Dodging default

RW Johnson writes on the massive scoop the media missed last week

The South African media is often jejune in its news selection. Huge space was devoted to the flight to and returning from Beijing to bring back South Africans from China. Those who made the flight were saluted as heroes and huge TV attention was devoted to pictures of the SAA plane taking off and landing. No one questioned whether those South Africans who decided to stay on in China were in fact making the rational choice, for they would undoubtedly be safer from the Covid-19 virus there.

Was it really clever to bring back citizens to face the rapidly increasing epidemic in South Africa? Was South Africa bringing its citizens back just because many developed countries had done so? But all those countries have far stronger health systems than South Africa does, so was the whole stunt irrational?

This was, though, as nothing compared to the last week when almost the whole media completely missed one of the biggest stories of the year. This occurred in the local bond market.

First, a word of explanation. When a country defaults on its debt, this usually happens in one of three ways. Obviously, the first case is one where the country realises that it can’t meet the interest payments on its debt and simply declares itself unable to pay.


A second case is where a heavily indebted country realises that it needs to keep borrowing but will have no hope of repaying its loans and thus appeals for help from the IMF, thus conceding that it cannot get out of the hole it has got itself into on its own. But the third way is when the market simply refuses to take a country’s paper – ie. buy its bonds – or is willing to do so only at such punitive rates of interest as to guarantee an eventual default. It is this third case which occurred in South Africa’s bond market last week.

Because bond yields in most developed countries are now so low, many investors have put their money into emerging market bonds which generally pay higher rates of interest. South African bonds have been a particular favourite since they are so easily traded and because they yielded almost 9 per cent, which was just about the highest rate on offer. However, the Covid-19 panic caused a huge flight of foreign investors into dollar assets.

This stampede was so great that it caused a sharp upward revaluation of the dollar even against other strong currencies – the Yen, Euro and pound sterling. Altogether 83 billion dollars fled from emerging markets. This included many – though far from all - of the foreign holders of South African bonds.

South African bond prices fell heavily under the weight of selling and yields soared. This then impacted those local investors who had bought bond futures. They now faced margin calls for which they lacked the cash so they tried desperately to raise cash by selling their own holdings of bonds. It was a nightmare for there were almost no buyers. The market was simply refusing South African paper. The country teetered on the edge of default.

It was at this stage that the Reserve Bank entered the market which, in the absence of buyers, had completely broken down. The SARB knew well enough how fatal it would be to the country’s financial credibility if it became clear that the market was refusing to buy South African paper.

So the bank stepped in and started to buy bonds simply to ensure that the market continued to work. Later, the Bank was accused by uncomprehending observers of having entered the quantitative easing game. This it indignantly denied, pointing out that QE was generally carried out in order to push up the rate of inflation – and South Africa had no need of that, thankyou. The buyer had acted as a buyer of last resort and only this desperate action prevented an effective default. Amazingly, the media missed the story completely. Economic illiteracy is not confined to the ANC.

The story does not end there, of course. During this crisis yields, which had been under 9 per cent, rose to 12.38 per cent on the R2030 long bond. Even by the end of the week this had subsided to only 11.45 per cent. Remember that the Treasury needs to sell R1.1 billion worth of bonds every single day. But at these rates the interest bill on South Africa’s debt would rise by over a quarter which would also push the country in the direction of default. And the SARB has announced that it plans to go on intervening because the market was “dysfunctional”.

This was followed by Moody’s long-expected downgrade of South African paper to junk. Moody’s behaviour has been peculiar. Investors who stuck by its advice will have suffered bad losses as Rand losses compounded with the falling price of South Africa’s bonds.

Those who listened to the much earlier warnings from Fitch and Standard & Poor will have avoided that. Moody’s noted both that the government really hadn’t carried out any of the desperately needed structural reforms and that it foresaw South Africa’s debt reaching 91% of GDP by 2023. Effectively Moody’s have lost all confidence that the South African government will take any of the desperately urgent steps required.

Tito Mboweni admitted that he was “trembling in his boots” at the likely results of the Moody’\s downgrade. For, of course, now that South African bonds no longer features in the World Government Bond Index, institutional investors will have to jettison their holdings of such assets. This will produce another tidal wave of selling, this time so great that it is doubtful if the SARB can hold the tide. Moreover, this is bound to create further upward pressure on the interest rates on South Africa’s debt. So last week’s near default will have been a dry run for what lies ahead.

Talk of default immediately raises the question of a bailout. It must be remembered that the Covid-19 crisis is bound to see a large increase in the budget deficit and a major expansion of the national debt. The result, as I have already pointed out, is to accelerate the timetable for a showdown and bailout. Market observers say that the government simply has no idea of how it is going to fund this much larger deficit. With the market already close to refusing South African paper, this is a real emergency issue. No doubt the government’s first thought will have been of getting help from BRICS – the BRICS Contingent Reserve Agreement would allow it 10 billion dollars and South Africa also has a 4.3 billion dollar swap arrangement with China. But given the size of the problem even this might be far from enough. The next stop after that is the IMF.

As it happens the IMF was in South Africa in January as part of its regular Chapter IV consultations. The IMF has, of course, been urging structural reform on South Africa for a decade and more – advice which has been steadily ignored. This time the IMF repeated its advice, urging the government ‘to implement strong fiscal control and SOE reforms to ensure debt sustainability, accompanied by decisive structural reform’. Although Covid-19 was then not even a cloud on the horizon the IMF’s Executive Board warned that ‘The outlook is subject to risks derived from further delays in adjustment and reform and changes in investors’ appetites for emerging markets’. This last phrase turned out to be a fatal warning.

The actual Staff Report on the IMF visit contained a few gems. It pointed out that under current economic policies GDP per capita would continue to decline steadily, that South African electricity tariffs were now some of the highest in the whole southern African region (they are twice that of Mozambique, four times those of Angola or Zambia), that borrowing costs have more than doubled since 2009 and that ‘South Africa’s undeniable economic potential remains largely untapped’. As for the deficit and the debt: ‘The deficit is mostly expenditure-driven as South African tax revenue relative to output is one of the largest in emerging markets while the wage bill-to-GDP ratio is among the highest’. A rough translation would be: your taxes are far too high, your wages are far too high and so is your government expenditure. Your government’s policies are so mad that they are steadily immiserating the whole population. You have to change course completely.

Once the Covid-19 crisis struck all eyes turned to the IMF. The new Bulgarian boss of the IMF, Kristalina Georgieva – a tough and competent lady who is doubtless finding that Christine Lagarde left her with some nasty problems – has announced that the current crisis is far worse than that of 2008-2009. There are literally dozens of low-income countries now in big trouble, many of them with large and unpayable debts. Already, she says, 50 such countries had been in touch with the IMF and she was sure that even at a conservative estimate 2.5 trillion dollars would be required by these countries. Moreover, no less than 31 middle income countries had also been in touch with the IMF – it is a staggering fact that no South African journalist or politician has asked the government whether it is among the 31. Asleep on duty again.

David Malpass, the head of the World Bank, has been working closely with the IMF on the problem of the low income countries. He says the WB would do what it can by front-loading grants and extending soft loans but he was emphatic that whatever happened, there would have to be debt relief – by which, of course, he means debt forgiveness. Without doubt such statements will have caused a sharp raising of heads among the many petitioners for aid, since debt forgiveness would be a dream solution for them.

This context has to be taken into account by South Africa. If it needs to go to the IMF it will find itself part of a long queue. Understandably, the IMF will see the low income countries as the most deserving and will look somewhat askance at middle-income countries like South Africa or Argentina which have got themselves into a mess simply by their own foolish policies. If you are dealing with the terrible problems of, say, Bangladesh, Somalia or Sierra Leone you are likely to become a little short-tempered when faced by special pleading as to the need to keep South African wages higher than all its emerging market competitors.

Faced by the plethora of demands upon it the IMF may well need to go back to its shareholders to ask for an extension of credit so as to give it more money to lend. The USA is chief among those shareholders and effectively has a veto. Donald Trump is no friend of the Bretton Woods institutions or, indeed, of foreign aid altogether, so he might well veto such an increase. So, even for the IMF, money could well be short.

Moreover, financial markets are gripped by the thought of an even bigger crisis. Even before the Covid-19 crisis Italy’s almost unpayably high debt was a cause of considerable concern, but the huge impact of the virus on its economy – and Lombardy, the heart of the Italian economy, is the hardest hit area of all. Moreover, many Italian banks are in a shaky position. So we could be facing the biggest debt crisis ever – the default of the world’s eighth largest economy.

It is difficult to see how Italy could stay in the Euro zone unless it gets massive support from the rest of the EU. The plan punted by France, Italy, Spain, Greece, Portugal and four others was for “Corona bonds” to be issued by the EU, ie. thus mutualizing its debt. This was, of course, yet another attempt to get the richer northern countries to pay the debts of the less frugal south. Mrs Merkel, backed by Austria, Finland and the Netherlands (“the Frugal Four”) has said a firm No to this. Indeed, Germany has compared the idea to giving your credit card to a friend, with no control at all over what he might spend. The default of tiny Greece caused a huge crisis for the Euro zone but it is not clear that the Euro could withstand an Italian default.

Where does this leave South Africa ? No doubt the government is greatly relieved that the local media is so dopey that it altogether missed the fact that South Africa was on the verge of default last week. But that leaves the question of what to do. The fact that even the SARB has no idea of how the now greatly expanded deficit is to be funded is fairly shattering. This follows the pay rises for Eskom workers where Eskom said it had no idea where it would find the money to pay them, and then the pay raises for public sector workers where the government admitted it had no idea where the money would come from. This is the sort of economic planning one expects from a child at the school tuck-shop..

That was serious enough – and the current freeze of public service pay signals that such days are now over. But to launch your central bank into the bond market to buy your own bonds simply to prop the market up is real last chance saloon stuff. The one thing you can’t do is do that with no plan as to how to extricate yourself from that situation or, worse still, no idea as to how you are going to fund the now much greater deficit. Yet that is exactly what has happened.

What this all amounts to is that South Africa is flying blind. The sudden urgency of getting someone to buy the country’s paper may well lead to prescribed assets, though of course the bond markets will see that as a negative signal. South Africa’s pensioners would have much harsher words than that. The truth is that a decade of South Africa refusing to listen to advice from the IMF and others has now caught up with the government. So, without ever having thought about it, they now find themselves having to gamble more and more with the country’s debt. This may not end well.

They might spare a thought for that most accomplished gambler, Doc Holliday. Doc only relied on gambling because his real profession, dentistry, paid so poorly. But Doc was a wonderful shot, which was why he was so useful to his friend Wyatt Earp at the gunfight at OK Corral. He was such a good gambler because “he knew when to hold ‘em, knew when to fold ‘em” but of course when all else failed he could always rely on his gun.

Doc, a heavy smoker, was once asked if he had a conscience about the many men he’d killed: “I coughed up my conscience along with my lungs long ago”, he replied. So, as gamblers go, Doc had more or less all the bases covered. He could win card games or, failing that, gunfights, and his conscience didn’t bother him, so he was invulnerable. Well, not quite. He died at age 36, vastly amused as he lay on his bed by the sight of his own stockinged feet, for he had always assumed he would die with his boots on. Not all bets come off.

RW Johnson

Updated 28 March 2020