Global debt vulnerabilities, financial repression, and the cost of carry.

The stock of global debt has been rising faster than GDP for the last 50 years. In the United States (US), credit extended to the non-financial sector was equivalent to little more than 130% of income in 1973. By 2020, this ratio had reached an all-time high of 294%. Aggregate private sector debt remains above the level which prevailed at the start of the global financial crisis (GFC) of 2008/09. Global government debt is also substantially higher than 2008 levels, as subsequent recessionary periods have been counteracted by increasingly aggressive fiscal stimulus, particularly in large economies.

In the presence of such unprecedented debt accumulation, the world’s vulnerability to a systemic financial crisis has increased materially. Profitable assets, viable under specific interest rate conditions, can become unsustainable when policy rates are hiked rapidly. It is no wonder then that questions over debt sustainability are re-emerging in the popular macroeconomic discussion. An inflation scare has led central banks to raise short term interest rates across the global financial system. Private sector debt servicing costs in several major economies, including China, France, Canada, the US and the UK, may now be at, or above, levels which triggered prior financial crises.

The threat of recession, and the lack of fiscal capacity to deal with a growth slump, is politically intolerable. To avoid a prolonged austerity, debt-vulnerable economies will thus require long-term borrowing costs to remain below the inflation rate for the foreseeable future. Financial repression aimed at achieving precisely this is not uncommon in history. The accumulation of massive government debt during World War II was eroded successfully by decades-long restrictions on capital flows implemented under the Bretton Woods system. Many would argue that central bank bond purchase programmes after 2009 were aimed at directly reducing the cost of borrowing across advanced economies. The case for maintaining negative real interest rates may be even stronger now than in 2009, as global debt continues its march higher.

Of course, not all economies are characterised by such critical sensitivity to interest rate changes. Where private or public debt dynamics are more stable, governments may be more willing to allow independent forces to shape the interest rate curve. The foreign exchange (FX) implications of this dichotomy cannot be understated. In South Africa, for example, monetary policy has been calibrated at a relatively tight level as the Reserve Bank has been tasked with taming inflation over the last 20 years. At the same time, RSA government borrowing costs have been largely market-determined, through freely floating bond yields. As a result, if you had invested ZAR100 in the South African money market at the beginning of the millennium, your investment would have grown to ZAR555 by the end of 2022*. By contrast, if you had invested your ZAR100 in USD, it would be worth ZAR433, a 28% underperformance. 

The over-simplified narrative of a “weakening” ZAR has clearly neglected the role of real interest rate differentials between RSA and other major economies. The FX market is, after all, nothing but a conduit between interest-bearing money markets denominated in different currencies. In fact. for an investor with predominantly ZAR liabilities, the ZAR investment has been unambiguously superior over the last 22 years – delivering generally positive real returns at significantly lower volatility. The past, however, is not always a reliable gauge of the future. 

South Africa faces its own problematic debt dynamics , which may create fertile ground for conditions of financial repression in future. The return on South African assets could decline in this scenario, causing the ZAR to depreciate well beyond interest rate differentials. Many investment professionals agree this is a risk worth diversifying, in some way. However, going offshore cannot simply be a question of USD vs ZAR. With debt-sustainability problems building across many of the world’s largest economies, it will be smaller, emerging markets that can most afford to pay positive real interest rates over time. History suggests that this will be an important driver of total offshore returns.

*Using 3-month interbank rates