The world is changing fast and to keep up you need local knowledge with global context.
EDINBURGH — Finance minister Tito Mboweni warned that South Africa is at a crossroads when he delivered the Medium-Term Budget Policy Statement in October and one of South Africa’s sharpest investment minds, portfolio manager Sandy McGregor of Allan Gray, agrees. Like Mboweni, McGregor is gravely concerned about the country’s mountain of debt, dwindling tax collections and an economy that has stalled. McGregor shares a broad-brushtrokes plan on how President Cyril Ramaphosa and his team can boost business development and, in so doing, fire up economic growth and reduce poverty. For McGregor, the risks of South Africa slipping into a serious mess are rising. – Jackie Cameron
By Sandy McGregor*
Faced with sky-high debt, a stagnant economy and disappointing tax collections, South Africa is on an unsustainable fiscal path. Difficult choices have to be made that can no longer be postponed.
One of the most astute insights on bankruptcy was provided by American writer Ernest Hemingway in his 1926 novel, The Sun Also Rises. A character named Mike Campbell was asked how he went bankrupt. “Two ways,” Mike responded. “Gradually, then suddenly.”
What is true for individuals also holds for nations: A long period of economic mismanagement, in which unpayable debts and unaffordable obligations accumulate, can be followed by a sudden financial crisis in which the state finds it cannot fund itself. Two examples of the possible consequences of such financial mismanagement are Zimbabwe, in the first decade of this century, and more recently Venezuela, both of which imploded into hyperinflation. South Africa’s financial metrics have also significantly deteriorated in the past decade, and while we are hopefully still in a position to reverse these trends, they are very concerning. The risk of entering the second, “sudden” stage of bankruptcy is increasing.
In presenting to parliament the government’s Medium-Term Budget Policy Statement (MTBPS) on 24 October 2018, Finance Minister Tito Mboweni delivered a very good speech titled “South Africa at a crossroads”. While the response of the market was negative, with the rand immediately weakening from R14.18/US$ to R14.50/US$, Mboweni’s maiden address was an honest appraisal of the difficult circumstances in which South Africa finds itself. It is clear from the MTBPS that we face difficult choices that can no longer be postponed if financial disaster is to be avoided.
The rise in the public sector wage bill
During the Zuma presidency, there was a massive increase in the state’s remuneration bill. Between the fiscal years 2006/7 and 2017/18, the compensation of government employees grew at an annual rate of 11.2%. In the same period, the current value of the gross domestic product (GDP) expanded by an average of 8.6% annually. Over 11 years, wages have grown 3.2 times while the value of economic activity, from which taxes are levied, grew only 2.5 times.
This inexorable rise in the wage bill was a consequence of above-inflation annual wage settlements with the public sector trade unions, a system of automatic additional increases linked to length of service, and an increase in the number of employees. Clearly former President Jacob Zuma, and others in the ANC leadership, regarded inflating the public sector wage bill as a politically rewarding exercise in patronage. However, as a consequence, other expenditures have been crowded out and the ambitious social plans of the ANC rendered unaffordable.
Bringing the spiralling public sector wage bill under control is essential if fiscal sustainability is to be restored. This will require difficult negotiations with a key ANC support base, public servants and their trade unions.
Tax collections disappoint
In recent years, tax collections have disappointed. In part, this is a consequence of a political climate that has promoted a culture of non-compliance. When large numbers of politically connected persons are blatantly looting public institutions, it is difficult to promote the message that all citizens are obliged to pay their taxes. Also, as the Nugent Commission has detailed in a cogent and well-documented report, the mismanagement of the South African Revenue Service (SARS) by Tom Moyane, whom Zuma appointed commissioner in September 2014, has proven disastrous. Tax collections have underperformed relative to what would normally have been expected from the actual level of economic activity, and have been artificially boosted by a failure to make timeous VAT refunds.
President Cyril Ramaphosa has acted to fix this mess. He has dismissed Moyane and appointed Mark Kingon, an experienced long-serving SARS executive, as acting commissioner until a new, hopefully competent, permanent appointment is made. Equally important is Ramaphosa’s strong message that looting state institutions is unacceptable and that the perpetrators of such crimes will be actively prosecuted.
Fixing the tax collection system can be done, but it will take a number of years. However, even if the tax system is fixed, the problem of insufficient state revenues will persist as long as South Africa remains trapped in economic stagnation. National Treasury’s forecast of economic growth in 2019, included in the MTBPS, is 1.7%, up from 0.7% in 2018.
Historically, growth in South Africa has been highly correlated with global growth rates. One of the great disappointments of 2017 and 2018 has been the economy’s failure to escape from its current stagnation despite strong synchronised global growth. Given that there are increasing signs that the world economy is now slowing, it is difficult to be more optimistic than the Treasury about economic growth in 2019, or to expect better than its cautious revenue projections.
A deteriorating debt outlook
Projections in the recent MTBPS are that the ratio of South African government debt to GDP will rise from 52.7% in March 2018 to 55.8% in March 2019, to 56.1% in March 2020, and peak at 59.6% in March 2024. However, the Treasury has a credibility problem because for many years it has predicted that things will get better a few years out, but since 2009 they never have. For example, in February 2017, it projected gross debt to GDP in March 2020 will be 52.4%. Now the estimate is 56.1%.
While the Treasury has done a very credible job in difficult circumstances, since Jacob Zuma became president in 2009, it has had to manage the nation’s finances within a political system that has continually undermined its efforts to be fiscally prudent. This is one of the serious concerns international ratings agencies have about South Africa’s longer-term financial stability.
In addition to its own gross debt, the government has also guaranteed parastatal debt, principally borrowings by Eskom, equal to about 10% of GDP. Were it not for government guarantees, Eskom, SAA and the SABC would all be trading in insolvency. Accordingly, these guarantees add about 10% to the national debt, increasing the 2024 debt projection to about 70% of GDP.
A market-imposed debt ceiling
A key question is, what level of debt will push South Africa over the tipping point and precipitate a financial crisis? Will a debt level of 70% in 2024 prove to be unfundable? In many other countries, the ratio of national debt to GDP is much higher. At the extremes in Japan and Italy it is about 250% and 130% respectively. South Africa struggles to service a proportionally much smaller debt burden because it has a very low savings rate and runs a large balance of payments current account deficit.
Whereas in many other countries interest rates are low and often close to zero, the annual cost of debt in South Africa is between 8% and 10%, which puts a lower ceiling on how much we can afford to borrow. We are dependent on continuing inflows of foreign capital to balance the books. Already about 40% of South African government domestically issued rand debt is owned by foreigners. Domestic political acrimony, and in particular issues such as confiscation of land without compensation, make such investors nervous. It will be very difficult to persuade them to finance a massive unaffordable increase in our national debt. In practice, the stagnation of the domestic economy puts a limit on how much we can borrow, and we may be closer to this limit than we realise.
The Eskom risk
One of the immediate challenges facing President Ramaphosa is what to do about Eskom. In the 12 months to 30 September 2018, Eskom’s borrowings increased by R52bn to R419bn. It required R45bn to service this debt but only generated a cash flow from operations of R27bn. Eskom is effectively bankrupt and can only remain in business by raising government guaranteed debt. Its new management faces formidable challenges and has proposed to government a rescue plan involving a substantial increase in tariffs and the transfer of R100bn of debt to the Treasury. Naturally such proposals are extremely unwelcome in the Treasury. Mboweni has openly stated that he does not favour the state assuming this burden, which would cost about R9 billion annually.
Probably the flaw in Eskom’s proposal is that it does not go far enough. The reality is that its debt has become an obligation of government. Trying to repay it by increasing tariffs will merely exacerbate the downward spiral whereby higher tariffs reduce consumption, further eroding Eskom’s competitive position and reducing its operating profit. The economic damage of higher tariffs will erode economic growth and impose unintended collateral damage on tax collections.
If increased tariffs are not the answer, then the only effective solution is to take a much larger proportion of Eskom’s debt, perhaps R300 billion, onto the books of the national fiscus. Apart from recognising an existing reality, this solution will allow Eskom to keep its tariff increases in line with inflation and thus promote economic growth. However, such a dramatic step will require vigilant control of government spending to keep the level of its debt under control.
Economic growth is the only panacea
At the heart of South Africa’s problems is the fact that the economy is not growing. President Ramaphosa clearly recognises this and is trying to kick-start the economy by promoting new business investment. However, what is needed is an honest debate about why the economy is stagnating. Economic growth is largely a matter of making things cheaper. Business in South Africa is subjected to the widespread and growing cost of the ANC’s social agendas. While everyone recognises the pressing needs that these agendas are trying to address, the collateral damage caused by the negative impact rising business costs are having on economic growth is largely ignored. Without greater prosperity it will be impossible to resolve the problem of poverty.
There are many issues that need to be tackled urgently to prevent South Africa’s debt problem from spiralling out of control. To expand on the message that South Africa is at a crossroads, we should remember the wisdom of Yogi Berra, who said: “When you come to a fork in the road, take it.”
- Sandy McGregor is a portfolio manager at Allan Gray