Month: February 2016

Budget 2016: Austerity is not enough

Austerity will not be enough to improve the RSA credit rating. Privatisation will be essential to achieve this.

The 2016-17 SA Budget to be presented on 24 February is set to be an austere one. A mixture of higher tax rates and faster growth in tax revenues seems bound to accompany slower growth in government expenditure. The objective will be to reduce the debt to GDP ratio and to impress the rating agencies accordingly.

But fiscal austerity, accompanying higher interest rates imposed by the Reserve Bank, coupled with more inflation, will not help the SA economy to escape its growth malaise. In the short term, taken on its own, such austerity is likely to inhibit any cyclical recovery.

Fiscal austerity may be necessary for securing a better credit rating for SA and lower costs of funding government debt. But it will not be sufficient – and the rating agencies may well come to remind the Treasury that the greatest risk to the SA economy is persistently slow growth. Something more than fiscal austerity is required to improve the national balance sheet and impress the global capital markets, as well as to improve confidence in the prospects for the SA economy.

A commitment to privatisation of state owned and funded enterprises is urgently called for. Asset sales to private owners and operators would reduce national debt and interest payments while relieving the tax payer from further calls on their cash that has far more useful alternative applications.

Private ownership and responsibility for operating failures would absolve the regulators from conceding abnormally high increases in electricity or water tariffs as an alternative to the hard pressed Treasury raising additional debt or equity to keep the public enterprises going. But such higher tariffs – tariffs that are by now more than high enough to secure private capital to supply the essential services – are taxes by another name. They reduce disposable incomes by as much as any indirect tax increase would and, by lifting the rate of inflation, they unfortunately and unnecessarily encourage the Reserve Bank to add to the misery by raising interest rates even further. Exchange rate shocks, tax shocks and drought are very poor reasons for raising interest rates – but are a likely outcome given the Reserve Bank’s modus operandi.

The national balance sheet would benefit greatly from a willingness to sell off (at any price) rather than continue to support failing public enterprises with bail outs in the form of taxpayer cash or guarantees of the debt issued by public enterprises. The scope for the better management of what are now publicly owned and funded enterprises is very large. The political will to do so would be very well received in global capital markets. There would be no lack of foreign capital to access the opportunities a well-designed process of privatisation would offer.

The sale (fully or partially) of SAA comes to mind – as does a listed private share in the Airports Company of SA. The other sea ports of SA are also very valuable assets that would benefit from private owners, while their customers would benefit from competition between them. The generating capacity of Eskom could be unbundled and sold off to a variety of owners and managers, who would then be subject to the full discipline of a competitive market for energy – and a cost conscious regulator.

Such reforms would add value to the rand and reduce inflation and interest rates. A recovery in the rand and lower interest rates would be a great stimulus to the economy. An upswing in the business cycle would follow and the structural reforms of failing public enterprises would raise the long run growth potential of the economy.

The state of the markets

The State of the Nation speech delivered by President Jacob Zuma to Parliament on Thursday 11 February revealed a more open and pragmatic approach to the prospect of privatisation. The capital markets so far have not registered any marked approval of such intentions. The sovereign risk spreads and the outlook for inflation have not yet improved in any immediately obvious way.

The spread between RSA long term interest rates and their US equivalents remain elevated, albeit below the levels recorded when President Zuma intervened in fiscal policy and sacked the then Minister of Finance, Nhlanhla Nene, on 9 December. This risk spread, currently over 7% p.a. is, the rate at which the rand is expected to depreciate over the next 10 years. What is to be gained by a US dollar investor in the form of higher yields is expected to be perfectly off set by exchange rate weakness in the market for forward exchange. If this were not the case, then arbitrage opportunities to make certain profits in the bond and currency markets would open up.

The market is clearly expecting a high rate of further rand weakness. Consistently, given the expected weakness in the rand, the expectation of more inflation to come over the next 10 years, remains equally elevated. A weaker rand must be expected to bring more inflation with it. The compensation for inflation provided in the RSA bond market thus remains at about the same level of over 7% p.a. Vanilla bonds, which are vulnerable to unexpectedly high inflation, still offer over 7% p.a more than the inflation protected variety yields of under 3%. This yield spread can be regarded as an objective measure of inflation expected.

In the figures below we show how the gap between RSA yields and US Treasury Bond yields widened significantly on 9 December. They have since receded but spreads remain elevated, as has inflation compensation. They do not appear to have reacted favourably to the State of the Nation speech.

A somewhat similar picture emerges when we compare the risk spreads on RSA dollar-denominated debt. The cost of insuring an RSA Yankee dollar-denominated five year bond moved sharply higher on 9 December and has widened further since then. But the risk spreads on even higher risk emerging market debt have also widened. This indicates that the higher risks associated with RSA debt have not been a purely SA event. Global risk aversion has also been an influence on credit ratings. However the current RSA credit default swap (CDS) spread of over 350bps, already effectively gives SA debt junk status.

We therefore compare the emerging market spread with the SA spread. The wider this difference the better the relative credit rating of SA debt. As may be seen on the right hand scale of the figure below, this difference narrowed sharply on 9 December, indicating an immediately inferior SA credit rating. But the SA credit rating then improved in a relative sense, given the larger difference between average emerging market yields and RSA equivalent debt. Encouragingly, this spread has increased further in recent days, indicating an improving SA credit rating – when compared to a peer group.

We await with great interest the detailed Budget proposals. Not only will the plans for government spending, tax and debt issues be influential. The plans for asset sales, that is for privatisation, may prove even more important. A combination of fiscal austerity with credible privatisation plans could have a profound influence on SA’s credit rating, the rand and the longer term growth prospects for the SA economy.

The rand and the SA economy: All about the dollar

Markets are all about the mighty US dollar at the moment – weakness rather than strength is the hope for the SA economy. But rand strength could follow the right SA responses to our impaired credit rating

The markets this year have been most concerned about the danger of the Fed raising interest rates as US growth prospects were deteriorating. A strong US dollar, in such circumstances, posed a particular threat to emerging market currency, bond and equity markets. The presumed greater risk of a global recession was increasingly reflected by significantly lower commodity prices and the shares of the companies that produce them. Emerging market equities, bonds and currencies markets all revealed these increasingly risk averse sentiments.

The highly correlated and not co-incidental weakness in commodity and emerging markets continued until the last week in January as we show below. The Commodity Research Bureau Index (CRB) shown below includes about a 27% weighting in oil. A further figure compares the prices of particular metals to the emerging market (EM) equity index (MSCI EM). Price weakness until late January 2016 and a recovery since is revealed in the figures below.

The previously strong US dollar however weakened this week, as the danger of higher interest rates in the US faded away. Dovish interest rate comments by the Chairman of the New York Fed led the dollar lower. It was a spark that lit up the shares of the mining companies. The shares of leading mining companies listed on the JSE responded dramatically to a weaker US dollar. As at Friday afternoon 5 January, Anglo leads the pack and is up about 36% since the Monday close on 1 February.

The rand and the JSE as a whole responded as it usually does to the global forces that move EM markets. SA had earlier revealed particular dangers to its policy settings that led to a significantly weaker rand and higher risk spreads, compared to its EM peers. But these SA-specific risks were a December event, though the EM influence is apparent throughout the extended December to February period with a degree of extra SA risk revealed in December.

The striking impact of the stronger rand on the long end of the RSA bond market is shown below. The rand – as influenced by global forces, as it usually does – overwhelmed the impact of higher short term rates on the bond and equity markets, as imposed by the MPC of the Reserve Bank on Thursday 28 January.

In the figure below we compare alternative measures of SA risk that reveal a very similar pattern of SA risk aversion. The difference between RSA and USA bond yields compensates investors for the expected weakness of the USD/ZAR exchange rate. This risk premium jumped up sharply on 10 December 2015 when Finance Minister Nene lost his job. The risk premium has since declined, helped by the stronger rand and lower interest rates since. Yet the SA risks priced into the markets remain highly elevated as is shown by the wider five year CDS spread, both absolutely and relative to the spread on equivalent Turkish dollar-denominated debt. This spread, equivalent to the difference between the running yield on RSA US dollar denominated debt and its US equivalent, represents the cost of insuring against RSA debt default.

The SA economy is growing very slowly. The decision by the Reserve Bank to further increase its repo rate will add to the contractionary pressures acting on the economy. Fiscal austerity seems very likely to be introduced in the 2016-17 Budget to be presented later this month. The hope must be that the painful demonstration of fiscal conservatism will lower the risk premium attached to SA debt and equities, so attracting more capital to SA and so add to the value of the rand.

Only a stronger rand, bringing lower than expected inflation and lower interest rates, can reverse the cyclical direction of the economy. A weaker dollar and stronger flows into EMs will be a great help to the rand. But it will take more than a credible commitment to fiscal conservatism to reduce the SA-specific risks holding back the rand and the economy. A recognition by the government that the partial privatisation of underperforming state-owned enterprises would improve the performance of the economy and the quality of the RSA balance sheet, is essential to reducing the risk premium added to the returns of investments in SA.

Point of View: Credit anxiety

There is much anxiety about how much poor South Africans are paying in interest for the credit they receive. Newly shocking to observers is the fact that if a good is purchased on credit the monthly payments may amount to much more than the purchase price. For example, if a fridge had a face value of R10 000 to a buyer on credit, paying 25% p.a interest and repaying the capital sum over 10 years, the buyer would be making monthly payments of R227. And so over the life of the loan would have paid in interest and capital repayments an amount of R27 299 of which R17 299 would have been interest. Had the loan been a five year loan at the same 25% rate of interest, the monthly payments would have been higher, R294 per month, meaning lower total payments of R17 611 of which much less, R7 611 would have been the interest expense.

Why then would anyone borrow for a longer rather than a shorter period if it costs so much more? One could however ask an even more obvious question. Why would anyone buy on credit rather than pay cash, especially when the cash price is very likely to be a lower discounted one? The answer should be obvious. They buy on credit because they do not have the wherewithal to pay cash.

Without access to credit they would be denied the essential services of the fridge. Further saving the R294 minus R227 (R67) per month might mean a fridge fuller with essential food. The value of the fridge to the household borrower is in fact what they are willing to pay for it, the R227 or R294 per month. They are consuming the services of the fridge for which they are clearly willing to pay. For the lender, shorter repayment periods, higher monthly payments and less interest accrued becomes a less risky transaction, one they otherwise might wish to encourage. Borrowers however have to be judged as credit worthy enough to enjoy extended credit terms. The choice of extending the repayment period, paying more interest, may in fact be a limited one- unfortunately.

The cash buyer will not be paying interest, but nevertheless will be foregoing the opportunity to earn interest or dividends on the cash they have allocated to a particular asset. It might well be a good decision for them to rent or lease an asset rather than pay cash and put the cash to better use elsewhere. For example, to rent rather than buy a home and do something much more valuable with the cash invested, perhaps even to pay the deposit on a house bought to rent with a mortgage loan.

As with the fridge, somebody buying a home on credit pays out a lot more in interest and capital repayments than the purchase price of their home. A R1m home bought on mortgage credit at a low 10% per annum paid off over 20 years, will mean a monthly payment of R9 650 and will accumulate total payments of R2 316 052 – more than twice the purchase price paid. But the proud home owner would have saved rental payments over the period and the home will have a market value after 20 years, unlike some household appliance.

The house bought on credit will have provided a flow of services, accommodation services, similar in nature to the services provided by a fridge or TV – benefits that are received in exchange for interest and principal paid. Also, such leverage may prove to be a very good financial deal if the house more than maintains its after inflation value. Access to such credit provides a rare opportunity for salaried homeowners to add to their wealth through leverage. Such lending and borrowing on terms agreed to by borrowers and lenders surely deserves every encouragement, even if, as is bound to be the case, interest paid apparently means a more expensive house over time.

Household appliances do not provide the lender with anything like the same protection against losses should the borrower default – hence the higher charges required by lenders competing for the business. These charges reward the dealer who incurs the costs associated with the bundle of goods and services associated with any transaction concluded on credit. Charges that will be intended to cover the interest costs of supplying credit, the costs of goods supplied with the credit, and the services associated with the goods, for example the rent paid for trading space and the working capital invested in an inventory of goods from which customers can choose. This bundle of benefits – goods and services including credit services supplied to a customer – may come with a single charge, for example for a dress bought on credit at a given price to be paid off over time. Yet the price of the dress is very likely to incorporate a very high, but unknown to outsiders, profit margin intended to cover all the associated costs including the risks of non-payment. There is fortunately very little comment about regulating gross profit margins on goods supplied on credit.

There is much comment however about the apparent inequity when the terms of the transaction are in a mix of separately itemised charges – some combination of listed price, interest charges, delivery and insurance charges etc. may be specified. And complained about if one or other of the charges, considered alone, appears exorbitant. But what will matter to all buyers paying a single charge or multiple charges is how much they will be required to pay each month and whether or not it is worth making the monthly payment. And what will matter to the seller of the mix of credit and goods supplied, is whether the revenues they collect – perhaps is a variety of itemised charges – will cover their costs, including a return on capital invested appropriate to the risks incurred. If the returns exceed the required returns, more competition to supply goods and credit can be confidently expected. But if some of the charges made are controlled on an apparent cost-plus basis, such as insurance charges, any loss of revenue will have to be made up in one or other of the other charges (if the goods and credit are to be supplied in the same volume and variety). If the loss of revenue cannot be made up, less credit will be supplied.

The SA government has however decided not to leave the outcomes in credit markets to be determined by market forces. They have regulated the terms of the contracts by more than what willing lenders and equally willing borrowers might otherwise agree to. Loans, including mortgage loans, may be forced to be limited to some proportion of wage incomes and the terms of the loan, including the interest rate agreed to or charges for insurance arrangements, may be subject to regulation.

Treating borrowers in this way, as less than capable of looking after themselves, as adults managing their credit affairs, has consequences. So too has not trusting potential lenders to compete with each other with loan facilities that will compete away excess risk adjusted returns in providing credit. Such interventions in the credit market mean less credit supplied. It means fewer fridges, TVs, computers and furniture in homes, less clothing in the wardrobe, all understandably very important to the household. It also means fewer houses owned by the occupier.

Regulations of this kind may protect some less than responsible borrowers and lenders from borrowing and lending more than they should have. Yet by imposing regulations on the potentially credit worthy, as judged by willing lenders, they frustrate the plans of potentially worthy borrowers to gain access to credit that is valuable to them, credit that might be supplied to them on terms they would be willing to agree to. In the absence of credit from established businesses with reputations to protect and repeat business to encourage, desperate borrowers may well be forced into the clutches of the informal payday lenders and their ilk. Lenders who will charge much higher rates of interest for loans of typically very short duration, with repayment secured violently if necessary.

The regulators appear only aware of the costs of poor credit decisions, rather than the benefits of many more good ones made, under the discipline of market forces. Access to credit has played a very important role in improving the standard of living of many South Africans with improving income prospects but little wealth to draw upon. It is in reality a South African success story.

The self- regulatory capabilities of a market place, including those of a credit market, receive too little respect in South Africa. The costs – intended and unintended – of the flood of additional rules and regulations that prevent agreements between willing sellers and buyers, willing borrowers and lenders, are too easily ignored by an ambitious bureaucracy. These ever growing regulatory burdens on market participants are an important part of the reason why the SA economy is stagnating.