On 16 December, the well-anticipated US Federal Reserve (Fed) interest rate hike of 25 basis points was finally announced, with the new benchmark rate ranging between 0.25% and 0.5%.
The decision to raise the benchmark rate, which is what commercial banks pay to borrow from the Fed, marks the end of a seven-year period of near-zero borrowing costs. What is more, it is likely that the Fed will further increase rates, with economists polled by the Financial Times predicting multiple hikes this year.
The prospect of higher US yields has attracted investment away from riskier emerging markets, and their currencies have generally weakened in relation to a strengthening US dollar as a result.
South Africa is no different. In November the South African Reserve Bank hiked its benchmark repo rate (for the second time in 2015) by 25 basis points to 6.25%. This was partly in anticipation of the expected US rate hike the following month, and the pressure it placed on the rand.
How we made it in Africa talks to Tom Elliot, international investment strategist at financial consultancy deVere Group, about what US interest rate increases means for South Africa. And while there are many socio-economic factors that affect economies, he highlights a number of likely results.
Government debt more expensive to service
Many African countries have issued debt in foreign currencies, namely in dollars and euros, to attract international investors. However, this debt is vulnerable to currency risks, especially if these foreign currencies strengthen. As African currencies take a hit from a stronger dollar, it will be more expensive for these markets to repay their dollar-denominated debt.
South Africa also borrowed in dollars when they were cheap and now faces rising debt repayments due to US Fed hikes. However, it does have less dollar-denominated debt than other African markets. In August the South African finance minister of the time, Nhlanhla Nene, said only a small percentage of the country’s debt is dollar-denominated which is helping to protect government finances from a weakening rand. Foreign-currency debt makes up less than 10% of the country’s total.
But servicing South Africa’s rand-denominated debt is also a concern. The country’s slow growth, unexpected finance minister reshuffle by President Zuma in December, and credit rating downgrades by global rating agencies, have all helped reduce investor confidence in the market. Coupled with the US now offering more attractive returns, South African government bonds have to pay much higher yields to compensate for their higher risk of default.
“There is a flight to safety within the fixed income market as the high-yield market goes through a bit of a spasm. And, as you will see with loans to non-investment grade countries and companies, the interest demanded on those go up at a far greater pace that the simple 25-basis-point rate hike from the Fed. There will be multiples of that because of the fact that investors are taking fright of what is happening in the high yields in credit market,” says Elliot.
“What has happened in the South African government bond market is a perfect illustration of this, whereby the 10-year borrowing rate has shot up in December – way more than you would have expected from a measly 25-basis-point rise from the US Fed.”
Imports more expensive, exports more competitive
With a stronger dollar, the South African rand buys less. This means that imports to South Africa will become more expensive, placing a strain on the country’s current account deficit.
A weaker local currency also means that South Africa’s exports should become more competitive globally. However, this offers little advantage as the prices of key exports, such as iron ore and coal, have fallen in dollar terms, notes Elliot.
“Weaker domestic currencies will help exports; there is no doubt about that. But the chief exports of Africa are in the form of commodities… A combination of the fall in demand in China, and oversupply in global markets, is leading to weaker [commodity] prices in dollars.”
He adds that if global commodity prices were stronger, the South African mining industry would theoretically benefit from the exchange rate. One of its biggest costs is labour, which is paid in rand. With a stronger dollar to the rand, labour costs would then fall in relation to their dollar earnings. Unfortunately, commodity prices remain weak and many mining companies are heavily in debt after borrowing extensively to expand capacity when prices were high.
But for those local firms exporting products and earning dollars, the strengthening US currency comes as a blessing.
What it means for the consumer?
The hike in South Africa’s repo rate (and any future increases) will mean higher borrowing costs for consumers, as debt becomes more expensive, continues Elliot. Mortgages, vehicle and bank loans will all become more costly. Banks might also become more conservative in extending loans.
Imported items, such as French champagne, vehicles and machinery, will also be more expensive for consumers with a weaker rand. A likely consequence will be cutbacks on discretionary spending by consumers.
“When you have a sudden rise in interest rates you always see a period of curving back [on consumer spending] when it comes to discretionary goods. And that is what we will see,” emphasises Elliot.
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