The city of Detroit very recently decided to default on its municipal bonds. While this still needs to be confirmed by a Federal judge, it was not completely unexpected given the slow but sure decline in the tax base of this once vibrant manufacturing centre of the USA. However, as pointed out by the very well-known banking analyst Meredith Whitney in a recent article in the Financial Times the decision to apply for Chapter 9 protection against its creditors does show that there is a very intense political battle going on in these cities. Some hard decisions have been made, and she argues that Detroit’s decision to default may be the first of many.
If correct, this does not bode well for the US bond market, and to the extent that panic may set it, for other bond markets around the world including SA. However, while possible, this apocalyptic outcome is not certain. What is important is that this highlights a political decision making dynamic that’s definitely in play here in South Africa. This does not bode well for local government bondholders in the medium term.
As Ms Whitney points out, in American municipalities there is a political battle going on between three key constituencies – the city residents, the municipal employees and the municipal bondholders. City residents demand services from the municipalities – roads, rubbish removal, fire services – in return for their taxes. Employees want income – both in terms of current wages and future pension commitments in return for their labour. Bondholders want interest and their capital back in return for the use of their money to fund current expenditure by the municipality. All of these claims need to be met from the tax revenues of the municipality. If these revenues start falling (as has happened in most US cities following the 2008 crisis compounded by the loss of manufacturing competitiveness in Detroit in particular) then some hard decisions need to be made.
Traditionally the elected municipal managers have been able to meet the expectations of the residents and employees through issuing bonds. Bonds are simply a way of transferring current expenditure on to future generations. This has allowed them to make politically attractive generous promises (particularly to employees regarding their wages and their pensions) without having to worry about the consequences. However, the chickens have come home to roost – in Detroit anyway. The city is bankrupt – it cannot meet all its commitments.
Some hard choices have to be made between who it has to disappoint. Ms. Whitney points out that the residents have been carrying the cost up until now – services have been cut drastically, but this can’t go on forever either. American municipal employees are unionised and so are not going to easily give up their income or retirement benefits. Bankruptcy is a way of squaring this particular circle. It allows for all the past commitments to be renegotiated and a sustainable alternative allocation of limited tax revenues be found.
Ms Whitney’s most contentious point is that she goes on to say that this logic is valid for other US municipalities and thus we should expect more defaults by other cities in the future. If correct the US municipal bond market is to be avoided at all costs, and there may be contagion effects across other bond markets, ultimately including SA.
However, it is not certain that this will happen – bankruptcy and ensuing renegotiations are political suicide (the Detroit decision was made by a non-elected official) and so will be delayed for as long as possible. But it does highlight a very dangerous dynamic between elected officials and workers in SA that will ultimately impact investors here.
To the extent that SA’s elected officials continue to make ultimately unsustainable commitments to public sector employees we clearly run the risk of a bond default like that of Detroit. This is facilitated by the close political ties between unions and the ANC and the presence of elections in 2014. We need to watch the upcoming public sector wage negotiations carefully.
Squaring the Circle in Detroit - Implications for South Africa?
