What wasn't said in the budget speech

Finance Minister Tito Mboweni presented National Treasury’s Supplementary Budget to Parliament on Wednesday 24 June. The key takeaway from his speech was urgency: that the decisions taken today will determine whether we take a hard – and probably slow – road to recovery, or if we take the low road, with a slippery slope to economic convulsion within the next two years.

To ascertain the likelihood of these two scenarios, we explore below the numbers behind the updated budget, as well as its market effects, its impact on the economy and implication for investors.

Herculean Tasks Arise from Herculean Problems

Mboweni did not mince his words when he mentioned the “Herculean task” that lies ahead. Herculean tasks arise from Herculean problems. We’ve known for years what we needed to do to avoid fiscal crisis – namely to stop spending, start reforms and deal with the structural imbalances in the economy. To our detriment, policy makers chose to ignore the problems and prioritise different issues.

While it is unsurprising that we find ourselves in this fiscal position, the speed at which we’ve arrived at this point is alarming. Just 10 years ago, South Africa boasted one of the strongest government balance sheets in the world. Since then, economic growth has evaporated, per capita incomes have flatlined and tax revenue has stalled. Yet, government has spent as if that growth would somehow reappear and has also put off tough reforms indefinitely in favour of political expediency.

The hippopotamus: budget revenue and expenditure

Graph 1
Source: Treasury, 2020

When presenting the graph above, Mboweni stressed the need to close the “hippopotamus’s jaws” and stabilise debt. As evident from the numbers, expenditure as a percentage of gross domestic product (GDP) has risen dramatically while tax buoyancy (reflecting National Treasury’s efficiency in collecting tax revenue in response to GDP shifts) has remained static. The lion’s share of government spend has gone to funding wages. South Africa has one of the highest wages bills as a percentage of GDP of all countries in the middle-income category. As a result, public sector consumption has crowded out public sector investment. This is simply unsustainable, and while it is sustained, translates into a feeble growth environment. These basic economic truths that policy makers have pushed around for years, have now come home to roost.

The crocodile: debt outlook scenarios

Graph 2
Source: Treasury, 2020

As Mboweni pointed out, we have reached a tipping point. If we continue on the current “passive” path of inaction, we will find ourselves in fiscal default. Should government choose the “active” road of implementing the reforms that they’ve been putting off for the past decade, the country could find the road to recovery.

Skeptics will cite the lack of implementation to date: spending has not been contained, and the revenue targets set by National Treasury are seldom attained (revenue collection targets have been met just three times over the past 10 years). Should implementation not be imminent and effective, we will quickly find ourselves in 100% debt-to-GDP territory.

Mboweni stated that debt-to-GDP will reach 80% this year. This is in fact understated, as this figure reflects just central government debt. What it does not record is the debt of state-owned enterprises (SOEs), such as Eskom and Transnet, and municipal debt, for which government is liable. Consolidating this debt adds another 15% to the cited debt-to-GDP number. With this included, South Africa’s debt-to-GDP ratio sits at 97% at the end of the current fiscal year.

The debt trap

What happens when a country has a 100% debt-to-GDP ratio? Few countries have reached this 100% mark and returned in sound shape. This is “zombie” territory: living-dead economies that limp along and oftentimes collapse. In the graph below, the red line marks the 100% debt-to-GDP threshold; and country lines end where the economies underwent dramatic economic, political or social defaults. In the case of economic defaults, they defaulted on debt repayments; in the case of politics, they experienced swift swings towards populism; and in the case of social defaults, promises made for government spending were retracted.

Debt-to-GDP dynamics post 100% debt threshold

Graph 3
Source: Cannon Asset Managers, 2020

Typically, when countries reach a 60% debt-to-GDP ratio, they cross into runaway debt territory; this is the point at which interest rate charges start to overwhelm their ability to service debt. To move from a 60% debt-to-GDP ratio to a 100% debt-to-GDP ratio usually takes a number of years. There is sufficient time to reverse course and rebalance the budget. South Africa achieved as much through the late nineties and into the noughties, as seen in the graph below. However, in the current circumstance South Africa is on a trajectory to move from 60% to 100% debt-to-GDP within 48 months, accelerated by an unaffordable interest bill.

Debt-service costs as a portion of main budget revenue

Graph 4
Source: Treasury, 2020

Foreign funding

Fortunately, South Africa has access to substantial credit via international markets. Multilateral lending agencies (such as the IMF, World Bank, African Development Bank and BRICS Bank) are cash rich and lending into a low (often zero) interest rate environment. This immediate funding pool for South Africa is about $5.2 billion, or nearly R100 billion: more than sufficient to meet South Africa’s immediate needs.

The rand and long-dated government bonds are good guides to gauging the appetite of the international community for lending to South Africa. And post Mboweni’s budget speech, both the rand and the price of 10-year government bonds moved stronger. Arguably, the updated budget was a note of confirmation, rather than new information.

Domestic funding

All told, whilst eyes and ears were on the financial deficit, the biggest deficit that South Africa faces is not fiscal. Rather, it is a deficit of confidence and delivery. Together, this makes a perfect (sic) trifecta of deficits. The fact is that the domestic savings rate for a long time has been more than adequate to fund the deficit, as the graph below shows. However, there has been an investment boycott on the part of local companies for the past decade. And the deficit on the part of government to deliver has lasted just as long. The result is the country finds itself at the end of a decade of anaemic growth, falling tax revenue, poor fiscal discipline and investment in the public and private sectors that has been crowded out by government and household consumption.

Global funding requirement unavoidable

Graph 5
Source: Cannon Asset Managers, 2020

Where to from here?

Will we be Chile, Venezuela or Argentina? In a state of fiscal and financial crisis in the 1970s, Chile put in place fierce structural government reforms that paid off to translate into a substantial and sustained reversal of fortune. Today, Chile ranks as a middle-income country with strong institutions, low rates of inflation and unemployment and a wide social welfare net. Argentina has promised the same for the past 20 years and currently sits with a fiscus in default and a 50% inflation rate. Venezuela is a failed country. The choice is ours and the time to act is now.

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