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The Reserve Bank in Pretoria. Picture: FINANCIAL MAIL
The Reserve Bank in Pretoria. Picture: FINANCIAL MAIL

SA government bond yields are abnormally high relative to our country’s economic growth potential. The yield-to-maturity on very long-dated bonds, about 11% at the time of writing, exceeds the IMF’s forecasts of nominal GDP growth by a hefty five percentage points.

Sometimes discrepancies such as these can present an opportunity to bond investors, as international market experience suggests wide differences between interest rates and growth do not typically persist indefinitely.

If the SA Reserve Bank’s relatively conservative inflation targeting regime remains intact over the long term, the spread between nominal yields and inflation expectations may narrow through lower interest rates, and bondholders would earn both a high real income and a significant capital gain. This remains the core investment case for SA’s nominal government bonds, as set out by several local fund managers recently.

However, stubbornly high bond yields, which in effect represent the cost of government debt, can also present a threat to investment and real economic conditions. When a government’s debt cost exceeds economic growth policymakers must, by definition, run a primary budget surplus to avoid explosive debt dynamics.

In fact, the longer the discrepancy between bond yields and nominal GDP growth persists unfunded the more debt accumulates on government’s balance sheet, and the more difficult it becomes to stabilise the public debt trajectory. Eventually something must break, as the pace of debt accumulation cannot accelerate indefinitely.

Urgent change is required if SA is to avoid this kind of fiscal death spiral. In practice there are only three ways to stabilise an otherwise explosive public debt trajectory.

The first option, politically difficult, is to practise fiscal austerity. In SA’s case we estimate that a primary budget surplus equivalent to 2%-3% of GDP would be needed within the next five years to achieve the necessary stability in debt dynamics (if prevailing conditions endure). The required surplus appears far from likely though. The IMF, for example, expects the primary budget balance to remain in deficit for the foreseeable future, just breaking even by 2027.

Graphic: KAREN MOOLMAN
Graphic: KAREN MOOLMAN

The last time SA achieved a primary surplus at the general government level was in 2008, immediately before the Great Recession. Today we doubt whether personal or corporate income tax rates could be increased much further without a neutralising response from taxpayers. SA may be at or beyond the Laffer Curve’s turning point, where increases in marginal tax rates perversely result in a lower tax intake.

On the expenditure front, the necessary austerity appears even less constructive. Inefficiency of expenditure lies at the heart of so much that has failed in SA’s public sector. However, assuming no imminent improvement in the scale of government waste, wage costs (at about 10% of GDP) appear to be the only practical target in pursuit of a sustainable expenditure path.

Unfortunately, the level of austerity required to stabilise debt implies hundreds of thousands of job losses. This would run the risk of undermining GDP growth potential even further, as SA’s private labour market is probably not efficient enough to absorb an influx of unemployed people at the necessary scale.

In fact, we have argued that the Treasury’s optimal fiscal strategy may ironically imply wider budget deficits in the near term, principally through the aggressive subsidisation of local capital expenditure. We believe SA’s growth potential is predominantly capital-constrained, and that widespread and generous depreciation allowances would produce a J-curve effect in government’s corporate revenue collection as short-term tax breaks are offset by greater private investment in the local economy. Structural changes such as these, which may produce higher real GDP growth outcomes over time, are the second, preferable option in stabilising the government debt-to-GDP ratio.

Failing an immediate improvement in growth conditions, and accepting that fiscal austerity is fraught with challenges, the only remaining way to stabilise the debt trajectory in the near term is to reduce the cost of debt. In this respect the Treasury should buy itself time by shortening the duration of its bond issuance substantially. The local yield curve is at an historically steep gradient, and short-dated bonds trade at considerably lower yields than their long-dated counterparts.

Though the strategy of regularly issuing long-dated debt has reduced government’s liquidity risks historically, we believe that under current conditions the Treasury should show more sensitivity to its cost of capital. At best, this can only be a short-term strategy as liquidity risks would eventually re-emerge and ultimately reach intolerable levels.

However, in the interim period a sensible reduction in the issuance of long-dated bonds would temporarily starve the market of these instruments, reduce running interest costs in government’s annual budget, and create some budgetary breathing room for the actual implementation of growth-boosting reforms.

None of the measures that are required to stabilise the debt trajectory (a primary budget surplus, higher nominal GDP growth, or a lower cost of debt) are inevitable. As patience with socioeconomic conditions wears thin and better growth outcomes take time to materialise, the risk remains that higher nominal GDP growth is pursued through the politically enticing option of money printing. If nothing changes SA will remain on an explosive government debt path.

The implications of this outcome would eventually extend far beyond the investment community as the balancing equation of debt dynamics would likely be resolved through a structural depreciation in the currency. The discrepancy between local bond yields and nominal GDP growth would then close due to higher inflation, and ordinary South Africans would suffer.

Nevertheless, as alarming as the downside scenario appears, the debt-stability equation is equally sensitive to small improvements in local variables, which will tend to reinforce each other. If capital constraints ease moderately, whether through the slow recovery of Eskom, elevated commodity prices or through greater private sector confidence, it is not implausible that SA’s economy grows at a nominal rate of more than 6% a year (given the current level of GDP per capita). The cost of debt may decline in this slightly more favourable growth scenario, and the primary budget balance may come in slightly better than current baseline projections.

If all three variables improve moderately, SA’s public debt-to-GDP ratio may well stabilise at a comfortable level over the next decade. In this scenario the bull case for local government bonds likely plays out. Rather than attempt an outright forecast, we thus believe one should take care to invest for widely divergent outcomes in the local market.

• King is head of fixed income at Counterpoint Asset Management.

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