How much legroom does Minister Tito Mboweni have for next week?
A Budget addressing investment risk and debt consolidation will be essential to prevent a further downgrade
WHEN FINANCE Minister Tito Mboweni delivers the Budget this month, investors will be watching keenly to see what the government plans to do about the country’s ever-worsening debt problem.
After kicking the debt consolidation can down the road year-after-year, investors will want to see whether the government is finally arresting the deterioration on the debt to gross domestic product (GDP) ratio.
The National Treasury’s forecasts in both February and October 2018 suggested that the government is not there yet.
The debt-to-GDP ratio has gone up steadily and is now projected by the Treasury to peak at just below 60 percent in 2023/24.
Debt servicing costs are the fastest-rising component of South Africa’s expenditure, with the country paying R180 billion in 2018/19 on debt repayments, fast catching up with the health budget of R205bn in the same year. If this trend is not arrested, South Africa will find itself in a debt trap, a vicious cycle of rising debt, rising debt servicing costs and reduced resources for social and investment spending.
Against this backdrop and following key announcements by President Cyril Ramaphosa during the State of the Nation Address regarding State Owned Enterprises (SOEs), rating agencies will be on the lookout for significant signs of deterioration in the government’s fiscal position.
The country awaits with interest the reaction of the ratings agencies to the Budget.
Of the three major rating agencies, Moody’s has maintained South Africa’s foreign denominated debt a level above non-investment grade or junk status; however, should they have a negative view of the Budget there’s the possibility of South Africa’s foreign currency rating being downgraded to junk status.
This means that the cost of servicing debt increases for the country, with less scope in the fiscus to spend on other essential services.
The major risk anticipated in the Budget are plans around Eskom and the potential impact on the fiscus.
In the State of the Nation Address, Ramaphosa announced plans to split Eskom into three units. Eskom’s debt woes and its worsening credit quality translate into a further negative sentiment on the sovereign. At present, Eskom’s debt stands at around R420bn. The success of Eskom is central to the South African economy, future economic growth prospects, fixed capital investments, as the SOE supplies most of the economy’s electricity needs.
Global investors often use global indices, such as the CitiGroup World Government Bond Index, as a basis for investing into a country’s bond markets. Should Moody’s foreign currency debt downgrade occur, this means that South African-issued bonds/debt would fall out of this index, leading to some volatility in bond markets, possible investment outflows, and risks to the domestic currency. All these possible outcomes create an environment of uncertainty.
Institutional and retail investors typically have some allocation of bonds and, should a credit ratings downgrade occur, investors in South Africa bonds face some risk and volatility. Investment managers within bonds are positioned differently, for instance via:
The type of issuers of bonds (government, parastatals, municipalities, companies);
Duration or maturity of the bonds (ie when the loans backing bonds have to be fully repaid);
The use of corporate debt (credit) instead of the sole use of government issued debt;
Limited use of other asset classes such as inflation linked bonds.
These factors differentiate investment managers and as such their investment portfolios react differently to the possible outcomes from the budget, including a credit ratings downgrade and the associated impact on local bond markets.
At Absa Multi Management we believe in diversification across securities and sectors, and given the uncertainties in bond markets, having exposure to differentiated managers, allows for further risk management and opportunities to enhance returns in an uncertain environment. Using multi-managed strategies not only aims to give the investor diversification benefits, but the understanding that all bond investment managers generate investment performance in different ways and patterns.
The government has struggled over the years to reduce spending despite many commitments and some changes in the governance and leadership structures. Mboweni, Ramaphosa and their government have some tough choices to make if the country’s sovereign credit ratings are to be sustained or be improved over the coming year.
While the decision taken by Ramaphosa to split Eskom is a step in the right direction, it remains to be seen what his government intends to do to curb debt.
It is clear a cosmetic reduction in state expenditure won’t be sufficient to bring South Africa’s debt-to-GDP ratio to comfortable levels.
Kwaku Koranteng, is Head: Institutional Clients at Absa Multi Management.