South-Africa’s fiscal position now the weakest in decades
In a relatively short space of time, the COVID-19 pandemic has caused one of the most eventful - if not horrific - quarters in decades, on a global scale. The supportive role that governments have played globally in an effort to offset the health and economic impact is unprecedented.
This classic example of a Keynesian-type intervention comes at a cost, with larger, unplanned, fiscal deficits being the most visible. For this reason, the tabling of an unprecedented South African Supplementary Budget at the end of June attracted much interest. In stark contrast to the 2008 global financial crisis, this time around the country had to initiate its fiscal response to a crisis from a much weaker position. Sharply higher pandemic-related expenditure and a dramatic drop in tax revenue collections due to the economic implosion dragged fiscal finances into an even more precarious position, with mutterings of a debt trap. This is best illustrated by our Fiscal Strength Score, which is now at its lowest point since the 1996/97 fiscal year.
Figure 1: South African Fiscal Strength Score (1996 – 2023)
Source: National Treasury, Futuregrowth
Ambitious plans to turn the leaking fiscal ship around lack credibility
The Ministry of Finance, and by implication Cabinet, cannot be faulted for its sober and brutally honest consideration of the precarious state of fiscal finances and, particularly, its acknowledgement that inaction will eventually lead to fiscal self-destruction.
The decision to adopt a more active approach that entails both significant expenditure reductions and revenue adjustments is therefore welcomed. However, we remain sceptical about the credibility – and viability - of this ambitious plan. The expected worst recession in decades, combined with organised labour that is unlikely to simply roll over, raises the odds for another disappointment in terms of desperately needed efforts to stabilise the fast-rising public sector debt burden. In turn, this spells more trouble for the country’s significantly weakened sovereign risk profile, increasing the probability of further downgrades from rating agencies and, in turn, keeping long-term bond yields trapped at elevated levels.
Table 1: June 2020 Supplementary Budget Summary: Even worse than our estimates
Source: National Treasury, Futuregrowth
Dramatic shift in government bond ownership since the onset of the crisis
Another significant development during the second quarter of this year has been a dramatic shift in the ownership of South African government bonds. The sustained general economic and particularly fiscal deterioration of the past few years forced all three of the major international rating agencies to downgrade the country’s sovereign currency rating to the sub-investment level. Over time, foreign investors responded to this deterioration by reducing their combined holding from a peak of 42% in May 2018 to 32% at the end of June this year. The bulk of the more recent net foreign sales has been absorbed by the local monetary sector, which includes the South African Reserve Bank (SARB). Latest available data shows a R30 billion holding of government securities on the SARB’s balance sheet. This reflects the extent of central bank intervention during the crisis. Central bank buying of South African government bonds in the secondary market was conducted with the objective of improving market liquidity and thus better price discovery at a time when the unfolding global crisis threatened to cause the market to become dysfunctional. The Bank made it very clear that the intention of this intervention was not to fund the budget deficit, something the South African Reserve Bank Act very clearly prohibits and we fully support as the monetisation of public sector debt cannot be endorsed under any circumstances.
Figure 2: Changes to government bond ownership (R billion)
Source: National Treasury, Futuregrowth
Aggressive monetary policy easing pushed the prime overdraft rate to its lowest level in decades
Apart from direct market participation in the bond market and a host of other measures to assist the monetary sector, the SARB also responded to the devastating impact of the pandemic by lowering the repo rate to 3.75% for a total reduction of 300 basis points (bps) from the peak of 6.75% in July last year, 150bps of which got trimmed this quarter. The combination of the worst expected recession in decades, very strong disinflationary forces and the general low level of global rates enabled the SARB to respond in this manner. While the extent of the recession and the expected shape of the economic recovery remains unclear, the inflation picture is much clearer. Although the five-week hard lockdown created challenges with the collection of survey data, it is clear that inflation is not a concern right now. In April, the rate of inflation at consumer and producer levels slowed to 3.0% and 1.2% respectively. The short end of the yield curve moved sharply lower in tandem with the repo rate adjustment. In contrast, the yields of longer-dated bonds were kept at relatively elevated levels as rising fiscal concerns overshadowed the disinflationary backdrop. This explains the high inflation-adjusted yields for longer-dated nominal bonds.
Figure 3: The 10-year nominal government bond is offered at a relatively high yield despite the repo rate being at the lowest level in decades
Source: Bloomberg, Futuregrowth
Despite significant fiscal deterioration, the bond market recovered some lost ground during the second quarter
The events described above served as catalyst for significant bond market volatility over the past few months. In the nominal bond market, the yield of the 10-year fixed rate government bond traded in a range of 8.72% to 11.21% during the second quarter before closing the period at 9.28%, or 155 basis points below the March 2020 close. The yield spread between the 10- and 30-year points reached a peak of 2.14%. This volatility was also evident in the inflation-linked bond market where the yield of the 10-year benchmark bond traded in a wide range of 4.01% to 4.68%.
Ultimately, the spike in yields, and thus improved market valuation, lured the bears from their caves, despite the fact that the general economic and fiscal outlook kept deteriorating. In the case of the nominal bond market, the JSE All Bond Index (ALBI) returned 9.94%, with bonds in the 7- to 12-year maturity band leading with an impressive 13.23% during the second quarter. The comeback by the inflation-linked bond market was less noteworthy with the JSE Inflation-linked Government Index (IGOV) rendering a return of 4.75%. That said, both indices managed to beat the cash return of 1.12% by a significant margin for the three-month period ending June.
The second quarter recovery only partly offset the performance drawdown for the first half of the year caused by the March sell-off
The extent of the market sell-off towards the end of March was bad enough to keep cash in the lead for the first half of 2020. Over this six-month period, the 2.69% return offered by cash compares favourably with the 0.36% and -2.43% rendered by the ALBI and IGOV respectively.
// THE TAKEOUT
During the second quarter of 2020, the local bond market regained some of the steep losses suffered in March. A collapse in economic activity, very strong disinflationary forces and the low level of global rates enabled the central bank to reduce the repo rate during the second quarter by a total of 150bps to 3.75%. During this period, the yields of short-dated bonds moved in tandem with the repo rate reduction, while the yields of long-dated bonds remained trapped at relatively higher levels in response to the deteriorating fiscal situation. Despite a strong disinflationary environment, the inflation-linked bond market, also recorded a recovery as real yields declined from the high levels recorded in early April. However, both the nominal and inflation-linked bond markets are still lagging the return offered by cash for the first half of this year.