The domestic bond market is at a crossroads, hostage to the opposing forces of inflation (positive) and heightened sovereign risk (negative) as a result of years of weak economic growth. Added to this, the situation at Eskom creates an increasingly high hurdle to turning things around - with major consequence for government finances and the bond market.
The interrelationship: economic growth, inflation and the bond market
In the simplest terms, interest rate management is centred on anticipating the ebbs and flows of the inflation cycle and managing the consequent valuation impact on a portfolio of interest bearing assets. In inflationary periods, the higher discount rate applied to periodic bond cash flows will have the effect of eroding nominal bond valuations, whereas disinflationary periods are favourable for nominal bond valuations given the lower discounting rate.
As with most economic variables in a free-market economy, the aforementioned “ebbs and flows” in the inflation cycle are symptomatic of aggregate supply and demand. This means that in periods of robust economic growth, it is easier for producers to pass costs onto consumers, which ultimately results in increased inflation. This train of thought might suggest that low economic growth results in low inflation and endlessly creates a wonderland environment for nominal bonds. Not so. There are times when low economic growth turns against bond bulls. Such instances would arise when the disinflationary benefit of persistently low economic growth is outweighed by the negative sovereign and fiscal risk associated with an over indebted state. The South African nominal bond market increasingly seems headed for this crossroads.
South African economic growth has remained persistently sub-trend for the greater part of the past decade, largely as a consequence of macroeconomic policy ineptitude. Gross domestic product (GDP) has grown at a wholly inadequate average of 1.8% year-on-year over the past decade, relative to a 3.7% year-on-year average growth rate for the prior decade. It is no coincidence that this period of insipid growth has been accompanied by an increasingly burdensome fiscal deficit and an erosion in sovereign credit quality. Gross debt-to-GDP has widened to 59% at present from 26% the previous decade. Equally reflective of the erosion in sovereign credit quality is South Africa’s present BB+ (sub-investment grade) S&P’s Foreign Currency rating, relative to BBB+ rating a decade ago.
The relevance of Eskom
Given the energy intensive nature of the country’s key productive sectors, stable electricity generation is a minimum requirement for elevated growth prospects, yet Eskom has become increasingly central to South Africa’s economic travails. Moreover, Eskom’s debt-laden balance sheet, the bulk of which is government guaranteed, not only threatens the utility’s solvency but also the country’s fiscal position and economic growth prospects. With this in mind, key to our investment view and strategy in recent years has been the strong link between endemic economic growth, fiscal policy erosion, increased bond issuance and ultimately, an expectation of increased nominal bond yields.
The evolution of South Africa’s fiscal position is a critical watch point for our investment view and strategy. The tabling of the 2019/20 budget again reflected an overestimation of forecasted GDP growth relative to the previous budget iteration, and an underestimation in the budget deficit – largely as a consequence of National Treasury’s R69bn commitment in fiscal support to Eskom over the next three fiscal years – and a total R230 over the next ten years. Despite the general market approval of this support, we stated our disapproval at the time given its complete inadequacy in alleviating Eskom’s liquidity constraints, let alone solvency risk, at the expense of abandoning two key fiscal consolidation pillars: deficit-neutral SOE funding and the expenditure ceiling.
Recent news flow increasingly suggests that an Eskom debt swap to the fiscus is imminent, with the foremost risk at this stage posed by the resultant increase in sovereign debt servicing costs. Assuming R300bn in outstanding government guaranteed debt to Eskom and a weighted average coupon rate of 8.04%, a debt swap would result in an estimated R72bn increase in budgeted debt servicing costs over National Treasury’s medium term expenditure framework (MTEF). All else equal, this would result in the budget deficit widening by an additional 0.4% each fiscal year relative to National Treasury’s MTEF expectations. In a worst case scenario, where National Treasury not only “steps in” to service Eskom’s debt but also capitalises its outstanding government guaranteed debt, could add as much as 5% to government’s debt profile in each year of the MTEF – pushing gross government debt-to-GDP well beyond the 60% threshold.
Debt profile unlikely to stabilise in the medium term
Unless wholly counteracted by expenditure constraint – an impossibility in this constrained growth environment – an Eskom debt take-on would necessitate increased bond issuance by National Treasury and threaten the idealistic ties between low growth, low inflation and favourable nominal bond valuation.
While material, the challenges are not insurmountable
Macroeconomic policy reform is a precondition to staving off further economic strife domestically, and positively, we read the unbundling of Eskom’s operating model as a sign of intent by President Ramaphosa’s administration. Reconfiguring Eskom into three units, focusing on generation, transmission and distribution could potentially create efficiency gains by allowing each unit the ability to spur focus and efficiency within the broader structure.
Further to this, there are plans afoot to help alleviate Eskom’s funding pressure. Eskom’s sustainability task team is currently developing a special financing vehicle in the form of a green fund with the aim of sourcing cheaper debt. The green fund could potentially save Eskom billions in debt servicing costs by allowing the entity to refinance a portion of its debt at favourable yields, on condition that it accelerates its reduction in carbon emissions. Although we await clarity on the specifics of this financing vehicle, it could go some way to slowing Eskom’s debt spiral if implemented successfully.
While persistent sub-trend economic growth and contingent liability risk threaten our assessment of fiscal risk, they are not insurmountable if macroeconomic policy reform is embraced and urgently pursued. Until there is clearer evidence of this, the nominal bond market will remain bound by the opposite forces of domestic disinflation and elevated sovereign risk.