Azar Jammine: Here’s why the 2018/19 Budget will be the toughest yet

JOHANNESBURG — Tomorrow, South Africa will hear what details the 2018/19 Budget will contain. It will be the first major test of President Cyril Ramaphosa‘s administration. But certain uncertainties still remain about the economy and the finance minister will have to walk a tightrope of rising several taxes while still trying to provide some incentives for growth. Rating agencies will be watching South Africa today like hawks. Below are Azar Jammine’s thoughts. – Gareth van Zyl

By Azar Jammine*

Arguably, the 2018/19 Budget due to be tabled on Wednesday is likely to be the toughest in recent memory.

Azar Jammine
Dr Azar Jammine

In response to the furore created by the Medium-Term Budget Policy Statement (MTBPS) which was presented in October, which suggested an abandonment of fiscal discipline by a populist faction within the ANC, the government appears to have got the message that nothing short of significant cutbacks on the budget deficit and public debt parameters presented in the MTBPS will be sufficient to satisfy Moody’s credit rating agency.

The latter is the only one remaining which still has South African government debt on an investment grade credit rating. A deterioration of this credit rating to junk status to come into line with the ratings of the other ratings agencies, threatens to cause large-scale capital outflows, a renewed collapse in the Rand, higher inflation and lower economic growth.

At the same time, an unduly draconian Budget could prove counter-productive in terms of dampening nascent growth which appears to be taking hold spurred on by what markets perceive as being favourable political developments domestically.

The Budget will be the first real test of Ramaphosa’s presidency, specifically in respect of whether he can prevail upon his supporters in Cosatu to abide by substantial constraints on public sector remuneration and an increase in the VAT rate for the first time in 15 years.

Scrutiny will also be given to the manner in which state-owned enterprises (SOEs) are treated in the Budget and whether a credible recovery in their finances can be foreseen.

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The third prerequisite for avoiding a credit rating downgrade, viz. improving economic growth, might be forthcoming to some extent, but whether this will be enough to stave off a ratings downgrade, is uncertain.

Whilst growth supportive developments remain in place, the negative effects of higher taxes and lower growth in government spending on overall economic growth will tend to neutralise the boost given to growth by the strong Rand, potentially lower interest rates and improved economic sentiment.

It is therefore doubtful whether there will be any clarity even after the Budget as to whether a negative scenario of moving into junk status by all ratings agencies, can be averted.

Accordingly, it would not be surprising if the Rand were to give up some of its recent gains after the Budget.

Incredible tightrope has to be walked in Wednesday’s budget

In each successive Budget in recent years, the feeling has been that it would be the most stringent in the past decade. Yet again, it appears as if the 2018/19 Budget, due to be tabled in Parliament on Wednesday, will meet this criterion.

The pressures on the government to maintain fiscal austerity arise from the concerns which followed the tabling of the MTBPS in October when it was perceived that, under the leadership at the National Treasury of Finance Minister Malusi Gigaba, the country had abandoned years of fiscal rectitude.

Instead, Gigaba was seen to be a lackey of President Zuma and one who pandered to the wishes of a populist regime eager to ensure financial gains for itself rather than for the country as a whole. Since then, it appears as if Gigaba has changed his tune and more recently expressed the view that the forthcoming Budget would be quite draconian.

Malusi Gigaba reacts during a news conference in Pretoria on April 1, 2017. Photographer: Waldo Swiegers/Bloomberg

Specifically, markets were frightened by the extent of the upward revisions in budget deficits for 2017/18, 2018/19 and 2019/20 in the MTBPS.

The 2017/18 budget deficit was revised in the MTBPS to -4.3% of GDP from -3.1% budgeted for back in February 2017.

The deficit for 2018/19 was revised upwards from -2.8% to -3.9% and that projected for 2019/20, increased from -2.6% to -3.9% of GDP. In the 2020/21, the budget deficit was left at a seemingly very high and -3.9% of GDP. It should be remembered in all these instances that the budget deficits forecast for the next three years are way in excess of the GDP growth rate being forecast.

Therefore, to the extent that the budget deficits exceed the projected growth rates in economic activity, borrowing has to increase and the public debt to GDP ratio has to be revised sharply upwards. In the February 2017 Budget, the public debt to GDP ratio had been projected to rise modestly from 50.7% in 2016/17, to 52.3% in 2017/18 and upwards a little further to 52.9% in 2018/19, but was then forecast to decline to 51.9% of GDP by 2021/22.

Instead, the MTBPS forecast of the public debt to GDP ratio was unilaterally upward, rising to 60.8% of GDP by 2021/22. Essentially, the bigger the budget deficit is in relation to the economic growth rate of a country, the greater the need to borrow money in relation to the amount of taxes collected.

This causes the public debt to GDP ratio to escalate sharply. Whilst figures of just over 50% of GDP may have seemed palatable up until the MTBPS, the dramatic upward revision to over 60% of GDP caused markets to take fright. South Africa’s solvency for the first time was really being called into question. What exacerbated such concerns was that it was felt that the overshoot of revenue by expenditure of the widened order of magnitude was in part attributable to funds being siphoned off into corrupt practices.

Huge pressure to avoid a credit rating downgrade to junk by Moody’s

Whereas S&P global did not hesitate in driving South Africa’s credit rating down by one notch across-the-board after the tabling of the October MTBPS, Moody’s credit rating agency seemed to give South Africa a chance to get its fiscal house in order.

It put the country on review which meant that it would need to decide within 3 to 4 months whether or not to follow the other credit ratings agencies decisions and downgrade South Africa to junk status as well.

Such an outcome is ominous because it would force the World Government Bond Index to drop South Africa out of the Index compelling tracker funds to sell out of their South African government bond holdings. Such an event could result in large-scale capital outflows that would depress the Rand, cause inflation to resuscitate to higher levels and possibly even compel interest rates to be increased as opposed to the current feeling that they might be reduced.

Such a conclusion is of course pure speculation. In the positive global financial environment currently, there is a view that even at junk status, South African government bonds would still attract a high number of purchases to take advantage of the attractive yields on offer.

As it is, perceptions of a reduction in the probability of a credit rating downgrade by Moody’s seems to have gained momentum in recent days as evidenced by the sharp decline in South Africa’s long-term interest rates. The benchmark R186 yield has tumbled from well over 9% at the time of the S&P credit rating downgrade and around 8.5% following Ramaphosa’s election as president of the ANC, to just in excess of 8.0% following Ramaphosa’s ascension to head of state over the past week.

Furthermore, the positive reception of the State of the Nation address has sustained the favourable sentiment regarding South Africa’s economic future.

Ramaphosa’s decision to replace the boards of SAA and Eskom have been seen as pandering to the other pre-requisite for forgoing a credit rating downgrade, viz. an improvement in the governance and efficiency of SOEs.

Slightly better growth and reduced interest rates could help but to be neutralised by more spending on education

In order to prove its credentials as returning to a regime of fiscal rectitude, the government is likely to have no option but to try to reduce the trajectory of budget deficits and public debt compared with what it presented at the MTBPS.

Unfortunately, it is unlikely to return to the kind of forecasts presented in last February’s Budget, but even some reduction on the MTBPS parameters, is likely to be received favourably by the ratings agencies.

To this end, the National Treasury might be assisted by the fact that economic growth in recent months seems to have been turning out to be slightly more upbeat than what was presented in the MTBPS. In the MTBPS, projected growth for 2017 and 2018 in the economy was 0.7% and 1.1% respectively.

According to our latest model forecasts, the economy could eke out a 1.0% growth rate for 2017 and 1.9% for 2018. Under such circumstances, projected growth in government revenue might be superior to what was contained in the MTBPS.

Then on the expenditure side, the reduction in long-term interest rates means that the amount to be spent on servicing the government’s borrowing requirement stands to be reduced slightly compared with the horrific 11.0% annual increase in this budgetary parameter.

In the MTBPS, this 11.0% annual growth in interest payments completely dwarfed the projected increase in all the other votes outlined. There could be a slight reprieve on that front. Against this, the Budget will have to contend with an increase in the higher education allocation to account for the rollout of free tertiary education to poorer students.

Fortunately, President Ramaphosa appears to have limited the extent to which the education budget will have to increase by announcing that this free tertiary education will be rolled out only to first year students. A few weeks ago he suggested that the free tertiary education for poor students would be “phased in” and in this way he has managed to steer the budget away from having to finance the entire free education budget in one shot.

However, one is probably still talking about having to find an extra R5bn, or 0.3% of the Budget, neutralising most of the increase in revenue arising from better than originally budgeted growth in the economy and the lower interest bill.

Significant pressure to limit growth in expenditure and increase taxes sharply

In the final resort, there is likely to be considerable pressure on the government to constrain public sector wage increases and to increase taxes sharply. At present the public sector wage Bill accounts for 35% of total government spending.

Were the government to award public servants an increase in pay in excess of 1% above inflation, this would cripple its three-year budget and any attempt at constraining the budget deficit and public debt. But will the trade unions in the public sector countenance such fiscal austerity?

The other issue that they will probably need to contend with is the imperative to increase the rate of VAT in view of raising other forms of taxation to the same extent.

A 1% increase in the rate of VAT would raise up to R22bn. This is insufficient to cover the R51bn shortfall in tax revenue, but would go a substantial way towards achieving that goal. A further R15bn could be gained by not granting relief for bracket creep through inflation of salaries for individual taxpayers. When one adds to these tax increases, a likely further above-inflation increase in the fuel levy, which could raise up to R10bn extra and the introduction of a sugar tax, as well as increases in the number of wealth taxes such as the capital gains tax rate and estate duty rate, one could close the funding gap. However, such measures, especially the increases in VAT and fuel levy, will also elicit huge opposition from trade unions.

It is for this reason that we believe this Budget will be a big test of the Ramaphosa regime’s commitment to fiscal constraint.

There will still be uncertainty regarding credit rating downgrade

In conclusion, we believe that Wednesday’s Budget will indeed come as a reality check to the euphoria which has engulfed the country following the ascendancy to the presidency of Ramaphosa over the past week.

The increase in taxes and reduction in government expenditure foreseen in real terms are likely to neutralise some of the more positive trends in the economy arising from lower than expected inflation linked to a stronger Rand and the improvement in the trade balance linked to improved global economic activity.

As a consequence, one should not be at all surprised to see some setback on domestic financial markets and the Rand in the wake of what promises to be a very strenuous Budget. As to who will present the Budget is still uncertain, but one suspects that it will be Malusi Gigaba.

One should bear in mind that the budgetary process has been in place for over a year, dating back even to the Gordhan regime in Treasury.

Furthermore, Ramaphosa himself had a number of meetings with Gigaba a month ago, clearly spelling out what needs to be done in the presentation. It therefore will not come as a surprise to either of these politicians and nor will it surprise the public at large. However, once the penny drops with regard to what it implies for restricting the rate of improvement in economic growth this year and next, it is conceivable that some sense of partial disillusionment might creep in.

  • Dr Azar Jammine is the chief economist at Econometrix. 
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