Debt spiral and recession on the menu

A year ago the collapsing oil price precipitated a crisis in Russia that saw the central bank raise interest rates by 6.5% in one step. The Russian economy contracted by 9.3% in first quarter of 2015, 5.4% in the second quarter and grew by 0.7% in the third quarter, according to the SA Reserve Bank quarterly bulletin.

While South Africa is not an oil-based economy, the example illustrates what an economic shock can do to an economy. The firing of finance minister Nhlanhla Nene is one of several ominous signs that South Africa could be headed for an ‘economic event’ and a far more aggressive interest-hiking scenario than was predicted.

Sharply higher interest rates will slow economic growth further and possibly push the country into recession and political and social instability.

The rand fell to its lowest level against the dollar, pound and euro on the news that Nene had been axed. The already beleaguered currency could fall further ahead of next week’s expected interest rate increase by the US Federal Reserve.

This puts pressure on imported inflation and puts the Reserve Bank under pressure to raise interest rates in an effort to stabilise the currency.

Bond yields exploded on the Nene news. Yields on South Africa’s ten-year bond – the most liquid of South African bonds – rose from 8.82% to 9.80% overnight. “This is unusual, it is an event similar to PW Botha’s Rubicon speech,” says Ray Wallace, CIO at Taquanta Asset Managers.

At the long end of the curve, yields on the 30-year bond increased by around 100 basis points from 9.5% to about 10.5%. “Bonds are being sold off aggressively, which raises the risk premium on the country and adds to the pressure on the Reserve Bank to raise interest rates,” he says.

Raising of interest rates, particularly if faster than expected, will dramatically slow down private sector investment, says Chris Malikane, associate professor of economics at the University of Witwatersrand. “On the consumer side, debt costs will increase. And for the public sector it means far higher interest costs,” he says.

Higher interest rates will swell government debt further. Without cuts in government spending, debt levels will explode. Including guarantees made on behalf of State-owned enterprises government debt is standing at over 60% of GDP. This shock alone could push it to above 65%, Malikane says. “South Africa is entering a debt spiral.”

Investors had already voted with their feet on SA assets following credit-rating downgrades by Fitch and outlook revisions by Standard & Poor’s last Friday. In the past three months, foreign investors have sold SA equities and bonds to the tune of R33 billion and R7 billion respectively, according to data from the Johannesburg Stock Exchange (JSE).

“This is another ominous signal and sets an uneasy tone for SA as it enters 2016,” says Lesiba Mothata, chief economist at Investment Solutions.

Aside from outflows, there are other signs that South Africa is facing a possible risk economic event, he says. The first is a sudden fall in the currency – the rand lost 5% of its value against the dollar between Wednesday and Thursday this week.

Spreads on credit default swaps have widened to almost 300 basis points (from 240bps in September). This is the highest level since March 2009 and reflects a higher risk of default, Mothata says. At this point South Africa is being priced as being more risky than Turkey, Russia and Brazil.

Bank shares are another ominous indicator, he says. The Financial 15 on the JSE fell 8.6% on Thursday. “SA banks are well capitalised and the financial sector is sound. However what we don’t know is how capital requirements will change if we have a ratings downgrade or significant economic event. It appears investors are pricing in an adverse economic situation.”

Inexplicable political decisions create heightened uncertainty. “With a new and untested finance minister South Africa’s predictable and transparent fiscal policy is now massively uncertain. This leaves us vulnerable to downgrade.” Downgrades, he says, don’t have to happen a notch at a time. “The rapid rand depreciation and economic mismanagement emanating from the political front could result in Moody’s downgrading SA’s sovereign credit by two notches, and other agencies following suit.”

Moody’s review of South Africa is expected early next year, with Standard & Poor’s and Fitch’s review due at the end of 2016. However they will be following events closely and will not hesitate to adjust their rating out of cycle.

The bottom line is that investors need to be on the lookout for a potential risk event for SA. If the capital outflows persist, and the related feedback loop between rand weakness and inflation becomes entrenched, Mothata believes the Sarb is likely to call an unscheduled meeting and increase borrowing costs.

Brought to you by Moneyweb