An extraordinary week has passed since the government ordered and prepared for a shutdown of much (how much?) economic activity to deal with the Covid-19 health crisis. All, including the participants in capital markets, have tried to come to terms with the evolving realities at home and abroad. And it was a week when the SA Reserve Bank moved from conventional to unconventional monetary policy.
At its monetary policy proceedings on March 17, the Bank reported in an explicitly conventional way. It cut its key repo rate by an unusually large 100 basis points on an improved inflation outlook. By March 25, it was practising a kind of quantitative easing (QE), buying SA bonds in the market to reduce “excessive volatility in the prices of government bonds” and freely providing loans to banks of up to 12 months.
The Bank is therefore creating money of its own volition. Cash reserves, that is deposits of the private banks with the Reserve Bank, are created automatically when the Bank buys government bonds and shorter-term paper from the banks or its customers.
These deposits serve as money, and are created without any cost to the issuer, which acts as the agent of the government. These additional cash reserves support the balance sheets of the banks. And it could lead to extra lending by them, as is the intention.
Had the Bank not acted as it did, the bond market would surely have remained volatile. But, more importantly, it might not have been able to absorb the deluge of bonds and bills the government would be issuing to fund its emergency spending, including coping with a drawdown of R30bn worth of bonds sold by the Unemployment Insurance Fund (UIF) to generate cash for the government to spend on income relief.
The yield on the 10-year SA bond was about 9% per annum in early March. By March 24 it was more than 12%, and declined marginally in response to the Reserve Bank intervention. The de-rating of SA credit by Moody’s on Friday evening, after the market had closed, seemed inevitable in the circumstances. On Monday morning, the yields on long dated SA bonds jumped higher at the opening of the market, then receded and ended as they were at the close on Friday.
Bond yields have risen for fear that SA would create money for the government to spend in response to ever-growing budget deficits and borrowing requirements
Central banks all over the world are also undertaking money creation — in very great quantities — as a predictable response to their own lockdowns, the collapse of economic activity and its threats to financial stability. But in the developed world they deal in bonds and other securities at much lower interest rates. And the scale of their bond and other asset-buying programmes (QE) is no doubt part of the explanation for very low yields — both short and long. Yet despite money creation on a vast scale more inflation is not expected in the developed world.
Not so in SA and many other emerging markets. Issuing longer-dated government bonds in their own currencies is a very expensive exercise, and has become more expensive since the coronavirus pandemic. Lenders to emerging-market governments, in their own currencies, demand compensation for high rates of inflation expected, and receive compensation for the inflation risks.
There is always the chance that the purchasing power of interest income contracted for, and the real value of the debt when repaid, will be eroded by inflation of the local currency.
The danger is that fiscally strained governments will, some time in the future, yield to the temptation to inflate their way out of the constraints imposed by bond investors — by turning to their central banks to fund their spending to a lesser or greater degree, rather than to an ever-more demanding bond market. Issuing money (creating deposits) at the central bank to finance spending carries no interest cost. It can be highly inflationary, depending on how much money is created and how quickly the banks use the extra cash to extend loans to their customers.
The growing risk that SA would get itself into a debt trap and create money to get out of it has been the major force driving long-term yields on SA debt higher in recent years. Higher both absolutely and relative to interest rates in the developed world.
Bond yields have risen for fear that SA would create money for the government to spend in response to ever-growing budget deficits and borrowing requirements, and a fast-growing interest bill, as the SA government has now done with the co-operation of the Reserve Bank — though in truly exceptional circumstances, and justifiably so.
Avoiding the debt trap, controlling budget deficits, and convincing investors and credit rating agencies that the country can fund its spending over the long term without resort to money creation is the task of fiscal policy. For SA to regain a reputation for fiscal conservatism and an investment-grade credit rating is now more unlikely than it was when a promisingly realistic budget was presented in February.
Expected inflation
The Reserve Bank may hope to control domestic spending and, thus, inflation through its interest-rate settings. It does not, however, control inflation expectations and, thus, neither the interest rates established in the bond market. The more inflation is expected the higher interest rates will be. Expected inflation over the long run is dependent, in part, on the expected fiscal trends and the likelihood of a resort to money creation. And these fiscal trends, thanks to the coronavirus, have deteriorated as they have almost everywhere else.
How, therefore, should the government and the Reserve Bank react to current conditions in the bond market? Long-term yields are unlikely to recede significantly, and the yield curve is likely to get steeper should the Reserve Bank reduce its repo rate further — as it is likely to do.
The government should, therefore, fund as much as it can at the cheapest, very short end of the capital market. It should issue more short-dated treasury bills to fund current spending and replace long dated bonds as they mature with shorter-term obligations. It will save a lot of interest this way. The actions of the Reserve Bank by adding liquidity (cash) to the money market through QE will have made it much easier to borrow short from the banks and others.
When the economic crisis is behind us it will remain essential to strictly control government spending to regain access to the long end of the bond market on more favourable terms. Only the consistent practice of fiscal discipline will deserve and receive lower longer-term borrowing costs.
• Kantor is head of the research institute at Investec Wealth & Investment. He writes in his personal capacity.
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