Funding government and State-Owned Enterprises (IX) - Conclusion

12 February 2020

The series deals with the following topics:

Introductory brief.

Pension funds.

Funds regulated by the Registrar of Pension Funds.

The Government Employees Pension Fund and other public sector funds not regulated by the Registrar of Pension Funds (1)

The Government Employees Pension Fund and other public sector funds not regulated by the Registrar of Pension Funds (2)

Funds other than pension funds which might be required to finance SOE’s

Country comparisons (1).

Country comparisons (2).

Conclusion.

Briefs 1 and 9 summarize the approach and findings, and they will be published first. Shortly thereafter, Briefs 2 to 5 will be published, and finally Briefs 6 to 8.

INTRODUCTION

If government were to go ahead and pass legislation that requires financial institutions to place a fixed percentage of their investments in prescribed assets, this could have a very real negative impact on financial institutions as well as the economy as a whole. Specifically, it could lead to the following negative outcomes:

Undermining government’s fiscal discipline.

Undermining the effects of market discipline as applied to SOE and government run projects.

Misallocation of funds away from deserving projects.

Erosion of investment value due to lower than market returns for investment funds.

Fiduciary duties of fund managers being superseded by regulations.

Asset / liability mismatches for pension funds, banks, and insurance companies.

Defined benefit pension funds not being able to meet their pension payment requirements.

Tax payers having to fund a shortfall at the GEPF.

Reduced incentives to save for retirement.

A negative impact on the stock-market and the country’s overall financial stability.

Decreased foreign investment in government bonds and SOE debt and government funding shortfalls.

Crowding out growth inducing private sector investment.

A slow-down in economic growth.

Hyper-inflation.

Distorted portfolio valuations.

Decreased liquidity in the bond market.

1. Undermining fiscal discipline

A study conducted by the World Bank in 1994, titled Developing a Domestic Funding Strategy for South Africa’s Public Sector, covered the experience of several countries that instituted a policy prescribed assets when it was popular in the 1960s and 1970s. The study found that:

“Prescribed investment policies have generated mostly negative results, and in a significant number of instances they have been financially catastrophic. The fundamental difficulty with prescribed asset programs is that, because they permit governments to commandeer financial resources, governments tend to view them as a source of virtually free funds, an attitude which severely undermines fiscal discipline. An economy's scarce financial resources are perceived to be plentiful, making it relatively easy for the government to misallocate them. The reports in South Africa that the contractual savings industry represents a huge source of funds that should be tapped to finance social upliftment reflect a comparable attitude. Prescribed investment programs in many countries have eventually led to negative economic growth and hyperinflation.”[1]

With South Africa’s debt-to-GDP ratio possibly nearing 80% within the next decade, any policies that disincentivise fiscal discipline should not be adopted.

2. Undermining market discipline

Forcing investors to fund specific state-owned-entities or projects will remove the incentive for these entities and projects to compete in the open market for funding through performance. Fiscal discipline would be undermined due to complacency created by a guaranteed supply of funding, so will South Africa’s government run enterprises and projects continue to under-deliver. These effects amount to moral hazard, with adverse consequences for service delivery and economic growth.

3. Misallocation of funds

The flip-side of point 2 is that investment funds are a finite resource, and driving funds to prescribed assets may well mean that more deserving projects that could drive sustainable growth are unable to raise the required capital.[2]

4. Erosion of investment value due to diminished returns for investment funds

Making investment funds instruments of government policy will result in lower than market returns for the beneficiaries. A large-scale forced asset allocation will most likely result in an imbalance between desirable projects and investment funds, with fund managers chasing after the same assets, i.e. those prescribed assets which are considered sought after. This excess demand will artificially decrease the return on these assets while increasing the risk to funds that have no choice but to invest in the less desirable assets, with the result being an erosion of fund value.

It will also limit a fund manager’s ability to allocate assets in reaction to market conditions. Not only will this cause lower than market returns, it may also cause negative real returns, which is what happened during apartheid’s prescribed assets policy era.

Since 2004, the average return for equities represented by the JSE All Share Index has returned 18% per annum, whereas the All Bond Index returned 9% per annum.[3] As shown in the brief on quantitative evidence earlier in this series, to illustrate the diminished returns, we created a capital levy spreadsheet/Excel model which calculates the capital levy (the net present value of the drop in returns) that could occur over 10 years as a result of prescribed assets as a percentage of total investments.

Using mid-market inputs in the left-hand-side table below, we get 10 year capital levies (effective cost to investors) as per the three different percentages of prescribed assets shown on the right:

5. Superseding of fiduciary duties

The lower than market returns for the beneficiaries, resulting from making investment funds instruments of government policy, would be counter to the fiduciary duty of fund managers to act in the best interests of its members – as per Regulation 28 of the Pension Funds Act for example. It would also be against the best interests of the beneficiaries to force fund managers to invest in loss making SOEs such as Eskom.

6. Asset / liability mismatches

Forcing the hand of financial institutions in asset allocation could very likely result in mismatches between the institution’s assets and the liabilities it needs to service. Asset / liability matching seeks to ensure that, first, the institution’s assets are growing at a rate of return which at least matches its liabilities and, second, that liquid assets are available to service the liabilities as and when they become due. 

a. Pension funds
As an example, consider a pension fund with a large portfolio of unit trusts, which qualify as appropriate investments for pension funds. Currently unit trusts hold around R2.3 trillion in aggregate, of which R350 billion is in money market assets with short term maturities of one day to a year. Forcing some of these investments into long-term government and SOE debt could lead to mismatches between the pay outs a fund is required to make and the liquid assets available – which would lead to major complications for both the funds and those relying on the pay outs, such as pensioners. Furthermore, most unit trusts allow daily liquidity for investors, which is not suited to long-term buy and hold strategies.[4]

b. Banks
A bank’s liabilities are the deposits it holds and the interest it is obliged to pay on the deposits. Its assets are loans for which it receives interest. Investment portfolios also form a part of bank assets which are used to ensure that their liabilities are matched and serviced when needed. Limiting a bank’s freedom to choose its investments given its liabilities will increase the risk of an asset / liability mismatch, forcing the bank to hold larger reserves, thereby decreasing the amount of loans it can make to the public, which would harm the country’s economic growth.

c. Insurance companies
The products offered by insurance companies require a premium for the service of receiving pay out for a claim when an incident occurs or a financial milestone is triggered. Thus, in order to match their investment assets (made up of premiums) with potential liability pay outs, insurance companies use sophisticated modelling strategies that integrate statistical probabilities of potential outcomes which may require large lump sum pay outs to customers. As with banks and pension funds, limiting an insurer’s freedom to choose its investments given its liabilities will increase the risk of an asset / liability mismatch. This is especially true for short-term insurers, because SOE and government debt are both long term investments.

7. Defined contribution pension funds

Unlike in the past, the vast majority of retirement funds today are defined contribution funds as opposed to defined benefit funds. With defined benefit funds, pension payments at a specific level were effectively guaranteed as the responsibility fell on the employer to see that they were funded. With defined contribution funds however, pensioners (and workers) are directly affected by the risk and return of the funds into which they have contributed their pension contributions. Therefore, maximising returns at acceptable levels of risk should be the pension fund’s only consideration.

Furthermore, defined contribution funds often offer their beneficiaries daily pricing and liquidity, which will become more difficult with an increase in long-term illiquid investments, such as infrastructure, which is likely to occur under prescribed investments.[5]

8. The GEPF

What about the county’s largest pension fund, the Government Employees Pension Fund (GEPF), which is a defined benefit fund; will it be able to avoid any difficulties if prescribed assets are applied to it? Unfortunately not, for the exact reason that it is a defined benefit fund and its pension payments need to reach the predetermined absolute level guaranteed by the employer, namely government. Government would therefore have to stand in to cover any shortfall, placing additional pressure on the already overburdened fiscus and tax-payers.

9. Reduced retirement savings

A limitation on the rights of pension funds to make choices about fund allocation and associated risks and rewards could reduce the willingness of pension fund members to save for retirement, which is counter to government’s aim to encourage savings through preferential tax treatment. Reduced retirement savings will cause future social issues and increase the burden on the fiscus in trying to deal with these.

10. The stock-market and financial stability

South Africa’s various categories of fund managers currently hold over R10.8 trillion in stock. This stock has been accumulated over a long time period, and the sudden and potentially very large scale sale of shares that will be required to move funds into prescribed assets will have a negative impact of the stock-market, with the potential to affect the country’s financial stability.[6]

11. Foreigners holding government debt and government funding shortfalls

Foreign investors are the single largest holders of South African government debt, holding 36.9% of total outstanding debt.

There is the risk that prescribed assets could discourage foreign holdings of local debt (government or SOE) because it will create artificial demand for bonds, resulting in lower yields. While this would be good for current holders of the debt, there will be a point where foreigners are not compensated for the risk in real terms and they decide to sell their holdings. The resulting oversupply would be too much for local savings/investment funds to absorb, resulting in a funding shortfall for government.

The resulting oversupply from foreigners eventually selling out of their bond holdings would be too much for local savings/investment funds to absorb. An inability to sell all of its bonds will cause a funding shortfall for government.

12. Crowding out of the private sector

The consequences of prescribed assets in point 7 above will be government crowding out the private sector due to less savings/investment funds being available for private sector borrowing, as a part of domestic savings is absorbed by government debt. Prescribed assets may also suppress the demand for other important asset classes, such as listed equities and corporate debt.[7]

13. Slow-down in economic growth

Crowding out of the private sector tends to coincide with periods of lower fixed investments and suppressed growth rates, especially if there is concurrent policy uncertainty.

14. Hyper-inflation

As noted in point 1 above, a study by the World Bank found that many of the countries that implemented a policy of prescribed assets in the past experienced hyper-inflation. This was due to the erosion of fiscal discipline the policy brought with it, and the countries then had to start printing money to pay back their debt obligations.

15. Distorted portfolio valuations

In order to meet the minimum prescribed holdings requirements for bonds, there is a real risk that portfolio managers will inflate the value of their bond holdings when marking them to market for portfolio valuation purposes. The distortion becomes easier when bonds are illiquid, as happened during the prescribed assets policy era in apartheid South Africa.

16. Decreased liquidity in the bond market

During the prescribed assets policy era in South Africa from 1956 until 1989, bonds were valued at the lower of their cost or redemption value, resulting in big discounts in their pricing and hardly traded because investors did not want to sell a bond at a loss. If they did they would have to buy more to top up on their prescribed requirements.[8]

CONCLUSION

As history has shown, without a strong macro-economic base and strict fiscal discipline, both of which are lacking in South Africa, the policy of prescribed assets has proven highly counter-productive, if not disastrous, for the countries that chose to take it on[9]. Even when the two prerequisites were in place, the effect was hardly noticeable and the policy abandoned.

Ultimately, imposing investment allocations from the top and ignoring market signals that call for proper governance of SOEs and other public institutions, will not help to incentivise public officials to improve their performance. Instead it will encourage them to kick the inefficiency can further down the road. In addition, a number of SOEs in any event hold both a monopolistic and regulatory advantage. This will also cause at least some of the negative consequences listed in points 1-16 above, which South Africa cannot any longerafford to bear.

By Charles Collocott, Policy Researcher, HSF, 12 February 2020

[1] Elena Folkerts-Landau, The World Bank Southern Africa Department, Developing a Domestic Funding Strategy for South Africa’s Public Sector, May 1994, p28.

[2]www.asisa.org.za

[3]Nedbank CIB Fixed Income Insight, 18 January 2019, p4.

[4]https://www.iol.co.za/personal-finance/investments/opinion-prescribed-assets-lessons-from-the-past-20092007

[5] ASISA, The Reality of Prescribed Fund Assets – and other Interventions, slide 18.

[6]https://www.iol.co.za/personal-finance/investments/opinion-prescribed-assets-lessons-from-the-past-20092007

[7]https://www.iol.co.za/personal-finance/investments/opinion-prescribed-assets-lessons-from-the-past-20092007

[8]https://www.iol.co.za/personal-finance/investments/opinion-prescribed-assets-lessons-from-the-past-20092007

[9]Zambia, Nigeria, Ghana and Egypt and most Latin American countries