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Mini budget: foreign investment
crucial to address fiscal woes
Investment Economist at Sanlam Investments
Oct 29, 2020
National Treasury’s 2020 MTBPS sketches a higher increase in the government’s debt trajectory, relative to the ‘active scenario’ published in the June 2020 Supplementary Budget. Gross loan debt is now expected to stabilise at 95.3% of gross domestic product (GDP) in 2025/26, relative to the Supplementary Budget ‘active’ scenario, which projected debt would stabilise at 87.3% of GDP in 2023/24. The new projection relies on an improvement in the Main Budget primary balance (revenue less non-interest spending) from -R474.8 billion in 2020/21 (-9.8% of GDP) to a surplus by 2025/26.
The emphasis of this planned consolidation falls on expenditure cuts (although tax increases of R40 billion are budgeted for from 2021/22 to 2024/25) with Treasury pointing out that ‘recent tax increases have generated less revenue than expected, and evidence suggests that tax increases can have large negative effects on GDP growth’. Main Budget revenue does increase, though, from 22.6% of GDP in 2020/21 to 24.9% of GDP in 2023/24, as the economy recovers and tax buoyancy improves.
Meanwhile, the higher debt trajectory announced in the MTBPS, compared with the June 2020 Supplementary Budget active scenario, mostly reflects lower non-interest spending cuts. These amount to a cumulative R156 billion in 2021/22 and 2022/23 in the MTBPS, whereas the Supplementary Budget showed cumulative spending cuts of R233.5 billion over the same two years.
According to the MTBPS, further cuts of R150.9 billion follow in 2023/24, indicating fiscal consolidation is back-ended with Treasury relying on implementation of zero-based budgeting by the 2023 Budget.
At the same time, the expenditure cuts imply negative real non-interest spending growth over the next three years, while the ratio of Main Budget non-interest spending falls from 32.4% of GDP in 2020/21 to 26.4% of GDP in 2023/24. This drives an improvement in the Main Budget balance from a deficit of 14.6% of GDP in 2020/21 to a deficit of 7.3% of GDP in 2023/24, which is still wide.
The guiding principles at play here appear to be, firstly, that the current state of the economy cannot bear a fiscal consolidation that is too sharp and, secondly, that to the extent spending holds up, there should be a shift towards capital expenditure away from consumption.
Critically, this implies that the emphasis of the downward adjustment to government spending falls on the government’s wage bill. Treasury notes that it has budgeted for a public-service wage bill increase of 1.8% in fiscal year 2020/21, followed by an average annual increase of 0.8% over the 2021 medium-term expenditure framework period. Effectively, Treasury has not allowed for implementation of the third year of the 2018 public sector wage agreement, while a wage freeze is proposed for the next three years.
The fiscal authorities are trying to adhere to the age-old adage that if a state borrows, it should borrow to fund the acquisition of capital assets and not to consume. In so doing, Treasury is stressing the importance of improving the government’s balance sheet. In pursuing fiscal consolidation, it is important to reduce budget deficits and debt ratios. But, in the end, a fiscal consolidation without an improvement in the state’s balance sheet is an illusion.
With the future of economic activity so uncertain, a long, arduous fiscal consolidation implies material risks to the outlook. Improved tax administration or proceeds from the sale of non-core assets represent potential upside risks, but this is arguably dwarfed by downside risks such as uncertainty around the ability to stick to the wage bill projection.
Further, although Treasury indicated the additional R10.5 billion allocated to SAA will be funded through reductions to the baselines of national departments, public entities and conditional grants, weakened state-owned company (SOC) balance sheets and the large amounts of SOC debt, which the government has guaranteed, continue to lurk as significant risks. Indeed, Treasury notes that the government’s guarantee portfolio amounted to R693.7 billion in March 2020, mostly granted to Eskom (R350 billion). By the end of March 2020, R583.8 billion of these government guarantees had been utilised. The MTBPS shows that over the next three fiscal years, guaranteed debt redemptions are expected to average R35.6 billion, compared to R27.5 billion in the last year.
The past decade has shown that as government expenditure has increased relative to total expenditure in the economy, the potential economic growth rate has slowed. One key reason for this is that the government’s large budget deficits imply the state is absorbing more and more of the available domestic resources.
At the same time, the continuous sovereign debt rating downgrades that have accompanied South Africa’s deterioration towards fiscal failure in recent years have placed material upward pressure on domestic real interest rates. These factors have effectively crowded out private sector borrowing and investment. Ultimately, one can observe from the history of numerous countries that excessively high government debt levels slow potential economic growth.
This is unlikely to change any time soon. Although the government’s borrowing requirement falls to R602.9 billion in 2021/22 (compared to the June 2020 estimate of R560.5 billion) from R774.7 billion in 2020/21, it remains high. Moreover, the borrowing requirement increases thereafter to R637.2 billion in 2022/23, partly reflecting higher redemptions.
The low effective nominal interest rate on government debt, expected at around 6% (in nominal terms) in the current fiscal year, is helpful. But this partly reflects a high level of short-term debt issuance. There are limits to this and pressure can be expected to mount in the medium to long-term as more and more maturing debt is issued at higher interest rates.
Overall, South Africa’s fiscal situation, which implies high levels of government borrowing over the medium term, continues to highlight the importance of foreign capital inflows to supplement domestic savings and grow the economy. Without increased growth, the planned fiscal consolidation is not plausible.
Commentary by Alwyn van der Merwe, Director of Investments:
In our view, the MTBPS simply underlined the unenviable position Finance Minister Tito Mboweni finds himself in. He needs to steer the South African economy away from a potential fiscal cliff, but social and political requirements don’t allow for the decisive action needed to achieve this objective. The risks associated with the planned expenditure cuts and the unwillingness to stop funding capital-hungry state-owned enterprises will do little to address the concerns of potential foreign investors.
Our interpretation of the MTBPS is that it was just another attempt to kick the proverbial can down the road. It will in all likelihood leave the South African economy in a ‘muddle-through’ situation as the state continues to crowd out private sector initiatives and economic activity. For local equity investors, this must be quite demoralising, as so-called SA Inc shares are cheap and there is ample scope for a material re-rating on signs of better local economic conditions. We still maintain these shares are cheap, but the upside would obviously be limited in suboptimal economic conditions. Similar arguments can be applied to local listed property companies.
Local bond yields appear attractive, but the borrowing requirement of R602.9 billion remains high. The risks associated with higher funding rates for maturing debt in the future suggest that potential investors would apply caution when buying government-issued debt instruments. We would therefore exercise caution by not ‘overinvesting’ in this asset class.
There were no real surprises in the MTBPS that could have changed the outlook of foreigners considering an investment in South Africa. In the short term, the rand is likely to remain a victim of global drivers, and over the longer term, inflation differentials with our most important trading partners are likely to dictate the direction of the currency, provided that the SA Reserve Bank remains independent in terms of policy implementation.
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