Katzenellenbogen: South Africa’s looming economic crisis – National Treasury at a crossroads

South Africa’s economic future hangs in the balance as the National Treasury grapples with an impending crisis. With an election looming, the government faces the conundrum of increased expenditure to woo voters while resisting raising taxes. A soaring budget deficit and mounting government debt leave little room for maneuver, risking a banking and exchange rate crisis. As the Reserve Bank highlights foreign investors’ waning interest in South African bonds, the Treasury must present a solution by November 1st. Diminishing buffers, declining tax base, and political hesitance compound the nation’s financial woes. Urgent, crisis-driven reform may be the only path forward, reminiscent of India’s transformation in 1991.

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The state has run out of money: Muddle or Reform?

By Jonathan Katzenellenbogen*

The National Treasury knows that South Africa is heading into an economic crisis, but it can’t do much about that. It lacks the political authority to raise taxes and reduce spending by the amounts needed to restore longer-term confidence. And an election is less than six months away.

“During an election, nobody wants to increase taxes, but everybody wants to increase expenditure to buy votes. You can’t have both,” said Finance Minister Enoch Godongwana at the News24 2023 On The Record Summit last week.

Our budget deficit and government debt are way above what is manageable, leaving borrowing by the government vulnerable to a market freeze as investors dump bonds. An exchange rate, and possibly even a banking, crisis would almost certainly follow.

Debt service is fast growing and pushing up borrowing costs as well as cutting into state spending on health, education, and capital investment. Foreign investors might like the yields they are getting on our debt, but at some stage their tolerance for the country’s risk will break.

The commodity boom over the past two years considerably boosted the Treasury’s coffers. But now with the possibility that global interest rates might remain high for longer and that the global slowdown could be prolonged, there is added pressure.

Ultimate arbiter

The bond market will be the ultimate arbiter of any attempt by the Treasury to stabilise the situation. In its Financial Stability Report that was released in June, the Reserve Bank pointed to foreigners being net sellers of South African government bonds since 2019 as “a significant structural shift” especially in view of large borrowing by the state. That, it said, raised concerns about the capacity of local investors to continue absorbing new government bond issues.

The Treasury must come up with a solution by 1 November when the Minister is due to present the Medium-Term Budget Policy Statement, which covers the next three fiscal years. This is against a backdrop of tax receipts which are down over R22 billion rand over the fiscal year so far partly due to lower commodity prices, the Eskom crisis, and problems with Transnet rail lines and the ports. Some economists expect the drop in revenue and higher expenditure over what was expected could result in a R90 billionfunding gap this year – that is about five percent of what was budgeted. The longer-term worry is that the already narrow tax base is eroding as many skilled high earners leave the country.

With the election looming, there might be few peripheral cuts that impinge little on vested interests, a small tax rise, and more borrowing to cover the gap. But it is unlikely to be sufficient, and even when the election is out of the way the government is unlikely to be decisive.

A bit of luck from slightly higher second quarter growth might slightly ease the predicament, but there is nothing that could fundamentally change the dire situation.

Diminishing buffers

We have diminishing buffers against a crisis. With the drop off in commodity prices and the problems at ports, South Africa has a widening current account balance of payment deficit – more than two percent in the second quarter is a point of vulnerability. But a large stock of foreign exchange reserves helps give foreign holders some assurance that they can get out when they need to do so.

If the state tries to borrow its way out it will have to pay higher interest rates, adding to the already dangerously high debt burden and budget deficit. It cannot achieve big cuts or raise VAT on the eve of the election, as that could punish the ANC at the polls. Increasing VAT by about two percentage points might help finance the continuation of the Social Relief of Distress grant that was brought in to temporarily alleviate hardship around the Covid-related lockdown.

The reforms to boost the economy, like privatisation of public enterprises to stop bailouts and reducing obstacles to investment like empowerment targets and burdensome labour laws, are not on the agenda. These would give investment and productivity a boost and with that could bring about a rise in tax revenue.

South Africa fiscal indicators are in dangerous territory and worse than many other emerging markets. Government debt is about 70 percent of GDP, and with slow economic growth and increased borrowing is due to rise further. The emerging market average of public debt to GDP was 67 percent last year, well above the 60 percent of GDP that is regarded as far safer ground, unless a country is a fast-growing dynamic exporter. Our fiscal deficit could be around five percent of GDP this year, compared to the under three percent the International Monetary Fund (IMF) likes to see.

Big decisions

Dodging the big decisions because it is election time could tip us into a crisis, particularly if there is a global economic shudder like a banking crisis or a spate of emerging markets running into problems. Crises tend to be contagious as markets take shelter in less risky assets when a domino falls.

If a crisis hits, South Africa may not have to rush to the IMF for a bailout, as it could draw on foreign reserves to at least try and stabilise the bond market. In most countries an unsustainable fiscal crisis is combined with a foreign exchange crisis. Our main problem is a budget deficit that we might not be able to finance, and not a shortage of foreign exchange. But if foreigners do not buy our bonds, there could be pressure on the foreign exchange reserves. Eventually we might have to go to the Fund.

That is what the ANC is very scared about, as the Fund is almost certain to insist that empowerment policies end, and that there are no more bailouts to state-owned enterprises. It would undo decades of rule by and for the cadres.

Best is reform before a crisis, but more likely would be a push from a crisis. The ANC is likely to let the crisis go to waste. Muddle rather reform is more likely. The ANC is likely to say yes to a limited range of cuts and reforms and then stop short when it thinks things are sustainable enough. So, we would still be open to crises – like Argentina and a host of other countries.

Crisis-driven reform

Second best would probably be sudden and wide-ranging crisis-driven reform. Unless this is after an election, when a mandate can be claimed or the economy is in a strong upswing, it is very rarely a good time to hurt your supporters. The country’s political leadership would have to come up with a story about having run out of options and a path of reform promising a better future. That is what India did in 1991.

India had almost run out of foreign exchange, the government was about to default, and the IMF suspended its loan. As a condition for a World Bank-IMF bailout, the economy was opened to foreign participation. Soon afterwards a new Prime Minister, Narasimha Rao, took over and undid decades of red tape, paving the way for India’s rapid growth. It was thought to be impossible.

Let us dream on.

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*Jonathan Katzenellenbogen is a Johannesburg-based freelance financial journalist.

This article was first published by the Daily Friend and is republished with permission

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