Why SA should avoid a sovereign debt default
South Africa’s finance minister, Tito Mboweni spoke at length in the Medium Term Budget Policy Statement (MTBPS) about the dangers of government’s rising sovereign debt. Unfortunately, the speech fell short of a detailed plan to escape a looming debt trap. The recent further downgrading of the country’s credit rating by Fitch and Moody’s do not make matters easier. With a growing debt burden at a time when SA cannot afford further economic pressure, how can the country avoid a default?
In 2008, SA’s debt to GDP ratio was 27% – an attractive ratio for a developing country trying to grow and create employment. Within a decade, we have lost this advantage mainly through populist interventions that dominated political decision-making.
Remembering a better time
Most may not remember that during the debt and commodity super cycle which preceded the 2009 global financial crisis, when emerging markets amassed large volumes of wealth from the windfall, South Africa ran a budget surplus allowing our government to hold auctions to buy back its own debt. The yield curve was inverted (i.e. longer dated yields were lower than shorter dated ones) because there was no need to borrow and issue longer-dated debt.
The country needed to invest in large infrastructure projects at the time, but there were significant capacity bottlenecks which constrained most developmental ambitions the country had. For a country that carried so much promise, how did we end up here?
2020: a year of growing debt to sustain our economy
Fast forward to 2020 and SA is fast running out of fiscal room to manoeuvre. Government now needs to make tough and unpopular decisions. The country was in trouble even before COVID-19 induced stresses that saw GDP growth decimated by 51% on a quarter-on-quarter basis and widening the budget deficit to -15.7% as presented by the Minister of Finance at the MTBPS.
This has led to higher revisions of issuance profiles by National Treasury to try to plug the gap. The debt servicing cost is expected to reach levels as high as 22% of GDP, larger than allocations made to crucial services like health care. SA’s primary balance is unlikely to revert to positive territory anytime soon.
Shifting the spend to drive growth
Debt is neither panacea nor poison – what matters is what a country does with the money. Borrowing to spend on infrastructure programmes is more sustainable than using debt to pay wages and fund programmes that do not lead to growth and future jobs.
The government needs to play its part in building confidence and creating an enabling environment for businesses to put to work the R1 trillion in cash that sits on their balance sheets. We also need Public-private partnerships to create sustainable, growing industries. Here, we are encouraged by the outcomes of the latest round of Nedlac engagements between government, business and labour.
Amplifying our debt problem
The risks associated with not taking immediate action have been aggravated by the pandemic. And while the country is facing the risk of a second wave of infections, government is forced to keep the economy open as it does not have the financial capacity to fund the recovery from COVID-19 in a counter-cyclical manner.
A previous source of funding, foreign holdings, has declined from over 40% to 29%. This is lower than the levels when South Africa was first included in the World Government Bond Index in 2012, from which we have now made an ungraceful exit. To be fair, foreign investors’ divestment of local bond holdings is an emerging market phenomenon. There are consequences to having a sub-investment grade rating, including most investors taking a speculative approach on our bonds, rather than building long-term portfolio position which our country needs.
The brunt of default
Sovereign debt defaults have several long-lasting economic implications. This includes lower investor confidence, higher borrowing costs and a long road to getting back to a sustainable path as spending on critical social services is most often curtailed.
As an example, Argentina has defaulted nine times in total, twice since 2000. Borrowing costs on average have remained above 12% as a result. The main issue is that most of the country’s debt was in foreign currency, which can lead to significant balance of payments challenges and IMF interventions.
South Africa’s saving grace for now is that most of its debt is in Rands. However, if meaningful economic and social reforms are not undertaken, this may not matter anymore. Our credit default swap spread, which measures the cost of buying insurance against the country’s default, had risen substantially although it has normalised now due to a supportive global environment.
We have the steepest yield curve amongst our emerging market peers. This should attract foreign investors to our bond market, but most have chosen to stay away. We are not alone in this mini boycott as other emerging markets have also experienced declines in foreign interest. For now, South Africa still has room to borrow in hard currency, but if we don’t do the right things, even this advantage can lead to challenges. Most countries tend to default on foreign currency denominated debt, and the larger foreign debt gets the higher the likelihood of default as the currency capitulates, increasing indebtedness furthermore.
A default on the horizon?
Valuations reflect what the markets are thinking about fixed income assets at a particular point in time. The long-term risk for the asset class is that we end up in some value trap as government struggles to find the political will to make hard but necessary decisions – and that can break the markets. This would mean further weakness for the bond market and potentially going to the IMF with a begging bowl.
Approaching the IMF would not necessarily be bad for the country, but it may prove politically untenable. It is better for South Africa to sort itself out than to run out of runway as this would raise the risk of irrational decision-making and hasten the pace down the slippery road. The country should avoid this scenario at all costs or accept that our future generations will feel the brunt of broken promises. Both the finance minister and President Ramaphosa appreciate this, and as such all policies to get out of this quagmire need to be implemented contrary to the failures of the past.
We have been positive in the short- to medium-term on bond returns given valuations, however we recognise the inherent risks of a potential fiscal cliff. National Treasury must continue to be the backstop for policy direction and deliver on the economic recovery plans announced by the President and highlighted in the MTBPS.