The immediate challenge for SA’s newly appointed cabinet is to do what it takes to stimulate faster growth in output, incomes and employment over the next few years. And to instill a strongly held belief that they will succeed in doing so.
The benefits of a more optimistic belief that growth will accelerate would be immediate. The interest rate on longer dated RSA bonds would come down as the danger of a debt trap for SA receded — as it does with faster growth in tax and other revenues for the republic.
Governments cannot formally default on the loans they issue in the local currency. But they may be tempted to pay down such debt by issuing more currency should the interest burden on the debt become politically intolerable. Printing more money than wealthy owners are willing to hold leads inevitably to more inflation, as investors are well aware.
Such inflationary dangers call for compensation for lenders in the form of higher interest rates. There is a lot of inflation priced into long term interest rates in SA that makes borrowing particularly burdensome for SA taxpayers. Very low interest rates of the kind now demanded of European and the Japanese governments practically eliminate any possibility of a debt trap, even when the debt to GDP ratios are more than double the ratio in SA, as they are.
The running yields provided to match supply and demand for RSA bonds provides a clear and continuous measure of how well the government is rated by investors for its ability to avoid inflation — and stimulate growth. The difference between the yield on a vanilla RSA bond and an inflation protected bond of the same period to maturity indicates how much inflation is expected by investors. It is a risk the owner of an inflation linked bond largely avoids.
Hence the difference between the yield on a five-year vanilla RSA bond (currently about 8% per annum) and the lower yield on an inflation protected bond (currently 2.4% per annum) reveals that inflation in SA is expected to average 5.6% per annum over the next five years and about 6.5% per annum over the next 10 years. Headline inflation is now significantly lower at 4.4% per annum.
RSA bond yields and compensation for expected inflation (5 year bonds)
Source: Thompson Reuters, Bloomberg and Investec Wealth and Investment.
Another important signal comes from the difference between RSA rand bond yields and those on US treasury bonds of the same maturity. This spread indicates how much the rand is expected to depreciate over the years. The difference between 10-year RSA yields and US 10-year treasury bonds is of the order of 6.6% per annum. That is, the rand is expected to depreciate against the dollar at an average over 6% per annum over the next 10 years. This clearly implies much more inflation in SA compared to the US,a further reason for much higher interest rates.
RSA and USA Treasury Bond Yields (10 Year) Daily Data 2019
Source: Thompson Reuters, Bloomberg and Investec Wealth and Investment.
The very latest news from the RSA bond market this week, before the composition of the cabinet was known, was not encouraging about the prospects for growth-enhancing reforms. If anything these interest rates spreads have widened rather than narrowed — indicating more, not less, inflation expected and no more growth expected. Hopefully the selection of the cabinet members and better knowledge of their good intentions will raise expected growth and lower long-term interest rates.
The level of short-term interest rates will be set by the SA Reserve Bank. We can hope the Bank will recognise that inflationary expectations are largely beyond its influence. More inflation expected can add upward pressure to prices as firms with price setting powers attempt to recover the higher costs of production they may expect. But such attempts to raise prices can be thwarted by an absence of demand for their goods and services.
Very weak demand for goods and services over which the Bank’s interest rates have had a direct influence has contributed to very slow growth — and lower inflation. But without reducing inflation expected. The Bank should recognise that lower inflation — achieved by deeply depressing spending and growth rates to counter more inflation expected — will not bring less inflation expected over the longer run. That is a task for the cabinet. The role for the Bank is to do what it can to stimulate more growth by lowering short-term interest rates.
• Kantor is chief economist and strategist at Investec Wealth & Investment. He writes in his personal capacity.
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