As the institutions’ exposure to the sovereign rises, quality of the state’s balance sheet worsens.
This column was first published in Business Day.
SA’s banks have experienced a sharp increase in exposure to government debt. In 2008, government bonds made up 3.3% of banks’ total assets, but in December last year, the most recent data available, that had ballooned 9.3%. In nominal terms, that is a tenfold increase to R607bn, from R64bn 13 years ago.
The steepest acceleration has occurred during the Covid-19 crisis. From March to end-2020, there was a 32% increase in banks’ holdings of government debt. Much more of SA’s deposits are being used to fund the government.
There are several reasons for this growth. Banks have too much cash relative to the demand for debt in the economy. Since the Covid crisis began, banks have seen their liquidity balloon as businesses and individuals have put cash in the bank rather than invest or spend it.
There has also been a sharp reduction in borrowing by companies and individuals because of wider economic uncertainty. When there’s no-one to lend money to at a higher rate, banks do the next best thing, which is to park it in government paper. Another reason is that government paper is paying relatively high yields, even though short-term interest rates have been slashed. Long-dated government paper will give you more than 10% while the prime interest rate is 7%.
The problem is, while the banks’ exposure to the sovereign has been increasing, the credit quality of the government balance sheet has been worsening. SA lost its last investment grade credit rating in March last year, as the pandemic was breaking and things have worsened since.
Unlike what you expect a bank to do, instead of a reduction in exposure to deteriorating credit risk, there has been an increase. This means that the overall risk facing the banking sector is increasing faster than the risk represented by government paper, damaging the credit worthiness of SA banks.
This so-called “sovereign-bank nexus” ties the fortunes of the banking industry to the government. It can create problems both ways: if governments rely overly on the banking sector, and the industry hits problems, it quickly becomes an issue for the government’s ability to fund itself. But the other direction is perhaps the bigger worry: if government finances hit trouble and doubts rise about the ability of government to meet its obligations, it quickly becomes a banking crisis. In the budget two weeks ago, the National Treasury forecast that gross debt will reach a peak of 89% of GDP in 2025/2026. The budget deficit will average 7.7% of GDP over the next three years. These are the worst figures SA has seen in recent memory — yet it is precisely when banks are landing up with the biggest exposures.
In in its Financial Stability Review in November last year, the Reserve Bank signalled concern about the growth in the sovereign bank nexus, declaring that the “interconnectedness between the financial sector and the sovereign has emerged as a major threat to financial stability in SA”. The European Central Bank, for instance, in which the average bank exposure to domestic government paper for the zone is less than 4% is concerned about Italy’s 11.9% and Spain’s 7.2%. SA’s 9.3% is clearly comparable.
Banks have limited options in dealing with their exposures. They could shift more assets towards private sector lending, reducing government exposure. But given the outlook for the economy, this may not be an effective risk reduction strategy overall. And the problem is that the regulatory architecture makes it hard to do this — government paper is treated as risk-free in bank regulation. Capital requirements are lower the more government paper banks hold.
Things would get interesting if the outlook for the economy improves. Then interest rates may be forced upward quickly as the government and private sector compete for the liquidity available, with government paper crowding out lending to the private sector. For now, banks’ only option may be to reduce funding by lowering the rates they pay for deposits so that they don’t have excess liquidity to park in government paper.
Banks have cut public exposures in some areas, particularly loans to state-owned entities which have fallen from more than 1% of bank assets in 2018 to less than 0.6% last year. The credit quality of Eskom particularly, but also Transnet and others, has deteriorated faster than the core government balance sheet. But there’s no getting away from the government balance sheet in the end.
The alarm bells have been flashing about government finances for some time. The budget was able to show a small improvement compared to what was presented in the medium-term budget policy statement in October last year, thanks largely to unexpectedly strong tax receipts thanks to high commodity prices. But we are still in trouble and navigating through the fiscal crisis is key to the outlook for the country. What people might not be as conscious of, is that it is becoming even more critical for the banking sector.
Theobald is chair at Intellidex.