'Gordhan alone can't restore financial stability' - economist

During the sovereign bond crisis in Europe, financial markets often forced politicians to make the correct decisions.

Bond yields rose to record levels - above 7% in some peripheral Eurozone countries such as Spain and Portugal - and endless summits were held as markets expressed dissatisfaction with political outcomes.

Bond vigilantes often pushed bond yields higher and fund managers sold equities in retaliation against an undesired economic trajectory.

Each time, financial markets had front-run the politicians, who in turn responded by hosting more summits, eventually and reluctantly arriving at the correct decisions.

Markets have often had the power to self-regulate and even induce change in the political arena when an undesired economic course has been set.

The underlying premise of this example from Europe is that the leaders were rational, had the best interest of the countries at heart and genuinely sought solutions.

The European Central Bank (ECB) was also heavily involved in the economic and political discourse during the crisis. What has ensued in South Africa is reminiscent of the European sovereign crisis.

Although the causes are distinctly different, as the domestic episode is self-induced, there is similarity in what financial markets are doing to force politicians to make the correct decisions.

Bond yield sell-off

The precipitous fall in bank shares and a surge in bond yields after the announcement that Finance Minister Nhlanhla Nene had been axed are reminiscent of the European example and also of the reaction to SA President PW Botha’s 15 August 1985 infamous Rubicon speech.

Specifically, during the latter episode, SA bond yields at 10-year maturity, the most liquid instrument on the yield curve, sold off by 362 basis points from 14.8% to 18.5%.

The difference then is that the sell-off took place over a seven-month period from the speech, while the current outcome resulted in a 200 basis points sell-off within few hours.

Admittedly, the constructs of the economy are very different between the two periods. In 1985, SA was a closed economy operating under onerous sanctions, while it is now a small open economy, with foreign investors holding a significant share of the country’s bonds.

Holders of SA bonds

According to the latest National Treasury Debt Management Report, foreign investors have become dominant players in the local bond market, currently holding 35.7% of the total.

In 2009, foreigners held only 13.8%, and much less in earlier periods – see Figure 1.

Given that SA has increased its debt to 49% of GDP from around 30% before the 2008 global financial crisis, most of that debt issued was lapped up by foreign investors.

In fact pension funds, which are dominated by the Government Employees Pension Fund (GEPF), have passed on the baton to foreign investors as leading buyers of SA bonds.

Figure 1: Holdings of domestic SA government bonds by investor type, 2009- 31 March 2015

Source: National Treasury (data to end-March 2015)

This outcome suggests the local bond market is not the same as it was before the global financial crisis and requires a different management style.

SA cannot afford economic policies detrimental to the well being of the international investors.

The country has become much more indebted to offshore stakeholders.

It cannot operate in isolation and make decisions not easily understood by the rest of the world without a backlash of capital outflows.

Ominous signs

There are ominous signs of threats to SA financial markets that are affecting the financial stability of the country:

 1.       The burgeoning Credit Default Swaps (CDS) spread, the premium bond investors pay for protecting investments against default, has priced in SA credit to be non-investment grade;

2.       The probability of default related to this outcome has increased substantially - at double its historic average - and is now similar to that of Turkey (which is rated non-investment grade);

3.       The 200 basis points sell-off in SA bonds on the 10-year maturity suggests fixed-income markets have priced in a sharp monetary policy tightening response and higher inflation; and possibly a recession if the surge in yields is sustained.

4.       The assault on bank shares last week (a 13%-15% decline in the shares of FirstRand, Barclays, Standard Bank and Nedbank) suggests a risk event is been priced in and that SA’s credit is likely to be downgraded to non-investment grade, given the symbiotic relationship between banks’ credit and that of a sovereign.

5.       Foreign capital outflows from equities and bonds have surged - yet another ominous sign of a brewing risk event.

The five ominous signs listed above need to be closely monitored as it feels like a 2014 Russian or  1998 Thailand/Russian “black swan”default  is lingering at our shores.

Tasks for Pravin Gordhan

New Finance Minister Pravin Gordhan is well accustomed to how the Treasury operates and how markets react to events.

It will be apparent to him that investors are voting with their feet on SA Inc assets and that the country is at the edge of an abyss.

He needs to turn the tide on the five ominous signs in order to restore confidence in the markets.

He will also need to confirm that the second tier of leadership at the National Treasury stays put.

National Treasury director-general Lungisa Fuzile has had various roles at the institution for over 13 years. He has the insights and expertise to assist in steering fiscal policy in the right direction and instilling confidence.

Gordhan will also need to convince markets, rating agencies and investors of SA’s commitment to the expenditure ceiling introduced under Nene’s tenure and, more importantly, show he is committed to reviving growth and stabilising debt accumulation.

Likely response from the SARB

Gordhan on his own is not enough to arrest the falling knives in financial markets.

As seen in the European example, central banks play an integral market role, especially when financial stability is compromised, as is the case for SA.

The South African Reserve Bank (SARB) needs to respond with higher interest rates, which would contribute positively to market and financial stability. 

Bottom line

Markets have reacted strongly to political machinations, resulting in the much needed u-turn that has led to the hasty appointment of a credible finance minister.

This might not be enough, though. To fix the damage already done requires a major overhaul of economic management. The rand alone will continue to give the SARB sleepless nights.

The rout in bond markets warrants a swift move on interest rates. As seen in Europe, politicians need to make the correct decisions, however difficult, in the interest of the country.

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