Financial Mail and Business Day

Bank’s new worries: bonds and sanctions

HILARY JOFFE

Tresilient he Reserve’Bank’s SA s banks latest and Financial Stability Review makes some of the usual soothing noises about how insurers have proved despite loadshedding, low growth, high inflation, rising interest rates and general global turmoil.

But it flags two alarming new risks to financial stability and indeed to the economy.

One is about the capital outflows SA has been facing and the way these have weakened local financial markets. The other is about the secondary sanctions SA could face, with the review spelling out their practical implications in gory detail.

The first one is a new twist on an old risk. The Bank has worried for a while about the sovereign bank nexus — the risk that banks are holding such a large chunk of government debt that if the government gets into trouble so do the banks. Now, the financial stability regulators are starting to worry about the bond market itself, because the relentless foreign sell-off has left it less deep and less liquid. That means even small shocks can have outsize effects on pricing. Worse, the market can dry up altogether — as it briefly did when Covid-19 and the Moody’s downgrade hit simultaneously in March 2020.

Foreign investors bought big into government bonds on the domestic market after the global financial crisis. Foreign holdings of domestic bonds peaked at more than 40% in the early Ramaphoria days but have been sliding ever since. The foreign sell-off accelerated after SA’s credit rating was junked in 2020; it’s got even worse in recent months. And while banks were initially the big buyers of the bonds foreign investors were selling, lately unit trusts have led the mop-up operation, with pension funds big buyers too.

The review points out that local investors now hold 75% of the government’s local currency bonds, up from 58% in April 2018. One consequence of that shift from foreign to local is that the behaviour of the bond-holders is quite different: locals tend to buy and hold their bonds, whereas the foreigners are more likely to buy and trade. That has big implications for the market itself, which is why the review flags “capital and outflows and declining market depth and liquidity” as a new risk to financial stability.

“While deep and diversified markets can act as shock absorbers, price discovery and the ability to raise liquidity in the event of an adverse shock can be severely compromised in undiversified and shallow markets,” it says.

The effects then cascade through the financial sector. It is all made worse by growing risks to SA’s public finances, not to mention our load-shedding and grey-listing “idiosyncrasies”, as economists now delicately call them.

But if the first new risk is disturbing, the second one is even more so — and could do a whole lot more damage to capital flows. The risk of secondary or indirect sanctions being imposed on SA “if its neutral stance on the Russia-Ukraine war is perceived as unconvincing” has increased since the previous review six months ago, which is why it has been added to the list of threats to financial stability. If secondary sanctions materialise, the financial system will be unable to function, the Bank warns. SA would not be able to make international payments in dollars, which could lead to a sudden stop to capital inflows, and even faster outflows.

Even without formal secondary sanctions, foreign counterparties could make life more difficult for SA’s banks and other financial institutions if they increase their scrutiny and reduce their exposure as part of their own risk management processes, the review warns. Formal sanctions would be a whole different ballgame, as the review describes it.

First is the impact on crossborder banking and payments, for imports and exports or whatever. Correspondent banking relationships between our banks and US (and possibly European) banks would end immediately. That would increase the cost of cross-border payments, not just for SA but also for its neighbours, many of which depend on SA banks for this. Cross-border transactions in foreign currency could become even more problematic if we were booted out of the New York-regulated global continuous linked settlement system, of which SA is the only African or Brics member.

Then there are our major trading partners, and not just the risk that SA loses its preferential access to the US market in terms of the African Growth & Opportunity Act but far more. The UK and US account for close to half of the SA banking sector’s foreign assets (Russia is immaterial). The US, EU and UK together account for 83% of foreign direct investment in SA (Russia is a tiny fraction). SA banks tend to rely on foreign markets, particularly European markets, as a stable source of funding, one we could lose altogether. This would make it more costly and more difficult for businesses and other financiers to borrow. The litany of disaster for markets, banks and even for SA’s foreign reserves goes on.

Being banned from the Swift international payment system, as Russia has been, would be huge — the review notes that more than 90% of SA’s international payments in any currency are processed through Swift, so these payments would be impossible. That’s a major risk to financial stability, as is anything that would prevent SA making international payments in dollars. The financial system would not be able to function.

It sounds melodramatic and frightening, and it is. But the Bank does not only look after price stability. It also has a mandate to safeguard SA’s financial stability. That means identifying the risks and putting measures in place to manage them, working with the banks, insurers, markets and other financial sector players it supervises.

It surely hopes that the politicians might hear it, if it warns loudly and clearly of what will happen if the government keeps piling on the foreign policy, load-shedding, public finance and other “idiosyncracies”.

Ultimately, while the Bank has an excellent track record it cannot prevent these risks to financial stability from materialising: it can only try to ensure the financial system does not fall over if they do.

SA BANKS TEND TO RELY ON FOREIGN MARKETS, PARTICULARLY EUROPEAN, AS A STABLE SOURCE OF FUNDING, ONE WE COULD LOSE

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2023-06-02T07:00:00.0000000Z

2023-06-02T07:00:00.0000000Z

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