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Companies, states and risk premiums

One of the goals of a company is to reduce its risk premium that the market assigns to it through the price of equity and bonds/loans. Reducing the risk premium generally decreases the cost of funding and increases the value of equity which are good for shareholders and staff. All staff have a part to play in risk reduction however executives are explicitly compensated to conduct risk reduction strategies. Note risk and the risk premium are ephemeral quantities and we have to proxy it as investors.

Usually the chief financial officer (CFO) has the responsibility to translate these strategies into balance sheet and income statement impacts. Therefore effective CFOs should have the experiential discretion to pump the brakes or push the accelerator on the funding for proposed projects thereby creating sustainable asset and revenue creation. Some CFOs engage in the grey art of regulatory and tax arbitrage to maximise free cash flow as well. One method to reduce the risk premium is to deconstruct the financials into an array of variables and then take action that moves them in the right direction. By taking positive actions that aggregate to higher earnings at a lower volatility, the market will reduce the risk premium through higher price to book/equity/sales metrics or credit ratings upgrade. This is no easy task for a CFO. Risk and risk premiums are complex spaces, for example the CFO (and the executive team) of Netflix versus General Electric have to take very different actions to keep the market happy on average. Cutting costs, a good thing, might increase the risk premium for Netflix while decrease it for General Electric. In all cases though the unit of measurement of action and success is currency. We will leave the influence of the Board and active vocal investors out for now. It is also very important to note that the risk premium is time variant as well. By the way a CFO who spends the time only drafting financial statements with the thoughtless 5% variance estimates is completely pointless, relative to the pay.

Now one can cast the CFO role onto the Minister of Finance (MoF). The balance sheet and income statement type items can be translated to its equivalent public finances macro-economic type items (like aggregate demand, debt/GDP, primary balance, tax, etc.). Loosely speaking, the public sector equivalent of balance sheet management is known as fiscal policy. The MoF needs to pump the brakes and push the accelerator on funding for projects emanating from other ministries and departments such that it delivers the appropriate fiscal impulse. Broadly commentators classify "cost cutting" as austerity and "investment" as stimulus. Taking and measuring the appropriate fiscal actions will lower the national risk premium which can be proxied by higher sovereign credit ratings. However the MoF (and the central bank) has additional complexity over and above a private firm. As opposed to just maximising and minimising a vector of variables the MoF has a matrix of factors that are measured in both currency and votes. It is an almost impossible task to generate a combined distribution measured in votes and currency. In many emerging markets the problem is acute because of the polarised demands from financiers and society on the fiscus i.e. fiscal buffers versus state spending respectively. One just has to observe election trends (brexit, populists, fascists, etc.) and government spending in the recent decade to get the sense of the conflict between fiscal prudence and the constituency. Corporates and governments alike cannot ignore the influence of the active vocal minority on planned objectives and the risk premium. Dark forces motivated by greed and vanity is of serious concern but can't be tackled through balance sheet or fiscal management. On average lowering the country risk premium leads to lower cost of funding for the entire population and enables business and capital formation which is a gift that keeps on giving in the form of total tax collected and access to local infrastructure, goods and services for the people.

South African (SA) fiscal and monetary policy over the last 30 years is an excellent candidate for a case study on risk premium dynamics, both the financial risk premium and the social risk premium (rich data is available). An analysis of the actions of the South African private sector displays risk premium mitigation which appears to be counter cyclical to the fiscal policy at first glance, a case of private sector reserves perhaps.

Now that South Africa is in fiscal bind and government is in desperate need to stimulate aggregate demand and productivity. There are some relatively cheap fixes that can stimulate demand and confidence that reduces the national risk premium without materially increasing fiscal deficits. In the short term, the new MoF can reference the good old IS-LM model albeit its simplicity. The three critical exogenous variables in the IS-LM model are liquidity, investment and consumption. SA does not have a liquidity problem while the levels of investing and consumption are determined by the marginal decisions of individual actors. The "thuma mina" campaign is a good start to swing further investments and consumption by local and foreign investors into SA, however the MoF needs to demonstrate government's contribution. The recent roll back of inane visa rules is a good start for growth in tourism. Further rollbacks and simplification of excessive regulations in telecoms, labour, permits, policing and a reduction in the turf war between municipalities, provinces and national legislatures would go a long way in assuaging the hurdles to economic activity. To amend legislation costs nothing more than parliamentary votes. It should be noted that foreign investors require regulation, tax and cost arbitrage between their home and host to compensate for the additional risk premium of foreign emerging markets. To appease the public the government must "hang and quarter" (figuratively obviously) those who engaged in deep dark corruption and fraud. The MoF needs a buffer between the active populist minority such that the MoF can focus on pumping the brakes and pushing the accelerator toward a sustainable path of fixing the fiscus and thereby reducing the bond market risk premium. These are just some actions available to the MoF, there is much more value to be unlocked through privatising, cutting the red tape and permitting free trade in the ZAR currency union. In addition one should not under estimate the power of honest and candid communication that government owes the people, the private sector can pick up the pace if government can demonstrate integrity.

At the moment SA is trading at an above average risk premium in the bond and equity markets which is not inappropriate. I am trading it like a commodity right now but I am moving towards buy and hold, the recent global sell-off is helping.

Happy trading!

*I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company/government mentioned in this article. This does not constitute investment or management advice.


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