Lesetja Kganyago, governor of the Reserve Bank. (Simon Dawson/Bloomberg/Getty Images)
Deteriorating government finances, including through its exposure to fragile parastatals such as Eskom, have been singled out by the Reserve Bank as a key risk to the stability of the local financial sector.
Although the Reserve Bank does not assign any overt probability of this risk materialising in the coming year, economists say that if the finances of state-owned entities (SOEs), particularly Eskom, are not addressed immediately the risks to the financial sector could become reality.
In its latest financial stability review, released on Wednesday, the Reserve Bank said the “state of government finances, and the sustainability of government debt in particular, remains a risk to the stability of the domestic financial system and is one of the main potential determinants of further sovereign credit rating downgrades”.
High levels of government debt could have a negative effect on international investors’ view of South Africa’s creditworthiness, which could result in refinancing difficulties and possibly trigger wider financial system instability, the Reserve Bank said.
The likelihood of these risks to the financial system materialising within the next 12 months was “high”, according to the review’s risk assessment matrix, and it classed the resulting potential effect as “high”.
It noted that support for the country’s troubled SOEs added to the pressure on the state’s budget, already weighed down by rising government spending and lower revenue collections, which have put pressure on government debt metrics.
According to the Reserve Bank, the state’s contingent liabilities, which consist of guarantees to SOEs, independent power producers and public private partnerships, are expected to increase from R879.6‑billion in 2018-2019 to R1.02‑trillion by 2020-2021. Eskom accounts for 55% of the R529.4-billion in guarantees granted to SOEs.
“The high level of the South African government’s contingent liabilities and the high probability of significant amounts of these contingent liabilities materialising as well as Eskom’s current large debt levels pose a threat to public finances and hence South Africa’s sovereign credit rating,” the Reserve Bank said.
It said the effects of a deteriorating domestic fiscal position included a sovereign ratings downgrade triggering capital outflows, lower household and corporate income and investment, a protracted period of low economic growth and pressure on financial sector profitability.
Despite these elevated risks, the Reserve Bank’s review concluded that the South African financial system could mitigate negative spillovers and disruptions. The financial sector is “characterised by well regulated, highly capitalised, liquid and profitable financial institutions, supported by a robust financial infrastructure and strong regulatory and supervisory frameworks”.
Nevertheless Reserve Bank governor Lesetja Kganyago last week flagged the negative implications of an event such as an Eskom default, and the effect this could have because of the interconnectedness of the financial system, particularly the exposure of pension funds and insurance companies that hold Eskom and other SOE bonds.
Many parastatal bonds are subject to cross-default clauses, meaning if an SOE defaults on one payment this could trigger a call on its other instruments. The state has, in recent years, stepped in to provide troubled SOEs with emergency funding to prevent its contingent liabilities being realised, but it is affecting the government’s ability to rein in its own debt levels and reduce its deficit.
Moody’s is the last ratings agency to hold South Africa one notch above investment grade and has repeatedly flagged the state’s exposure to the chronically weak financials of SOEs.
In 2018, as part of a common scenario stress-testing exercise, six banks, accounting for 93% of all banking assets, were asked to submit their top five loan exposures to SOE borrowers and assess the effects of a default, said Hendrik Nel, head of financial stability at the Reserve Bank.
Although the exercise found that the banks were adequately capitalised to withstand the fallout, it did not examine the exposure of public and private pension funds, insurers or social welfare funds, such as the Unemployment Insurance Fund (UIF), to such an event.
The scope of the stress test also did not examine the implications for the sovereign which, as a guarantor for almost R530-billion, will be liable to repay the debt if it is called on.
Although separate from the assessment regarding the SOEs, the risk of further downgrades to the sovereign’s credit rating was implicitly allowed for in one of the scenarios.
But Reserve Bank officials said this is on the cards, particularly for the likes of life insurers. Under the new twin peaks model of financial regulation and the advent of the Financial Sector Regulation Act (FSRA), these are now regulated from within the Reserve Bank through the prudential authority. The new regime became active last year.
Officials said that stress testing for insurers is still in its infancy globally, but the Reserve Bank is pursuing it.
According to Reserve Bank data, entities such as the Public Investment Corporation — the state-owned asset manager that invests about R2-trillion on behalf of the Government Employees Pension Fund and social welfare funds such as the UIF — hold about R486-billion in government-issued fixed interest securities, and about R178-billion in fixed interest securities issued by public enterprises.
Life insurers hold about R43‑billion of fixed income securities issues by public enterprises, and about R203-billion in securities issued by the government. Official pension and provident funds — those administered by Transnet, Telkom and the Post Office, which are not regulated by the Pension Funds Act — hold R396‑billion in government-issued securities and R160.2-billion issued by public enterprises.
Private pension funds hold about R190-billion in government bonds and just more than R22.2-billion issued by public enterprises.
To add to the complexity, since the implementation of the Basel III requirements, the local banking sector has been increasing its holdings of rand-denominated government debt to meet liquidity requirements. In a previous financial stability review the Reserve Bank highlighted that the increasing interlinkages between the banking sector and government expose the sector to risk due to sovereign distress.
This is the most overt the Reserve Bank has been about the risks the government’s financial strain poses to the financial sector — in part because the risks are becoming more acute. But it is also because, with the advent of the FSRA, the Reserve Bank’s mandate has been expanded to consider systemic risk, officials noted.
Kganyago emphasised that the Reserve Bank had attached no probability to these risks becoming reality, emphasising only that there is “a likelihood of this thing happening, and if it happens the impact will be significant because of the interconnection between the sovereign and the banking system”.
Although the Reserve Bank had yet to conduct stress testing that included insurance companies, “there is a reason you start with the banks”, said Kganyago. Typically, he noted, in the event of a crisis “you do not quite have a run on pension funds or a run on the insurers. That is why we focus so much on the banking system. If you have a run on the banks you have a problem at the core of the financial system.”
The review did note that in the case of a sovereign rating downgrade, losses may be limited because of mitigating factors. These included attractive 10-year bond yields that could be taken up by funds able to invest in sub-investment grade debt, as well as buying opportunities for domestic pension funds and insurers, who traditionally were underweight government bonds.
Jannie Rossouw, head of the school of economic and business sciences at the University of the Witwatersrand, said it was significant that the Reserve Bank was “now recognising the fiscal dangers”, adding that if Eskom is not urgently “brought into line now, these [risks] will materialise”.
The power utility is facing immense operation and financial problems, with debt levels at R440-billion and expected losses for the financial year to hit R20-billion. Last Friday chief executive Phakamani Hadebe resigned, citing ill-health.
A restructuring plan for the SOE was announced in February, as was additional support from the treasury starting with a R23-billion equity injection. This is expected to rise to R150-billion in the coming years. Rising costs and a long-delayed, expensive capital expenditure programme, plus disappointing tariff increases granted by the national energy regulator, have meant Eskom is also not earning enough revenue to meet its debt repayments.