Interest rate cuts by the South African Reserve Bank (SARB) will weaken the rand and increase financial instability as it will reduce the compensation investors receive for taking the risk of investing in South African assets.
In a note to clients, Stanlib chief economist Ndivhuho Netshitenzhe said significant risks are associated with cutting interest rates before the Federal Reserve does so in the United States.
Netshitenzhe said investors have punished many emerging markets that have cut rates this year.
Cutting rates before the Fed does means a narrower interest rate differential, thereby reducing the compensation investors receive for taking emerging market country risk.
South Africa has to pay a premium to investors on its debt due to the additional risk of investing in the country.
The country’s risk premium has risen significantly over the past decade due to consistent budget deficits, policy instability, load-shedding, and a stagnant economy.
This is reflected in the rise in government bond yields, which is the interest rate the country has to pay investors to purchase its bonds and compensate for uncertainty.
To emphasise the growing risk of investing in South Africa, the gap between the yield of South Africa’s long-term debt and the yield on the United States’ 10-year Treasury bond has widened consistently since 2015.
However, this also makes South African assets, particularly fixed-income investments such as government bonds and money market instruments, attractive to investors as they offer a higher rate of return.
In turn, this brings investment into the country and helps stabilise its financial situation by providing fiscal buffers.
Thus, by cutting interest rates before the Federal Reserve, South African assets will become less attractive than safer assets in developed countries.
This will make South Africa vulnerable to currency weakness and increased financial market instability, said Netshitenzhe.
The currencies of major emerging markets that have cut rates this year have generally weakened since their first cut.
For example, the Chilean peso has weakened by 11% since July and the Brazilian real by 5% since August 2022.
In addition, 10-year bonds for Brazil, Chile, Peru and Poland have been more volatile since the respective cutting cycles started.
The SARB is closely watching these developments as an indication of the possible response by the market if it were to cut rates before the Fed.
If it can demonstrate that the decision to cut rates is appropriate and in line with maintaining sound monetary policy, any negative market reaction is likely to be limited.
There is also a risk that the SARB will start to cut rates before the local inflation rate has been brought fully under control.
The latest inflation data indicates that there is still some upside risk to South African inflation. Persistently high food inflation and the potential for “second-round” effects from the sharp increase in electricity and recent petrol price hikes could push core inflation higher over the coming months.
If the SARB were to cut rates during this time, it risks keeping inflation at an elevated level for longer and undoing the progress made in getting inflation expectations lower.