Debt, Government Debt, potential default and the ZAR. Lessons for South Africa from Lebanon and Argentina.
“Annual income twenty pounds, annual expenditure nineteen [pounds] nineteen [shillings] and six [pence], result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.”– Charles Dickens in David Copperfield
“Neither a borrower nor a lender be; For loan oft loses both itself and friend.”– William Shakespeare in Hamlet Act-I Scene III
Amidst the market turmoil last week, Lebanon announced that it was defaulting on its debt for the first time in its history. After several weeks of political debates around potentially defaulting on its hard currency debt, prime minister Diab announced on Sunday the 8th March that the Lebanese authorities would not be repaying 1.2 billion USD of debt due on the 9th March 2020.
Debt is a marvellous device, vital to the functioning of the global economy if effectively deployed. Here’s how it works: At a cost called interest, people called lenders make sums of money available to borrowers, which allows them to consume straightaway not only what they need, but also what could be prudently delayed until affordable. There is the annoying inconvenience of having to pay back the money, together with the interest of course, at some predetermined time in the future. But tomorrow is tomorrow, mañana and all that, the party is underway and everyone is itching to dance. All the while, the future creeps up with a nagging relentlessness, or is destined to for the next five billion years, when the sun will turn into a red giant star and its outer layers will expand out to the orbit of Mars, engulfing our planet in the process. So, one fine day the pay-back date arrives.
What happens if debtors cannot pay back the money on the allotted date, if they default? Ah, therein lies the rub. In Victorian times, debtors were thrown into prison. Charles Dickens’s novel Little Dorritt is centred around life in the Marshalsea, London’s notorious debtors’ prison. In some Arab states, debt is still criminalised to this very day. In financial markets today, caveat emptor applies. The dispenser of loans beware; the lender takes the risk. Of course, lenders have ways and means of extracting their cold cash from reluctant payers. They can turn nasty on debtors who do not pay. Some of their methods are none too salubrious. Threats, baseball bats, guns, heavies, hitmen, torture and other horrors have been visited on reluctant debtors, some of which, at times, work. But at the end of a day, you cannot squeeze water from stone. If the money has been squandered, it’s just not there for all the baseball bat waiving. The way not to lose money is not to lend it out in the first place. Or if you do, take care. Spread your lending and ensure that the interest rate compensates you for the degree of default risk. This is bizarrely why the weakest borrowers, those who need debt most, pay more for it – if they can get it.
At the level of nations, the same principles apply as to individuals. There are debtor and lender nations, as well as the baseball bat equivalent of enforcing payments. Debt repayment used to be enforced by gunboat diplomacy. For example, during the Venezuelan crisis of 1902-1903, European powers imposed a naval blockade against Venezuela in order to get it to pay its foreign debt. An armada of warships menacing around their ports can be a persuasive sight to reluctant payers. The global landscape is seemingly gentler today. Countries raise money on international bond markets, which is a community of professional investors across the world who lend money, including to sovereign states, in exchange for bonds. Bonds are essentially legally enforceable notes issued by borrowers, promising to pay the money back at the end of a period, typically years, together with periodic interest payments called coupons, typically every six months. In bond markets, borrowers get the money, lenders get pieces of paper and hope not to bother their lawyers once the debt falls due.
But lenders still hold a big stick. Essentially, when a country runs out of money, it typically defaults by missing a coupon payment, or not paying back a maturing bond. [E.g. South Africa did not pay out its debt obligations for four months in 1985]. This triggers a legal process, but lenders to defaulters invariably lose money. The debt of the defaulting country is usually restructured, and lenders get whatever the restructured value of the debt is deemed to be when the process settles. An economic crisis follows, usually followed by a political crisis, as faith in the government collapses.
That does not mean that the defaulter goes without punishment. The problem is that the defaulting country still needs money. It needs foreign reserves to keep its economy afloat (to import oil, say). Alas, owing to the default, the international bond markets close ranks on the defaulting country. Credit lines freeze up. The defaulter is now in a desperate situation, with limited options. A defaulting sovereign might approach a power such as China, which might lend to the troubled country subject to certain conditions, usually in the form of trade deals or concessions. The defaulter may also approach the IMF, which is a punitive option. When approached for funds, the IMF sends in a team of people and effectively takes over the finances of the country. Money is disbursed according to a checklist system. It’s called ‘attached conditionality’ in the trade. Austerity rules. Toe the line, comply, be good and do as you’re told by the IMF, and you’ll get money paid out from their programme. Else you don’t. That’s a rather precarious situation for the debtor nation to find itself, for it may be ordered to cut down drastically on its civil service or social grants, say, which could wreak havoc with political stability. Understand that, and you understand why protests flare-up against the IMF across the globe from time to time. Not that it’s the IMF’s fault, no. They’re only there to help.
How did Lebanon land up in this situation? It took on too much debt.
Chart 1: Lebanon: Debt/GDP (Source: Ministry of Finance, Republic of Lebanon)
Lebanon’s debt rose to over 150% of the size of its economy in 2018. Interest payments on its debt as a percentage of government revenue inflated to 45.7% in 2017, clearly an untenable situation. Something had to give, and it did. They failed to pay. Falling on their sword were investors in Lebanese bonds. Faced with negative interest rates in large swathes of the developed world, they were prepared to chase yield at any risk wherever they could find it across the globe. Their ventures led them to the spicy sub- investment bond markets, also known as junk bond markets in the trade, which comprise exotic locations such as Lebanon. In just over two years, the price of the Lebanese 15y USD bond fell from 100 to below 25, a drop of 75% in value. An investment in an index of safe-haven US treasuries, the debt of the US government, would have returned 20% over the same period.
Argentina is another case in point. Unlike Lebanon, Argentina has been a periodic defaulter on the world stage since the first of its nine defaults in 1827. It has a history of debt crises, including three times in the 21st century. Two of these credit events occurred between the year 2000 and 2017. Yet the bond market, as though afflicted by a short memory or dazzled by the higher dangled yield, was there anew for Argentina in 2017. Despite a rapidly worsening debt situation, in June 2017 Argentina was able to raise 2.25 billion of USD debt at 7,125% interest, the principal to be paid back in 2117. In other words, three years ago, Argentina managed to float a 100-year USD bond in the markets, the principal to be paid back a century hence.
Chart 2: Argentina: Public Debt to GDP (Source: Argentina Economy Ministry). An alarming deterioration.
In August 2019, just over two years later, Argentina defaulted. It began re-structuring its towering debts, as before. The price of their bonds collapsed once again (see Chart 3).
Chart 3: Argentina 100y USD bond, price. (Source: Bloomberg).
Most alarming was the action of the Argentinian peso against the US dollar. A mere five years ago, in March 2015, a dollar bought around 8 Argentinian pesos. Today, a US dollar buys 63 pesos. The Argentinian currency has depreciated by over 85% in five years.
Chart 4: Argentina Peso versus US Dollar. (Source: Bloomberg).
In the case of both Lebanon and Argentina, a rapid accumulation of debt got them into trouble. Which raises the question: What is the situation in South Africa?
South Africa’s debt-to-GDP has been rising at a vertiginous pace since 2008, when the ratio reached a low of around 25%. The latest figures released by the South Africa national treasury during the February 2020 budget speech make for rather disconcerting reading.
Chart 5: South Africa – Debt/GDP and Debt-Servicing costs (Source: SA National Treasury, February 2020). On an unsustainable path?
The forecast gross debt/GDP profile, which in previous budgets rose to an inflection point a few years into the future, after which it was projected to turn downwards, no longer does so. It is now projected to rise monotonically over the forecast window. Debt servicing costs are projected to rise to over 18% of the main budget revenue by 2022/3. This means that of every rand expected to be raised in taxes in that fiscal year, 18 cents will go into paying off interest, crowding out other forms of expenditure. Government realises that stabilisation of the debt burden is crucial and is relying on negotiations with unions etc. to moderate wage increases, as well as on natural attrition and voluntary retirement to bring down its costs. What the government really needs is a strong economy to lift it out of its debt spiral, in fact a sustained GDP growth rate of close to 3% is needed to bail it out of its malaise. This seems quite unlikely at present, as economic problems will be compounded by the nefarious effects of the COVID-19 virus this year. In fact, South Africa will likely experience a full-blown recession in 2020. Economic forecasters we follow are downgrading SA 2020 GDP growth to zero and even into negative territory. A weakening economy makes it more likely that parastatals will call in their government guarantees, placing a greater burden on the fiscus.
If economic growth fails to materialise, higher taxes are implicated, further dampening growth. Projecting the situation a few years into the future, the Moody’s debt downgrade will be a fait accompli, yesterday’s concern. South Africa will be a sub-investment grade destination, proscribed to investment grade investors. When money proves hard to find, the IMF lies benignly in wait, China too. At that point, the ZAR (rand) at around 16/US dollar might seem a distant bargain. Steep ZAR depreciation might lead to higher inflation, placing hardship on the populace, 18 million of which receive social grants that might have to be cut. That is a recipe for social upheaval. It is imperative that the hard medicine be taken now, and that government proceed with more stringent savings and lose no time in implementing the necessary reforms.
Chart 6: The ZAR and the Argentinian Peso vs. the US Dollar (5 years, March 2016 to March 2020). (Source: Bloomberg).
Alex Pestana is head of Fixed Interest and an Investment Strategist at Counterpoint Asset Management (CPAM). Views reflected are his own and should not necessarily be attributed to CPAM.