Treasurers’ Conference – A Relatively Unscathed Financial Sector - What was different about the latest crisis?

Sharika Salie, Portfolio Manager at Taquanta Asset Managers, reflects on why South Africa’s financial sector emerged relatively unscathed from the Covid crisis compared to the Global Financial Crisis.

Crisis indicators – VIX Index
Equity market volatility during the Covid crisis initially reacted strongly and quickly to the news of lockdowns, the effect on employment levels and the total seizure of economic activity. There was a lot of fear and uncertainty in the market as could be seen on the VIX Index, and the VIX index increased to levels last seen in the Global Financial Crisis of 2008/2009. There were massive sell offs in both the equity and bond markets and fear in the money market.

Evolution of spreads
It was surprising to note that spreads did not blow out any more than they did in 2020, despite the IMF claiming this to be the worst economic crisis since the Great Depression of the 1930s. The financial sector experienced a very small bump in spreads in March 2020 and these elevated spreads lasted a mere 3 months, before deteriorating significantly.

Inflation and interest rate environment
Going into the GFC, SA was coming out of massive commodities boom. Inflation was very high and the SARB was struggling to get inflation within the target range.  However, the environment going into the Covid Crisis was very different.  SA’s inflation was well contained within the target range of 3%-6% since the third quarter of 2018.  Inflation was also being mostly driven by rising costs and not consumer demand, and that reflected the weak economy and lacklustre GDP growth prevailing at the time.

South Africa GDP growth
In the years prior to 2008, SA’s economy was growing well over 5%. In 2018-2020, the SARB was operating in an exceptionally low growth environment. Our economy was very weak.  Inflation was not a huge concern for the SARB and the environment for them was conducive to rate cuts. Going into the Covid crisis, we had a Repo rate of 6.5% with low inflation and the fat real interest rate at the time bode well for aggressive rate cuts by the SARB.

SA debt issuance
Prior to the GFC, securitisations were the biggest issuers in debt capital markets. Basel III came into effect after the GFC because governments were bailing out banks using taxpayers’ money. Banks had to start managing themselves more prudently. Regulations were introduced that resulted in securitisations, which was one of the biggest issuing sector on the JSE, to now being negligible. Regulation also made securitisations very expensive for banks and no longer a profitable sector for banks to issue debt out of.  We should not forget the power regulation and legislation has on a sector.  How will new regulation post covid change the debt landscape? This is something to ponder.

Impacts of Basel III
The big four SA banks (Firstrand, ABSA, Nedbank and Standard Bank) have a history of being well capitalised and Basel III did not therefore have a huge impact on them. However, Basel III did have a permanent impact on our spreads. Prior to the GFC, banks did not differentiate between term funding. A 3-year NCD was priced the same as a 5-year NCD. At certain points in the month, they did not differentiate between 1,3 and 5-year funding. Basel III made long-term funding more valuable to the banks. When there is new regulation, markets usually overreact and this was no different with the difference between a 1-year spread and a 3-year spread at around 60 bps. Things have normalised and over last few years, the difference between 1,3 and 5-year spread is between 10 and 20 bps.

SARB’s mandate and tools
The SARB’s mandate is to protect the value of the currency in the interest of balanced and sustainable economic growth. In order to protect the value of the currency or its purchasing power, the SARB has to keep a low and stable inflation rate, hence the adoption of inflation targeting, which is between 3% and 6%. A stable banking sector is fundamental to the efficient implementation of monetary policy and broad-based price stability. This is why big banks are systemically important to the entire system. Banks enable the SARB to push their policies into the real economy. The SARB has two tools that they can use, namely monetary policy and regulatory tools. During the GFC, the SARB significantly reduced the repo rate; made additional liquidity available to the banking sector by increasing the size and duration of repo facilities and by purchasing government bonds; partnered with banks and National Treasury to implement a loan guarantee scheme for small and medium sized enterprises; while SARB’s Prudential Authority (in charge of Banking Regulation) assisted banks by providing capital relief, lowering capital requirements and lowering the liquidity coverage ratio.

Effect of SARB’s actions in the money markets
Instead of spreads blowing out to levels last seen in the GFC, the increase in spreads was very muted in comparison.  Unlike the GFC when spreads were elevated for over 2 years, spreads in the Covid crisis stayed elevated for less than 3 months.