Prescribing Assets is a Form of Financial Repression

Daniel Makina, University of South Africa

The outcry over the governing party’s intention, contained in their 2024 Election Manifesto, to re-introduce prescribed assets is palpable given the history of the country. This is not the first time the governing party mooted the idea. The intention to re-introduce prescribed assets first appeared in its 2019 Election Manifesto after having been one of the resolutions of the 2017 Party’s Elective Conference, where it was adopted that:

“Government should introduce measures to ensure adequate financial resources are directed to developmental purposes. A new prescribed asset requirement should be investigated to ensure that a portion of all financial institutions’ funds be invested in public infrastructure, skills development and job-creation.”

The policy of prescribed assets was further advanced in the ANC’s 2019 Election Manifesto:

“Investigate the introduction of prescribed assets on financial institutions’ funds to mobilise funds within a regulatory framework for socially productive investments (including housing, infrastructure for social and economic development and township and village economy) and job creation while considering the risk profiles of the affected entities.”

There was a similar outcry then, but it ended up being just political noise. Instead, Regulation 28, which governs allocation decisions of retirement funds, was liberalized to allow offshore investments to an increased limit of 45% (previously it was 30%). Back in 2019 the fiscal situation was not as bad as it is now and that might explain why the resolution was not implemented. Now that there is a fiscal crisis, the appetite for implementing prescribed assets could be very high.

Forms of Financial Repression

Prescribed assets are one of the many forms of financial repression whereby government policies channel funds to specific sectors or state-owned entities (SOEs) through directives to financial institutions. It was a practice widely implemented by colonial governments. In contemporary times, it is often practiced by countries that are either command economies or under economic sanctions or at war.

In essence, there are five main forms of financial repression.  The first one’s defining form relates to interest controls whereby governments artificially determine interest rates to be below market levels. In contemporary times we have seen it happening in countries such as Turkey, Venezuela and Russia. This practice reduces returns, thus discouraging both savings and investments. Usually, the practice of controlling interest rates is prevalent in countries with central banks that are not independent. South Africa has an independent central bank and would not be able to set interest rates below market rates.

The second form of financial repression involves introducing and maintaining capital controls. This is the act of restricting the movement of capital in and out of a country. Such practice limits the ability of individuals and businesses to diversify their investments internationally. Although South Africa has gone a long way in eliminating capital controls, some exchange controls are still in place for some transactions. For instance, Regulation 28 limits offshore investments of retirement funds to 45%.

The third form of financial repression involves having exchange rate controls whereby government controlled central banks intervene in currency markets to maintain an artificially low or high exchange rate, impacting trade and investment flows. The South African Reserve Bank under the apartheid government had this policy but it was done away with in 2009.

The fourth form of financial repression involves state regulatory requirements. This happens when the government compels financial institutions to participate in government bond markets. Alternatively, the government would set reserve requirements for banks, effectively creating cheap money for the government.

The fifth and final form of financial repression is prescribed assets whereby government directs credit to specific sectors or state-owned entities deemed to be strategically important. This is the practice currently envisaged by the governing party. It is a retrogressive practice because it does not allow market forces to allocate capital efficiently. It creates imperfections in financial markets and deprives savers and investors a fair return on their investments. Furthermore, it would undermine domestic and international investor confidence, encourage foreign capital outflows, discourage discretionary savings, weaken SA’s international credit rating, and undermine the country’s ability to raise foreign finance.

Prescribed Assets during the Apartheid Era

Before the advent of democracy, the apartheid government repressed financial markets through prescribed assets and exchange controls. In 1956 the Nationalist Party, in power at that time, enacted the Pension Funds Act which introduced prescribed assets.  Prescribed assets were created to fund quasi-governmental institutions, state-owned entities, and the former homelands. Pension funds and insurance companies were compelled to invest part of their funds as prescribed assets in government bonds, government guarantee bonds, and bonds approved and specified by the registrar of pensions, often at rates below the fair market rates. In fact, prescribed assets stifled the development of financial markets as a fair market rate could not be determined because of these requirements. In other words, the practice amounted to interest controls, another form of financial repression. For about 30 years, retirement funds and insurance companies were required to invest more than half of their assets in government bonds and SOE bonds.

The performance of prescribed assets was lacklustre as compared to the performance of the JSE. Figure 1 below is illustrative. During the 1960s, when inflation averaged 3%, prescribed assets had a positive real return (1.9%) but were outperformed by real returns (8.3%) on the JSE so that the opportunity cost in nominal terms of investing in prescribed assets was -6.4%. In the 1970s when inflation averaged 11.3%, prescribed assets posted negative real returns of -4.0% while real returns on the stock market were positive at 13.2%, and the opportunity cost was -17.2%. During the 1980s when inflation averaged 14.5%, prescribed assets posted negative real returns of -1% while real returns on the stock market were positive at 5.7% and the opportunity cost was -6.7%. Thus, it clear that prescribed assets only served to erode the wealth of investors.

Source: HSF Briefs

The apartheid government justified the practice on the grounds of economic sanctions and international isolation. However, prescribed assets were such a stumbling block in the development of financial markets that the apartheid government abandoned them in 1989. They distorted investment decisions, reduced returns for investors, and propped up inefficient and uncompetitive SOEs. Furthermore, they contributed to capital flight as investors fled to avoid investing in assets with low returns and perceived high political risk. Thus, the three decades of prescribed assets in South Africa had undesirable implications for investment allocation and economic efficiency.

Financial Liberalization

The abandonment of prescribed assets in 1989 paved the way for the South African financial markets as we know it today. Bond benchmarks 5-, 10-, 15- and 20-year maturities were created and state-owned entities started making two-way prices (quoting bid and offer prices) in their bonds. Following the recommendations of the S Jacobs Committee, a formal bond exchange began to take shape in South Africa. Recognizing that self-regulation by the market participants was more desirable than imposed control, bond-trading firms formed a voluntary association – the Bond Market Association. Eventually, it was licensed in 1996 (post-democracy) as a formal exchange known as the Bond Exchange of South Africa. After the closure of the Bond Exchange of South Africa (BESA) in 2009, bond trading continued in South Africa through alternative channels. The JSE became the primary platform for trading bonds in the country. Additionally, electronic trading platforms and over-the-counter (OTC) markets facilitated bond trading activities. This transition allowed bond markets to remain active and accessible to investors despite the closure of BESA. South African financial markets have blossomed since then to become world class.

Contemplated Re-introduction of Prescribed Assets is Retrogressive

For the government to contemplate bringing back prescribed assets sounds like a throwback to apartheid. It may not be aware that the success of financial liberalization in South African financial markets, which commenced in earnest in 1989, was because it was market-led. Furthermore, it may not be aware of the nexus between financial development and economic growth. One of the reasons why the apartheid government experienced pedestrian economic growth was financial repression in the form of prescribed assets. Post-democracy growth rates were on the upward trend (at least up to 2008) because of the liberalization of financial markets, among other factors. As earlier mentioned, in contemporary times governments that typically prescribe assets are either command economies, at war, or under economic sanctions. The present government is not under economic sanctions or at war as was the apartheid government. And neither is South Africa a command economy, despite slogans indicating a desire to move in that direction.

The Way Forward

We often forget that the Stone Age was not abandoned because of a shortage of stones; there were plentiful. It was abandoned because of technological advancements. Similarly, financial repression was gradually replaced with financial liberalization. While South Africa has gone a long way on the path of financial liberalization, the journey has not yet ended. Regulation 28 governing retirement funds still has benign prescriptions, the notable one being the limitation in investing offshore. Some exchange controls are still in place, but progress is being made to gradually remove them. Policy advice is that authorities should keep following the financial liberalization lane rather than dreaming about nostalgic ideas already proven unsuccessful. Government, SOEs and municipalities should submit themselves to the discipline of financial markets to be able to raise funding. They should follow the example of the DBSA which has been able to raise finance without government guarantees. The hope is that SOEs and other quasi-governmental entities will be well-managed enough to be able to source funding without the aid of prescribed assets and government guarantees. That should be the aim of policymakers, including promoting public-private partnerships (PPPs), and not going for the easier, but likely harmful, route of prescribing assets.