Kantor: Sidestepping junk. Privatisation Gordhan’s budget key, not Austerity.

With the dark cloud of ‘junk’ status looming ever closer, Finance Minister Pravin Gordhan is due to deliver what is likely to be his ‘most important’ and ‘most watched’ budget address. But what methods does Gordhan have at his disposal to sidestep a downgrade? Well known economist Brian Kantor believes that austerity won’t be enough to improve the credit rating, and instead believes privatisation would do the trick. He mentions the obvious choice of South African Airways (fully or partially) as well as a listed private share in the Airports Company of SA. It’s an interesting read and one wonders if the ministry is listening to this and what’s likely another million and one ideas to save South Africa. – Stuart Lowman

By Brian Kantor*

Austerity will not be enough to improve the RSA credit rating. Privatisation will be essential to achieve this.

The 2016-17 SA Budget to be presented on 24 February is set to be an austere one. A mixture of higher tax rates and faster growth in tax revenues seems bound to accompany slower growth in government expenditure. The objective will be to reduce the debt to GDP ratio and to impress the rating agencies accordingly.

Pravin Gordhan, South Africa's finance minister, speaks during an interview in London, U.K., on Thursday, Mar. 4, 2010. Gordhan said he is “disappointed” by the response of developed countries to the government’s plan to seek about $4 billion in loans from the World Bank. Photographer: Chris Ratcliffe/Bloomberg*** Local Caption *** Pravin Gordhan
Pravin Gordhan, South Africa’s finance minister

But fiscal austerity, accompanying higher interest rates imposed by the Reserve Bank, coupled with more inflation, will not help the SA economy to escape its growth malaise. In the short term, taken on its own, such austerity is likely to inhibit any cyclical recovery.

Fiscal austerity may be necessary for securing a better credit rating for SA and lower costs of funding government debt. But it will not be sufficient – and the rating agencies may well come to remind the Treasury that the greatest risk to the SA economy is persistently slow growth. Something more than fiscal austerity is required to improve the national balance sheet and impress the global capital markets, as well as to improve confidence in the prospects for the SA economy.

A commitment to privatisation of state owned and funded enterprises is urgently called for. Asset sales to private owners and operators would reduce national debt and interest payments while relieving the tax payer from further calls on their cash that has far more useful alternative applications.

Private ownership and responsibility for operating failures would absolve the regulators from conceding abnormally high increases in electricity or water tariffs as an alternative to the hard pressed Treasury raising additional debt or equity to keep the public enterprises going. But such higher tariffs – tariffs that are by now more than high enough to secure private capital to supply the essential services – are taxes by another name. They reduce disposable incomes by as much as any indirect tax increase would and, by lifting the rate of inflation, they unfortunately and unnecessarily encourage the Reserve Bank to add to the misery by raising interest rates even further. Exchange rate shocks, tax shocks and drought are very poor reasons for raising interest rates – but are a likely outcome given the Reserve Bank’s modus operandi.

Brian Kantor, chief economist and strategist, Investec Wealth
Brian Kantor, chief economist and strategist, Investec Wealth

The national balance sheet would benefit greatly from a willingness to sell off (at any price) rather than continue to support failing public enterprises with bail outs in the form of taxpayer cash or guarantees of the debt issued by public enterprises. The scope for the better management of what are now publicly owned and funded enterprises is very large. The political will to do so would be very well received in global capital markets. There would be no lack of foreign capital to access the opportunities a well-designed process of privatisation would offer.

The sale (fully or partially) of SAA comes to mind – as does a listed private share in the Airports Company of SA. The other sea ports of SA are also very valuable assets that would benefit from private owners, while their customers would benefit from competition between them. The generating capacity of Eskom could be unbundled and sold off to a variety of owners and managers, who would then be subject to the full discipline of a competitive market for energy – and a cost conscious regulator.

Such reforms would add value to the rand and reduce inflation and interest rates. A recovery in the rand and lower interest rates would be a great stimulus to the economy. An upswing in the business cycle would follow and the structural reforms of failing public enterprises would raise the long run growth potential of the economy.

The state of the markets

The State of the Nation speech delivered by President Jacob Zuma to Parliament on Thursday 11 February revealed a more open and pragmatic approach to the prospect of privatisation. The capital markets so far have not registered any marked approval of such intentions. The sovereign risk spreads and the outlook for inflation have not yet improved in any immediately obvious way.

The spread between RSA long term interest rates and their US equivalents remain elevated, albeit below the levels recorded when President Zuma intervened in fiscal policy and sacked the then Minister of Finance, Nhlanhla Nene, on 9 December. This risk spread, currently over 7% p.a. is, the rate at which the rand is expected to depreciate over the next 10 years. What is to be gained by a US dollar investor in the form of higher yields is expected to be perfectly off set by exchange rate weakness in the market for forward exchange. If this were not the case, then arbitrage opportunities to make certain profits in the bond and currency markets would open up.

The market is clearly expecting a high rate of further rand weakness. Consistently, given the expected weakness in the rand, the expectation of more inflation to come over the next 10 years, remains equally elevated. A weaker rand must be expected to bring more inflation with it. The compensation for inflation provided in the RSA bond market thus remains at about the same level of over 7% p.a. Vanilla bonds, which are vulnerable to unexpectedly high inflation, still offer over 7% p.a more than the inflation protected variety yields of under 3%. This yield spread can be regarded as an objective measure of inflation expected.

In the figures below we show how the gap between RSA yields and US Treasury Bond yields widened significantly on 9 December. They have since receded but spreads remain elevated, as has inflation compensation. They do not appear to have reacted favourably to the State of the Nation speech.

inflation_compensation

A somewhat similar picture emerges when we compare the risk spreads on RSA dollar-denominated debt. The cost of insuring an RSA Yankee dollar-denominated five year bond moved sharply higher on 9 December and has widened further since then. But the risk spreads on even higher risk emerging market debt have also widened. This indicates that the higher risks associated with RSA debt have not been a purely SA event. Global risk aversion has also been an influence on credit ratings. However the current RSA credit default swap (CDS) spread of over 350bps, already effectively gives SA debt junk status.

We therefore compare the emerging market spread with the SA spread. The wider this difference the better the relative credit rating of SA debt. As may be seen on the right hand scale of the figure below, this difference narrowed sharply on 9 December, indicating an immediately inferior SA credit rating. But the SA credit rating then improved in a relative sense, given the larger difference between average emerging market yields and RSA equivalent debt. Encouragingly, this spread has increased further in recent days, indicating an improving SA credit rating – when compared to a peer group.

sovereign_risk

We await with great interest the detailed Budget proposals. Not only will the plans for government spending, tax and debt issues be influential. The plans for asset sales, that is for privatisation, may prove even more important. A combination of fiscal austerity with credible privatisation plans could have a profound influence on SA’s credit rating, the rand and the longer term growth prospects for the SA economy.

  • Brian Kantor, chief economist and strategist, Investec Wealth & Investment
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