Investors are waiting in anticipation for Treasury's Medium-term Budget Policy Statement (MTBPS) scheduled for 1 November 2023, to accurately gauge the country's worrisome debt-to-GDP ratio and evaluate the potential implications for debt servicing expenses.

Worse-than-budgeted revenue collection and expenditure overruns have raised the prospects of a fiscal crisis. Escalating debt levels present a significant concern for the fiscus, as they shave off a growing share of the budget to cover interest on the debt, consequently diminishing the funds to be allocated for crucial services and infrastructure.

While concerns of a debt default are exaggerated, a failure to check the rise in debt-to-GDP could put further pressure on interest rates, the currency, and the inflation outlook. These factors could force asset managers to reevaluate asset allocations across their portfolios.

A comprehensive assessment of the impact of debt on the investment landscape is crucial.

Portfolio managers must consider factors such as the effective cost of servicing debt, the share of government expenditure allocated to servicing interest and capital repayments, the maturity profile and currency mix of the government’s debt and investor willingness to lend to the government.

All else being equal, faster economic growth, lower interest rates, and a higher primary surplus or lower primary deficit would result in a lower debt-to-GDP ratio. However, government expenditure is the only component directly under government control, making the fulfilment of promised austerity measures vital.

Unfortunately, a continued deterioration in the primary budget outlook, with a recent estimate of a R72 billion revenue collection shortfall for 2023-2024 by the Bureau for Economic Research (BER), has raised concerns about the medium-term debt trajectory.

Government revenue is coming in lower partly due to lower corporate tax, which is being partly driven by lower mining sector tax based on lower commodity prices currently. Commodity prices are expected to continue to be significantly impacted by China’s declining economic prospects.

A high debt-to-GDP ratio significantly impacts the domestic economy as it increases lending risk, leading to higher compensation demands from investors.

Furthermore, higher bond yields are needed to incentivise investors to continue funding the government deficit, putting pressure on the overall cost of capital in the country, increasing the investment hurdle rate for the private sector and consequently reducing investment in the domestic economy. This scenario is referred to as ‘crowding out,’ where banks choose to invest in government debt rather than lending to the private sector. Locally oriented and cyclical businesses are particularly vulnerable to rising debt costs, exacerbated by government actions like cutting social spending or raising taxes.

A South African government debt default is very unlikely since most of the government’s debt is denominated in rand and the government can raise taxes or, in extreme conditions, resort to printing money to finance the deficit. However, while avoiding outright default these solutions both have negative consequences. Higher taxes would reduce growth prospects while printing money would be highly damaging for the currency, eroding real returns from bonds due to higher inflation.

The fiscal situation in the country has already led to higher interest rates as investors seek greater compensation for elevated risk.

High debt servicing costs limit the government's ability to take on additional debt for large infrastructure projects, which is a top concern for the investment community, and other domestic capital allocators.

South Africa’s growth deficit is primarily attributed to inadequate investment in infrastructure, encompassing energy and transport infrastructure. However, this problem extends beyond physical infrastructure to inefficient government spending in areas like education, health, and policing.

How do we manage the risk posed by fiscal deterioration at Old Mutual Investment Group? We build diversified portfolios which actively manage the risks to investors under outcomes. While the fiscal risks are real, investors should remain focused on their long-term investment strategies.