Years of fiscal consolidation - cutting expenditure and raising revenue mainly through tax increases, have failed to deliver the desired outcome. The Main Budget deficit is likely to exceed 6% of GDP in 2019/20 with the gross loan debt ratio increasing to more than 60% of GDP by the end of this fiscal year.
Granted, a debt level of this magnitude is, in itself, not a great concern. After all, it’s unlikely to prompt Moody’s to downgrade South Africa to sub-investment grade this year, given the methodology followed by the ratings agency.
We do have a problem
But that does not mean there isn’t a problem. Should growth remain modest in the medium term – a likely scenario considering current information – the Main budget deficit is likely to remain above 6% of GDP in the next two years – absent any policy intervention. The debt ratio would continue its relentless increase. Add in contingent liabilities in the form of government guarantees extended to ailing state owned companies and other entities, amounting to about 10% of GDP, and this leaves South Africa in a precarious position. One could exclude the government’s cash balance, but this would not make much difference. In any event, it is the gross loan debt which savers are expected to fund.
We are not in a debt trap yet, though
It is clear the intent of the National Treasury is to guide South Africa’s unsustainable fiscal path back towards a sustainable position. For now, that implies arresting the upward trajectory of the debt level. There is no benchmark for the appropriate level of debt. However, if the real interest rate paid on debt persistently exceeds the real growth rate of the economy it’s a red flag. In South Africa’s case it implies the National Treasury must run a material surplus primary budget balance (revenue less non-interest spending) to steady the ship. The risk is that bond market participants decide the government is not in a position to run that surplus and that the upward debt trajectory is heading into runaway territory. If so, they would dump government bonds, signaling the onset of a debt trap.
Fortunately, we are not at this point at present and the government has options. In part, the Treasury is likely to respond in the Mini-Budget in standard fashion by increasing taxes a bit and by cutting expenditure.
We need to balance unemployment with the need to cut state expenses
Indeed, the National Treasury proposed that government departments cut expenditure by 5% in 2020/21; 6% in 2021/22; and 7% in 2022/23. That’s not easy, given the responsibility on the Treasury that an unemployment rate of 29% entails. Simply put, other than the obligation to service debt there are expenditure items that simply cannot be cut. One is social grants. Another is the budgeted transfers to Eskom – unless an alternative solution is found for funding the state owned company.
It will also be difficult to cut compensation of employees, especially considering that recent government employment numbers have been increasing. Also, government spending priorities, notably health and education are human capital intensive. We assume that if the government sticks to the plans included in the initial Budget for 2019/20 to rein in the compensation of employees, it would be a good result. The existing scenario does show slight moderation in compensation as a percentage of total expenditure over the medium term.
A deteriorating balance sheet is coming home to roost
Amidst rising demand for more expenditure, we estimate the government can cut spending by close to R40 billion 2020/21 and by close to R50 billion in 2021/22. But, it is difficult to see how restraining spending to this extent and raising taxes a little is enough. The reason is that the underlying problem, which has come home to roost, is the deteriorated government balance sheet. General government net worth, which we measure as fixed assets less liabilities, has decreased by more than 20% of GDP per cent since 2007.
On a related point, the immediate problem is the deterioration in the finances of state-owned companies that are now being accommodated in the Main Budget. The Eskom bail-out has boosted government spending by R49 billion in 2019/20 and R56 billion in 2020/21 and by R23 billion per year for the next eight years. In effect, former off balance sheet contingent liabilities are no longer contingent.
What are the options open to the state?
This unwanted outcome must be dealt with in order to stabilise the government’s financial position. At least, the government has options. One is to enter into partnership with the private sector, by selling the future income streams associated with public sector assets, for example Eskom’s power stations, as opposed to selling those assets. These contracts could include clauses to ensure developmental objectives are met. They could also include an end-date, underlining the point that the assets remain state owned.
These alternatives are not news. The recently released National Treasury paper on a growth strategy for South Africa references work along these lines in deriving an estimated possible value of R450 billion from the sale of the income stream from Eskom’s generation assets.
In the end, no amount of fiscal adjustment can compensate for the core problem, namely the lack of economic growth. Neither is it plausible, especially against the background of slower global growth, to expect the growth problem to be resolved anytime soon. In the interim, the best alternative is to show a credible path back to fiscal consolidation. In essence, the plan needs to reflect an improvement in the state’s balance sheet. That implies greater emphasis on capital expenditure, rather than consumption, and a turnaround in the financial position of state owned companies.
If this can be achieved it should change the narrative around sovereign debt rating downgrades and, all else equal, lead to relatively cheaper government borrowing. The Medium Term Budget should provide strong clues as to whether or not South Africa will pursue this path.