We have just had the Medium Term Budget Policy Statement (MTBPS) delivered, an annual stock-taking exercise, where the Minister of Finance reviews progress on the existing budget and updates the revenue, expenditure and borrowing guidelines for the coming three years. As we expected, Minister Enoch Godongwana brought bad news. Revenues are down and expenditures up, resulting in a higher budget deficit (4.9% compared to 4% in the original budget) and a higher peak in debt-to-GDP (78% compared to 74% previously expected). Despite the bad news, the market reacted positively with bond yields falling and the rand firming on the day. Clearly, the market expected worse tidings from the Minister.
So how should we judge the latest MTBPS and what does it mean for investors?
On the upside, the MTBPS sets out a more credible framework for revenue over the medium term. The February Budget was over-optimistic about revenue collection given a likely slowing in the global and Chinese economy, but this budget is more realistic. The Minister also delivered a commendable effort to stay the course of fiscal discipline. The reduced revenue collection has been met by spending cuts and modest increases in tax (likely to be easily funded from fiscal drag). As a result, the increase in borrowing has been limited and the government still targets a primary surplus. In the current low-growth environment this is vital to stabilising the debt-to-GDP ratio over the medium term.
The MTBPS unfortunately also highlighted how unsustainable our current fiscal position is. Most worrying is the inexorable rise in the cost of servicing government’s debt – debt servicing is now the second largest single item on the consolidated budget, having increased from less than 9% of main budget revenue in 2008/09, to more than 20% now. According to the Minister “for every R5 collected in revenue, the government pays R1 to lenders instead of funding education, policing, health and other critical services.” The rise in debt servicing costs reflects not only the sharp rise in government debt-to-GDP – up 47 percentage points since 2008 – but also the increase in the government’s cost of funding. The Minister stated that the weighted average cost of funding for the government has increased from 8.3% in February to 9.5% currently.
The current fiscal trajectory is unsustainable, and it is reflected in the material increase in South Africa’s 10-year bond yield in both absolute and relative over the last decade. Compared to 10 years ago, South African bond yields are nearly 400 basis points (bps) higher at just over 12% and the spread over US Treasury bonds has increased by nearly 200bps, while the spread over emerging market local currency bonds has increased by 400bps. The rally in South African bonds, following mildly worse-than-expected fiscal deterioration, is at least partly explained by just how much bad news is already priced in by South African bonds.
At the heart of the country’s problems is the weak growth environment and the failure of government to deliver the ecosystem that will turn that around. This was eloquently acknowledged in the MTBPs:
“Government faces difficult choices. The central problem is low economic growth. Frequent power cuts make it hard for firms to do business while deteriorating rail freight and slow port operations mean fewer goods are transported to markets here and abroad.”
South Africa has become more vulnerable to external shocks, which makes major reforms critical and unavoidable. At present capital investment is too low; too many government activities are inefficient, overlapping and non-critical; and the economy does not generate sufficient revenue to service government debt over the long term. These are the key shortcomings that government proposes to address over the next three years.
“Over the medium term there are important opportunities for deeper reforms, The 2024 Budget Review will propose to scale down outdated and unproductive programmes and entities. A new mechanism will be created to crowd in financing from the private sector and international finance institutions for large infrastructure projects. And government will propose new fiscal anchors to ensure a sustainable long-term path for the public finances.”
The measures identified (rightsizing government and private sector participation in driving infrastructure investment) are the right ones and with decent execution would go some way to restoring South Africa’s fiscal sustainability. It’s clear what needs to be done: aggressive cost-cutting by the government while protecting productive spending and wholesale privatisation of South Africa’s failed state-owned enterprises. The Minister has promised more on both in next year’s budget. While that’s good news, 2024 is also an election year with the ANC slipping in the polls. Whether his political masters have the appetite for pushing through unpopular reforms remains to be seen. For now, this means investors will remain in wait-and-see mode with actions, not more fine words, being the necessary catalyst to drive a stronger recovery in bonds and the rand.