It is tempting to only see the negatives when it comes to South Africa (and other emerging markets), but when it comes to local sovereign bonds, there are several positive developments being overlooked in this time of fear.
The SARB has cut the repo rate to stimulate the real economy and reduced the capital and liquidity regulatory requirements of banks, enabling them to extend credit to business and individuals requiring support during this period.
“Because South Africa did not experience cyclical credit extension, our banks entered this period relatively well capitalised on a global scale,” says Lyle Sankar, fund manager at PSG Asset Management.
“Monetary policy appears to have been effective to date in easing liquidity concerns in the market, reducing the risk of another liquidity induced sell-off. Importantly, both the SARB and the banks are now fully able to act countercyclically due to years of prudent policy action and balance sheet management.
There should be sufficient domestic demand for further government issuance
Sankar says the impact of a lower GDP base for the year, and the impact on tax revenue will undoubtedly require additional borrowing. There may also be additional SOE support pressures on the fiscus.
“The broad assumption is that the additional funding requirement places too much pressure on the local fund management industry and banks, given the lack of support from foreign investors in our local bond auctions.
“Foreigners have not participated actively in our auctions for almost two years, and it is difficult to predict whether foreign investors will continue to shun our auctions. However, there are a few positive aspects to consider,” says Sankar.
“Firstly, real yields on SA bonds are high relative to other emerging markets and to history. And many developed market bonds are in negative yield territory, which makes our offering look even more attractive. But a lot depends on whether Government will restore the credibility of our budgetary framework,” says Sankar.
“Indications that the stimulus package will need to be offset with austerity measures is a positive development in terms of credibility.
Emerging market outflows should reverse when panic subsides
Foreign flows are inherently unpredictable, says Sankar, but there is a widely held view that emerging market outflows will continue for South Africa, even if global risk sentiment eases.
There are some mitigants for South Africa relative to other emerging markets, however:
- Our floating rate currency tends to react to stabilise the current account, as rand weakness translates into greater exports. Importantly, the SARB does not seek to intervene in foreign exchange markets to protect the value of the rand, increasing the value of this buffer. While the rand has weakened more than peers, this is counterintuitively a potential positive as other central banks have utilised limited foreign reserves to buffer the devaluation of their currencies.
- Regulation 28 limits the offshore allocation of local funds to 30%, with a 12-month grace period to correct should this limit be exceeded. In previous periods of rand weakness, this acted as a self-correcting mechanism for the rand as capital is eventually repatriated into the local market.
- South Africa’s low levels of expiring sovereign debt in 2020 and 2021 provide increased room to act fiscally. South Africa can leverage off a strong debt structure (long dated with low foreign currency denominated debt) to issue debt that could be extremely attractive to investors, with real yields among the highest on offer globally, and well in excess of yields on developed market bonds.
Tough conditions signal opportunities ahead
Investors should demand higher yields compared to the globe when lending to our government due to an expected increase in debt and the deteriorating fiscal situation. However, SA yields were high going into the COVID-19 crises and some recent developments, such as falling inflation and rate cuts, are bond supportive.
“Long bond rates have always been indicative of economic and inflation pressure points, and this time is no different,” says Sankar. “However, the extent to which investors are being rewarded with a rate well above inflation points to an opportunity to reap benefits from the dislocation that a crisis inevitably brings.”