Economists have been left scratching their heads in the aftermath of South Africa’s 2024 budget. The National Treasury’s controversial move to tap valuation gains on foreign exchange reserves to create more fiscal space seems not to have initially paid off the way many hoped it would.
This is despite the fact that drawing R150bn from the Gold & Foreign Exchange Contingency Reserve Account (GFECRA) will reduce the general borrowing requirement and slow the accumulation of government debt, allowing for considerable savings on debt service costs.
An important expected upside was that the reduction in government debt issuance would provide some relief on domestic capital markets, helping to lower yields, and so reduce the marginal cost of government borrowing.
Only, after rallying initially from 11.44% to 11.25% immediately after the budget on February 21, the representative 10-year bond yield is now almost exactly back to where it started, at 11.43%.
The rand/dollar exchange rate has followed much the same pattern. From R19.20/$ before the budget it quickly strengthened to R18.90/$ immediately thereafter. But last week it was back at R19.30/$.
Economists are divided about why the markets haven’t been more appreciative.
One interpretation is that nobody buys the Treasury’s fiscal consolidation story — that gross government debt will now stabilise at 75.3% in 2025/2026 compared with a previous estimate of 77.7%.
Certainly, the main ratings agencies were noncommittal about the implications of the GFECRA move, with both Fitch and S&P saying they still expect the debt ratio to hit 80% of GDP in the next year or two.
“Though gross debt will be lower than it would otherwise have been, the impact on the sovereign credit profile will be limited,” Fitch said in a statement, noting that the GFECRA windfall doesn’t address underlying issues driving debt accumulation, including the country’s low economic growth potential, persistently large fiscal deficits and exceptionally high levels of poverty and inequality.
Michael Sachs, who heads Wits University’s Public Economy Project (PEP), doesn’t buy the Treasury’s debt stabilisation promises either. In fact, Sachs says the country is caught in a “low-growth, high-interest-rate trap”.
In a submission to a parliamentary hearing after the budget, the PEP explained that South Africa suffers from “an underlying macro-fiscal crisis, which is rooted in the low-growth, high-interest regime”. Simply put, the root cause of the fiscal constraint is that the country has experienced a prolonged period of economic stagnation, it says. This is a key reason government debt has been rising faster than income for more than two decades.
In an attempt to slow the rapid escalation in debt from less than 30% of GDP in 2008 to almost 75% now the Treasury has had to double down on austerity. The maths is simple: when the interest rate on government debt exceeds a country’s growth rate by a large margin on a sustained basis, as it has done, debt will continue to climb unless taxes are hiked or spending is cut back ruthlessly.
The PEP estimates that whereas the government’s unpopular growth, employment & redistribution strategy led to a 6.3% reduction in real per capita spending between 1996 and 2000, the current bout of austerity, which began in 2019, has already cut real per capita spending by 7.6%.
Core government spending (which excludes debt service costs) fell from R30,440 per capita in 2019 to R28,116 in 2023. The 2024 budget aims to reduce it by a further 3.5% (nearly R1,000 more per person) over the medium term.
A less painful way to do things would be to raise the growth rate or lower the interest bill. However, there is little prospect of economic growth lifting meaningfully over the medium term, given that the economic crisis is structural in nature and market sentiment is stuck deep in negative territory.
The idea behind using the GFECRA is that it will help to lower the interest bill and free some fiscal space, which could be best used to fund capital expenditure (infrastructure) to spur future growth.
But for now, the Treasury continues to battle scepticism over whether it will achieve either its proposed spending cuts or its infrastructure ambitions. This, combined with the government’s patent inability to accelerate economic reforms, fuels the fear that the economy will continue to stagnate and that debt will continue to rise.
The combination of rising debt and economic stagnation suggests that the cost of borrowing will likely remain high as the markets continue to demand a premium to offset the risk of lending to a fiscally unsustainable country.
In short, this view suggests that the reason the post-budget bond market rally hasn’t been sustained is that market participants don’t see South Africa escaping from its low-growth high-interest-rate trap any time soon.
Krutham MD Peter Attard Montalto says, however, that the bond market and ratings agencies have become far too bearish about South Africa’s fiscal prospects and will ultimately have to recalibrate their views when the worst-case scenarios fail to materialise.
He says market participants are failing to appreciate the full, positive significance of the GFECRA drawdowns for bond issuance as well as the Treasury’s ability to hold the line on spending, regardless of the election.
“The poor Treasury can never seem to catch a break,” he writes in Business Day. “I have long had this sneaking suspicion in response to the age-old question ‘Why is the yield curve so steep?’ that no matter what the Treasury does — even not issuing bonds altogether — it just wouldn’t move.”
The decision to tap the GFECRA spurred a brief bond market rally, but it will take far better fiscal news to sustain these gains
— What it means:
Reza Ismail, head of bonds at Prescient Investment Management, has an interesting take on this point.
He notes that the bond market rallied very strongly in the immediate aftermath of the budget when it became apparent that there wouldn’t be an increase in the size of weekly bond auctions thanks to the GFECRA decision.
That the yield curve hasn’t been able to remain sustainably stronger, he says, is entirely due to global factors. Two developments in particular stand out, both of which occurred around the time of the budget.
The first, in early February, was the release of US inflation figures for January 2024. Though the headline figure moderated to 3.1% year on year from 3.4% in December 2023, this dashed market hopes that inflation would drop below 3%. Underlying measures of super-core inflation (essentially services less shelter inflation) also surprised to the upside.
The second important factor was that the Federal Open Market Committee (FOMC) released somewhat hawkish minutes from the January meeting of the US Federal Reserve (Fed) on the day of South Africa’s budget.
The minutes revealed that several FOMC participants were concerned that progress on lowering inflation could stall if financial conditions became less restrictive than appropriate. Other sources of upside risks to inflation, including geopolitical developments, were also highlighted.
These two developments have shifted market sentiment from expecting one 25 basis point cut by the Fed in June to expecting the Fed to stay put.
The problem for emerging markets generally, including South Africa, is that a “higher-for-longer” policy stance in the US raises the opportunity cost for capital leaving the US as investors believe they are getting a better risk-free deal by staying at home. However, if foreigners don’t support South Africa’s weekly bond auctions, the onus falls to local banks to “mop up” excess stock. This results in the auction being cleared at very poor levels (high yields) week after week and contributes to a rising, steeper yield curve, which raises the marginal cost of debt for the Treasury — precisely what it wants to avoid.
“This is why we have not seen more lasting strength in the South African bond market,” says Ismail. “It’s not chiefly due to any idiosyncratic South African [factor] at all.”
The poor Treasury can never seem to catch a break
— Peter Attard Montalto
But what if recent bearishness in the domestic currency and bond market reflects not global dynamics or fiscal jitters but rather rising political risk? Concerns are certainly mounting, especially over the tail risk of an ANC-EFF coalition being formed after the May 29 election.
BNP Paribas chief regional economist Jeff Schultz explains that one way of ascertaining whether current rand weakness is due to a new domestic risk factor, like the election, is to look at fair-value models for the rand that rely solely on global macroeconomic variables to estimate the currency’s value.
By BNP’s fair-value measure, the rand is not excessively weak, which suggests that no new specific idiosyncratic risk is being priced in.
Schultz also undertook a historical comparison of asset swap spreads to see if there was an additional election-related risk premium being demanded on South African government bonds, but again found nothing is being priced in beyond historical norms.
Only time will tell whether the Treasury will achieve the holy grail of debt stabilisation in 2025/2026 as promised. If it is able to hold the line on spending, while growth revives and global financial conditions ease, the markets will surely reward South Africa. Until then, we will have to remain on our toes.
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