Triple threat for South Africa’s finances

Despite renewed optimism surrounding the South African economy due to the formation of the Government of National Unity (GNU) and declining interest rates, the country still faces significant risk from the government’s poor financial health. 

South African assets have rallied strongly since the country’s election at the end of May, with their performance being the best among emerging markets. 

In the third quarter, South African government bonds returned 10.54%, bringing their year-to-date return to 16.68% and one-year returns to 26.14%. 

Coronationa’s head of fixed interest at Coronation, Nishan Maharaj, said the primary reason for the strong performance of local bonds has been a reduction in the risk premium under the GNU. 

This means that despite the strong rally in global bond markets, local bonds have significantly outperformed global bonds. 

Since the formation of the GNU, the 10-year South African government bond yield has hovered around 10%, which is still above its average of 9% in the prior decade. 

This is largely due to the government’s poor financial health, with the fiscus continuing to be a major long-term risk that investors are not willing to discount. 

Maharaj explained that South Africa’s financial problems are threefold and will take years to unwind or reverse. These three problems are outlined below. 

1. Slow economic growth, which has led to subdued tax revenue 
2. Increased pressure on spending in the form of SOE bailouts and a bloated public servant wage bill
3. A cost of funding that has far exceeded the country’s economic growth rate 

A core issue for the fiscus is that South Africa’s nominal growth rate (real growth + inflation) remains far too low, Maharaj said.  

The renewed optimism in the reform path following the announcement of the GNU could see real growth accelerate towards 2% by 2026 and even higher afterwards if the momentum is maintained. 

However, with inflation forecast to be lower (4.5%) than previously expected (5%-5.5%), this offsets a large part of the increase in real growth, implying nominal growth will be basically unchanged. 

Furthermore, expenditure pressure has not eased. Currently, the public sector worker union is demanding a 12% wage increase versus the 4.5% National Treasury has pencilled in for 2025/2026. 

Deteriorating infrastructure at both the national and municipal levels suggests the need for more money to be spent. 

Finally, despite the reduction in the risk premium, South Africa is still funding itself in the bond market at levels in excess of 10%, which is better than the 11% seen pre-election but still well above the best expectations of nominal growth going forward. 

As such, we expect deficits to remain wide and SA to continue to accumulate debt, putting debt to GDP above 80% in 2029/2030. This leaves the outlook for government finances less optimistic than sentiment would suggest.

Despite these concerns, Maharaj said South African bonds still offer good value for investors as they continue to trade above fair value. 

He explained that the global monetary policy easing cycle should continue to boost the performance of emerging market assets, including South African bonds. 

This can be seen in emerging market bond yields being significantly lower than at the start of the year. 

South African bonds have seen renewed investor optimism following the formation of the GNU and as global bonds have rallied. 

The country’s fiscal accounts remain at risk over the longer term, and current bond valuations fully discount a more optimistic outcome. 

Inflation-linked bonds (ILBs) still offer value relative to nominal bonds if inflation materialises higher than forecast or if real yields follow nominal bond yields lower. 

Maharaj said that bond portfolios should be positioned at neutral duration at current levels with a healthy dose of ILBs for good measure. 

Two things continue to warrant including ILBs in a portfolio. Firstly, the real policy rate is coming down. 

At current levels, the coincident real repo rate is close to 4%, while historically, this has been closer to 1.5%. In addition, ILBs provide inherent protection against higher inflation relative to forecast.

All of this depends on the National Treasury staying on its path of fiscal consolidation. If it is derailed, the picture can significantly worsen. 

There are a few green shoots that indicate the Treasury’s efforts are beginning to bear fruit. It expects to run a primary budget surplus for the next few years. 

This should stabilise debt-to-GDP at 75% in the next financial year and see it decline in the coming years. 

The main risks to this turnaround are the public sector wage bill, potential further support for Transnet and other SOEs, and municipal debt to various utilities.