The Medium Term Budget Policy Statement Preview (MTBPS) is usually a fairly hum-drum affair that presents the Finance Minister with an opportunity to update government’s spending and taxation plans for the three-year budgeting period. But this year’s mini budget will be the most closely watched yet for a number of reasons:
Since Nhlanhla Nene was suddenly removed from his post in December, Pravin Gordhan’s tenure as Finance Minister has been in doubt. The announcement that Gordhan was charged with fraud and due to appear in court in November was still a surprise, particularly as it was made shortly before the MTBPS.
South Africa escaped a credit rating downgrade to junk status in the second quarter, but scheduled reviews by the three major ratings agencies loom in late November and early December. S&P Global has affirmed South Africa’s foreign currency debt on a BBB- rating with a negative outlook, and therefore it is most likely to strip the government of its investment grade credit rating.
Expectations from investors and ratings agencies that the Minister is narrowing the budget deficit to stabilise public debt competes with pressure for more spending as highlighted by the ongoing student protests.
The Treasury’s economic growth forecasts from February are out of date and were way too optimistic: economic growth of 0.9 percent in 2016, 1.7 percent in 2017 and 2.4 percent in 2018 is highly unlikely. This implies that the tax revenue forecasts from February are at risk, and tax rate increases may be necessary to fill the gap.
Debt must stabilise
Relative to our peer group of emerging markets (who have a range of credit ratings), our government debt levels aren’t exceptionally high. Compared to most developed nations, it is low. The problem is that it increased rapidly since 2009, as borrowing had to make up for the difference between spending and tax revenue. Interest payments are now the fastest growing item in the Budget, and if the debt ratio is not stabilised, they will increasingly crowd out other spending items. Government expects to pay a massive R147 billion on interest payments in the current fiscal year.
To stabilise the debt ratio, government needs to reduce its deficit, something which has happened only very gradually, partly because Treasury realised that reducing it too quickly (through tax hikes and spending cuts) risked tipping the economy into recession.
Some positives
Fortunately, there have been some positive developments since the February budget:
* The global environment is more favourable. Investors abandoned emerging markets (not just South Africa) over the past few years, but since the start of 2016 their risk appetite has shifted. Emerging market currencies have stabilised and yields have declined. This is in part because developed market bond yields have declined sharply and there is a huge demand for higher-yielding assets. For example, South Africa issued $3 billion in dollar-denominated 10 and 30-year bonds in September. The issue was oversubscribed and at a spread over US yields of just over 270 basis points, down from $1.25 billion issued in April at a spread of 335 basis points.
* Commodity prices appear to have stabilised in 2016 after relentless declines in the previous four years.
* The obsessive focus on austerity and public debt reduction is fading. For instance, both US presidential candidates emphasise more spending on infrastructure, and the IMF has been calling for growth enhancing investments.
* The rand remains volatile, but is well off its January lows. At the time of last year’s MTBPS it was trading at R13.47 per US dollar while it traded at R15.67 per dollar at the time of the February Budget.
* Similarly, after rising through the course of 2015, the rate at which Government borrows over 10 years has declined from 9.7 percent at the start of the year to 8.8 percent. This eases the long-term impact of the estimated R140 billion in new borrowing this fiscal year.
* The current account deficit has narrowed to 3.1 percent of gross domestic product, half the level from three years ago. This represents a substantial reduction in external vulnerability.
* The inflation outlook for the next two years has improved. This is good news for consumers obviously, but it also gives Treasury a bit of flexibility to manage nominal spending growth without cutting real spending growth, cushioning the blow to the economy. In February, Treasury worked on an assumed 6.3 percent inflation rate in 2017 and 5.9 percent in 2018, while the latest Reuters consensus forecast is for 5.7 percent and 5.5 percent respectively.
Probably most significantly, it appears that the economy is bottoming and growth will improve in the coming years as the impact of a number of shocks (including a commodity price plunge, currency collapse, load-shedding, prolonged strikes and a severe drought) fades. While growth is still likely to undershoot the forecasts made by Treasury in February, private sector forecasters and the SA Reserve Bank are starting to upgrade their projections. Since disappointing and declining growth have been the main drivers of downward pressure on our credit ratings, this could stave off downgrades, provided political uncertainty does not worsen by year-end.
What to look out for
For the first time, the attention of the general public will probably be more on who is presenting the MTBPS than on the content. However, the content is what matters and the key information will be the budget deficit target. In February, these were stated as 3.2 percent of GDP for the 2016/17 fiscal year, gradually narrowing to 2.8 percent and 2.4 percent in the following two fiscal years. Tax collection for the fiscal year to date is running behind target due to the weaker than expected economy. However, the impact of this shortfall on the budget will be somewhat mitigated by lower payments to the Southern African Customs Union and revaluation profits on foreign currency transactions. For the current year, Treasury will probably opt for a slightly wider deficit of around 3.4 percent, with the projected deficits for 2017/18 and 2018/19 remaining more or less the same.
Also of note will be if government achieves the projected primary budget surplus (where revenues exceed non-interest payments). The February Budget pencilled in a primary surplus of 0.4 percent in the current fiscal year, rising to 1.2 percent over three years. Sticking to these projected deficits will be difficult to achieve, requiring a combination of reduced spending, job cuts (through attrition), reprioritisation and tax increases. Even more challenging is cutting the deficit without knocking the economy’s promising recovery too much.
The revenue requirements for the next two fiscal years will probably result in tax rate increases, but these are expected to be announced only in February, informed by the work of the Davis Tax Committee. While the MTBPS is not normally used for major policy announcements or tax changes, the looming ratings review does demand a certain urgency in implementing growth-enhancing reforms, and elaboration on the reforms around the structure, governance and financial position of state-owned enterprises that were proposed in the February budget.
A very important consideration for the ratings agencies will be whether the expenditure ceiling is adhered to. The ceiling places a cap on the rate at which spending can grow, and over the course of the previous two years the Finance Minister has lowered the ceiling (i.e. spending will still grow over the budget period, but at a slower pace). He is expected to do so again, despite the massive pressure to ramp up spending (particularly from student protests).
Finally, an update on the workings of the office of the Chief Procurement Officer (CPO) in reducing wasteful spending and reducing costs is expected. Kenneth Brown, the CPO, was recently quoted as saying that 40 percent of government’s R600 billion procurement bill is affected by inflated prices or outright fraud. Given its size, Government should in fact be buying goods and services at substantial discounts to market prices. This is one area where easy gains should be available, helping to close the deficit.
Looking for the milestones
The phrases “between a rock and a hard place”, “balancing act” and “walking a tightrope” have been applied to South Africa’s fiscal situation ever since Pravin Gordhan’s first stint as finance minister (2009 to 2014), as South Africa battled slowing economic growth, increasing spending needs and pressure from ratings agencies and investors. Gordhan and the National Treasury are still walking a tightrope, but it is now also being swung about. If they can stay upright, the 2016 MTBPS might just be one of the milestones on a road to a better performing economy.
Dave Mohr is Chief Investment Strategist, and Izak Odendaal is Investment Strategist at Old Mutual Multi Managers. Their opinions do not necessarily reflect those of IOL.
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