Finance Minister Pravin Gordhan.  Picture: AFP PHOTO/MUJAHID SAFODIEN
Finance Minister Pravin Gordhan. Picture: AFP PHOTO/MUJAHID SAFODIEN

IN 2003, the Pentagon developed a market for terrorism futures. The idea was that speculators could take positions based on the likelihood of future terrorist attacks. The concept was never implemented — critics understandably decried the idea of anyone profiting from terrorism.

But the Pentagon was working from an understandable premise: financial markets are extremely good at predicting the future, and the market may, therefore, provide good guidance for policy makers. Markets for election outcomes, for instance, are more accurate predictors than exit polls or analysts’ forecasts.

So when President Jacob Zuma said last week that the response from financial markets to his firing of finance minister Nhlanhla Nene last month was "exaggerated", Mr Zuma was saying that the best prediction institution mankind has yet developed wasn’t working.

Financial markets reward those who are able to make better calls than others, so if anyone is genuinely better at predicting the future, the obvious step is to put their money where their mouth is … profits await. Yet despite this opportunity, after Mr Zuma mused on the irrationality of the market, the reaction was even more selling of rand-based assets including government bonds. So, the market’s response to Mr Zuma’s view that they were being irrational, was, apparently, to be even more irrational.

But instead of Mr Zuma’s view that markets are irrational, let’s try out the standard approach of economists, and start with the assumption that decision makers are rational.

When bond yields increase, this means investors consider the probability of default to have increased. Before the Nene decision, the R186 was trading at 8.4%. It is now at 9.64%.

Any investment decision involves thinking through two main issues. First is the returns that an investment can make. Second is the certainty of those returns. So if an investor thinks there is a 50% chance an investment will make 10%, but there is a 50% chance it will make 0%, then they would work on a "risk adjusted" return of 5%. With a big enough portfolio, the risk-adjusted return is going to be the average actual return.

Politicians have significant power over the risk adjustments investors make, what analysts call "political risk". When it comes to analysing a country’s risk profile, there are two main things to consider: the ability to pay and the willingness to pay.

A government that is rapidly accumulating debt — from 29% of gross domestic product in 2009 to 47% last year in the case of SA — has a weakened ability to pay. But we knew that before the Nene decision.

A country whose president appoints finance ministers with no experience, and then accuses financial markets of being irrational, can be seen as exhibiting a decreased willingness to pay.

When Mr Zuma accuses the financial markets of being irrational, he is demonstrating that he is unable to connect his own ambitions to the choices available to him. It makes it much more difficult to predict what he may do next.

Mr Zuma’s surprise at market reaction demonstrates his decisions do not obey the laws of rational expectations — otherwise he would not have been surprised.

Analysts’ views of the hard numbers, which represent SA’s ability to pay, did not change because of the Nene decision. What did change was their view of the president’s rationality.

Pravin Gordhan, who has the task of restoring SA’s credibility as the reinstated finance minister, understands very well the way expectations work and are factored into asset prices. No matter how well Mr Gordhan does, however, Mr Zuma’s irrationality is now globally recognised and understood.

The pummelling handed out to the rand and bond yields reveals the rest of the world’s prediction that SA’s future is much bleaker.

Only genuine political change, and a recommitment to rational engagement with financial markets to achieve mutual objectives, will shift that prognosis.