13 January 2016
In part, the increase in long bond yields reflects heightened concern about the outlook for inflation. Indeed, the sharp depreciation of the rand against all the major currencies in a short period, if sustained, could push inflation above 7% by year-end 2016. Furthermore, government’s fiscal position holds long-term inflation risk should fiscal policy prove to be unsustainable.
South Africa’s economy, constrained by inefficiencies, is unlikely to deliver sufficient tax revenue to support the government’s intended level of spending. The problem is compounded by the increase in government bond yields. In the long run, real government bond yields in excess of real GDP growth imply the National Treasury needs to run a primary budget (revenue less non-interest spending) surplus to stabilise government’s debt ratio. That is difficult to achieve, given the demands on government spending implied by the 25% unemployment rate.
This unfortunate set of circumstances demands a decisive policy response to restore fragile investor sentiment and appease credit ratings agencies. The negative outlook attached to the sovereign debt ratings of Standard and Poor’s and Fitch credit rating agencies implies a downgrade of South African foreign currency denominated government debt to junk status by one or more of the agencies is a distinct possibility this year.
Amid waning liquidity, higher funding costs, sustained rand weakness and increased inflation risk, the National Treasury should deliver a more stringent budget than implied by the October 2015 Medium Term Budget Policy Statement (MTBPS) and the Reserve Bank’s real policy rate should increase.
Despite depressed growth prospects, the Reserve Bank’s task is to respond to the imminent inflation threat as currency weakness threatens to ignite inflation expectations.
Meanwhile, the National Government Budget for 2016/17, scheduled for publication in February 2016, will be one of this year’s most important financial market events. An increase in the tax burden appears inevitable. The range of revenue-raising measures under consideration by the Treasury is broad and includes a higher VAT rate, further increases in top marginal tax rates, potential changes to estate duty, increases in taxes on savings (capital gains and dividends taxes) and possibly the introduction of new wealth taxes. However, the burden of adjustment cannot fall solely on tax increases. In my view, the Treasury will fall short of what is required if it merely sticks to the expenditure plans for the next three years outlined in last year’s MTBPS. Government spending must be cut.
Ideally, this is what should happen. If, however, our policymakers fail to grasp the nettle, this will merely perpetuate the current economic malaise with damaging consequences for long-run macroeconomic stability.