This is arguably the most optimistic we have been going into a budget in a decade. In his MTBPS speech in November, Finance Minister Godongwana made a number of key commitments including, a list of structural reforms, reducing support for dysfunctional SOEs and utilizing any near-term windfalls to reduce the country’s overall debt burden. Encouragingly, the Finance Minister has also communicated that there is a need to crowd in the private sector, allowing it to play a more significant role in augmenting economic growth. That said, these promises require action to have any material impact on the path of SA both from a fiscal and economic perspective.
The government has been gifted a lifeline after a change in the methodology used to calculate GDP suddenly makes the country’s debt pile look significantly more manageable. Therefore, the government must use the window of opportunity provided by the rebasing of GDP and better than expected mining revenues to steer the country towards a brighter future for all.
Financial markets will be watching closely to see how the government uses this fiscal space in the upcoming budget. Concrete evidence of fiscal constraint and commitment to structural reforms will undoubtedly position SA as a top emerging market investment destination in 2022. It is in the hands of the Finance Minister to make the most of this opportunity.
Highlighted below are some budget scenarios, and market responses thereof:
Best Case Scenario:
- Spending is re-evaluated to promote sustainability
- Reductions in SOE support despite revenue windfall
- Growth-enhancing reforms prioritised and detailed, including greater private sector participation and privatisation of core assets of the state
- No public sector wage hikes
- Ending of COVID emergency grant
- Reduction in borrowing requirements
Market Response: Bullish
Base Case Scenario:
- Revenue collection revised higher on commodities windfall
- Improvement in key fiscal metrics owing to revenue windfall and GDP re-calculations (as noted in MTBS)
- Provide details of feasibility study of basic income grant
- Public sector wage progression at 1.5% annually
- Focus on structural growth reforms but with limited details provided
- Additional support to SOEs from revenue windfall
Market Response: Neutral – Bullish
Worst Case Scenario:
- Announcements of tax hikes, including VAT increase and wealth tax
- Further SOE support
- Additional fiscal stimulus measures, including the introduction of a social grant that exceeds R350 ( making this permanent)
- Funding redirected from investment purposes to fund debt and greater social expenses
Market Response: Bearish
Prudent fiscal policy still warranted despite improvement in fiscal metrics
While the methodology change used to calculate GDP has made SA’s debt pile look significantly more manageable when looking at debt-GDP, fiscal risks remain elevated. The rebasing of GDP has meant that 2020 nominal GDP was 11% higher than previously reported, affecting key credit metrics including GDP per capita and government debt/GDP. Moreover, it is worth pointing out that the robust rally in commodity prices and the reopening of the global economy has resulted in vastly improved tax revenue numbers. The mining sector provided the government with a lifeline as the significant increase in revenue helped prevent what might have been a catastrophic fiscal crisis.
Due to the recovery in consumption and wages in recent months and mining sector tax receipts, 2020/21 revenue collections were expected to be R99.6bn higher than estimated in the 2020 MTBPS. Given the impressive performance of the mining sector and sustained rally in international commodity prices, the expectation is for government to upwardly revise revenue for the mining sector in the coming budget. The agricultural sector recorded strong growth in 2020 and continued to expand by 8.3% in the first half of 2021. SA’s summer crop harvest for the 2020/21 season was one of the largest in history. The solid crop yield against the backdrop of elevated international agri prices and a stronger than expected economic recovery will also contribute to favourable revenue figures.
Elevated international commodity prices won’t be sustained indefinitely
Although the marked rise in mining is constructive, we continue to caution that it must be treated as cyclical and not structural as the current environment of elevated international commodity prices won’t be sustained indefinitely. Therefore, the need to implement a prudent fiscal policy remains as important as ever. Broad-based growth underpinned by structural reforms is required if the favourable revenue figures are to be sustained.
SA’s budget deficit is seen narrowing in the years ahead but more needs to be done
SA’s budget deficit soared to 9.7% of GDP in 2020 following the introduction of Covid-19 related measures and the continued transfer of funds to SOE’s whose operational and financial performance, for the most part, deteriorated further. This came against the backdrop of a sharp drop in revenue as the economy suffered following the introduction of lockdowns. While SA’s fiscal deficit moderated to an estimated 8.4% in 2021, this is still an alarming figure when considering the country’s fragile fiscal position, with public debt estimated to have reached almost 70% of GDP in 2021, even after the massive revision to GDP.
As highlighted in the latest report from the IMF, although SA’s fiscal deficit is expected to narrow in the years ahead on recovering revenue and the phasing out of Covid-19-related measures, the growing interest bill and demands from SOEs and public servants will keep the fiscal deficit high. The IMF forecasts that SA will run a budget deficit of above 7% of GDP over the medium term. This is notably higher than what the government is forecasting. The Finance Ministry projects a budget shortfall of -7.8% for the 2021/22 fiscal year, -6.0% in 2022/23, -5.3% in 2023/24 and -4.9% in 2024/25. Given that the government is expected to continue running budget deficits in the years ahead, SA’s public debt pile is expected to continue to rise at a significant rate in the years ahead. Note that SA’s gross debt pile has almost doubled over the past 5 years amid failed attempts from the government to rein in expenditure against the backdrop of anaemic growth. If this pace of fiscal degradation is sustained, it won’t be long until SA is back at risk of falling into a position of fiscal distress.
Funding pressures moderate but are still a concern for investors
The MTPBS showed that there has been a significant improvement in the fiscal landscape since the 2021 February budget, primarily due to better than expected revenue collections. For the 2021/22 fiscal year, the government’s gross borrowing requirement was revised down from around R550bn to R475bn. Gross borrowing is however set to rise slightly in the upcoming fiscal years, averaging R503bn for the next three years. Note that this is significantly lower than the numbers feared during the pandemic when the government forecast that it could be required to borrow up to R750bn from the debt market.
While the improved revenue has come as a major relief for the bond market, traders continue to demand a sizeable discount for holding SA bonds. This is reflected when looking at the spread between SA’s 10-year bond yield relative to the comparable US Treasury yield as well as SA’s 5-year USD credit default swap, which both rank amongst the highest amongst emerging markets.
Currency resilience model
ETM’s currency resilience model shows that SA ranks poorly in terms of fiscal dynamics. Specifically, the country scores just 2.3 out of a possible 10. While this means that SA is the fourth most fiscally fragile country out of the 22 country sample, it is worth noting that there has been a notable improvement when compared to the levels seen in 2020 when SA scored 1.1 in terms of fiscal risk.
SA’s fiscal buffers and savings remain insufficient should SA face another crisis
While there has been an improvement in SA’s fiscal position over the past year, due to surging commodity prices and the rebasing of GDP, SA’s economy remains vulnerable in the event of another crisis given its weak fiscal position and lack of fiscal buffers. Given SA’s lacklustre economic outlook, the heavy dependence of SOE’s on the state, and lingering social problems, it is unlikely that the government will be in a position to rebuild these buffers in the coming years unless some serious reforms are rolled out.
The IMF and credit rating agencies have called on SA to define concrete measures towards fiscal consolidation. The IMF also noted that this should be done by containing public-sector wage growth, rationalising bailouts of SOEs, streamlining tax expenditure, and improving the targeting of education subsidies.
The urgent need for more private sector inclusion
Although there have been some encouraging developments on the privatisation front, progress has been slow and arguably underwhelming from an investor’s perspective. Given the fragile position of almost all of SA’s SOEs and the lack of service delivery in the country, there is no question that the government needs to include the private sector in the running and ownership of SOEs. Contingent liabilities related to SA’s heavily indebted SOEs has heavily hindered the government’s financial performance over the past decade. For context, Eskom’s debt currently sits at around 8% of GDP. Unless there is more inclusion of the private sector, particularly in terms of Eskom and power generation, the risk going forward is that additional support from government beyond what is budgeted for, will be needed.
The ever-pressing need to address the Eskom crisis
As mentioned above, one of the main hindrances to growth in SA remains unstable and expensive electricity. Load-shedding continues to constrain economic activity as businesses are forced to suspend operations or make use of alternative sources of electricity, including costly generators. According to Western Cape’s Minister of Finance David Maynier, load shedding is costing the economy R500mn a day in lost activity.
Not only is Eskom a constraint to growth, but it is also one of the largest drags on the government’s books. Concerningly, reports have surfaced that the government is considering taking on a portion or even all of Eskom’s R392bn debt as it looks to restructure the cash-strapped power utility’s loan obligations. Following consultation with government officials, the IMF said that Eskom’s financial position is of particular concern and requires a decision on how to address its unsustainable debt levels. According to the IMF, the government is discussing whether the state should assume part or all of the debt upfront or continue making annual transfers of funds to the power utility, which could be higher than budget estimates.
According to IMF data, transfers to Eskom averaged 1% of GDP over the past two fiscal years, while the utility’s government-guaranteed loan facility reached 6% of GDP. In a bid to get rid of some of its debt, the Finance Minister proposed in his November budget update that Eskom should sell some of its coal power stations. Were the coal-fired power stations in a fully operational state and the usable life of the power stations of any significant number, this would be plausible. However, this is not the case and, in our opinion, not a feasible solution to resolving Eskom’s debt crisis. That said, we still find it encouraging that the Finance Minister is proposing such measures.
Extended welfare spending
While President Ramaphosa pledged to deliver bold reforms in his SONA speech to address corruption, endemic poverty, inequality, unemployment and an unreliable power supply, he also announced that the government is extending its monthly social welfare program until March 2023. The social welfare program provides monthly payments of R350 to around 10.5mn South Africans. Recall that the program was set to end in March this year. While the extended program will support those in need, it is a massive burden to the fiscus.
A concerning stat to swallow is that there are twice as many social welfare recipients as registered taxpayers. The government can arguably afford the extended social program for now. However, it can ill afford to fund a more permanent program given SA’s structural fiscal constraints. Funding of a social program is considered unpalatable, with interest expenses on debt already the fastest growing line item in the budget over the past decade.
The laffer curve at a point of marginal decline
While the government will be considering raising taxes to generate more revenue, doing so could further erode the tax base. History shows that SA is nearing the peak of what it can tax the private sector. As mentioned in recent budget supports, whenever the tax burden is raised too far, there is a negative blowback to the fiscus. That may come in the form of a tax base shrinking, less incentive to invest in the future, tax emigration, tax avoidance and general underperformance as financial resources are channelled away from productive sectors. In a sense, this reflects the Laffer curve in action, where every extra attempt to extract more revenues from SA’s tax base becomes more marginal and will at some point turn negative.
Government needs to address labour union demands
A major sore point for investors is the fact that the government continues to spend a significant portion of its budget to compensate just 2% of the population. According to the MTBPS, the public sector wage bill sat at R665.7bn, making it the single largest component of government expenditure. Specifically, the public sector wage bill accounts for an eye-watering 35% of the government’s expenses. Although the government has attempted to consolidate the inflated wage bill in recent years, average wage growth has exceeded inflation as well as average private-sector wage growth at 5%. That said, the government has pledged to drastically reduce the public sector wage growth rate, with the average growth in the government’s expenditure to remunerate public servants expected to be 1% between 2021 and 2024. Although this is encouraging, the government will be hard-pressed by labour unions in the years ahead and, if history is anything to go by, will struggle to stick to its commitment.
SA is still a favourite amongst investors despite heightened fiscal risks
Although SA remains in a fragile fiscal position, the government’s bond term structure is favourable from a credit rating perspective, given its relatively long duration debt profile and the fact that most of its debt is denominated in local currency. Adding to the attractiveness of SA bonds is how liquid the local bond market is relative to some of its EM peers.
South Africa is a standout investment choice for fixed income investors at the moment, given that SA assets provide a handsome risk premium compared to other emerging markets. Moreover, the Rand has proven to be resilient as the rally in commodities supports the country’s trade account. The combination of the factors mentioned above has pushed SA towards the top of the carry attractiveness rankings. This comes against the backdrop of contained price pressures, attractive valuations, and improved exports as China’s economic stimulus package drives international commodity prices higher.
SA bonds outperforming emerging market peers
Looking at the year-to-date performance of SA bonds relative to the broader EM basket, SA bonds have been a clear outperformer. Specifically, the Bloomberg SA Local Currency Total Returns Bond Index is up by almost 9% this year, while the comparable emerging market bond index is down -0.2%. Going forward, given all the uncertainty in the world at the moment, investors will want to be in highly liquid assets in the case there is a need to run to safety. Therefore, we expect that emerging market investors will continue to favour SA bonds in the months ahead despite heightened fiscal risks as investors take advantage of the attractive premiums on offer while having peace of mind that they can quickly exit their positions if needed. Moreover, SA assets could become even more attractive should the Finance Minister deliver a market-friendly budget, where prudent fiscal and growth supportive reforms are adopted.