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JOHANNESBURG — Economists and South Africans will be anxiously awaiting decisions from S&P and Moody’s today regarding the country’s latest credit ratings. A deteriorating fiscal position, messy politics, as well as sluggish growth, are hampering the economy. And should South Africa’s rating be cut by both agencies, Rand debt would fall out of the likes of Citigroup’s World Government Bond Index, sparking outflows of up to R100bn. Coincidentally, today is also ‘Black Friday’ – a US phenomenon that has caught on like wildfire in South Africa in recent years, highlighting the country’s out-of-control consumer spending on every level. How ironic it will be if we’re downgraded today. – Gareth van Zyl
By Arthur Kamp*
Attention is firmly fixed on the coming round of sovereign debt rating decisions. Whatever the outcome of these reviews, it is clear that in the absence of reform, government’s fiscal position is unsustainable. Its revenue collection track record has been eroded and additional spending priorities and liquidity problems at state-owned companies threaten its expenditure ceiling.
Fiscal consolidation has failed, and little attention has been given to the decline in government net asset value due to the erosion of its asset base relative to GDP and the rise in debt and contingent liabilities.
Ultimately, in addition to more taxes, a deteriorating fiscal position risks currency weakness and inflation and perhaps the implementation of prescribed assets. It also implies fewer resources are available to provide quality health and education services.
Ratings decisions are incidental
Ratings agencies use quantitative methodologies in assigning sovereign credit ratings, including analyses of per capita income growth, the government’s budget balance and its debt ratio and the health of the country’s external accounts. Considering these quantifiable factors South Africa’s BB+ (non-investment grade) rating currently assigned by Standard Poor’s (S&P) to its long-term foreign currency denominated debt appears fair.
There is, however, an element of subjective judgement in ratings decisions, which also reflect the country’s institutional strength and economic policy direction. This turns attention to the warning issued by the National Treasury in its October 2017 Medium Term Budget Policy Statement (MTBPS). The MTBPS indicates a sustained increase in government’s debt ratio to more than 60% of GDP over the next four years is likely, unless there are more tax increases and expenditure cuts, as well as reform of the economy, including the repair of state-owned companies (SOCs)’ finances.
Perhaps next year’s National Budget contains additional fiscal consolidation measures that could lead to a less alarming route than suggested by the MTBPS. But, whether or not the agencies will grant the Treasury time until the National Budget speech in February 2018 is not known. That said there is a material risk S&P will lower its rating for South Africa’s local currency debt from investment grade to sub-investment grade at some point. The same goes for Moody’s.
But ratings decisions merely confirm that fiscal policy is on the wrong path. Ultimately, the persistent deterioration in government’s financial position over a number of years is already reflected in the high real interest rate it currently pays on newly issued government debt.
The year tighter fiscal policy came undone
On the revenue side, South Africa’s hitherto stellar track record in collecting taxes unravelled in 2017. In February 2017, Main Budget revenue was projected to increase 9.3% in 2017/18. However, the projected increase for the year was revised to just 4.9% in the MTBPS, lagging nominal GDP growth, while tax revenue growth was budgeted to exceed GDP growth in 2017/18, given the announcement of new revenue raising measures amounting to R28 billion.
On the expenditure side, there are two reasons to fret. First, aggregate support of R13.7 billion for SOCs, namely SAA and the SA Post Office, in the fiscal year to date has not been “deficit neutral”. According to the MTBPS several SOCs are “heavily indebted, without sufficient cash to service their debt obligations or even to run their operations”. It further suggests government intervention is likely to be required in Denel, South African Express and the SABC due to liquidity shortfalls.
Second, in addition to faster than expected population growth the MTBPS lists additional spending priorities which are not yet budgeted for. These include National Health Insurance (NHI), if fully implemented, additional funding for higher education, childhood development improvements and infrastructure projects. The white paper on NHI estimates public health spending alone will increase from 3.9% of GDP in 2017/18 to 6.8% of GDP by 2025/26 if the economy grows at 2.5% in real terms.
This year’s MTBPS states that Treasury expects the main primary budget balance (revenue less non-interest spending) to record a deficit of 1.2% of GDP in 2017/18, significantly larger than the deficit of 0.5% of GDP for 2016/17. The MTBPS projects that in the absence of additional fiscal consolidation, the primary budget balance will remain in deficit over the next three years. If so, the gross loan debt ratio continues to increase, breaching 60% of GDP by 2021/22.
The Treasury also calculates expenditure cuts and/or tax hikes amounting to 0.8% of GDP (the equivalent of R40 billion in 2018/19) will be required just to stabilise the debt ratio below 60% of GDP over 10 years. Finance Minister Gigaba indicated in parliament yesterday that this would likely entail tax hikes of R15 billion and expenditure cuts of R25 billion. Treasury’s intent to rein in the debt level remains intact. But the widening of the primary budget deficit in the current fiscal year is significant and calls into question whether the fiscal authorities’ intent will translate into the desired outcome.
Fiscal consolidation does not always reduce fiscal risk
It is easy to become fixated with deficit and debt levels, believing that fiscal consolidation programmes which fix these ratios reduce fiscal risk. However, fiscal adjustment programmes, which improve budget deficits and debt levels, but also erode the government’s asset base relative to GDP, may decrease government’s net asset value. If so, fiscal risk increases.
Whereas we cannot accurately measure all government’s assets we can observe that not only has fiscal consolidation failed to arrest the increase in the debt ratio, the programme has been pursued amidst a decline in the share of government’s fixed capital stock in GDP, an increase in contingent liabilities (including a guarantee exposure to public institutions of R308.3 billion at end March 2017), the emergence of maintenance backlogs and the sale of assets to address liquidity issues, rather than to target efficiency. These developments point to the erosion of the general government’s asset base relative to GDP – at least the easily observable portion of it.
Data for the period from the mid-1990s show that government has been borrowing for the wrong reasons: spending has been skewed towards consumption rather than capital expenditure. And, even though the debt level is the same as 20 years ago, the data points to a clear deterioration in general government’s net asset value.
It must be noted Reserve Bank data shows that the fixed capital stock of public sector corporations has increased from 30% of GDP in 2007 to 48% of GDP by 2016. Also, additional capital expenditure of R433 billion was budgeted for by SOCs, specifically, over the next three years. Hopefully, this investment will be reflected in stronger revenue growth down the road.
But the debt of public corporations has also increased, limiting any improvement in their net asset value. In addition, the Treasury calculated that the return on equity at the SOCs was barely positive between 2013 and 2016, which it noted is a concern considering that government is borrowing at a far higher interest rate than this to fund these institutions. Moreover, liquidity issues at several SOCs expose the national government to risk due to the debt it guarantees.
Implications: introduce prescribed assets or print more money?
The government can fund itself, but at a markedly higher real interest rate than we would like, given the increase in fiscal risk. In the absence of an improvement in the government’s primary budget balance, the current real interest rate paid on government debt is far too high relative to real GDP growth to establish fiscal sustainability.
The persistent increase in the debt level in the absence of an adequate improvement in the primary budget deficit, the large gap between the real interest rate on debt and growth, the increasing share of interest payments in total government spending and the deterioration in government’s net asset value are all consistent with a debt trap.
This does not necessarily imply default is imminent. A government has the ability to tax more or reduce tax credits. It may introduce prescribed assets – effectively instructing pension funds to purchase government bonds. It can sell assets. Or, in an extreme scenario it can print money.
The apparent risk for the foreseeable future is therefore currency weakness and inflation rather than default.
What should be done?
If Budget 2018 introduces measures to stabilise the debt ratio in the next few years, it would mean little unless government’s net asset value improves too. This speaks to the importance of shifting from consumption towards capital expenditure, but also to the pressing need to lift economic growth.
Although revenue raising measures can have a role to play, history suggests successful fiscal consolidations require expenditure cuts in aggregate.
Growth is important. Unless taxes are increased (to which there is a limit) or the structure of the economy changes (which takes a long time) tax revenue can be expected to grow in line with nominal GDP. The ability to tax is a government asset. But, whereas the expected revenue shortfall of R50.8 billion in 2017/18 has gained much attention, the problem is that calculations of South Africa’s potential growth rate have been lowered significantly. This implies the present value of tax revenue has declined.
Meanwhile, asset sales could help fund SOCs, but the government’s Inclusive Growth Action Plan indicates an audit of SOCs’ non-core assets and a framework for the disposal of non-core assets will only be completed by March next year. By the same token, asset sales reduce the government’s asset base relative to GDP and are only worth considering if they are likely to boost productivity, overall income growth and the government’s tax base. Far more helpful would be reform (which may include privatisation) of SOCs to curb the build-up of debt guarantees and end the need for liquidity support funded by taxpayers.
Absent these interventions government can expect to have fewer resources available to supply quality health and education services.
- Arthur Kamp is an economist at Sanlam Investments.
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