Mid-term budget review - what it means for investors

For the first time since 1994, there is a task team set up to deal with the fiscal challenges facing South Africa. It is led by the Minister of Finance who will report to the President of the Republic. The goal of this focused and select team is to come up with the actions needed to restore the sustainability of fiscal policy, and which will be put forward in the February 2018 National Budget. Fiscal authorities at the National Treasury have performed an honest assessment of the fiscal matrix in the Medium-Term Budget Policy Statement (MTBPS) and painted a worrisome picture. 

Contrary to the previous budget formulation processes, what came out of this MTBPS was only a diagnosis of the problems and the fiscal hole was quantified. The MTBPS did not indicate how these issues will be solved. Instead, all potential actions and resolutions have been deferred to the presidential task team on fiscal policy, with an expected delivery on the outcomes in the February 2018 Budget. This represents a fundamental shift away from the budgeting framework South Africa has been accustomed to since 1994, and it will have negative consequences for how markets react – including potential credit ratings downgrades.

Revenue shortfall

For the first time since the 2009 global financial crisis, there is an under-collection of R50.8 billion (US$3.7 billion), which was bigger than the market consensus of R40 billion (US$2.9 billion). All categories of tax revenue disappointed, with a material decline in personal income tax and value added tax (VAT). With weak growth and rising unemployment persisting in South Africa, the outlook remains challenging on tax collections.

For the first time since the budget expenditure ceiling was introduced in the 2014 fiscal year, it has been breached, to the tune of R3.9 billion, mainly as a result of bailouts for South African Airways and the South African Post Office. This will be viewed negatively by ratings agencies. The evidence of fiscal consolidation was expressed by maintaining the ceiling. However, breaching it indicates a lack of discipline on the expenditure side, with spending growing at a pace of more than 7% year-on-year. New expenditure items, such as national health insurance (NHI), are proposed to be financed through adjustments to medical tax credit.

Wage bill

Compensation to public service workers has grown quicker than the overall budget over the past eight years, and accounted for 35% of consolidated expenditure in 2016/17, up from 33% in 2008/09. Although detail on the public sector headcount was provided, it did not reflect the promise of consolidation introduced by previous Ministers of Finance in earlier years.

A full 6 percentage points slippage.

Source: National Treasury, Medium Term Budget Policy Statement, October 2017

Debt load

There is a projected slippage in the gross debt to gross domestic product (GDP) ratio over the medium term of a full six percentage points (see graph). To stabilise the debt/GDP ratio below 60%, the National Treasury has said that for the next decade, substantial tax hikes are needed. In the ensuing fiscal year 2018/19, tax hikes of up to R40 billion will need to be collected.

Debt-service costs remain the fastest growing category of expenditure. In the next five years, 15% of main budget revenue will be spent servicing debt. This will prove to be South Africa’s Achilles heel. At these levels, the significant risk of debt sustainability begins to surface, especially when the primary balance (the difference between total revenue and non-interest expenditure) — which was expected to be positive over the forecast horizon in the February Budget — has nosedived into negative territory.

Rating downgrades

This MTBPS has increased the likelihood of additional credit rating downgrades before the year closes and ahead of the African National Congress (ANC) electoral conference. Substantial fiscal policy uncertainty has been introduced by the weak economic growth outlook, altered budgeting process, and deteriorating debt position.

Crisis or not?

There is a notable and material deterioration in South Africa’s fiscal position, which will result in the 90% of debt issued in rands being downgraded into non-investment grade, with potential capital outflows ensuing as a consequence. This has now become a base case scenario with possible negative consequences for the rand, lofty equity markets, bonds and economic growth as a whole.

While these outcomes are undoubtedly dire, they do not represent a classical emerging market crisis scenario, as observed elsewhere in history. The fact that South Africa still has fiscal policy levers to pull (VAT and corporate tax), an independent central bank, a solid and well-capitalised banking system, and a cheap currency, provides comfort that the country can weather this storm. It can be argued that the markets, for some time now, have begun pricing in an outcome where South Africa is assigned a credit quality rating of non-investment grade in local currency.

Clearly the fiscal path presented in this MTBPS cannot be sustained. Much of the required changes need a different political input. Without a well-considered reform in the political construct at the December ANC electoral conference, the stakes have risen for an impactful negative economic scenario, which will adversely impact the financial well-being of all South Africans.

Consequences for investors

It is during times such as these that a risk-led investment strategy is needed. Economies go through cycles, influenced by global factors and domestic political outcomes. During an investor’s journey, there will be periods of bounty and those punctuated by bumps. Much of what could ensue in South Africa’s markets and its economy will be categorised by heightened volatility. Through all these cycles, there is a need to have a very clear objective in investments - and to stay the course for the long term.

Written at the budget lock-up, Parliament Cape Town: Lesiba Mothata, Executive Chief Economist,
Alexander Forbes Investments

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