SA economy could swing back to recovery next year - IMF May 07 2016 09:00 South
ID: 1111395 • Letter: S
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SA economy could swing back to recovery next year - IMF May 07 2016 09:00 South Africa's economy could swing back to recovery in 2017, says the International Monetary Fund (IMF), but cautions that Africa's second largest economy would have to stave off expected further shocks from China, heightened global financial volatility and sovereign debt credit rating downgrades a) Assume that the problems mentioned (shocks from China, credit rating downgrade, global financial volatility) do not arise and that the SA economy begins to recover in 2017. Assuming that this recovery is expected by the business sector, illustrate and explain how and why the current supply of corporate bonds, and hence prices and interest [7%) rates, will be affected. A recovery in economic growth means that revenues derived from taxes will increase; assuming that the level of government debt is held constant (as promised by the Minister b) of Finance), this means in turn that the Debt/GDP ratio will fall. Explain: Why it is necessary to use the Debt/ GDP ratio rather than the actual level of debt; How the fall in the Debt /Ratio is likely to affect international perceptions of the probability of sovereign default; Using US treasury bills as a basis for comparison, illustrate and explain how risk premium on SA sovereign debt is likely to be affected (you may take the rate on (7%) . US Treasury bills as given and thus do not need two diagrams). Assume that, prior to the event identified in a) above, a plot of the actual SA bond yield curve revealed it to be moderately positively sloped. With reference to the expectations theory only of the term structure of interest rates, explain what this would mean in terms of expected future short-term interest rates. Given your answer to a), how are these c) 15) expectations, and hence the slope of the yield curve, likely to be affected? Page 8 of 11Explanation / Answer
a. If it is expected that the recovery is expected by the business sector, then it will lead to increase in the supply of corporate bonds. The increase in the supply of corporate bonds will lead to decrease in the price of bonds. There is negative relationship between price of the bond and interest rate and thus decrease in the price of bond will lead to increase in the level of interest rate.
b. This is because debt GDP ratio gives us the level of debt in the economy relative to the level of Gross Domestic Product. Considering absolute values of GDP will make the comparison difficult as GDP will not be considered.
Decrease in debt GDP ratio will increase the investor sentiment and thus decrease the probability of sovereign default as debt GDP ratio has declined.
This will also lead to reduction in the risk premium on SA sovereign debt as business expectations will turn positive now.
c. Increase in the expectations will lead to increase in the expectations that interest rates will increase in the long run. The slope of the yield curve will steepen with the positive business expectations.
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