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There have not been any significant new developments around the 2019-nCoV coronavirus since last week. Its spread is still largely contained within China, though factories across the world are feeling the effects of disruptions to their supply chains. Beijing has introduced several measures to cushion the blow to the Chinese economy, including a reduction in import tariffs that was cheered by markets. However, rumours of a vaccine breakthrough unfortunately seem premature. So we may as well turn our attention to another frightening subject: the upcoming Budget Speech on 26 February.
Across the spectrum, investors are hoping for the best while expecting the worst from Finance Minister Mboweni. For the past eight years, government has consistently missed tax revenue targets despite increases in personal income tax rates, the VAT rate, the dividend withholding tax rate and fuel levies. Government spending has continued to rise in real terms throughout this period. As a result, the government has been unable to narrow the budget deficit despite repeated promises to do so. The budget deficit, usually expressed as a percentage of national income (gross domestic product), is the difference between spending and revenue that has to be made up through borrowing. (It averaged 4.9% between the 2011 and 2019 fiscal years.)
Chart 1: Government spending and tax revenue, R millions
Source: Refinitiv Datastream
In fact, the latest update (from the October 2019 Medium Term Budget Policy Statement) all but gave up any pretence of trying to close the deficit. As a result, the overall government debt-to-GDP ratio could rise above 70% in the next three years, from only 29% a decade ago. Treasury data on revenue and spending over the last nine months of the fiscal year (April to December) suggest even the pessimistic October projections are at risk. The initial 4.7% deficit projection for the current fiscal year was increased to 6.2% in October. It could end up closer to 7%.
While the bailouts to Eskom, SAA and other state-owned enterprises (SOEs) and the bloated public sector wage bill have been blamed for the sharp projected increase in the deficit, another major culprit is hidden in the shadows.
Nominal growth shock
The Budget is essentially a projection over three years of government’s spending plans and revenue expectations. The latter is based on the growth rate of nominal gross domestic product (GDP) – real growth plus inflation. Nominal growth matters most for the fiscus, since tax revenues are simply a slice of nominal growth, with the exact size of the slice varying over time with the ‘buoyancy’ of tax revenue. The buoyancy rate has also recently declined, partly due to governance and operational problems at SARS. While the real growth rate has been disappointing, hovering between 0% and 1% over the past few years, nominal growth slowed dramatically, from around 8% to 4%. This is lower than at the time of the Global Financial Crisis. The government was not prepared for this. The 2019 Budget - only 12 months ago - still projected nominal economic growth of more than 7% per year over the next three years.
Each percentage point that nominal growth declines equates to roughly R50 billion in economic activity that is ‘missing’ and with it, around R12 billion in tax revenue.
Chart 2: Nominal and real economic growth, %
Source: Refinitiv Datastream
Lower nominal growth delivers a second blow, since it impacts the denominator in the debt-to-GDP and deficit-to-GDP ratios. These ratios are therefore increasing both because of a higher numerator and a smaller-than-expected denominator. While neither ratio is very high by global standards, the problem for investors and ratings agencies is that there has been no sign of stabilisation.
And while nominal growth has declined, interest rates remain stubbornly high, among the highest of the major emerging markets. They are stubbornly high because the market is worried about debt getting out of hand. As a result, government already spends almost as much on paying interest as it does on social grants, and debt servicing consumes an ever greater share of the Budget. This trend is not sustainable, but is set to continue for the time being.
Not all bad news
Before getting completely despondent, it is worth remembering the country’s fiscal strengths. These were highlighted in the International Monetary Fund’s (IMF’s) recently released extensive report on the South African economy. They include the fact that the average maturity of government debt is about 13 years, meaning there is limited roll-over risk (the risk that interest rates jump at the point where you need to refinance a large amount of maturing debt); foreign exchange denominated debt is low at around 10%; open and liquid capital markets attract foreign investors (when the price is right); the public sector defined benefit fund is fully funded, the banking system is sound (unlike in some European countries, where a “doom loop” connects shaky banks and highly indebted governments); and the flexible exchange rate is a shock absorber (export incomes rise as the rand weakens, and there is no need to spend precious resources in an ultimately futile exercise to prop up the currency).
For all these reasons, South Africa is highly unlikely to need an IMF bailout, even though the fiscal picture is dire. The IMF supplies US dollar funding to countries in need; we don’t require dollars (our foreign exchange reserves stand at $54 billion, enough to cover five months’ imports).
What can we expect?
Given that there will be a flood of commentary from the media, politicians, economists and others on Budget Day (far more than is warranted,) it is worth repeating the following: a good Budget from the point of view of consumers will not be a good Budget from the point of view of bond investors. The former wants tax relief and more social spending. The latter wants a smaller deficit, which means some combination of higher tax revenues, less spending, wage cuts etc. Treasury will likely try to steer the Budget outcome between these two interest groups. If it imposes austerity measures too harshly, the fragile economy could crumble. However, if it doesn’t give investors a credible plan to cap the growth in debt, its borrowing costs are likely to rise.
In a nutshell then, taxpayers shouldn’t expect much in terms of respite, and what relief there is will be skewed to lower income earners. However, major tax increases are unlikely. Tax increases, including a higher VAT rate, which remains low by global standards at 15%, will probably wait for a stronger economy.
The size of the government’s wage bill is increasingly in focus, and highlighted by the Treasury itself. Wage and job cuts are highly unlikely given union opposition and could well be counterproductive. At any rate, the current three-year wage agreement, which allowed for real salary increases, is still in force. The best we can hope for is a commitment to keep future salary increases in line with inflation (or somewhat below) and halt automatic progression up pay scales. It will take time to sell this idea to public sector unions, so don’t expect any announcements. Perhaps government should start with a wage freeze on the 29 000 civil servants earning more than R1 million per year.
The IMF recommended adopting a debt ceiling in addition to the expenditure ceiling. The latter has been somewhat successful in containing non-interest spending. However, it has not been adjusted down for the decline in inflation, and still allows for growth in spending of 6% on average over the next three years, according to the MTBPS. The Eskom bailouts also fall outside the expenditure ceiling. The debt ceiling is a good idea, drawing a line in the sand and forcing tough decisions. This is easier said than done, of course.
Needless to say, there is no room to stimulate the economy with expansionary fiscal policy (tax cuts and/or spending increases). Therefore, the Budget is not going to jump-start economic growth.
While revenue could recover somewhat as SARS improves its efficiency, including collecting tax arrears, what we really need is faster nominal economic growth. This, coupled with greater discipline on the spending side, could narrow the deficit and stabilise the debt ratio. The list of reforms that can boost growth has been extensively covered, but falls broadly into four categories: policy certainty, making it easier and cheaper to do business (including cutting red tape and unnecessary regulation), increasing competition (including in industries where SOEs are near-monopolies) and improving the quality of public services.
In the short term, stable electricity is also crucial. The announcement by the Energy Minister that private enterprises will soon be allowed to generate electricity for own use without prior permission is a big step in addressing the latter. Also notable is that Cosatu has recently come to the table with solutions (rather than just demands) to address Eskom’s debt woes. Neither of these developments is likely to be finalised by the time of this week’s State of the Nation Address (SONA) or next week’s Budget, so we’ll probably have to wait longer for details.
Given that the growth outlook has weakened and government is unlikely to be able to announce major progress on reform initiatives any time soon, Moody’s will probably downgrade South Africa. However, recent comments from their lead South Africa analyst suggests they are not in any hurry to do so.
Moody’s is the last ratings agency with an investment grade rating on South Africa’s local currency government bonds. A downgrade means we would fall out of the FTSE World Government Bond Index, a source of much anxiety to some. However, it is only funds that replicate that index (i.e. passive funds) that will be forced sellers. Active managers that use the index as a benchmark would probably have sold out long ago. After all, South Africa’s weight of less than half a percent is hardly worth the trouble. At any rate, most foreign investors look to emerging markets like South Africa for yield, not for excellent credit ratings. The wide gap that has opened up between local bond yields and that of our peer group (like Brazil and India) suggests the fiscal and ratings risks have been largely priced in already.
For the time being, local investors can therefore benefit from these high real interest rates. However, diversification always makes sense. In an adverse scenario, the rand tends to weaken more than bonds, so offshore exposure remains an important portfolio hedge.
Ultimately, global conditions still matter greatly. Risk appetite has been up and down since the start of the year. Even as the global economy seems to be recovering from last year’s manufacturing slump – notwithstanding the short-term blow as China basically shuts down its economy to halt the spread of the coronavirus – interest rates remain close to record lows. Global central banks, including the US Federal Reserve, are more worried about deflationary risks than inflation, which means the bias is towards even lower rates. This limits the risk that local borrowing costs will explode higher, even if the Budget disappoints investors. However, we should not waste this window of opportunity to get our house in order.