Fiscal juggling act buys the state some time
There seems to be rising scepticism about the gold & foreign exchange contingency reserve account (GFECRA) rabbit finance minister Enoch Godongwana pulled out of his fedora. The concern goes something like this: SA has — through economic mismanagement, muddled policymaking and rampant corruption — seen its currency depreciate against the dollar at a rate greater than the natural rate of weakness implied by the inflation differential between SA and the US.
Thankfully, the Reserve Bank holds hard currencies and gold as reserves to hedge against this. The gain on these holdings is caused by currency deprecation, which also contributes to a loss in wealth for every South African. One part of the government, in the form of the National Treasury, wants to transfer this gain from another (independent) part of government, the Reserve Bank, to improve the appearance of its sovereign debt ratios.
However, in effect this is just a glorified accounting entry. Meanwhile, despite assurances that this windfall will be used to pay down debt, it is essentially just providing space to continue to defer difficult expenditure cuts and efficiency-enhancing programmes inside the state. There are a lot of factors to consider, and the critique has some kernels of truth, but in its entirety it misses the bigger picture.
The majority of the Reserve Bank’s equity sits in a revaluation account called the GFECRA. SA is an outlier by international standards, having accumulated close to 8% of GDP in positive central bank equity. The next closest peer group country is Poland among emerging markets, at under 1%.
In correspondence with Investec chief economist Annabel Bishop after the budget, she pointed out to me that from a consolidated public sector perspective it constitutes an inefficiently allocated resource: zeroyielding cash liquidity that is not usable, despite being costly to fund (given elevated government bond yields). SA’s Treasury has a zero-yielding claim of close to 8% of GDP on the Bank, while it funds its own financing needs at yields close to 13%.
Bishop believes there is a need for the Bank to align with international practice. On the down side, the Bank already has one of the smallest balance sheets by international comparison, and halving it (by selling forex reserves equivalent to the current equity buffer) — which is what it would take to realise its equity — would make it an even greater outlier. As a percentage of GDP the Bank’s balance sheet is roughly 18%, while Poland’s is roughly 29% and Brazil’s 40%. You get the picture.
However, the fact remains that by international standards the Bank’s profits captured in the GFECRA account are large and hence have attracted interest for some time now. Bishop believes this has driven calls to nationalise the Reserve Bank. She also feels it’s probably better to use the GFECRA to reduce debt before a possible multiparty coalition after this year’s election could see it diverted less usefully elsewhere.
Bond investors will be the ultimate judge, Futuregrowth portfolio manager Yunus January sees the use of the GFECRA as “positive in the short term as it reduces government’s funding requirement and puts it on a more favourable debt trajectory ... Having said that, we don’t see it as a sustainable long-term solution. To sustainably stabilise the fiscal position, continued fiscal discipline in addition to higher real GDP growth, which hinges on economic reforms being implemented, is needed.”
While there is still much scholarly dispute regarding the extent to which fiscal policy can drive economic growth, one thing is certain: poorly managed finances and loose money may destabilise a country rather than strengthen it.
By holding firm on his pursuit of a primary budget surplus and bringing down the peak of expected debt-to-GDP from nearly 80% to just over 75% in the outer years, Godongwana is starting to lean into one of SA’s primary hurdles to greater fixed investment: stubbornly high bond yields.
If you allocate capital to your hurdle rate for the 10-year bond of about 11% plus an equity or project risk premium of roughly 5% on average, it means your internal rate of return has to exceed 16% annually or you’re better off parking your surplus capital in government bonds. This might suit a government looking for cash in the short term, but it’s one of the key constraints on economic growth over the medium to long term.
This is also where monetary policy can play a role. By anchoring inflation at a lower point than the present 3%-6% range (in reality the Bank has already set it at 4.5%), interest rates can settle at a structurally lower level, bringing bond yields down with them. Chris Loewald, head of the Reserve Bank’s economic research department and member of its monetary policy committee, signalled this idea in Business Day last week.
But this has to be a three-part act, with economic reforms doing the bulk of the heavy lifting in support of fiscal and monetary policy. The GFECRA has in effect bought the reformers inside Operation Vulindlela a bit more time to get Transnet back on track and speed up the unbundling of Eskom. They dare not squander it.