SOUTH AFRICA'S EVIL TWINS:
IT'S COMPLICATED

In recent times, the rand has been hit by a plethora of negative shocks, including higher global risk-free interest rates, a fall in commodity export prices, greylisting by the Financial Action Task Force and loadshedding. The fundamental problem underlying all of this, however, is that South Africa is a capital-scarce economy running twin deficits – a current account deficit (which means our imports are greater than our exports) as well as a fiscal deficit (government expenses exceed revenues) – amid tight global financial conditions and heightened geopolitical tension.

Note, too, the trend of declining net foreign capital inflows into South Africa since 2015, likely reflecting deterioration in the potential return on investment, given the country’s palpably weak gross domestic product (GDP) growth rate. In short, if capital inflows are not enough to cover the current account deficit, which is expected to deteriorate to -2% of GDP in 2023 from -0.5% of GDP in 2022, the result is rand depreciation. In turn, sustained rand weakness is likely to be inflationary, while the dearth of foreign savings inflows condemns South Africa to a low growth path.

ECONOMIC REFORMS

This set of circumstances requires macroeconomic adjustment and the implementation of economic reforms to attract foreign capital by lifting South Africa’s potential growth rate and returns on investment.

However, our socio-economic circumstances preclude meaningful fiscal consolidation. Indeed, the downturn in commodity export prices and downward revisions to the GDP growth forecast point to lower government revenue growth. Sufficient expenditure restraint also continues to prove elusive, given expenditure pressure related to unemployment and poverty, a sustained high government wage bill and ongoing support for ailing state-owned companies.

We expect a Main Budget deficit of -4.8% of GDP in 2023/24, significantly larger than National Treasury’s projection of -3.9% of GDP published in February 2023. However, this excludes the announced support for Eskom amounting to an estimated 1.1% of GDP (provided certain conditions are met), which must also be funded.

Meanwhile, new debt is being issued at higher real interest rates (i.e., after allowing for inflation) and in the absence of stronger real GDP growth, South Africa’s debt dynamics remain unfavourable. We expect the government’s gross loan debt ratio to increase to 76% of GDP by 2025 from 70.9% at end March 2023.

South Africa’s long debt maturity profile and the high share of local currency debt in total debt (88% at end March 2023) stands it in good stead. However, in time, this would be insufficient to compensate for any failure to arrest the upward trajectory in the debt ratio and to improve per capita incomes (to reduce expenditure risk). This speaks to the importance of fixing infrastructure and implementing economic reforms.

THE GOOD NEWS

In the interim, the onus rests on the South African Reserve Bank (SARB) to ensure the necessary macroeconomic adjustment. As such the SARB has had little choice but to hike its policy interest rate aggressively. The good news is that the early, decisive action of the Bank’s Monetary Policy Committee appears to be bearing fruit. Inflation has slowed significantly from a peak of 7.8% in July 2022 to 5.4% in June 2023, while the heavily undervalued rand has firmed against the (admittedly softening) US dollar. This is consistent with the history of former rand shock episodes. Indeed, the SARB has a good track record of responding effectively to rising inflation and inflation expectations induced by currency weakness.

Looking ahead, it seems reasonable to expect the heavily undervalued rand to fare better over the medium term as the US interest rate hiking cycle turns down, new electricity capacity is installed (albeit delayed) and the negative terms of trade impact fades. This should help contain inflation and pave the way for interest rate cuts as we head into next year.

That said, we should tread carefully. Further progress on reducing inflation is likely to be slower from the second half of this year. Given its twin deficits, the rand remains vulnerable should global risk aversion rise, or should South Africa’s economic reform programme stall, prompting potential capital outflows. Considering relatively high inflation expectations to begin with (6.5% and 5.9% for 2023 and 2024 respectively, according to the Bureau for Economic Research’s Inflation Expectation Survey for the second quarter of 2023), any sustained, material rand weakness would hold significant inflation risk.

Further, we should note the SARB’s more explicit treatment of government finance in its Quarterly Projection Model. Suffice to say that should the government debt ratio continue unabated along an upward path, it would complicate the Bank’s task, since too loose fiscal policy sustained for too long would be viewed as a risk for the inflation outlook. Indeed, fiscal failure is the root cause of some of the fiercest inflation episodes in history. A continued rise in the debt ratio could prompt the Bank to take a more restrictive monetary policy stance than would have been the case otherwise.

IMPACT ON BONDS

The current high real return on South Africa’s long bonds is markedly above the historical return. However, this reflects an increase in our country and inflation risk premia. Specifically, the higher country risk premium reflects the rising government debt level relative to GDP against the backdrop of low potential real economic growth. It will be difficult to return to fiscal sustainability while growth remains weak.

Comment by David Lerche, Chief Investment Officer of Sanlam Private Wealth:

In our clients’ multi-asset portfolios, our current positioning in terms of South African government bonds is marginally above our ‘neutral’ level, as the SARB retains credibility, and we therefore see a reasonable likelihood of local inflation being within the target range of 3-6%. This points to prospective returns of around 5% above inflation for long bonds. The recent addition of hedge funds to our portfolios allows us to gain fixed interest exposure with lower volatility.