The South African bond market will be slaughtered if the debt-to-GDP ratio continues to deteriorate.
Earlier last week I had a few pertinent and important questions regarding South African bonds by one of our readers and I thought I’d share my responses to those questions with you. At what point does South Africa’s debt-to-GDP ratio become unsustainable?
Two weeks ago, Finance Minister Tito Mboweni made a presentation to National Economic Development and Labour Council where he estimated that gross government debt would rise to 80.5percent of gross domestic product (GDP in current money terms) in this fiscal year compared with a projection of 65.6 percent in February. He projected that the ratio will exceed 100 percent by 2025.
It is clear that South Africa is past the tipping point as aptly mentioned by a research paper titled “Finding The Tipping Point – When Sovereign Debt Turns Bad” presented to the World Bank in 2010 by the authors Thomas Grennes, Mehmet Caner and Fritzi Koehler-Geib.
They established a threshold or tipping point of 64 percent debt-to-GDP for emerging markets. According to their calculations, the loss in annual real growth with each additional point in public debt amounts of 0.02 percentage points.
In another working paper of the IMF in the same year, titled “Fiscal Affairs Department Interest-Growth Differentials and Debt limits in Advanced Economies”, author Philip Barrett argued that the critical factor determining a country’s maximum sustainable debt level is the difference between its future nominal interest and growth rates.
“This interest-growth differential determines the rate at which a country’s public debt rises relative to its output. A higher interest-growth differential means that a country must raise larger surpluses in order to stabilise its debt-GDP ratio.”
In South Africa’s case the difference between nominal interest rates and GDP growth rates in nominal terms averaged 2.7 percent from the first quarter in 2018 to the final quarter of 2019. As such it is evident that South Africa is past the tipping point in as far as the country’s debt levels are concerned.
If this ratio continues to badly deteriorate, is there a possibility that the government may default on its debt and wipe out bondholders at some point?
The composition of South Africa’s debt is very important though. According to the Joint External Debt Hub series where external debt data are available for individual countries for three broad instrument categories: loans + deposits, debt securities, and trade credits, South Africa’s national external debt amounted to 41 percent of nominal GDP in the third quarter last year, while the country’s total external debt amounted to 51percent of GDP. This is relatively in line with an IMF report in 2002 which noted an external debt ratio of about 40 percent as a useful benchmark for developing countries.
In regard to domestic debt, a quote in a post by Anis Chowdhury on November 9, 2010, on https://voxeu.org: “Is there an optimal debt-to-GDP ratio?” sums it all up. “It is assumed that when debt gets very large, it may be difficult to generate a primary balance that is sufficient to ensure sustainability, and that shocks can push countries beyond their debt limit. So, the advice is to remain well below the limit for the sake of prudence. This advice is not derived from the analysis of liquidity/rollover risk. Liquidity is not an issue for domestic debt as it can be paid off by printing money, a sovereign right which households or firms do not have.”
Major hard-currency-issuing countries or regions are finding themselves in enviable positions – deflationary pressures and a zero interest rate. The higher debt-to-GDP ratios are due to very low inflation.
Although printing of money may be applicable to South Africa, the exponential growth in domestic debt is unsustainable and could fuel inflation. As Barrett stated, the absolute debt limit is the debt level at which the government loses access to debt markets and any finite default premium will cause such high debt service obligations that default is almost a certainty. Significant intervention is required.
As I have recently said in this column, the time has arrived for inward investing by the savings sector by lowering the Regulation 28 limits of investing offshore and to ensure that the repatriated funds are productively employed in the economy through the prescribed asset mechanism. South Africa cannot afford to try moral suasion to get a buy-in from financial institutions to invest in specific projects or state-owned enterprise situation is such that a blanket prescribed asset must be introduced to take the pressure off the government’s finances to reduce or stabilise the debt-to-GDP ratio. Lower interest rates and fast-tracking fixed investment projects are non-negotiable.
President Cyril Ramaphosa and his A-team just have to look at how swiftly Sasol’s executives and board reacted when crisis upon crisis recently struck the company. You cannot manage by consultation when the chips are down. Time is not on your side.
Would you expect bond yields to progressively rise, as the debt-to-GDP ratio worsens?
The global investment cycle has turned for the better, despite huge uncertainties on how the coronavirus situation will develop in coming months and uncertainties about President Trump’s actions ahead of the elections.
South Africa’s economy looks to the up in coming quarters and our government bond yields will probably follow other emerging market bonds lower. The performance of our bond market relatively to other emerging markets will be hampered by a worsening debt-to-GDP ratio. Our bond market will be slaughtered when the global investment cycle moves to Risk-Off territory again, specifically if the debt-to-GDP ratio continues to deteriorate.