GFECRA: What is it and why does it matter?

On the balance sheet of the South African Reserve Bank (SARB), there is a peculiar account called the ‘Gold and Foreign Exchange Contingency Reserve Account’ (GFECRA). While formerly relatively unknown, this account has recently received a lot of attention from investors and policy makers alike. It holds unrealised profits of South Africa’s (SA) foreign exchange reserves and has grown over the last few decades to about R500 billion. That is more than 7% of our current GDP. While the account belongs to the National Treasury, it can only be accessed in agreement between the finance minister and the SARB Governor, which has not happened to date. This approach is different from other countries, where such gains are settled periodically and automatically.

Since there has never been a pay-out, the Treasury has, in essence, been left holding an ever-larger IOU from the SARB, while it continues to fund itself dearly in the bond market. This is similar to holding a low-yielding savings account and borrowing long-term on a credit card at the same time. Most agree that it is not economical.

While there hasn’t been a pay-out from the account, there has been an instance of GFECRA settlement back in 2003, but then the Treasury paid funds into the account as it had gone in the red following a sharp rand rally. It is now however far in the black, and while the account size is volatile in nature and can swing in both directions, it is widely expected to rise over time as the rand depreciates in nominal terms against hard currency and gold, if nothing else, then at least due to inflation.

Treasury and the SARB have recently confirmed that there are ongoing discussions about the account, and they have also sought outside council from the IMF. At ABAX Investments, we believe there is a high probability that an announcement will be made soon, possibly as soon as the upcoming budget on 21 February 2024, where the SARB will begin to settle some of these balances to the benefit of the Treasury. In practice, this would mean that the SARB creates new money (“bank reserves”) and transfers it to the Treasury’s bank accounts, thereby reducing the outstanding GFECRA balances and increasing Treasury’s cash balances.

An announcement of this nature may just be for a given amount to be paid once-off, but to avoid shocks to the money markets, we expect (and would prefer) to see smaller periodic settlements, for example, payments made weekly or phased-in over a longer period.

While the money is not free, as it will carry an interest cost for the SARB equal to the repo rate, it is much cheaper than alternative financing options available to the government. What we do not want to see is the release of these balances contributing to funding ever wider deficits. We believe any deal struck between the SARB and Treasury would be conditional on the funds being used for debt reduction. An excellent choice would be to lower the amounts offered in the weekly auction of long-dated government bonds from the current pace of R3.9bn and instead, for Treasury to use GFECRA balances to cover the shortfall. Another option would be to halt switch-auctions where bond investors give back short-dated bonds in exchange for long-dated ones - in this scenario, Treasury could use cash balances to simply redeem the short-dated bonds at maturity. Lastly, but least likely in our view, Treasury could introduce buy-back auctions of long-dated bonds using GFECRA balances for settlement. We may also see a combination of the various alternatives. The common denominator in each of these scenarios is that they reduce the net supply of bonds in the long end of the curve.

        Source: Bloomberg, Abax Investments

At present, all bonds beyond the 15-year point trade at a yield to maturity well above 12%. Calculating the forward-yields beyond the 10-year point reveals them to be at an eye-watering 16%, a whopping 11% higher than the realised rate of inflation over the last decade. In our view, bond investors are handsomely rewarded for taking on the extra duration risk by sitting in the long end of the curve.

Part of the bond curve’s steepness is as a result of the deterioration of SA’s macroeconomic outlook and credit fundamentals. We believe however, that an even more important driver is a long-standing (and in our view, ill-advised) modus operandi where Treasury has targeted long duration for their bond supply, which has far exceeded demand. The market imbalance was exacerbated further after SA government credit rating downgrades sparked a forced exodus of many foreign investors.

A reprieve then, in the issuance of new duration as a result of GFECRA utilisation, could unlock significant capital gains for bond investors in the long end of the curve, as the curve shape could flatten materially. In addition, we have seen increasing initiatives by Treasury where they look at alternative financing avenues to further substitute away from expensive, long-dated nominal bond issuances.

The Nedgroup Investments Opportunity Fund is well positioned to benefit from this with a 35% allocation to government bonds, the majority of which is long dated.