The bond and capital markets still doubt the government’s ability to control its spending. Jacques Magliolo reports
TRADERS in the bond or capital market remain pessimistic about the ability of the government to control inflation. This is the meaning of the continuing high interest rate of long-term bonds, the IOUs whose interest rate reflects expectations of inflation.
Mid-week the R150 closed at 16,78 percent and the E168 at 16,88 percent. This is below the psychologically important 17 percent level, but is still high in the light of inflation being in single digits.
Traders are unequivocally bearish about long-term bonds, and will remain so for a while, after this week’s bad economic news. It will take a lot to convince them of the government’s fiscal rectitude.
Says a dealer: “Long bonds are technically oversold and rates should drop to 15,5 percent, but are unlikely to do so.”
He adds that a host of factors played havoc with rates this week, forcing “them into a short-term irreversible bear trend”.
The big shock was the Central Statistical Services release of a rise to nine percent in the July Production Price Index (PPI), which measures inflation at the wholesale level and is a precursor of consumer price inflation.
Deputy Finance Minister Alec Erwin’s tough stance on public spending assuaged some deep-seated fears that government spending will spiral out of control in response to demands of the ANC’s plan to put right the economic wrongs left in apartheid’s wake, the reconstruction and development programme.
But some in the market perceived his words to imply that such spending was out of control.
The Reserve Bank’s stand that exchange controls will not be scrapped until foreign reserves reach R30-billion, and governor Chris Stals’ comments on a possible rise in short- term interest rates, fueled an already bearish trend.
Some economists believe the spike in wholesale inflation was a one-off, caused by the rand’s recent severe weakness against foreign currencies.
But Sanlam economist Pieter Calitz believes: “Inflationary expectations for this year are now back in the double digits.”
He believes that South Africa’s credit rating in October by United States investment bank Goldman Sachs will at best be a BBB. This is the absolute minimum rating required before a country is able to raise loans easily overseas.
A calculation of amounts needed to cover only some of government spending or, as Calitz says: “Funds to be used as standby for the next year could amount to about US$5- billion (R18-billion).”
Analysts say that the Reserve Bank will only be able to raise R5-billion in bonds from overseas investors and that the shortfall will have to be raised through International Monetary Fund loans.
At present South Africa’s foreign reserves amount to R7,8- billion, equal to five weeks of imports. International standards require that these reserves equal at least three months of imports. This indicates that South Africa needs to increase its reserves by R15-billion to about R23- billion. This will leave about R3-billion “to use for the RDP”, says another economist.
At present, the high return obtained in buying long bonds or gilts, as they are known, through the financial rand provides an attraction for overseas investors, giving them a net annual return of more than 18 percent. An explanation of gilts highlights why overseas investors would likely take up the Reserve Bank’s issue of new gilts.
*There are three issues to consider when buying gilts, including a discount on the purchase price, a coupon rate and a yield-to-maturity rate. If a buyer gets a R1-million gilt today for, say R775 000, the difference is called a discount. When the government buys the bond back in 15 years time (maturity date), it pays the full R1-million for the bond. No discount is obtained from the equity market.
This discount, together with the interest the bond holder gets for buying a gilt (coupon rate), forms the interest rate quoted in the media (yield-to-maturity).
At around 17 percent this yield is linked to a perception of political and economic stability in South Africa. The higher the yield, the more bearish is sentiment, and the cheaper the gilt becomes, especially for foreign buyers using the financial rand. In addition, the higher the yield-to-maturity, the greater return investors desire from shares in the equity market.
For South Africa, gilts offer an opportunity to raise overseas money cheaply without having to resort to International Monetary Fund loans, which create perceptions of instability.
*IMF loans are not attractive for South Africa as a host of conditions are usually imposed.
So what other options does the government have?
Says Calitz: “Before the elections, the ANC were talking of nationalising a number of industries, now they have made noises to us that — if they have to — they may consider privatisation.”
No definitive studies have been done on how much could be raised, but figures bandied about have run as high as R500- billion.
Under such conditions, analysts believe that foreign investors would perceive economic strength in South Africa and the bond rate would turn around and head for the 15,5 percent mark.