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South Africa's slow moving fiscal crisis

Since the emergence of international capital markets in the latter half of the 20th century, both FDI and portfolio flows as a percentage of global GDP have primarily been concentrated in the developed world. However, the last decade’s experiment with negative interest rates has seen 11 trillion of the most stable government bonds issue negative yields. This fall in interest rates caused international investors to increasingly look to riskier, but higher-yielding, fixed income products in emerging market economies to ensure safer returns.

Especially during the recent commodity boom, emerging and frontier markets were justifiable investments despite relatively high debt-to-GDP and longstanding budget deficits. And so, there was an inflow of capital to destinations such as Brazil, Egypt, and China. The demand of international investors for sovereign debt issuances by mostly stable EM’s also allowed high spending countries like Argentina, Lebanon, and Pakistan to finance high expenditures and perpetual current account deficits. The presence of foreign capital also staved off the need for governments to enact politically disruptive structural reforms within their own economies.

This tenuous position exposed South Africa to the analysis and decisions of global finance professionals, the big three rating firms especially. Despite exiting apartheid as Africa’s most optimistic economy, the advantages of location, demographics, and relatively high rates of industrialization, the economy has deteriorated in the face of unstable public finances, collapsing productivity, and stagnation that originated with ineffective public policy. From energy to airlines, the South African economy has been hit by the recent corruption of the Zuma years and general mismanagement of the ANC. Unfortunately, unwillingness to control budget deficits that have averaged 4.2 percent since 2010 reflects the ease with which sovereigns can borrow to cover high expenditures, a move often easier than domestically controversial reforms.

Collapsing mining output, failing state-owned enterprises, and a weak banking sector have thus led two of the major investment services to cut their credit ratings on South African debt down to junk status, leaving Moody’s as the only investment-grade rating. Ironically, the very capital which allowed successive governments to avoid difficult choices might end up fleeing; being driven out by their maintenance of South Africa’s tarnished status quo. At this point, the Ramaphosa government lacks the political capital to deal with the structural problems cited by other rating agencies, and to manage the domestic constituencies that are active in aggravating failing economic policies. In the context of weakening global demand for commodities, the country’s debt looks likely to be downgraded later this month.

After losing investment-grade status, even many yield-hungry investors will be forced by risk mitigation metrics, capital requirements, and general continence to both close out their positions and potentially even avoid future issuances. With demand for South African bonds depressed, the yield will rise, and the government’s cost of borrowing will increase in step, making budget deficits even harder to support. At which point an exogenous shock, like the currently spreading coronavirus or threats to stability from the growing Cabo Delgado insurgency in neighboring Mozambique, could force South Africa to the IMF for the first time since the end of apartheid.

Changing risk profiles, capital flight, and a sovereign unable to fund to support, budget, and current account deficits are seen time and time again in emerging market economies. As the global economic outlook clouds, investors are also abandoning riskier assets in favor of havens, which means that this week’s turbulence has seen the South African Rand weakening and increasing liquidity risk. Thus, the international financing that has papered-over structural economic issues is ending while the high expenditures and non-performing capital allocations remain ubiquitous throughout the economy. To be transparent, this is the primary mechanism that inflicts sovereign debt crises on unsuspecting sovereigns, and South Africa’s risk profile suggests a substantial potential for further downside as investors flee. Unfortunately, this case highlights how sovereigns are dependent on fickle international capital markets in an increasingly uncertain world to continue unsustainable levels of spending, leaving domestic populations exposed, either through the pain of recession of upheaval of restructuring.


This post is from the ERI archive. Read more about the ERI project and its researchers here.

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