HOW TO FUND THE DEFICIT
SA needs a new funding plan for next year — one that boosts investor expectations of growth. Economic reforms are urgent and imperative. Tinkering with quixotic policies will only prolong the agony
SA’s most pressing fiscal problem is how to fund the R500bn deficit projected for next year once the country has used up the International Monetary Fund (IMF) and other international loans obtained to plug this year’s swollen, Covid-related borrowing requirement.
The local bond market is flashing strong warning signs that SA’S fiscal situation is not sustainable, and that it cannot be relied upon to continue to absorb ever larger amounts of SA government debt.
“In the year to date, the bulk of the new issuance has been taken up by local SA banks,” says Ninety One’s head of SA investments, Nazmeera Moola. “Their ability to buy government debt is fast eroding. SA needs another plan for next year.”
Despite the moderate bounce-back in GDP expected for next year and the National Treasury’s intention to cut expenditure by almost R90bn relative to its February 2020 estimate, the main budget deficit is still expected to be R495bn in 2021/2022. If financed entirely locally, that would result in a local bond issuance of R10bn a week, explain Moola and Peter Kent, Ninety One’s co-head of SA & Africa fixed income, in a research note.
But even if investors are willing to take up so much government debt initially, the premium they are demanding to do so suggests they are pricing in a reasonably high probability of an eventual sovereign default.
In fact, SA now has the steepest yield curve in the world. With inflation expected to average 2.8%-3.2% over the next nine months, SA is offering real interest rates of at least 6% at a time when real rates are negative in most developed markets.
SA is an outlier even among other emerging markets. Historically, SA’S 10-year government bond has yielded 1.5% more than the emerging-market average. This doubled to 3% when Nhlanhla Nene was fired as finance minister in 2015. After trending down subsequently, the differential began widening again over the past year and now sits at 4.4%.
Such high borrowing costs relative to SA’S ability to grow mean that interest charges are set to cannibalise an ever-larger share of the budget. Interest charges consumed 15.2% of total revenue in the 2019 fiscal year and are projected to claim 21.5% in fiscal 2020.
“If no actions are taken to rein in spending and boost growth, one-third of all revenue will be used to make interest payments within five years,” warn Moola and Kent. “Interest costs need to fall sharply to make the situation sustainable.”
The only sustainable way to do that is to lower SA’S fiscal risk premium by removing the spectre of a sovereign default. This means SA needs to boost investor expectations of growth dramatically, to instil confidence that the country will be able to generate sufficient tax revenue.
However, after years of prevarication, few believe the government has the wherewithal to implement the reforms necessary to get growth going. The ratings agencies have lost faith in SA and the bond market is fast reaching the same conclusion.
“Confidence levels are extremely depressed,” say Moola and Kent. “Years of corruption, regulatory uncertainty and the hollowing out of public sector capacity have resulted in a government whose default [position] is to do nothing.
“We are five months into the Covid crisis and there has yet to be any progress in policy initiatives from the government. Cosatu has produced a plan; Business for SA has produced another plan; the government has yet to produce a plan.”
Not that they think SA needs another plan from government. “We simply need the government to grab hold of the Treasury’s plan that was produced a year ago and implement at least three initiatives before the February 2021 budget,” they argue.
On the bright side, with confidence so low, one shouldn’t underestimate what a big impact even a small amount of progress
could make, says Moola.
The top priority, she believes, should be to stabilise SA’S electricity supply and unbundle Eskom. The other reforms could include any of the following: auctioning spectrum; establishing special economic zones for export processing; accelerating the infrastructure pipeline; shifting government services online; facilitating visas for
TAPPING THE MARKET
tourists and highly skilled workers; and reducing regulatory uncertainty in mining.
The bottom line is that in the absence of progress that boosts confidence, SA will struggle to fund the budget deficit next year.
“The good news is that the solution is clear,” say Moola and Kent. “The bad news is we do not know if there is sufficient understanding within the government of the need to act with urgency.”
Morgan Stanley economist Andrea Masia argues that in the absence of progrowth reforms there are several stop-gap measures the government may pursue to forestall a funding squeeze and the need to hightail it back to the IMF for assistance.
Among these is to convince the Public Investment Corp, which has about R1.9-trillion in assets under management, to increase its exposure to SA government bonds by about 8%, to take its holdings up to their maximum threshold of 40%.
Another option is for the government to introduce prescribed asset requirements. This could be done in various ways, ranging from the imposition of a tax on trades in equities to channel funds towards bonds, to a regulatory change that forces commercial banks to hold more government bonds as a liquidity buffer.
A more draconian option, and the one most feared by SA markets and investors, would be to specify a minimum limit on the percentage of assets under management that institutional investors must invest in government bonds. Local asset managers have expressed strong reservations against prescription. They hope the government would negotiate a settlement in which it makes various undertakings in exchange — possibly to rein in corruption or accelerate reform in areas such as energy, ports and spectrum allocation.
To prevent a destabilising flood of investment out of local equities, the government could also conceivably reduce the offshore allowance from the current 30% of assets under management at the same time. This would mean that the investment funds that flowed home would head straight into government bonds.
While this could be less disruptive to the local equity market, it would still amount to a tightening of exchange controls, undoing some of the liberalisation of the past 25 years.
More importantly, prescription would provide only a temporary solution to SA’S funding crisis and allow the government to kick the can down the road instead of forcing it to tackle the fiscal problem head-on by undertaking wholesale economic reform.
Masia sees two possible outcomes for SA. On the one hand, SA remains a sub-1% economy for the next five years, fails to achieve meaningful fiscal consolidation, continues to run wide deficits and so experiences bond yields far ahead of GDP growth. Under these circumstances, approaching the IMF for concessionary finance may be necessary.
On the other hand, Masia is impressed by the extent to which the Treasury has dug in its heels on the wage bill. He believes it could plausibly achieve the required R160bn in wage bill cuts, in addition to about R140bn of the required R230bn cuts to non-wage bill spending.
Such concerted action would be well received by the markets, he believes. It may be sufficient to lower SA’S fiscal risk premium, soften bond yields and get the debt ratio to stabilise below 90%. Assuming some success in lifting potential GDP growth, the economy could reach escape velocity and grow out of its debt problem.
This is a less-bad scenario but, even so, it emphasises the point that in the absence of a growth revival, the Treasury’s active scenario, in which debt stabilises below 90% of GDP, seems rather unlikely.
Years of corruption, regulatory uncertainty and the hollowing out of public sector capacity have resulted in a government whose default [position] is to do nothing
Nazmeera Moola & Peter Kent
The big question is what happens when SA finally runs out of road. Despite the ANC’S antipathy to the IMF, many economists believe SA will ultimately have no choice but to submit to an IMF programme with strict conditionality.
However, under normal IMF conditions, SA could access only about R80bn a year for the next three years — hardly enough to make a dent in its galloping debt trajectory.
Under exceptional circumstances SA might be able to access up to five times this amount. But, in terms of the IMF’S rules, it would have to be convinced that not only is SA’S debt trajectory sustainable, but that there is a reasonable prospect of its reforms being implemented successfully. Only, if SA is back at the IMF in a few years, it will be precisely because it meets neither of these conditions.
A huge programme of quantitative easing and extensive prescribed asset requirements remain as last-ditch solutions, but the current hierarchies in the Treasury and Reserve Bank would have to be disabled or persuaded for these policies to be adopted.
The only positive way out is to grow the economy. Let’s hope the government realises that before it’s too late.