As has been the case for the past few years, the main theme heading into this year’s National Budget tabling centred on National Treasury’s commitment to fiscal consolidation, given the massive funding requirements of State Owned Enterprises (SOEs) and a still fragile domestic economic growth environment.
WRITTEN BY: RHANDZO MUKANSI, PORTFOLIO MANAGER | SOURCE: INTO AFRICA, MARCH EDITION
Real domestic economic growth has averaged 1.9% year on year since the turn of the decade, not dissimilar to South Africa’s often quoted 2% potential growth rate. This pales in comparison to the prior decade, where year-on-year economic growth averaged 3.6% and peaked at a buoyant 7.1% in the last quarter of 2006. It’s no coincidence that this boom period for the domestic economy, admittedly aided by China’s super commodity cycle, coincided with the peak in fiscal revenue collection relative to gross domestic product (GDP) of 30% in the same year. Despite comparatively higher value-added tax (VAT), personal income tax and excise duty rates, fiscal revenue collection has lagged behind the acceleration in counter-cyclical fiscal expenditure effected to prop up the economy in the past decade.
Fiscal revenue and expenditure trends: Deferred fiscal consolidation
South Africa is not alone in having engaged in aggressive counter-cyclical fiscal expansion in the years following the global financial crisis. However, a disproportionate share of this expenditure has gone towards current expenditure, at the expense of growth-enhancing capital formation. This has resulted in a stubbornly wide budget deficit, which has averaged -3.9% in the past decade and is forecast to average an even wider -4.2% over Treasury’s medium-term expenditure framework. Naturally, the cumulative effect of consistently wide budget deficits has been the near doubling of South Africa’s gross debt-to-GDP ratio in the past decade, to 56% at present and forecast to escalate further to 60.3% in the next three years.
Two key fiscal consolidation anchors
Given this backdrop, two key anchors for fiscal probity in recent times, and certainly key to preserving South Africa’s last remaining investment grade sovereign credit rating (from Moody’s), have been Treasury’s dogged determination to support ailing SOEs in a budget deficit-neutral manner, and to maintain the expenditure ceiling to ensure fiscal debt stabilisation over the medium term.
Contrary to the generally positive take on the budget by domestic financial market participants, we remain underwhelmed by the medium-term budget expectations. While fully appreciating the challenging fiscal environment and the progress made towards expenditure constraint in the 2019/20 budget, we remain disappointed by the loosening of the above- mentioned two key fiscal consolidation anchors – namely deficit neutral SOE financial support and the previously sacrosanct expenditure ceiling. This has again resulted in a forecast widening of the budget deficit over Treasury’s medium-term expenditure framework and the postponement of the forecast peak in the gross-debt to GDP ratio to 2023/24.
The loosening of the previous deficit-neutral SOE financing was as a result of the extraordinary fiscal support provided to Eskom, with R69bn budgeted over the medium- term expenditure framework as a “provisional allocation” for reconfiguring Eskom – to be transferred as a cash injection of R23bn per year over a three year period.
Our concerns
Our reading of the budget would be kinder if we were convinced that the extraordinary support to Eskom would be enough to negate the economic risk the entity poses over the medium term. While overdelivering in its support of Eskom relative to prior market expectations, we’re of the view that this support still falls short of what’s required to adequately support the entity over the medium term.
Given the dependence of South Africa’s sovereign credit quality on the health of government finances, the retention of South Africa’s last remaining investment grade credit rating by Moody’s remains tenuous over the medium term. South Africa is likely to be given a ratings reprieve when Moody’s next issues its rating review on 29 March pending the country’s presidential election on 8 May 2019. Of more immediate concern for domestic bond market participants will therefore be the preservation of a stable ratings outlook by the ratings agency when it issues its rating review, given the historically high probability of a soon to follow credit rating downgrade.
The domestic nominal bond yield curve slope, given by the difference between the generic 30-year and 10-year nominal bonds has steepened in the past decade, largely in line with the escalation of government debt relative to GDP. The heightened execution risk we attach to the fiscal targets set out in the 2019/20 budget suggest that yield curve slope should at best remain elevated over the medium term and at worst widen even further – in accordance with the continued widening of government debt in the medium term.
Government debt metrics maintain nominal yield curve steepness
In conclusion
Without improved domestic growth, SA’s debt burdening looks increasingly unsustainable – particularly in light of the abandonment of two critical fiscal consolidation anchors (expenditure ceiling and deficit neutral SOE funding). Rating downgrade risk therefore remains elevated over the medium term – with the preservation of South Africa’s last remaining investment grade sovereign rating from Moody’s looking increasingly tenuous.
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