Much has been written and said about last week’s national budget, but as usual there is one aspect that has not received a great deal of attention: how government intends financing the budget deficit and the implications thereof for the course of government debt.
Usually only investors in the bond market analyse this part of the budget carefully to determine how it might affect their investment strategies. As South Africa runs the risk of its credit rating being downgraded to below investment grade – which would eliminate a large portion of the pool of potential investors in South African government bonds and result in higher long-term interest rates – the details of the management of government debt has, however, gained a wider meaning. Furthermore, in recent years foreign investors have been playing an increasingly important role in financing South Africa’s borrowing requirements at a time when international investors’ interest in emerging markets has balanced on a knife-edge.
Although the National Treasury has for many years been careful not to raise too many foreign loans owing to the associated foreign exchange risk (foreign loans accounted for 9% of government debt in January 2015 compared with a benchmark of 15%), it has no control over foreign purchases of rand-denominated government bonds. In fact, 36% of domestic government bonds is currently held by non-residents compared with only 13.8% in 2009.
The government prefers to refer to South Africa’s net government debt (gross debt minus the government’s cash balances) rather than to the gross figure as it paints a rosier picture. According to the budget South Africa’s net government debt, for example, is expected to reach a high of 43.7% of GDP by 2017/18 (which implies a continued increase of 2.9 percentage points from the level of 40.8% at the end of 2014/15).
If provisions and conditional commitments (mainly guarantees given to public enterprises such as Eskom) are taken into account, they would add a further 13.6% of GDP to the 2017/18 debt level for a total of 57.3%. However, the gross government debt, which amounts to more than 48% of GDP, is of more importance to investors as this is the amount that has to be refinanced continually in the bond market.
In any case, not all the cash held by the government is available for the financing of government expenditure. Of the R182 billion held in cash at the South African Reserve Bank and commercial banks at the end of 2014/2015, only R45 billion is available for financing purposes.
The first priority is to stabilise the level of government debt relative to GDP and the budget is taking important steps in this direction. However, these are not enough and the level of government debt will have to be lowered resolutely in the medium term to create room for possible future requirements. To my mind the first target should be a reduction of 10 percentage points.
A relatively painless way in which to achieve this is for any increase in government revenue in response to an improvement in economic growth in the coming years to be utilised for debt reduction instead of increased spending. Should this not happen, further tax increases would be unavoidable. At this stage it is also important to consider the future course of South Africa’s government debt (see below graph).
Maturity profile of SA government debt
Once government bonds amounting to only R48 billion in 2014/15 and R31 billion in 2015/16 have reached their maturity date, the amount increases to R69 billion in 2016/17 and R91 billion in 2017/18, after which it remains around this level for a number of years. Therefore South Africa’s refinancing requirement will increase dramatically over the next few years and this at a stage when the availability of capital could be curtailed by rising international interest rates (although one should bear in mind that the difference between bond yields in emerging markets and those in developed markets would still be favourable).
Thus it is important for the National Treasury to manage the refinancing risk effectively. Its proposed strategy of borrowing more than is necessary in the current relatively favourable climate and switching short-term bonds for long-term bonds as market conditions allow, is therefore prudent. But what about the risk of possible high sales of local bonds by foreigners?
Fortunately there are two factors that would soften the impact of such an event. Firstly, the withdrawal of foreign capital would have a negative impact on the rand exchange rate and result in an immediate repricing of South African bonds, which would discourage future sales by favourably impacting the value proposition. Secondly, the presence of strong local financial institutions lends the necessary depth to the South African bond market to absorb foreign sales and dampen the resultant upward pressure on long-term interest rates.
Therefore there is no need to panic about South Africa’s government debt. The management thereof is in good hands. The critical issue is the future course of the expenditure side of the budget – hopefully common sense will prevail.
Jac Laubscher is an economic advisor at Sanlam Limited.