The founding father of macroeconomics, John Maynard Keynes, once offered this advice: “The boom, not the slump, is the right time for austerity at the Treasury.” His argument was that during economic downturns, it may be necessary to increase government spending to stimulate the economy, even if it leads to higher government debt. Probably, the more than 100 academics, economists, professionals, and civil society organizations who penned an open letter to President Cyril Ramaphosa on 16 October 2023 to halt budget cuts were sniffing this Keynesian advice. Before celebrating this advice, let us put it into context. Keynes offered this advice during the era of the Great Depression (1929-1939). His seminal book – The General Theory of Employment, Interest and Money – was published in 1936 during the Great Depression. The government borrowing he advocated was for productive activities such as those for building infrastructure and expanding the frontiers of economic production. He was not advocating increasing government debt to pay salaries of civil servants and to repay interest and principal of previously incurred debt as is the case in South Africa. Such type of borrowing is not sustainable, meaning that there may be no prospect of generating sufficient revenue or economic growth to cover the debt repayments. Such borrowing creates an endless vicious cycle of government borrowing in credit markets. Eventually, it will lead to excessive budget deficits, high interest payments, inflation, and potential default on loans, which will negatively impact financial stability and future economic prospects.
Definition of crowding out in credit markets
When we say the government is crowding out the private sector in credit markets, we mean that the appetite for government borrowing is causing higher interest rates and reduced availability of funds for private businesses and individuals. Crucially, when the government increasingly borrows to finance its budget deficits (an excess of expenditure over its revenues) by issuing bonds, it competes with the private sector for available funds in the credit market. For the government to increasingly borrow, it has to offer higher interest rates to attract investors. It succeeds in doing so because it is considered a safe borrower by virtue of having the privilege of printing money. This in turn increases the interest rate at which the private sector borrows because the rate at which the government borrows is used as a benchmark in credit markets. Naturally, higher interest rates make it more expensive for businesses and individuals to borrow money for investments and consumption, thus discouraging private sector borrowing and spending. Reduced private sector borrowing leads to lower investments in the economy, which in turn, stifles economic growth and job creation.
Invariably, the spectre of government borrowing crowding out private sector borrowing is associated with underdeveloped capital markets. It has never been associated with liquid and deep capital markets that characterise those in South Africa, Europe, and North America. South Africa’s financial markets are world class and comparable to those in advanced countries although the country itself is classified as an emerging economy, meaning that it is an economy potentially in the process of rapid industrialization, and experiencing significant economic growth. In the case of South Africa there exists this dichotomy whereby world class capital markets exist in an emerging economy with economic growth potential but not experiencing rapid growth. What has gone wrong in the capital markets, particularly with the bond market, one might ask? Before answering the question, let us briefly review the history of the South African bond market and how it has evolved over the years.
Overview of the history of the South African bond market
The South African bond market has a long history which can be traced back to the 17th century when Dutch settlers issued bonds to raise funds for the development of Cape Colony. Such bonds were backed by land and agricultural products. When the British took control of the Cape Colony in the early 19th century, municipalities commenced issuing bonds to fund infrastructure development. Following the aftermath of the Union of South Africa in 1910, a single currency and a centralized bond market were put in place, and the government continued to issue bonds to finance various developmental projects. During the apartheid era, that is, the period from 1948 when the Nationalist Party won elections up to the dawn of democracy, South Africa faced international sanctions, which had adverse impact on its bond market as the participants in the bond market were limited to domestic investors. Notwithstanding economic sanctions, the government nevertheless continued to issue bonds to finance its activities. Following the advent of democracy in 1994, the bond market became more integrated into the global financial system. The government issued bonds in international markets, and foreign investors showed increasing interest in South African bonds. Since then, the bond market has continued to develop to include a wide range of bonds, such as government bonds, parastatal bonds, municipal bonds and corporate bonds. To facilitate bond trading, the Johannesburg Securities Exchange (JSE) plays a significant role. Notably, democracy also democratised the financial markets in the sense that market participants became global both with respect to the bond and equity markets. South Africa became classified as an emerging market, and its bond market became part of the broader emerging market bond universe. Investors around the world consider South African bonds as a potential investment option due to their yield and diversity.
Another milestone was achieved in 2000 when South Africa achieved investment-grade status from major credit rating agencies – Moody’s, Standard & Poor’s (S&P), and Fitch Ratings. This investment grade achievement signified confidence in the country’s economic stability and opened the door to more international investment. Figure 1 below shows the trend foreign investors’ interest in SA bonds over the years.
By 2011 foreign SA bond ownership had reached over 20% and it continued to rise until it reached a peak of nearly 45% in 2017. After reaching that peak, foreign ownership of bonds took a dive which has continued and has since escalated from 2020 to about 25% in 2023. What has gone wrong? One may ask.
Having obtained an investment grade sovereign rating in 2000 presented South Africa with a lot of opportunities which policy makers might not have understood. The investment grade rating meant lower interest rates on government bonds, thus reducing the cost of borrowing for the government and in turn saving significant amounts of money on debt servicing. It made the country more attractive to investors, both domestic and international and increased the availability of capital for economic development. An investment grade sovereign rating signalled stability and responsible fiscal management, further boosting investor confidence in the country.
Unfortunately, what got lost to policy makers was that maintaining the investment-grade rating required consistent fiscal discipline, effective governance, and a stable economic environment. Equally, what was not well understood was that losing the investment grade rating could have adverse consequences, such as higher borrowing costs and reduced investor confidence. South Africa experienced a series of credit rating downgrades in the 2010s. These downgrades were influenced by factors such as corruption scandals, slow economic growth, and rising government debt levels. By 2017, South Africa had lost its investment-grade status with both S&P and Fitch Ratings, and Moody’s downgraded the country’s credit rating to junk status in March 2020. It is evident as Figure 1 shows that from 2018 to the present day, foreign investors in the bond market have been selling off their SA holdings because these investors largely do not invest in bonds with junk status. As if losing the investment grade rating wasn’t enough, in 2022 South Africa was greylisted by the Financial Action Task Force (FATF), an intergovernmental organization which sets global standards for combating money laundering and terrorist financing. Some of the implications of being greylisted include, among others: limited access to international financial markets; domestic banks would face challenges when conducting international transactions; foreign investors are discouraged due to concerns about regulatory risks and financial stability; and the country’s reputation is damaged making it less attractive to foreign investors.
Crowding out channels
The junk status and greylisting are reducing the universe of investors in government bonds as foreign investors are taking flight. In the past the government could easily issue long-term bonds (with maturities of 10 years and above) because of the presence of a diversity of investors. Now it has only to rely on domestic players, mainly, banks, pension funds, and insurance funds. These domestic investors are demanding high yields to compensate for higher risk. Notably, they are demanding yields of over 12% on long-term government bonds. This is expensive for the government but because they are desperate to finance the budget and their only choice is to issue bonds of shorter duration which are nevertheless attracting yields of no less than 10%. Domestic banks now face a choice of either lending to the government or to the private sector. Since bonds are considered safe and risk-free, they would prefer to lend to the government rather than the private sector. Furthermore, since bond yields are high, and they raise bank lending rates to the private sector because benchmark interest rates are set by government bond markets.
Similarly, the market for corporate bonds is affected because it uses government bond yields as a reference in determining the interest rates for corporate bonds. Typically, the yield on corporate bonds is higher than government bond yields to compensate investors for assuming additional risk associated with corporate credit. What we observe now is little activity in the corporate bond market because it has been made too expensive. Thus, excessive government borrowing is crowding out the corporate bond market as well as other credit markets. The credit market is becoming awash with government bonds. Incidentally, defying the standard risk-return logic, the bond market is currently offering better yields than the equity market to the amazement of investment managers.
Another undesirable phenomenon is that excessive government borrowing seems to be affecting the interbank market, that is, the market in which banks borrow among themselves. Government bond yields are higher than the rate at which banks borrow among themselves. Therefore, banks with excessive funds prefer to buy lucrative government bonds (Treasury bills, in particular) rather than lending to other banks in need of short-term funding. In other words, the bond market is also starting to crowd out the interbank market.
While there are tangible concerted efforts being taken to remove South Africa from the FATF greylist, there is no evidence of similar actions to regain investment grade status. Regaining investment grade status requires sustained efforts to implementing reforms such as achieving fiscal discipline (i.e. implementing measures to control budget deficits and reduce public debt), structural reforms to improve the business environment and enhance competitiveness to catalyse economic growth; addressing infrastructure and logistics bottlenecks; embracing labour market flexibility, and reducing corruption; effective monetary policies; and regularly monitoring and reporting on the progress of reforms to signal commitment and transparency to rating agencies and other interested stakeholders. Actions currently being undertaken to be removed from the FATF greylist constitute one of the necessary steps but not sufficient to regain investment grade status. A lot more reforms, many of which are painful as they involve fundamental changes of mindsets and ideologies, require to be undertaken and embraced as new guiding standards going forward.