SOUTH AFRICA Selected Issues
Author: International Monetary Fund
Publication Date:
19 Sep 2005
eISBN:
9781451966763
Language:
English
Keywords:
ISCR; CR; government; break; asset quality; strength Index; market share; banking sector; capital adequacy ratio; Nonperforming loans; Insurance companies; Commercial banks; Housing prices; Africa
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This Selected Issues paper for South Africa presents a quantitative analysis of inflation dynamics in the country. The conduct of monetary policy has been complicated by a variety of unanticipated events that have had important effects on inflation. Exposed to exchange rate and other shocks, the model confirms that a delayed policy response to inflation shocks leads to persistently higher inflation rates and, subsequently, to a sharp real contraction of the economy.

Abstract

This Selected Issues paper for South Africa presents a quantitative analysis of inflation dynamics in the country. The conduct of monetary policy has been complicated by a variety of unanticipated events that have had important effects on inflation. Exposed to exchange rate and other shocks, the model confirms that a delayed policy response to inflation shocks leads to persistently higher inflation rates and, subsequently, to a sharp real contraction of the economy.

III. South Africa—Financial Sector Vulnerability1

1. This chapter summarizes the main findings of the financial sector surveillance work in the 2005 Article IV mission to South Africa.

A. Structure of the South African Financial System

2. South Africa’s banking system is deep compared to those in other emerging economies and its insurance sector has one of the highest penetrations in the world. The ratio of M3 over GDP reached 64 percent in 2004 and insurance company premiums stood at 16 percent of GDP in 2003, led by long-term (mostly life) insurers at 13 percent of GDP.

3. Banks and long-term insurance companies are the most systemically important financial institutions in South Africa. Assets of the banking system reached 109 percent of GDP and deposits 65 percent of GDP at end-2004. In contrast, assets of the long-term insurance sector fell slightly to 63 percent of GDP in 2004. Local capital markets, including derivatives, are well developed and securitization is growing rapidly. Stock and bond market capitalization reached 187 percent and 43 percent of GDP, respectively at end-2004.

Table III.1.

South Africa—Assets of the Financial System

(in percent of GDP)

article image
Sources: SARB, FSB, and Staff estimates.

4. The commercial banking sector is highly concentrated with no government ownership. Currently, the four largest banks are universal banks offering a full range of banking services and have a market share of 84 percent in terms of assets. If the fifth largest bank were added, the top five banks would have a market share total of 89 percent, a relatively high concentration by international standards (figure shows three banks due to data availability). As of December 2004, the banking system included 38 registered banks, of which 15 are locally controlled banks, 6 foreign controlled banks, 2 mutual banks, and 15 local branches of foreign banks. In addition, 44 international banks have non-deposit taking representative offices. The banking system also includes development and postal banks—which do not fall under the Banks Act—as well as microfinance institutions. Micro-loans outstanding reached 1 percent of GDP, and one bank accounts for about 35 percent of that total.

A03fig01

Share of three largest banks (in percent of total assets)

Citation: IMF Staff Country Reports 2005, 345; 10.5089/9781451966763.002.A003

Source: World Bank.

5. The penetration of foreign banks in South Africa increased substantially in July 2005. The recent acquisition of one of the four largest banks by a U.K. bank increased foreign presence to about 16 percent of total assets from 8 percent. Foreign banks are mostly active in corporate banking but the acquisition of a large domestic bank may challenge that business model.

6. Through mortgages, banks are mostly exposed to the household sector. At end-2004, mortgage loans and installment debt accounted for about 37 percent and 14 percent of total loans and advances, respectively. In addition, credit card debt is growing rapidly albeit from a low base to reach 2 percent of total loans and advances. In contrast, loans and overdrafts amount to about 25 percent of total as corporates increasingly issue their own paper. Foreign loans—of which 80 percent were extended to Europeans borrowers—stood at about 10 percent of total.

Table III.2.

Market Share of Banks and Long-Term Insurers

(In percent of assets and net premium income, respectively)

article image
Sources: Capital Intelligence Ltd (2003) and 2003 KPMG Survey.

7. Similar to the banking sector, a few insurance companies dominate the industry: five companies account for 68 percent of total net premium income. The insurance companies and pension funds are heavily exposed to the local equity market.

8. As in many mature markets, complex bancassurance structures have led to cross-ownership between the banking and the insurance sectors. No cross shareholdings between banks are permitted but insurance companies own shares in banks. Although risks appear limited, the cross-shareholdings between insurance companies and banks expose the financial system to possible contagion risk between the two sectors. A failure of one large insurance company could have negative spillover effects on the banking industry. The largest insurance company, Old Mutual, owns 53 percent of Nedbank, the second largest bank and 20 percent of Standard Bank, the largest bank. Similarly, Sanlam, the second largest insurance company owns 23 percent of Absa, the third largest bank.

Table III.3.

Large Insurance Companies’ Share in Large Banks

(in percent, 2004)

article image
Source: SARB.

9. The regulation of banks is governed by the Banks Act of 1990, which gives the Minister of Finance the prerogative to set out a series of regulations with directives and interpretations. SARB’s banking supervision department (BSD) supervises banks and the Registrar authorizes and cancels the registration of banks. In contrast, the financial services board (FSB) regulates and supervises nonbank financial institutions and the financial markets, in collaboration with self-regulatory organizations such as the securities exchanges. The Micro Finance Regulatory Council (MFRC) regulates the micro-lending industry.

B. The South African Financial System—Macroprudential Analysis

The macroeconomic environment

10. The macroeconomic environment continues to be favorable to banks. Buoyed by domestic demand, GDP growth remains strong. Real GDP grew by 3.7 percent in 2004 and 3.5 percent in the first quarter of 2005. Inflation has stayed in the 3–6 percent range since end-2003. Consumer spending remained buoyant led by an increase in disposable income, lower debt servicing costs, stronger consumer confidence and the wealth effects from higher property and other asset prices.

11. Interest rates have reached 24-year lows. The SARB has lowered its repo rate by 650 basis points since June 2003. As a result, mortgage rates—which are typically floating rates—fell to 10.5 percent and deposit rates on 6-month fixed deposits to 6.5 percent.

12. Property prices have been rising consistently over the last few years (year-on-year) and equity prices continued to increase in 2005. Increases in nominal house prices exceeded 35 percent in September 2004 but eased gradually thereafter. Similarly, month-on-month increases in house prices declined from a peak of 3 percent in January 2004 to 1 percent in July 2005. Low domestic interest rates and favorable growth prospects coupled with improved business confidence helped push up the JSE all-share index by 24 percent in real terms in 2004, and a further 8 percent in the first half of 2005.

13. Due to the sharp reduction in interest rates, bank credit to the private sector is growing rapidly, mostly on the back of strong household demand for mortgages. Loans and advances grew by 16 percent in 2004 and 18 percent in the 12-month period through March 2005. Mortgage loans increased by 26 percent in 2004. Installment debt increased by 21 percent and credit cards by 25 percent. In contrast, credit to the corporate sector (about 28 percent of GDP) increased by 9 percent in the last quarter of 2004.

Financial soundness indicators

14. Financial indicators point to a broadly sound banking and insurance system. Moody’s financial strength index ranks South African largest banks well in international comparisons. As of March 2005, the average capital adequacy ratio (CAR) was adequate at 12.9 percent (compared with a regulatory minimum of 10 percent). At end-2004, only one small bank did not meet the minimum CAR. Tier I capital represents about 71 percent of qualifying capital and reserves (before deduction of impairments) compared with the regulatory minimum of 50 percent.

15. Asset quality improved partly due to a favorable macroeconomic environment. In 2004, gross non-performing loans (NPLs) fell to 1.8 percent of total loans from 6.8 percent in 1999 in the aftermath of the Asian and Russian crises.2 Non-performing mortgage loans as a percentage of total mortgage loans decreased to 1.7 percent at end-2004. NPLs on other loans and advances and on installment sales also declined to 2 percent and 1.7 percent of their respective total loans.

Figure III.2.
Figure III.2.

Moody’s Weighted Average Bank Financial Strength Index (December 2004)

Citation: IMF Staff Country Reports 2005, 345; 10.5089/9781451966763.002.A003

Table III.4.

South Africa: Financial Soundness Indicators, 2001–2005

(Credit and Depository Institutions)

article image

March 2005 data.

Source: South African Reserve Bank, banks’ returns, and staff calculations.

16. The insurance industry also appears to be well-capitalized. The free assets of the five largest long-term insurers cover their capital adequacy requirements two to five times compared to a minimum of one.3 The long-term insurance sector is benefiting from a decrease in lapses and surrenders, as well as an increase in the number of new policies. In 2004, the number of new policies increased by 19 percent, while individual lapses and surrenders of policies for long-term insurers fell to 24 and 20 percent.

17. Banks’ asset quality is healthy and provisioning remains adequate. Non-performing loans net of provisioning are equivalent to 6.1 percent of capital at end-2004. Specific provisions covered about 64 percent of gross NPLs at end-2004. As a result, banks’ reliance on collateral has decreased over time to amount to about 36 percent of overdues in contrast to 55 percent in 2001. This trend is encouraging as South African banks have relied heavily on collateral value in the past, as pointed out by the FSAP.

18. Large exposures are well below the regulatory maximum of eight times capital and reserves.4 As of March-2005, large exposures (including to government and interbank settlements) represent 5 times net qualifying capital and reserves in contrast to the peak exposure of more than 15 times reached in 2002. The utilized portion of large exposures, which historically has always been below the granted amount, stand at about 1.3 times net qualifying capital. NPLs on large exposures decreased also.

19. Corporate sector vulnerabilities seem to be limited. Corporate exposures of banks have performed well although some companies have been affected by the strengthening of the rand5. In general, corporate indebtedness is relatively low with an average gearing ratio below 40 percent and profitability is healthy with an average ROE of 25 percent.

Table III.5.

Financial Ratios for the Nonfinancial Corporate Sector, 1998–2004

article image
Sources: Worldscope; and IMF staff estimates.

Current assets to current liabilities.

Earnings before interest and taxes (EBIT) as a share of sales.

EBIT in percent of shareholders’ equity.

20. Banks’ profitability increased significantly in 2004 from already healthy levels in 2003. ROE (after-tax and 12-month moving average) reached 15 percent in 2004 from 11 percent in 2003. ROA (before tax) improved to 1.6 percent in 2004 from 1.3 percent in 2003. This higher profitability translated into higher share prices as the banking index outperformed the overall share index.

Figure III.3.
Figure III.3.

Banking Sector-to-Total Stock Market Index Ratio

Citation: IMF Staff Country Reports 2005, 345; 10.5089/9781451966763.002.A003

21. In spite of their healthy profitability, South African banks are not as efficient as in mature markets. Operating expenses are relatively high at 3.5 percent of assets and 64 percent of gross income in 2004. Operating expenses increased by 13 percent in 2004, driven by a 17 percent growth in total staff expenses, which accounted for about 55 percent of total operating expenses.

Table III.6.

South Africa—Profitability of Banks

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Sources: SARB and Staff estimates.
Table III.7.

Profitability of Major Banks, 2004

(In percentage of total average assets)

article image
Sources: BIS, Reserve Bank of India, and Staff calculations.

C. Potential Sources of Vulnerability

22. Liquidity risk indicators are high but manageable. As of end-2004, banks’ liquid assets stood at 114 percent of their statutory liquid-asset requirement compared to 116 percent at end-2003. High loan-to-deposit ratios and banks’ reliance on short-term wholesale deposits (43 percent of total funding) pose a risk which is, however, mitigated by an emerging trend toward securitization of mortgage and car loan books. In the past, a relatively small institution (then the sixth largest bank and now part of one of the top four banks) faced a deposit run from its wholesale depositors and ended up seeking liquidity assistance from the authorities, which provided a temporary government guarantee to its depositors.

23. Foreign exchange risk indicators point to little vulnerability. Banks’ net effective open position (NOFP) is limited by the regulator to 10 percent of qualifying capital and reserves (or lower if deemed necessary). The net open position in foreign currency remained stable at 1 percent of capital and reserves in March 2005.

24. Banks are increasingly exposed to the property sector through residential mortgages, a trend similar to that in other mature markets. As a result, a flattening or reversal of house price growth could reduce mortgage activity and fee income, as evidenced by developments in Australia and the U.K. over the past five years. Mortgage loans in South Africa have increased rapidly in recent years and reached 37 percent of total loans and advances. NPLs on mortgage accounts decreased to 1.7 percent of these accounts in December 2004, but banks still rely somewhat heavily on mortgage collateral as provisions covered just 38 percent of NPLs on mortgage loans.

Figure III.4.
Figure III.4.

Residential Mortgages

(5-year cumulative growth, percent)

Citation: IMF Staff Country Reports 2005, 345; 10.5089/9781451966763.002.A003

Sources: BIS, SARB, Staff estimates.

25. Residential mortgages in South Africa typically carry variable rates, which expose households to an increase in interest rates. A marked rise in interest rates could immediately affect the debt servicing capacity of households and thereby banks’ asset quality.

26. Household indebtedness has increased recently reflecting the large fall in interest rates. As a result, the ratio of household debt to disposable income increased from about 49 percent at end-2002 to 57 percent at end-2004, the highest level recorded since 1999. The ratio remains, however, below the 1996–98 peak of 60 percent.

Figure III.5.
Figure III.5.

Households Debt-to-Income Ratio

Citation: IMF Staff Country Reports 2005, 345; 10.5089/9781451966763.002.A003

Sources: IFS and Staff estimates.

27. Household debt has, however, become more affordable. Real household disposable income increased in 2004, partly due to wage settlements above the inflation rate and lower income tax rates. This has contributed to the fall in the debt servicing cost of households as a percentage of disposable income—the income gearing ratio—to 6 percent in 2004 from 8 percent in 2003. The ratio of mortgage repayments to disposable income—the RDI index—also suggests that there has been limited deterioration in affordability in recent years. In addition, the number of household and corporate insolvencies decreased by 42.4 percent in 2004.

28. Real estate prices in South Africa have grown very rapidly in recent years. Since 1997, the growth rate of housing prices in South Africa has been the highest in a large sample of economies. More recently, annual growth in house prices reached their peak in September 2004 with 35.5 percent, and have eased to 21 percent in July 2005, about 17 percent in real terms.

Figure III.6.
Figure III.6.

Real House Price Indices 1997–2005(Q1)

Citation: IMF Staff Country Reports 2005, 345; 10.5089/9781451966763.002.A003

Sources: The Economist and Staff estimates

29. The rapid growth of real estate prices has been in part supported by fundamental factors. These include higher disposable income following gradual reductions in personal taxes and transfer costs. Economic growth has also increased the income of previously excluded communities while broadening their access to the housing market. In addition, the emergence of securitization of mortgage assets and the extension of the duration of mortgages are also important.

30. For a more analytical assessment of financial stability, staff has conducted a stress test designed to assess the banks’ ability to absorb potential losses due to adverse ecomomic shocks to their mortgage portfolio. A worst-case scenario is assumed on the basis of past experience. In South Africa, the highest level of NPLs for mortgage loans was 7 percent of total mortgages in 1999, after interest rates increased sharply in late 1998. Also, following the house price boom in the early 1980s with its peak in 1984, house prices fell by over 40 percent in real terms within three years.

Table III.8.

Stress Testing the South African Banking System’s Mortgage Portfolio

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SARB (Banking Supervision Department 2004 Annual Report) and Staff calculations

NPLs include substandard, doubtful and loss mortgage loans. Substandard loans are assumed to be equal to 40 percent of overdues (doubtful + loss).

Specific provisions and the market value of collateral cover 105 percent of NPLs

Specific provisions are equal to 38 percent of NPLs

Provisioning rates are 20, 50, 100 percent for substandard, doubtful, loss loans, respectively.

31. The stress test assumes that the banking system experiences an increase in mortgage NPLs to 7 percent and a 50 percent drop in real estate prices, which would bring real estate prices back to early 2002 levels and reduce collateral values in the same proportion. We find that under such a scenario and using the aggregate banking mortgage portfolio as of December 2004, the average CAR of the banking system would fall to about 11.3 percent from 13.3 percent. This drop is significant, but the average CAR would still remain above the regulatory minimum of 10 percent. A limitation of this exercise (imposed by data availability) is that it is based on the aggregate banking sector’s portfolio and average financial soundness indicators. This approach, therefore, cannot capture the fact that individual institutions might be much worse off and some banks could potentially become undercapitalized as a result of the shocks under consideration. Stress tests undertaken by the SARB have concluded that the banking sector is resilient to a range of plausible adverse macroeconomic events, including a deterioration of banks’ mortgage portfolios.

D. Conclusions

32. Continuation of a supportive macroeconomic environment and healthy financial soundness indicators should help the South African financial system weather adverse shocks. However, as in many mature markets, banks’ high level of property exposure is a source of vulnerability. In spite of the relative soundness of the South African financial sector, the balance of risks warrant a close monitoring of real estate prices and the household sector. The authorities are cognizant of these issues and have initiated since 2004 a review of the main risks to financial stability in the context of a semi-annual financial stability review. The authorities are also implementing a number of actions to further strengthen and develop the financial system, including FSAP recommendations on the supervisory framework.6 These actions include steps to help banks prepare for the move to Basel II by January 2008 and for the planned introduction of a deposit insurance scheme.

E. References

  • Ballim Goolam and E. Moolman, 2005, “Is Debt About To Fall Under Its Own Weight?” Standard Bank, South Africa, 16 March 2005.

  • BIS, 2004, “75th Annual Report”, (Basle: Bank for International Settlements).

  • The Economist, 2005, “The Global Housing Boom”, Special Report, June 18th, 2005.

  • Financial Services Board, 2004, “Annual Report 2004”, Pretoria.

  • Funke, Norbert, 2004, “Asset Prices and Monetary Policy: Some Lessons from Industrial Countries for South Africa”, South Africa: Selected Issues, IMF Country Report No. 04/379, pp.18–34, www.imf.org.

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  • Reserve Bank of India, 2004, “Report on Trend and Progress of Banking in India, 2003-04”.

  • Selialia L. F., P.V. Mabuza, K. C. Matlapeng, and T. T. Mbeleki, 2003 “Effects of Macroeconomic Developments on Credit Risk of the South African Banking Sector: A Stress Testing Approach”, South African Reserve Bank Working Paper.

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  • South African Reserve Bank, 2004, “Annual Report 2004”, Bank Supervision Department, Pretoria.

  • South African Reserve Bank, 2005, “Financial Stability Review”, March 2005, Pretoria.

  • South African Reserve Bank, 2005, “Quarterly Bulletin,” June 2005, Pretoria.

1

Prepared by Amadou Sy (MFD).

2

In South Africa, “NPLs” or “overdues” comprise “doubtful” and “loss” loans. In most countries, substandard loans are added to “doubtful” and “loss” loans to calculate NPLs. If substandard loans were included in the definition, then NPLs would amount to 2.6 percent of total loans as of end-2004.

3

The capital adequacy requirement is defined to be the minimum capital required by the Financial Services Board for registration of an insurance company and is equivalent to 13 weeks’ worth of operating expenses. Free assets refer to the difference between total assets on the one hand and the sum of total liabilities and required capital on the other hand. The ratio indicates the number of times the capital adequacy requirement is covered by free assets. A current ratio of two-to-five times is generally considered sufficient coverage.

4

Exposures granted (excluding those to government and interbank settlements) that exceed 10 percent of capital and reserves should not exceed, in total, 8 times the level of capital and reserves. In addition, any single exposure exceeding 25 percent of capital should be an impairment against the capital of the bank.

5

Exposure has increased among some corporates which incur costs in rand but earn revenues in US dollar.

6

These measures are described in the staff report for the 2005 Article IV consultation, www.imf.org.

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Cover IMF Staff Country Reports
South Africa: Selected Issues
Author: International Monetary Fund
Volume/Issue:
Volume 2005: Issue 345
Publisher:
International Monetary Fund
ISBN:
9781451966763
ISSN:
1934-7685
Pages:
99
DOI:
https://doi.org/10.5089/9781451966763.002

Share of three largest banks (in percent of total assets)

Moody’s Weighted Average Bank Financial Strength Index (December 2004)

Banking Sector-to-Total Stock Market Index Ratio

Residential Mortgages

(5-year cumulative growth, percent)

Households Debt-to-Income Ratio

Real House Price Indices 1997–2005(Q1)