South Africa’s economy has become increasingly vulnerable to the sale in large numbers of government bonds and other financial investments by foreign investors whose ownership of these investments has grown substantially since 2009. Should the sale happen, the country could face a serious crunch. It faces tough decisions if it wants to avoid this scenario.
The South African Reserve Bank’s Monetary Policy Committee commented on this vulnerability last year when announcing its decision on interest rates.
The MPC warned that past patterns suggested some more weakening of the rand and the rise in the cost of government debt as the start of increases in US interest rates became more certain. US investors account for half of all investments by foreigners in South Africa’s bond and equity markets, linking these markets to US financial conditions.
After a decade of narrowing fiscal deficits, South Africa’s finances have worsened since 2009 as government borrowed heavily to support to the economy. The growing debt pile exposes the country to the risk of external shocks, such a sell-off by foreign bond holders.
Rise in civil servants’ pay fuels deficit
But administering the bitter medicine South Africa needs to place its finances on a sustainable footing is proving difficult for the country’s political leaders. This is evident in the wage deal government struck with public sector unions last year.
The increase was more than government can afford, with National Treasury warning that government’s ability to sustain high levels of investment in infrastructure depended largely on moderating consumption expenditure, the largest share of which is the public-sector wage bill.
Before the latest wage deal unit labour costs had increased over the past decade by more than 80% after adjustments for the effects of inflation. By government’s own admission these increases have been not been accompanied by improvements in services to the citizenry. Most government workers are already in the top 30% of highest paid workers in South Africa.
Civil service salaries now account for 40% of the budget (excluding interest payments). This growth in civil service pay accounts for a significant portion of the structural fiscal deficit - the persistent gap between what government spends and what it collects in revenue.
Debt owed to the rest of the world
South Africa’s increasing vulnerability stems from the growing debt the country owes to the rest of the world and the rising share of government bonds issued on the domestic market that are now owned by foreigners.
Vulnerability is measured by computing gross debt owed by government, state-owned companies and the private sector to the rest of the world as a percentage of the size of the South African economy.
On this basis, gross external debt has risen from 29.3% of the economy in 2009 when the global financial crisis hit to 40% in 2014.
The other measure of vulnerability is the share of government bonds issued in the local currency, rands, that are now owned by foreign investors. Foreign ownership of these bonds has increased from 13.8% to 36% of the total bonds issued by government by the end of 2014.
Double-edged sword of foreigners owning more government bonds
Government borrows money both from domestic investors in rands and from foreign investors mostly in US dollars or Euros. Foreign investors can also buy, as they have done increasingly in recent years, government bonds denominated in rands.
While the purchase of domestic bonds has helped keep government’s cost of borrowing low, there is the real risk that these inflows will reverse. This is expected to be triggered by the withdrawal of the financial support the US Federal Reserve has been injecting into the US financial markets since 2009.
In response to the global financial crisis and the subsequent economic recession, the US central bank injected money into the US financial system by buying assets held by banks and other investors. This drove interest rates low in the US, sending investors elsewhere in the world, including South Africa, in search of higher interest rates.
A sudden and sharp reversal of these flows into South Africa could lead to the further weakening of the rand, which has already declined by 43% in the last three years. This in turn would mean an increase in the rand value of the debt South Africa owes to the rest of the world.
Downgrades pose an additional threat
South Africa’s fate is increasingly in the hands of the credit rating agencies. The country has faced a constant threat of downgrading. This is likely to raise the cost of future borrowing by government.
Some solutions
South Africa has one of the lowest savings rates among developing economies, a negative household savings rate of -0.8% compared to India’s 25% and China’s 28%.
A short-term measure to counter South Africa’s vulnerability would be to increase tax incentives for long-term savings in the form of infrastructure bonds.
South Africa should also accumulate adequate foreign exchange reserves (foreign financial assets and gold held by a reserve bank) to soften the impact of a sale by foreign investors of South African assets (capital flight).
Government could also restructure its debt portfolio by moving more of its borrowings from short-term instruments (repayment due within five years) to those of a long-term duration (repayment due after five years or more).
Spreading out the debt repayment profile helps government avoid the risk of not being able to borrow enough money to repay debt.
Alternatively government may be forced to pay very high rates of interest when borrowing money it needs to repay old debt. Governments typically borrow to repay debt when its term comes to an end.
A symptom of deeper economic malaise
South Africa’s increasing vulnerability is largely a symptom of its deteriorating economic performance. Its growth rate is among the lowest in the class of developing countries.
Its low growth is attributed to the slowdown among its major traditional trading partners which has reduced demand for South African exports.
Reduced exports together with imports which have continued to grow despite slower domestic growth have resulted in a yawning trade deficit paving the way for the depreciation of the rand.
A freely traded currency, as the rand is, acts as a shock-absorber. When the value of the rand declines it makes it possible for South African firms for example to earn more rands for each unit of goods they sell overseas. This should enable them to hold their own against their global competitors.
Exports under this scenario should increase, enabling the country to have more inflows of foreign currency which should eventually restore the equilibrium exchange rates.
Domestic factors are holding back growth
South Africa has not been able to take advantage of the weakening rand or other impediments to economic activity. These include the militancy and frequency of labour strikes and the inflexibility of labour laws which are deterring investment.
The uncertainty in the supply and increased prices of electricity in the short to medium term also weigh against investment.
So government should implement long-term measures to address issues that hinder faster economic growth. These include promoting sectors of the economy that have the potential to hire more workers and those technologies that make possible the use of more workers.
State companies a drain on economy
Government should also focus on measures that can reduce barriers to entry for new firms. Such measures would over time help increase the competitiveness of the South African economy when measured against its global peers.
Government should also consider selling to the private sector parts or all of the state-owned entities that are currently a drain on its resources. This would help government raise cash in the short-run. It can also improve efficiency and sustainability in the long run.
Attracting foreign investment would be another way of financing the investment needs of the country. Foreign direct investment (FDI) flows in recent years are nowhere close to bridge the saving investment gap facing the country. This is what has forced further borrowing. Bit it’s also important that FDI isn’t viewed as a panacea to resolve all the country’s investment needs.