Reserve Bank governor Lesetja Kganyago. Picture: SUPPLIED
Reserve Bank governor Lesetja Kganyago. Picture: SUPPLIED

The severe economic consequences of the Covid-19 pandemic will cause an already bad fiscal situation to become even worse, with the government’s main budget deficit sure to reach more than double last year’s 6.7% of GDP. Equally, it should surprise no-one if the gross debt load races past 80% of GDP this year, and keeps rising to levels far exceeding the IMF's 70% “danger” flag for emerging markets.

Yet when finance minister Tito Mboweni committed in his June 24 supplementary budget to advance growth-boosting reforms and to rein in spending to tackle the ballooning debt burden, fixed-income investors were sceptical. This credibility failure is evident in the steep slope of the bond yield curve, indicating that investors’ concerns about public debt sustainability in the longer term have, if anything, increased. If actions by government cannot turn that around in time, there could well be a case for the Reserve Bank to play a role in bridging the credibility gap in the short term.

In the June budget the Treasury chose the pragmatic route of balancing support for economic growth with fiscal rigour. The budget deficit is projected to narrow from next year onwards thanks to planned cutbacks in recurring spending combined with the unwinding of special Covid-19 fiscal support and an improvement in tax revenue as the economy turns the corner. Further impetus ought to come from the favourable impact of structural reform on GDP growth. Consequently, the pace of debt accumulation should slow, ultimately resulting in the debt load peaking at about 90% of GDP by 2023. On the face of it, a workable plan.

So why have fixed-income investors not bought into the strategy? If they had, the slope of the bond yield curve would have flattened, not steepened. Instead, with long-dated bond yields having risen by more than shorter-dated ones have fallen, the yield gap, at 700 basis points, is now a good 70 basis points larger than it was before the supplementary budget. Instead of falling, sovereign credit risk, allied to large public borrowing requirements, has risen. Talk about a supposedly good fiscal story have fallen on deaf ears.

Graphic: KAREN MOOLMAN
Graphic: KAREN MOOLMAN

It’s not hard to realise why this is the case. Too often in the past SA’s creditors trusted the government to deliver on the Treasury’s pledges — ranging from reducing the wage bill to cutting wasteful spending, streamlining state-owned entities and accelerating reforms such as the licencing of new high demand broadband spectrum — only to be disappointed. After years of inaction, investors have grown weary of the government’s habit of talking but not delivering.

This raises a hypothetical question. What if the government were at last to take creditors’ message to heart and begin to deliver on what is required to achieve the finance minister’s debt-stabilisation targets, but serious fixed-income investors, so disillusioned with the state’s poor track record, remained on the sidelines?

In this scenario the danger would be that the slope of the bond yield curve would stay steep. That would mean longer term borrowing rates would continue to substantially exceed the country’s prospective GDP growth rate (which determines tax revenue growth), a dynamic that would undermine any effort aimed at stabilising the debt load. It is not inconceivable that under such conditions interest payments, which are already unsustainably high at about 20% of tax revenue, would keep on rising, crowding out social grants, wages and other outlays.

If the government does commit and begins implementation, but the credibility deficit remains such that the cost of borrowing doesn’t fall, this could be the point at which to consider a bridging strategy to give the government time to win over sceptical investors. The Reserve Bank might well be the institution to provide such a bridge.

Reserve Bank governor Lesetja Kganyago said in a recent speech: “If debt sustainability can be assured with high probability, then near-term borrowing will be more readily available. However, were the government still to experience financing disruptions we would feel confident that these were liquidity problems, which the Bank could help to address.” 

We interpret this to mean that the Reserve Bank would be willing to expand the bond market operations it began in March, but only if certain initiatives are successfully undertaken. Though we don’t know exactly which of these the Bank would have in mind to ensure debt stabilisation, the measures contained in SA’s recent letter of intent to the IMF, which both the finance minister and the governor signed, are probably an accurate list.

Simply put, were national and provincial departments, for example, to agree to  adopt zero-based budgeting as official policy, and if this strategy were complemented with a new fiscal rule putting a hard cap on public debt, it presumably would go some way to persuade the Bank to come on board. Simultaneously, it would no doubt want to see the government acting on the range of structural reforms included in the letter, starting with those aimed at boosting the country’s competitiveness by reducing the operating costs of business and advancing fixed investment. Any reform programme would obviously be incomplete without specific targets being set, including clear deadlines.

In return, provided inflation remains low the Bank could agree to buy more bonds in the secondary market, with the option of evaluating this strategy based on government’s progress with its debt stabilisation programme. The Bank would, in other words, build on the successes already achieved in contributing to lower bond yields — but only under conditions that would start to see fiscal credibility being rebuilt.

The Reserve Bank has been as disappointed as any investor by the government’s failure to deliver on promises of reform. If the Bank were to respond in a way that provides a financing bridge as opposed to enabling fiscal laxity, that would be a strong signal to serious investors. It should help persuade them that the government is on track to deliver, that this time is different, and that sitting on the sidelines cannot be a long-term strategy.

Ideally that would limit the risk of more generalised and distortionary financial repression and enable the Reserve Bank to pull back from its bond buying programme sooner rather than later, while sustaining its own credibility in the eyes of SA’s creditors.

Will the government be willing to deliver, giving the Bank the opportunity to back it? Only time will tell.

• Le Roux is chief economist, and Silberman foreign exchange and fixed income strategist at Rand Merchant Bank.

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