Finance

Warning for South Africa’s big banks

Banks

The Reserve Bank has warned local banks and financial institutions about their increased exposure to government debt, which makes them increasingly vulnerable to sovereign risks, instability, and increased borrowing costs. 

South Africa’s financial system is highly exposed to government debt due to a rise in the absolute amount of debt issued by the state and its attractive yields. 

A major reason local financial institutions have had to increase their holdings is that foreign investors have been dumping South African assets. 

Foreign investors have been net sellers of local bonds for the past two years, with billions of rands worth of investments pulled out. 

This has forced local banks and insurers, in particular, to step up their buying of newly issued government debt, increasing their exposure to the sovereign. 

“The government’s borrowing requirement has been financed with an increased issuance of long-term government bonds,” the Reserve Bank said.

“The domestic financial sector has increasingly absorbed these bonds amid the steady decline in non-resident investors’ holdings in recent years.”

In its first Financial Stability Review of the year, the Reserve Bank warned that this may negatively affect local financiers and the wider economy. 

It warned that increased holdings of government bonds could potentially crowd out lending to or investing in the private sector, exposing the financial system to market risk in the event of a sharp repricing of government debt. 

This also undermines market resilience as the financial system is increasingly exposed to a single common risk. 

A higher concentration of government bonds on domestic financial institutions’ balance sheets also inhibits the capacity of the domestic financial system to absorb financial shocks. 

It may also lead to increased high volatility and low-liquidity episodes in the domestic bond market, impairing price discovery and deteriorating trading conditions in the rest of the financial market. 

In turn, this would reduce the overall resilience of the domestic financial system.

Government bonds have continued to take up a greater share of the overall bond market, this is shown in the graph below. These instruments now take up 81% of the value of all outstanding bonds. 

The government’s relatively large financing requirements place upward pressure on government bond yields and increase funding costs across the financial system. 

As borrowing costs in the economy are linked to the yield curve, an upward shift and steepening of the yield curve result in higher funding costs for both public and private sector borrowers. 

This could make more long-term investment projects unviable and create a negative feedback loop between the elevated debt levels and debt-service costs.

This has a lasting dampening impact on potential economic growth, the Reserve Bank said. 

The yield on local government debt has risen due to the increased risks associated with investing in this asset. 

South Africa’s financial health has deteriorated significantly in the past two decades, with the government last running a budget surplus in the 2007/08 financial year. 

Since then, the state has consistently run budget deficits – spending more than it collects via taxes.

Running a budget deficit is not a bad thing in itself. However, if a government runs consistent deficits, it may result in a debt spiral where new debt is issued to cover existing debt. 

This is what the government has had to resort to in recent years, raising investors’ concerns about its debt pile’s sustainability. 

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