South Africa: The Financial Sector-Sovereign Nexus

Abstract

published comments and encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. ABSTRACT: Globally, financial institutions have increased their holdings of domestic sovereign debt, tightening the linkage between the health of the financial system and the level of sovereign debt, or the “financial sector-sovereign nexus,” during the ongoing COVID-19 pandemic. In South Africa, the nexus is still relatively moderate, albeit rising, and the increased focus of the Prudential Authority on the associated risks provide reassurance. Options to mitigate such risks through the use of regulatory measures can be explored. However, absent the necessary fiscal consolidation and structural reforms, risks from the nexus to both the financial system and the sovereign will increase. to the financial sector and vice versa. It surveys the literature on the fiscal cost of banking crises––strong linkages between banks and the sovereign could substantially weaken bank’s balance sheets, and government interventions have been found to be expensive in cases of banking problems in some countries. This nexus is likely to remain important, and the paper outlines some recommendations, in line with the 2021 Financial Stability Assessment Program (FSAP), on how to limit risks from the bank-sovereign nexus. The paper finds that the financial sector-sovereign nexus in South Africa is relatively moderate at present but warns about risks going forward. The large domestic investor base could help keep sovereign bond yields relatively stable. However, a continued increase of sovereign exposures could crowd out lending to the private sector and cap private investment. As fiscal risks increase further, such exposures could weaken financial institution’s balance sheets, and fiscal consolidation is the first line of defense. Meanwhile, the implementation of the Financial Sector Laws Amendment Bill (FSLAB), which seeks to reduce fiscal costs in the event of a bank failure, should also be accelerated. The Prudential Authority (PA) should continue monitoring the deepening financial sector-sovereign nexus to help maintain these institutions’ strength, particularly as macroeconomic conditions are expected to remain challenging.