Last year was traumatic for the vast majority of the globe. The combination of the large number of deaths, deep recessions and widespread mental depression means that 2020 will long be remembered as one of the worst years since World War II. Unfortunately, the effects are likely to be long-lasting.
The IMF recently estimated where the level of overall GDP output would be in a range of countries in 2024 relative to what they had expected for that year prior to the onset of COVID. Although South Africa would have recovered to 2019 levels by then, it will still be 8.3% lower than they had previously projected for 2024.
Shortfalls of between 7% to 10% are forecast for a host of large emerging markets including Brazil, Chile, Mexico, Indonesia and Thailand.
Add in the massive increase in borrowing during the year, and there is a growing concern that debt burdens are in danger of becoming unsustainable for many countries. However, assessing the sustainability of debt in any given country is a complex question.
The Institute for International Finance and Deutsche Bank recently compiled the list of change in debt-to-GDP ratios between the fourth quarter of 2019 and the third quarter of 2020 across 32 countries across their household, corporate and government sectors. South Africa ranked 11th from the bottom, with an increase of 17% of GDP, the bulk of which was in the government sector. In contrast the UK has seen a 33% increase in that period, again concentrated in the government. The US has seen a 43% increase spread between borrowing by the government and corporates. Japan has seen a 50% increase.
Their overall government debt-to-GDP levels are also above South Africa’s levels at this point. Why then is South Africa’s debt viewed as unsustainable at 81% this year when this is not a concern in the UK (85%), the US (91%) and Japan (250%)?
The reason is debt serviceability, which is the ability of borrowers to make interest payments on their debt. In 2010, South Africa spent roughly 6.5% of revenue on interest payments. In the current year, this will rise to 21.2% of revenue and is projected to rise to 24% of revenue in the fiscal year ended 31 March 2024. A scarier way to think about this is that 50% of the debt government raises next year will be used to pay interest costs.
The surging share of revenues (or borrowing) diverted to making interest payments is due to two main factors; the growing debt burden and persistently high interest rates (which in turn compound the debt burden). The former is unavoidable at this juncture. The latter is the problem.
The reason the UK, the US and Japan can afford massive increases in debt burdens is because their borrowing costs have plunged. If the US government borrows for 10 years at just under 1%, they can afford to support the massive amount of the money they have borrowed this year. If Japan or the UK government borrows 10-year money at slight negative interest rates, they have no problem with debt serviceability.
In contrast, South Africa has no such leeway. South Africa’s interest costs are high, and the 10-year yields have shown little downward movement through this crisis:
- Inflation is expected to average 3.8% in 2021. This leaves South Africa with real interest rates of at least 5.3%. In a world where real interest rates are negative in most developed markets, a 5%+ real interest rate stands out.
- The repo rate is 3.5%, leaving us with a term premium of over 5.5% currently when the 10-year term-premia are less than 1% in much of the world.
- Local banks can issue 5-year NCDs at 5.9%, whereas the government R186 is trading at 6.6%. Investors would rather lend to local banks than the South African government.
- South Africa’s 10-year bond historically yielded 1.5% more than the emerging market average. This doubled to 3% when Nhlanhla Nene was fired. After trending down in subsequent years, it has headed higher in the last year, and is now at 4.5%.
Why do South Africa’s government interest rates remain high when they have plunged in much of the rest of the world? The answer is simple: in contrast to the big developed markets, the SA bond market does not believe the proposed budget consolidation will be achieved and the associated debt trajectory will eventually be sustainable. The bond market does not believe there is any commitment in South Africa to reining in the government wage bill or enacting the reforms necessary to promote growth.
The result is that the real cost of debt exceeds the real growth rate. Unless this changes, debt will not be sustainable, particularly in the context of persistent primary budget deficits. The result is an exploding debt path. The solution involves raising the growth rate through reforms, which would also lower the cost of debt.
After all, the root of SA’s problems is weak growth. Since 2009, South Africa has experienced weaker growth than all major emerging market countries that form part of key indices such as the JP Morgan GBI-EM and Citibank WGBI indices.
At this point it may be helpful to indicate what we mean by reforms. There is so much that needs to be done that it would be easy to conclude that there is just no way to get it all done.
Fortunately, confidence levels are so depressed that investor expectations of future growth prospects can be dramatically boosted by a few key actions. Here is our three-point plan to boost South Africa’s growth prospects, reduce our borrowing costs and make our debt sustainable.
- Stabilise government expenditure. Conclude a deal with public sector unions that sees the government wage bill remain relatively flat over the coming three years. Preferably this would be by containing salary growth rather than by cutting jobs.
- Alleviate the energy constraint. Ensure that the unbundling of Eskom that will create an independent transmission company remains on track for functional separation by March 2021 and legal separation by December 2021. This would allow the acceleration of independent power procurement, notably from renewables. This accelerated carbon transition would also allow South Africa to access cheap global financing to facilitate the transition.
- Remove the key constraints to mining sector investments. It appears increasingly likely that the post-COVID global economic recovery will be supported by an increase in infrastructure spending, particularly on renewables. South Africa has relevant commodities for the carbon transition – and we should ensure the industry has the ability and incentive to expand production to take advantage of this.
Instead of a twenty-point plan, Operation Vulindlela should focus limited public sector skilled capacity on concrete action on these three critical issues. Progress on these issues will boost potential growth by one to two percentage points per annum. This would dramatically lower borrowing costs and stabilise SA’s debt burden. We have a plan.
We even have the first steps of the plan. Government held the line on public sector wages to date for much of 2020 – though that commitment is now in question. Eskom CEO Andre de Ruyter has begun to implement the unbundling plan. Relations between the mining industry and the Minister of Minerals and Energy have repaired in the last year. In each of these cases, more is needed. And quickly.
If National Treasury believed that the reforms would be enacted, they could reduce the quantity of bonds they are issuing weekly. That would be very helpful to lower bond yields. DM/BM
This article was written by Nazmeera Moola, Head of SA Investments, and Adam Furlan, Portfolio Manager, Ninety One