Pravin Gordhan’s first posting as Finance Minister coincided with the global recession and its immediate aftermath. Today’s Budget Speech will be even more challenging and the pressure even greater for three reasons, according to Dave Mohr & Izak Odendaal, Old Mutual multi-managers.
No more fiscal space
Firstly, South Africa had ‘fiscal space’ during the 2008-2009 recession after years of prudent budget management left the country with low debt and the ability to ramp up government borrowing and spending. This fiscal space has now been eroded mainly by large wage increases for civil servants and bail-outs for struggling state-owned enterprises.
Due to the persistent large deficits since 2008, South Africa’s government debt to gross domestic product (GDP) ratio raised from 29% to around 45% (or 55% if guarantees to parastatals are included). This debt ratio is not high relative to our peer group, but the speed at which it increased is a concern. A loss of investment grade status could lead to permanently higher borrowing costs.
Since government does not only borrow to fund spending, but also to roll over maturing debt (more than R50-billion a year for the next three years), higher interest rates mean the cost of servicing debt (almost at R130-billion a year) increasingly displaces other important areas of spending while also placing further downward pressure on our rating.
Weaker economy
Secondly, economic growth has disappointed over the past four years and the economy is expected to grow less than 1% in the coming fiscal year. This is a difficult environment in which tax revenue growth will be slow and raising tax rates run the risk of pushing the economy into recession. The major ratings agencies appear to place South Africa’s weak economy at the top of their list of concerns, as a weak economy limits the ability of the government to service its debts.
GDP growth forecasts have continuously been cut since 2012 in absolute terms, although growth was still expected to rise over the forecast period. Government’s fiscal consolidation strategy has therefore been relying heavily on improved growth to gradually reduce the budget deficit to levels that would stabilise the debt-to-income ratio. But as GDP growth has consistently come in below budget projections, the budget deficit has remained stuck around 4% of GDP and the debt ratio is projected to continue rising.
The National Treasury cut its growth projection in the October medium-term budget policy statement (MTBPS), but even these forecasts now seem very optimistic when compared to the Reserve Bank’s most recent projections. Treasury anticipated deficits gradually declining from 3,8% of GDP to 3% by 2018/19, with a rising revenue assumption (on the back of improving GDP growth in the outer years of the budgeting period) doing most of the work.
Credibility to be restored
Thirdly, the events surrounding Gordhan’s re-appointment after President Zuma replaced Minister Nhlanhla Nene with David van Rooyen in December have dented the credibility of South Africa’s economic institutions and perceptions of policy continuity. While the Reserve Bank’s steep rate hike in January has done much to shore up the credibility of independent policy-making, it would have compounded the growth problems.
Since 2012, Treasury has been talking the talk on fiscal consolidation, but not really walking the walk. Consolidation was continuously shifted out to the outer years of the three-year planning period, in the hope that growth would pick up again. “Back loading” fiscal consolidation will probably not be good enough for the market and ratings agencies this time round. While they were willing to give South Africa the benefit of the doubt in prior years, the events of December probably destroyed their patience as suggested by the slump in the rand and the surge in bond yields. To avoid a downgrade, the Minister probably will have to present a deficit narrowing to below 3% of GDP over the next three years.
Catch 22
Gordhan’s Catch 22 is therefore that if he promises too little fiscal consolidation (as set out in the Budget Speech), South Africa almost certainly faces downgrades and higher borrowing costs. But if he proceeds too rapidly, it could tip the economy into recession (given that monetary policy is also tightening at the same time and the international environment remains unsupportive) which would be counterproductive. If the economy goes into recession, tax revenue is likely to fall and the deficit will widen. Gordhan not only has to walk a tightrope, he has to do so in gale force winds while carrying large rocks. This will clearly not be easy.
On the revenue side, a VAT hike remains the most efficient way to generate large additional amounts of tax income, but this is socially and politically tricky and would hurt household spending. It is almost inconceivable that there will be a VAT hike without an increase to the income tax rates. The 50c per litre petrol price cut that lies in store next month must also be a tempting area to raise revenue without putting consumers in a worse position over the short term. Both VAT and fuel levy hikes have implications for inflation. There is almost no point in hiking corporate tax rates as company profit growth has slowed to a crawl.
Tax revenue (especially from Personal Income Tax) held up reasonably well throughout 2015 despite the weak economy, but the last few months of the year saw a slowdown. Expenditure growth has also been slightly below target in the current fiscal year. But to make up for the expected shortfall in tax revenue of the next three years – which could be between R50 billion and R80 billion – either tax rates will have to rise or expenditure cut. That is to just get back to the October MTBPS deficit targets, but achieving these targets is probably not sufficient to avoid a downgrade.
On the spending side, the challenge is that the public sector wage settlement increased the salaries and benefits of public servants by 10,1% last year, followed by inflation plus 2% increases in the next two years. In other words, the wage bill will rise by more than 2% in real terms (unless employment is reduced) which is more than the expected real growth in the economy. Cutting back on banquets (as announced in the State of the Nation Address) is tiny compared to the ballooning wage bill which is crowding out other important areas of spending. Similarly, cutting back on conferences and catering pales in comparison to bail-outs of struggling state-owned enterprises (SOEs).
The expenditure ceiling, which Gordhan has already insisted is “sacrosanct”, does ensure some credibility, but it has to be adhered to (it was left largely unchanged from the February Budget Speech to the October Mini-Budget).
Is there a way out?
The best way to proceed appears to be a promise of credible but gradual fiscal consolidation and narrowing the deficit at a faster pace than laid out in the October Mini-Budget. But importantly, there has to be growth enhancing reforms, as well as measures to reduce the burden underperforming SOEs place on the fiscus. These reforms – which could include reducing red tape, easing the functioning of the labour market, selling off stakes in SOEs, involving the private sector in key infrastructure projects, facilitating skilled immigration and improving domestic education – won’t lift the growth rate immediately. But they could boost business and investors’ confidence.
In summary, to avoid a downgrade, we need to see:
* A budget based on realistic macroeconomic assumptions.
* A credible strategy to reduce the budget deficit without pushing the economy into recession. This will include tax increases and spending restraint.
* Concrete steps to reduce the burden underperforming SOEs place on government finances (and the broader economy).
* Confidence-building economic policy reforms that will boost economic growth expectations.