Budget Quandary Spooks Dollar Bondholders: South Africa Credit

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Feb. 27 (Bloomberg) -- South African Finance Minister Pravin Gordhan may struggle to rein in the budget deficit as a slowing economy curbs tax revenue, pushing the risk premium on the nation’s bonds to the highest level in more than six months.

The extra yield investors demand to hold South African dollar debt instead of U.S. Treasuries has risen 45 basis points this year to 205, according to data compiled by Bloomberg. In Mexico, the spread widened 24 basis points in the period and increased 39 basis points in Turkey.

Gordhan, who gives his fourth budget speech today, is under pressure before next year’s election to step up spending and create jobs for the one in four South Africans without work. Even as the rand and local-currency bonds recovered this month, he’s been forced to scale back revenue projections as a slump in exports from Europe and strikes in the mining industry curbed economic growth, prompting three credit-rating downgrades.

“Our credit metrics are deteriorating and the minister sits in a bit of a squeeze to improve that,” George Herman, head of South African investments at Citadel Investment Services, which manages the equivalent of $2.5 billion in assets, said by phone from Cape Town on Feb. 25. “I don’t see how they can change too much of it.”

Tax Targets

Gordhan, 63, will probably maintain his deficit target of 4.5 percent of gross domestic product in the year through March 2014, according to the median estimate of 11 economists surveyed by Bloomberg. He is due to speak to lawmakers in Cape Town at about 2 p.m.

The shortfall may reach 3.9 percent of GDP in the following year, compared with an earlier projection of 3.7 percent, the survey shows. As recently as 2012, Gordhan was aiming to narrow the gap to 3 percent in the year through March 2015.

The government will probably undershoot its revenue target of 900.6 billion rand ($101.9 billion) for this year, adding to its debt burden, according to Arthur Kamp, an economist at Sanlam Investment Management in Cape Town. In October, Gordhan forecast South Africa’s net debt would reach 39.2 percent of GDP in the year through March 2016, up from 35.7 percent this fiscal year.

“If you look at projections for the next three years, we are going to have shortfalls on revenue,” Kamp told reporters yesterday. “Our debt ratio is still rising and there is some uncertainty about when it will peak and flatten out.”

Wage Bill

An increase in borrowing to plug the deficit may curb a rally in bonds. The yield on notes due December 2026 has dropped 37 basis points to 7.22 percent in the past six months. It fell to a six-week low of 7.21 percent on Feb. 20 after a report showed inflation slowed to 5.4 percent in January, lower than the 5.7 percent median estimate of 20 economists surveyed by Bloomberg.

While Gordhan pledged in October to keep spending targets unchanged in the next three years, he may struggle to curb the state wage bill. Public-sector salaries rose an average of 14 percent annually in the past five years, more than double the inflation rate of 6.3 percent in the period. On Aug. 1, the government reached a three-year pay deal with its 1.3 million employees, giving them a 7 percent raise for the year through March, and 1 percentage point above inflation in the next two fiscal years.

Credit Ratings

Standard & Poor’s, Moody’s Investors Service and Fitch Ratings have all cut South Africa’s credit rating by one level since September, concerned that the government may fail to stick to its budget targets amid pressure from labor unions and the poor to boost social spending.

S&P and Moody’s have a negative outlook on the nation’s rating, indicating it may lower the assessment again if economic conditions don’t improve. South Africa is rated BBB at S&P and Fitch, the second-lowest investment grade and in line with Mexico and Brazil. Moody’s has a rating of Baa1, the third- lowest investment grade.

The yield on South African dollar debt due in May 2022 rose 47 basis points, or 0.47 percentage points, to 3.48 percent this year, while the yield on similar-maturity Treasuries rose 15 basis points during the same period to 1.82 percent.

The cost to protect South African dollar debt against non- payment for five years using credit default swaps has risen 34 basis points to 171 since reaching a three-month low in January. The swaps, which increase when risk perception deteriorates, pay the buyer face value in exchange for the underlying securities or the cash equivalent if a borrower breaks debt agreements.

Rand Gains

The rand has gained 1.3 percent this month, paring January’s 5.7 percent decline, indicating some investors see less risk in investing in the nation’s stocks and bonds, according to Thu Lan Nguyen, a Frankfurt-based currency strategist at Commerzbank AG. The currency rose 0.2 percent to 8.8454 a dollar by 6 p.m. yesterday in Johannesburg.

“The negative consequences of the strike wave and political risks are likely to fade,” Nguyen said in an e-mailed response to questions on Feb. 25. “I am quite optimistic about the rand.”

With weak consumer spending and mounting job losses, Gordhan has little room to raise taxes to help finance the budget deficit. The economy expanded 2.5 percent last year, the slowest pace since a 2009 recession, the statistics office said yesterday. That’s less than half the 7 percent expansion the government estimates it needs to meet its goal of cutting the jobless rate to 14 percent by 2020 from 25 percent currently.

“The minister will be towing the line and making sure he doesn’t make comments that will scare the rating agencies,” Citadel’s Herman said.

--With assistance from Robert Brand in Cape Town. Editors: Nasreen Seria, Ana Monteiro