would be entitled to as much as $18.7m over three years at exceedingly low interest rates.
The snag is that it would come with conditions. Though the IMF has become more flexible, and its conditions are designed to restore macroeconomic stability and lay a sustainable basis for growth, such adjustments are seldom painless.
The Reserve Bank rejects large-scale quantitative easing unless SA enters a deflation-depression scenario
— What it means:
In SA’s case, the IMF would likely set targets for narrowing the budget deficit, which means public sector wage cuts, strengthening public financial management and the restructuring of state-owned enterprises (SOEs).
In short, it would "strap SA to the mast of structural reform", says Intellidex’s Peter Attard Montalto. However, he sees little difference between the conditions the IMF would insist on and the reforms spelt out in Mboweni’s growth paper, which the government has adopted.
That is, of course, the crux of the problem — the government has adopted a "neoliberal" growth plan that many of its cadres don’t support and will continue to obstruct.
The plan requires that the government clear away regulatory hurdles and SOE inefficiencies to unleash the energies of the private sector. Such action is even more urgent in the wake of the pandemic — but it is doubtful that the ANC will drop its interventionist, developmental state model, even now.
Yet if a path back to growth cannot be found, neither will a return to fiscal sustainability. And so, when the bond market revolt finally happens — whether in five years or 10 — SA will have no choice but to approach the IMF or NDB. Only, then the country will be that much poorer, and more indebted, and the path back to stability that much steeper to climb.
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