BRIAN KANTOR: Assurances of fiscal conservatism and firm commitment to the privatisation of SOEs will save SA

What could be done to reduce the burden of SA’s national debt and the dangers of the debt trap the country has entered?

One obvious answer would be to borrow at lower interest rates. However, lower inflation would not necessarily reduce the interest paid on conventional RSA debt. Only lower expected inflation could do so. Lenders demand compensation in the form of higher interest rates for taking on the risk inflation poses to the purchasing power of their interest income and the market value of their debt. The more inflation expected the higher will be interest rates.

The governor of the Reserve Bank believes lower inflation — the result of realising the Bank’s inflation target — will lead to lower expected inflation and bring interest rates down with it. But the link between realised inflation and expected inflation is not direct or obvious, as the recent behaviour of the bond market and interest rates confirms. In recent years inflation compensation in the RSA bond market — the difference in yields offered by a conventional bond exposed to the danger of unexpectedly high inflation and an inflation-proofed bond of the same duration that offers a real yield — has remained stubbornly high at about 6% per annum, which has not declined with lower inflation that has fallen to about 4% per annum.

Long term (RSA) interest rates, inflation compensation and inflation in SA

Source: Bloomberg and Investec Wealth and Investment

The problem for the central bank is that it is only partially able to control the inflation rate because it is driven by forces beyond its influence. The exchange value of the rand, so important for inflation in SA, follows a course highly independent of the Bank’s reactions. It is much influenced by the sayings and actions of South African politicians, for instance. The rand also responds directly to the global capital flows that drive the dollar stronger or weaker, and emerging market currencies in the opposite direction. And prices in SA respond directly to the price of imported oil and the taxes levied on it. The weather, food prices and the Eskom tariff are among other forces that are always acting on prices and which the Bank can only react to, not influence.

In addition, the interest rate reactions of the bank can only influence the demand side of the price equation. Reducing demand with higher interest rates to counter supply-side shocks to prices can mean a very depressed state of demand indeed.

The trouble with slow growth in SA is that it raises the risk that SA may abandon its fiscal conservatism and elect sooner or later to inflate its way out of its debt. Debt would then become ever more burdensome with slower growth and, paradoxically perhaps, the burden would also rise with lower inflation. When nominal GDP growth — real growth plus inflation — falls below interest rates, given much lower recent GDP inflation combined with slow real growth the burden of debt (debt to GDP) increases rather than declines.

Long term interest rates and growth in nominal GDP

Source: Bloomberg and Investec Wealth and Investment

SA can only hope to reduce the cost of funding its debt and escape the threatened debt trap by convincing the marketplace that it will not abandon fiscal conservatism. This will take even more than raising taxes or reducing the trajectory of government expenditure to reduce long term interest rates meaningfully, austere actions that hold back growth in the short run.

A firm commitment to the privatisation of, rather than the reform of, our failed public enterprises is called for. This will reduce risks to lenders, bring down interest rates and permanently raise the growth rate. It would support the rand and reduce inflation by attracting much additional foreign investment and capital.

Without such a change of mind, and actions to back them up, the risks of our sooner or later inflating our way out of debt trap will remain, pushing up inflation expectations and interest rates. Without such reforms, our problems will continue to be exacerbated by permanently slow growth, for which the failed public enterprises will bear a large responsibility.

Any unwillingness to take this obvious action will keep up the high cost of funding our borrowings and do so independently of the realised rate of inflation, which will remain under constant cost pressures.

• Kantor is chief economist and strategist at Investec Wealth & Investment. He writes in his personal capacity.