One thing Cyril Ramaphosa and Donald Trump are afraid of

Everyone, including President Cyril Ramaphosa and his US counterpart Donald Trump, is afraid of capital markets and the so-called “Bond Vigilantes” who can make or break a government’s finances. 

This market, which is just made up of individuals trading government debt, has the power to significantly increase or decrease a government’s borrowing costs at the drop of a figurative hat. 

Efficient Group chief economist Dawie Roodt explained at the recent BizNews Conference that capital markets are the ultimate check-and-balance for a government. 

Roodt said that, despite what any politician says, they are afraid of and will listen to the capital market when it speaks. 

This market sets the interest rate at which the government must pay investors to borrow money from them to fund its operations and investments. 

Roodt explained that this interest rate is not under the control of the government or any central bank, as these institutions only control short-term interest rates.

Longer-term borrowing at a large scale is determined by the market and the returns investors demand for holding government debt. 

Thus, these rates are largely based on perceptions of a given country’s financial health, its fiscal management, and its economic fundamentals, particularly its growth rate. 

“The interest rates that are far more important than the prime lending are the bond yields or interest rates investors demand the government pay them to hold state debt,” Roodt explained. 

“The Reserve Bank has very little control over these rates. It can adjust short-term rates up and down, but not the bond yields the government pays. That is the capital market, and everybody is scared of that, believe me.” 

Roodt explained that while the South African government may say it is not worried about capital markets and financial indicators, its actions show otherwise. 

The capital markets and the interest rates investors are demanding to hold South African government debt have forced the National Treasury to focus intensely on stabilising the state’s debt burden. 

This has resulted in the painful process of fiscal consolidation, increased aggression from SARS in enforcing compliance, and the drive to encourage private investment in key areas of the economy. 

South Africa’s government can no longer afford to be expansionary and borrow money to invest in infrastructure, as capital markets will not give the state any more money at favourable rates. 

“Everybody is scared of the capital markets. If they are not scared yet, they will become scared. Even Donald Trump is scared of the capital markets,” Roodt said. 

The bond vigilantes

Modern capital markets, in relation to the government, mostly try to keep state spending in check by increasing or decreasing the interest rate at which they are willing to buy debt. 

While often referred to as a “market,” it is, like any market, made up of individuals and institutions buying and selling things. In this case, government debt, in the form of bonds, is being bought and sold. 

Given the scale of government borrowing, in South Africa, the state has over R5 trillion in debt, and the bond market is dominated by large institutions. 

In South Africa, the market is dominated by large banks and financial institutions, which hold a significant share of the government’s debt. 

Government debt is seen as a relatively safe, near-cash asset that, in South Africa, can generate significant interest earnings. This makes it attractive to financial institutions. 

However, this also means that a small number of institutions have significant sway in the bond market and can greatly impact bond yields by buying or selling the instruments in large quantities. 

Economist Ed Yardeni coined the term “bond vigilantes” in the 1980s to describe institutional investors who try to keep government spending in check this way. 

When these investors lose confidence in a government’s ability to manage its finances, repay its debt, or keep inflation low, they begin to send warning signals to the state through the bond market. 

They do this by selling government bonds in large quantities, which lowers bond prices. As a result, bond yields surge, making them more attractive to investors. 

This means the government ends up paying significantly more to borrow money from the market, making it increasingly expensive to fund a deficit. 

As a result, a state will typically rein in spending and seek avenues to raise additional revenue to lower its deficit, tame inflation, and appease the bond market. 

Thus, these investors do not just look to make a profit. They try to force a policy change to make the state’s finances more sustainable. 

Such a situation is what makes governments and leaders fear the capital markets, as a spike in bond yields can create significant financial pain for the state and its citizens. 

If yields spike too high, a country can face a debt crisis where it can no longer afford to service its debt. Financial institutions left holding bonds may face their own crises. 

The fear of such a crisis often makes politicians walk back spending plans, cut budgets, or raise taxes to appease bond investors and bring rates back down to manageable levels.