Dave Mohr | Chief Investment Strategist | Old Mutual Wealth | mail me |
Izak Odendaal | Investment Strategist | Old Mutual Wealth | mail me |
Last year’s Budget Speech was delivered in front of a full house in the National Assembly. Politicians, journalists and special guests mingled before and after the speech. There were hugs, handshakes and back slaps aplenty. Next week’s version takes place in a world that has completely changed.
One thing that hasn’t changed is that the South African government continues to spend a lot more than it receives in terms of tax revenue. A year ago, before there was any inkling that the economy was about to collapse due to the Covid pandemic, the National Treasury expected a budget deficit (the difference between spending and revenue that is mostly funded by borrowing) of R370 billion for the 2020/21 fiscal year. It amounted to a massive 6.8% of projected nominal GDP. This was already a shock, as it represented a large deterioration on what was projected the prior year as a weak economy and much lower inflation suppressed tax revenues, while bailouts of loss-making SOEs jumped.
The deficit numbers had to be adjusted in a special Supplementary Budget in June as the economy was not just weak but contracting at a record pace while health and social spending increased in response to the pandemic and soaring unemployment. They were adjusted again in the October Medium Term Budget Policy Statement (MTBPS). The October MTBPS pencilled in gargantuan deficits of 14.6% of GDP (R707 billion) for the current fiscal year, and 10.6% and 8.6% for the next two years. This put the public debt-to-GDP ratio on course to surpass 100% in the absence of deliberate steps to halt its rise.
Chart 1: South Africa monthly tax revenues, seasonally adjusted
Source: National Treasury
Better than expected
Since then, however, the economy has rebounded better than expected, and with it all categories of tax revenues.
One big positive has been the jump in commodity prices that raised exports. The deficits projected for the next three years are still likely to be large, but not quite as bad as was thought six months ago.
The most recent monthly budget update suggests SARS will bring in somewhere between R50 billion and R100 billion more than previously thought. Treasury might choose to be conservative in assessing this overrun. After several consecutive years of overestimating tax revenues, it will not want to overpromise again.
What this means is that there should be enough money to fund a vaccine roll-out and to temporarily extend the Covid support grant as announced by President Ramaphosa in the State of the Nation Address (SONA) and still end up with a smaller deficit than was projected in October.
What it doesn’t mean is that any of the underlying fiscal problems have been fixed. The government still spends much more that it earns, even when adjusting for the outlier that 2020 (hopefully) was, and the spending is still skewed towards salaries instead of investing for the long term.
Either tax revenues need to rise or spending needs to fall. Tweaks to tax rates can lift tax revenues somewhat, but the economy is probably close to being taxed to the maximum. The last VAT increase yielded much less than anticipated, for instance. While the Davies Committee on tax affairs feels strongly that a rejuvenated SARS can crack down on tax avoidance and generate a jump in tax revenue, only faster economic growth can materially raise tax revenues on a sustained basis.
On the spending side, the key initiative is of course to slow the growth rate of the public sector wage bill. The government did not give salary increases in 2020, a matter that is subject to a court case that the government won but unions have appealed. Salary adjustments for the next three years will need to be negotiated. This remains a risk as the outcome is subject to politics and can end up being quite different to what Treasury projects. However, despite it being a local authority election year, all the communication from government so far is that it is serious about holding the line on this issue.
The burden of interest
Meanwhile, interest payments will continue to consume an ever-growing portion of tax revenues. This is not all bad news, since most of it flows to domestic investors and ultimately circulates in the economy again. However, rising interest payments leave less room for spending on other important areas.
The impact of the fiscal crisis everyone is warning against is therefore not necessarily on financial markets. It can also be a crisis of service delivery if the government has to cut back on health, sanitation, safety or education spending, or more likely, capital expenditure. Ideally, as the interest burden rises, it will force a deep reprioritisation exercise, to ensure that every buck goes to where the bang is biggest.
In terms of a fiscal crisis manifesting on financial markets, an outright default seems unlikely. In the modern era, defaults normally happen when a debt crisis combines with a balance of payments or currency crisis.
To put it in simple terms, it happens when a country borrowed too much in dollars, and now struggles to find the dollars to make interest or principal payments. This is normally where the International Monetary Fund (IMF) steps in with emergency dollar loans. Since our government’s debt is mostly rand denominated and we have a floating currency, this is an unlikely path for us.
Our biggest risk – how a fiscal crisis is most likely to manifest – is a loss of market access, when the market is unwilling to roll over maturing debt or absorb new debt. It helps that South African debt is of a very long maturity, mostly due after 2030. But things can still go wrong in the meantime if global markets seize up as they did in March last year.
Different thinking about debt
Fortunately, the global backdrop is currently favourable. Firstly, as noted, firm commodity prices and stronger global growth mean exports can continue to lead the domestic recovery.
The current debt trend is unsustainable but becomes more manageable if the economy can post real growth rates of around 2% over the next five years compared to 0.5% in the five pre-pandemic years.
Secondly, the narrative around debt has changed. The IMF, historically the high priests of the religion of budget austerity (the old joke is that IMF stands for It’s Mostly Fiscal), has completely changed its tune following the slow post-2008 recovery. The turn to austerity in the US and Europe after the Financial Crisis delayed economic recovery and gave rise to populism. This time round, the advice is to make sure that economies heal first, before worrying about debt. ‘Spend as much as you can, but keep the receipts’ was the counsel from IMF president Kristalina Georgieva. The big difference between South Africa and the US, for instance, is that we borrow at long-term interest rates that far exceed even optimistic estimates of nominal economic growth. Rich countries can borrow at interest rates below long-term expected growth and inflation. It’s essentially free money and future interest payments on the debt issued now will not crowd out vital areas of government spending or service delivery.
Which brings us to the third point. These low global yields have a gravitational pull on our bond yields. In other words, things would be a lot worse if global interest rates were higher.
We therefore have some time on our side.
What about rising US yields?
Recent moves in global bond markets might seem to contradict that statement. US 10-year yields hit their highest level since March as investors anticipate that a large fiscal injection would heat up the economy and revive inflation. Is this not a danger to our own bond market?
Typically, when global growth is strong, the component of our bond yields that compensates investors for credit risk also declines as investor risk appetite increases. If this credit spread over equivalent US bond yields declines, our yields can remain stable or fall even if US yields rise. It matters therefore why the US bond yields are rising.
Chart 2: US 10-year Treasury yield, %
Source: Refinitiv Datastream
Recently, these long-term rates have increased in response to a better growth outlook. Short-term interest rates remain firmly anchored by the Federal Reserve’s zero-interest rate policy. The Fed has explicitly said it would let inflation rise above its target for some time before hiking rates.
If US long bond yields moved higher because of an expectation of a premature change in Federal Reserve policy, it would most likely be negative for bond markets across the world. This was the case in the 2013 ‘taper tantrum’ when the US 10-year yield shot up by 1.3 percentage points and our own 10-year jumped by 2.7 percentage points in a few months. Since bond prices move inversely with yields, these moves inflicted a massive capital loss.
US bond yields again jumped by a full percentage point after Donald Trump’s surprise election in 2016, but this time markets were pricing in stronger growth and therefore South African bond yields did not rise in tandem.
Chart 3: Emerging Market 10-year local currency bond yields, %
Source: Refinitiv Datastream
Interest-ing
To summarise then, we think the government is committed to ending the decade-long surge in the wage bill, which, with recovering tax revenues, should gradually narrow the deficit to more acceptable levels.
The implementation of structural reforms to raise the economy’s growth potential mostly lies outside of the Finance Minister’s ambit, but will have a big impact on longer-term budget sustainability. Here too, the government is moving, but frustratingly slowly. In his SONA President Ramaphosa spoke at length about electricity, as power supply issues are the biggest single constraint to growth. Although both the emergency procurement programme and the much larger independent power purchase process are underway, they are unlikely to contribute much to the grid this year.
Far more promising is the announcement that the government will consult on raising the limit below which licence approvals aren’t needed to generate electricity for own use (the current limit is 1MW). This is a no-brainer if ever there was one. Let companies move quickly to install their own small solar plants, increasing fixed investment, achieving energy security for themselves while reducing pressure on the grid and lowering their carbon footprint. All this without costing the fiscus a cent.
Despite everything that went wrong over the past year, SA Bonds returned 9.5% since the 2020 Budget Speech, of which 3 percentage points were delivered in 2021. This is well ahead of cash and inflation.
The recent rally in bonds reflects the better-than-expected outcome in terms of tax revenues and general investor optimism about global growth, but our long bond yields remain higher than any of our peers, apart from Turkey (chart 3). This is unlikely to change any time soon, unless the government unexpectedly speeds up economic reforms. In the meantime, bond investors can still earn generous interest payments well above inflation.
