SA government debt implications: The public sector was in a dangerous debt position prior to the COVID-19 crisis, particularly regarding Eskom. Although the lockdown offers a brief respite for Eskom in terms of load management and maintenance, it creates further challenges for the utility’s debt position. Where many governments worldwide have turned to stimulus packages, the South African (SA) government is handcuffed by this parastatal debt with very few levers to pull. Do you foresee (i) the need; and (ii) the likelihood of a World Bank/IMF bailout? What would the implications of such an intervention be on local bond markets and is this a material risk to bond returns in the foreseeable future?
The respite for Eskom has allowed it to perform some overdue maintenance. We have also seen some Independent Power Producers (IPPs) such as SA Cable Technologies (SACTEC) complete projects and connect to the grid during this time. The demand for electricity will only increase gradually once the lockdown is phased out and we think that it will be a while yet before we see load shedding again. Even so, the capacity in SA remains too low, and Eskom’s problems have gotten worse with the passage of time, not better. This remains an urgent task for the government.
SA’s fiscal situation was unsustainable prior to the COVID-19 crisis. We had estimated that government previously had about 10 years before an approach to the IMF would become necessary. However, the economic consequences of COVID-19 mean that this runway has shortened to maybe 5 to 7 years. The need for policy and fiscal reform has accelerated. We have seen government respond on the fiscal front, with meaningful action on the government wage bill and SAA. The ideological challenges to partnering with business, winning back the trust of job creators and addressing labour market rigidity are significant. Unfortunately, we have not seen sufficient traction on this front. We do not think that government will need to approach the IMF within the next 5 years. In the unlikely scenario where government were to approach the IMF, the result would be faster structural reforms towards a sustainable set of policies. This would be immensely positive for the bond market.
Anchor currency view: The rand has seen much volatility over past decade, with extreme reactions to both local and international news. However, as shown by your rand valuation graph, the rand returns to a fair value every time post a spike. You mentioned in your presentation that you expect the rand to return to its fair value following the current spike as well. Can you give an indication of the time period for the rand to return to fair value? How does your model move in the event of increased inflationary pressures in SA especially following the impact of a devalued rand and a defensive monetary policy in pursuit of protection of the local economy?
The rand is naturally a volatile currency. This is mainly a consequence of the high degree of liquidity and the higher domestic interest rates in a global context. It is impossible to say exactly when the local currency will recover. However, we would estimate that this will not be before the end of the COVID-19 crisis, which is probably six or more months away. We think that the rand recovery will become more pronounced once financial market volatility has died down and global sentiment is more positive.
Higher SA inflation will result in the trajectory of rand depreciation accelerating. We think that there is limited risk of this occurring under the current central bank regime. The biggest policy risk to the local currency is that the SA Reserve Bank (SARB) tries quantitative easing ([QE], which we believe wouldn’t really work in SA anyway).
SA bond yields: SA’s bond yields are an anomaly in terms of global fixed income where the norm is near-zero yields on fixed income. With the rand where it is and with far greater upside than downside considering your rand view, can we expect significant foreign investment in SA bonds, offering a material return opportunity in fixed income? Or do we have more pain to come in terms of the implications of a global recession and reduced foreign direct investment (FDI)?
In the near term, SA financial assets are being tossed about by the global COVID-19 crisis. We will go where the crisis goes. If it escalates, we see more financial pain. However, If it abates, then SA will start to heal. The currency will be less of a help on FDI. Nevertheless, we do believe that the combination of attractive yields and a likely strengthening currency will attract foreigners to our bond market. In fact, notwithstanding the Moody’s downgrade, we have seen foreigners being net buyers of local bonds through the first three weeks of March.