06 Feb 2018

The rising cost of the cabinet reshuffle

Nazmeera Moola

Co-Head of Fixed Income, Investec Asset Management

“Reshuffle” is such a benign word.  It sounds normal.  Unfortunately, President Zuma’s cabinet reshuffle of March 30th has already had significant economic consequences for South Africa – and they will grow. Ultimately, those worst hit will be the poor.

It’s been five weeks since President Zuma removed the Finance Minister and Deputy Finance Minister.  Since then both Fitch and S&P have downgraded South Africa’s hard currency credit rating to sub-investment grade and Moody’s have put both the local and hard currency debt on watch for a downgrade.

 

Despite this, South Africa has thus far appeared to have escaped without serious financial consequences.  The rand remains below 14/US$.  The ten-year government bond yield is only 15 basis points higher than it was prior to the cabinet reshuffle. Unfortunately, the calm is only an illusion.

 

There are already serious signs of stress due to the erosion in confidence the cabinet reshuffle has caused.  Let’s lay them out:

Government borrowing costs are (already) up R2.3bn in 2017

While 10-year yields have remained well-behaved, 30-year government yields are 75 basis points higher relative to the emerging market average than they were before the cabinet reshuffle. 

 

Government needs to borrow R191bn in the local bond markets this year. This issuance will be concentrated in the 30-year part of the yield curve.  As a result, it will cost the government and state companies R2.3bn more in interest costs in the current year alone due to the cabinet reshuffle. 

 

That number – which could rise in the coming weeks and months – is equivalent to 10,000 new houses or free university education for 30,000 students.

Government bond auctions are facing stress

The liability team at the National Treasury is a well-oiled machine.  Over the years, the team has been led by the likes of current SARB Governor, Lesetja Kganyago, current head of commercial banking at Absa, Phakamani Hadebe and outgoing Treasury Director-General, Lungisa Fuzile.  Since the Global Financial Crisis, they have been concentrating issuance on long-dated debt. 

 

As a result, the average maturity of South African government debt is 12.8 years – this is the second only to the UK in the G20.  As a result, South Africa faces limited roll-over risk.  The portion of debt maturing that it needs to re-borrow in any given year is limited.  Unfortunately, even this excellent team is unable to make up for waning confidence. 

 

In the first government bond auction of May, yields cleared 4 basis points higher than the pre-market trading level.  Four basis points sounds insignificant, but it is far from normal and it is a clear sign of stress.  Each basis point amounts to around R30m extra costs for this year’s new issuance from government and state entities. 

State entities cannot issue

If the central government is seeing signs of stress, the state companies are unable to raise funding from the bond markets. Investors have no demand for their debt. 

 

Eskom has been struggling to issue in the market since early 2016.  SANRAL had to pull a planned auction due to a lack of demand. Since the beginning of April, Transnet has had three auctions in a row, where they have been unable to attract enough bids to raise their desired amount.  Transnet only managed to issue R10m in the second week of April, R25m in the last week of April and R10m in the second week of May – this is well down from the R100m per auction they were raising prior to the cabinet reshuffle. 

 

To put this into context, Barloworld issued R580m in the first week of May in an issue where investor demand amounted to R1.3bn.  In addition, PetroSA is trying to file for business rescue. There have been reports that PRASA is also struggling to pay salaries.  Both are due to poor governance and financial mismanagement. Aside from the strains in the bond market, there are also real economic consequences that are already visible:  

Growth momentum is plunging

The BER PMI, which has been a good leading indicator for manufacturing activity, fell to 44.7 in April after being firmly in expansionary territory since December 2016. Vehicle sales contracted by 13.5% year on year in April.  As a result of the loss in confidence, business will only be making investment that is vital and consumers will continue to curtail spending. 

 

Prior to the cabinet reshuffle, I was expecting GDP growth of 1.7% in 2017.  After the reshuffle, we will be lucky to get to 1% growth this year.

Government revenues are under pressure

Contrary to the impression created by SARS Commissioner Tom Moyane’s press conference, the only reason government met its revenue targets in the financial year ended 31 March 2016 was the R5bn windfall from dividend receipts due to the hike in the dividend tax rate in the February 2017 Budget.  This is unlikely to be repeated in the current financial year. Add in weaker than expected growth and revenues will continue to disappoint.

Gigaba's faces major challenges

Combined, these developments leave Finance Minister Malusi Gigaba facing a conundrum. He has repeatedly promised to respect the fiscal framework of the February 2017 Budget and restore investor and business confidence.  With revenues disappointing, that means further expenditure cuts. 

If he doesn’t keep the budget within the fiscal framework, he has no hope of restoring confidence to reopen the bond markets to state companies and to contain the rise in government borrowing costs.  If he cannot do this, the dependence of state companies on the fiscus will continue to rise.  

There are some signposts for us to watch in the coming weeks and months.  First up will be the key appointments at the National Treasury.  A new Director-General is due to be appointed by the end of May. 

 

Equally vital is the appointment of a new Head of Procurement – which has been vacant since Kenneth Brown left the Treasury at the end of 2016.  If the Minister hopes to observe the fiscal framework, he will have to ensure value for money in all procurement while still broadening the supplier base.  A very experienced procurement expert is needed for the job. 

 

South Africa has the capacity to rescue the situation if we focus on shoring up business and consumer confidence, improving the governance and balance sheets at state enterprises, spending within our means and improving service delivery to promote inclusive growth. 

 

Without these measures, South Africa’s growth outlook will continue to deteriorate, fiscal revenues will disappoint, state companies will become less and less effective and interest costs will spiral.  It will become a vicious negative spiral.