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What is South Africa’s debt to GDP? Recent issuance by state-owned electricity utility Eskom should give investors pause.
On August 2, 2018, Eskom issued a $1bn 10-year bond guaranteed by the South African government at a yield of 6.35%, vs. 5.69% for 10-year South African government debt on that day.
At the end of 2017, South Africa’s government debt to GBP ratio stood at 53%, and while the government has guaranteed the debts of various state-owned enterprises, including Eskom, for several years, few consider the true nature of the guarantees.
The bonds that bind
Guarantees normally work as follows for a debt holder. If my borrower does not fulfil their obligations, I take recovery action against them and, assuming I have a shortfall, then I turn the provider of the guarantee to make up the shortfall.
The guarantor is only liable for any shortfall after all the value available at the borrower is exhausted. It is truly contingent on both the borrower not fulfilling their obligations and their being insufficient value in the borrower to cover the guaranteed debt.
However, Eskom’s guarantees are different.
In the case of Eskom, if the company fails to meet its obligations, rather than take recovery action against the utility, bondholders turn to the government to make the payment.
This does not cause Eskom to default, as would be typical, and neither does it offer the opportunity for bondholders to declare their debt due and payable, providing the government makes the payment, as would be typical.
If the government fails to make the payment, bondholders are not able to take recovery action against Eskom despite it being the borrower of the funds.
Limited options
As a result, Eskom would have to seek repayment from the government. While the sovereign has waived its right to immunity as part of the deal, there are several carve-outs, leaving bond investors with relatively few options.
A further complication is the requirement on the part of Eskom under the guarantee to use any available cash to fund payments to un-guaranteed debt prior to payments on government guaranteed debt.
As a result, rather than being Eskom debt with a government guarantee, these bonds, and other guaranteed debt issued in local markets, appears to be more akin to government debt that Eskom has the option to pay, if it is able.
So why does this matter?
The trouble with debt
The travails of Eskom are well reported, as the company has been embroiled in various corruption and bribery allegations, with the latest FY18 financial statements including a qualified audit opinion regarding R20.7bn of 'irregular expenditure' and R1.5bn in losses from criminal conduct.
Over the last five years, the company’s cumulative free cash outflows amount to nearly R220bn.
With total debt representing 8.9 times the group’s annual earnings before interest, taxes, depreciation and amortisation (EBITDA) and R61.6bn of debt due within twelve months of March 31, 2018, the company’s situation would be unsustainable, were the company in the private sector.
Due to Eskom’s weak performance, investors should weigh the likelihood of the guarantees being called.
If all R268bn of guaranteed debt landed on the government’s balance sheet, we estimate that this would raise South Africa’s debt to GBP towards 70%, rather than the 53% disclosed by the government for 2017.
Public debt in the country is forecast to rise to 57% by 2020 according to Factset estimates, even prior to any further support for Eskom. Further cash burn by the utility that requires government support to finance will raise debt / GDP above 70% as per our estimates.
Recent weakness in emerging markets, driven by the situation in Turkey, saw the rand tumble at speed. Ensuring the stability of Eskom is crucial to ensuring South Africa’s own stability, given the intimate ties between the company and the Sovereign.
To do so will be difficult. The World Bank estimates that Eskom needs only 14 000 of its current 47 000 employees, while management currently estimate that the optimal staffing level is 33 249.
Further, Eskom is owed R14bn from municipalities in the country. Several of the group’s coal-fired power stations are no longer able to source adequate supply from their tied mines which is likely to add cost to the group.
Eskom’s board is due to present a new strategy at the end of September 2018. Any new strategy must not only ensure the bleeding stops at Eskom, but should also aim to remove the interdependence between Eskom’s debt and the government.
*Nick Smith-Saville is Head of EMEA Credit Research at Debtwire.
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