A promising bridge to October and the medium budget
DURBAN - Treasury has described its supplementary budget as a “bridge” to the October 2020 Medium Term Budget Policy Statement, promising that government “will prepare a set of far-reaching reforms” before then that “will stabilise public debt”.
It indicates that the bulk of the future correction will come from expenditure adjustments, on which it has a good track record. Smaller revenue increases, including only modest tax hikes and assuming a reasonably conservative trend growth trajectory (around 1.5 percent p.a.), are envisaged.
The combination of government finally confronting its fiscal crisis and sending the strongest signal yet that it intends addressing this in a pragmatic manner, and intending using a realistic strategy to achieve this, underpins our assessment that this Budget Review is somewhat positive for the rand and bonds and should, given the prevailing global setting, be sufficient to buy government more time to get its fiscal house in order.
This general commitment is more important now than the detailed numbers, though the wider-than-expected deficit in the current fiscal year is not insignificant, especially for the local bond market that will have to absorb yet another sizeable increase in weekly issuance.
That said, the execution risk is high given the magnitude of planned expenditure adjustments. The growth forecast risks generally remain biased to the downside, and cynics may fear that the debt stabilisation commitment was necessitated as a precondition for sizeable IMF funding, and that it may fade as the practical implications of cuts to budgets and programmes crystallises; bonds and the rand will therefore likely continue to discount a high risk premium.
This year’s main budget deficit is now projected to widen to 14.6 percent of GDP. The gross debt-GDP ratio is lifted to 81.8 percent in FY20/21, which is significantly higher than the 65.6 percent projected in the February 2020 Budget, but a peak is now envisaged at 87.4 percent in FY23/24.
In a nutshell: the right strategy but high execution risk
The scenario that would likely materialise in the absence of the promised fiscal consolidation is clearly set out in the Budget Review, and it was presumably this threat that extracted the various commitments from Cabinet that would have been difficult to foresee under normal circumstances. We suspect that the increasing risk that a full-fledged IMF programme would in a few years be required if the fiscus is not placed on a very different trajectory was particularly persuasive.
As expected, the spending reallocations were broad-based, comprising a combination of inevitable spending delays during the national lockdown, intentional delays on programmes and spending that can be postponed, and reallocations within departments. Treasury has not provided a detailed update of the infrastructure spending forecasts, though this has presumably also been a casualty of spending cuts and delays, implying a further shift in spending in favour of consumption at the cost of capital expenditure.
Government acknowledged that the projected public-sector wage bill estimates, which include R160 billion of savings announced in the February 2020 Budget, remain a forecast risk. Moreover, Treasury recommended that municipalities, who are facing intense revenue and spending pressures, apply for exemption from implementing wage increases for municipal employees this year. It is concerning that the potential future fiscal support required by municipalities because of their increased Covid-19 related spending and reduced revenues during the lockdown and economic contraction may be a major fiscal risk.
Revenues: collapse, followed by shift in the burden
Government’s near-term economic growth forecasts are broadly in line with the prevailing consensus, and the revenue projections seem reasonable. A fiscal consolidation path dependent on strong economic growth would not have been credible.
Unsurprisingly, government is pencilling in very modest tax hikes amid the weak economic growth trajectory. Our view remains that there is limited scope for tax hikes to support any fiscal consolidation. Treasury tentatively assumes R5bn of tax hikes in FY21/22, followed by R10 billion and R15 billion in FY22/23 and FY23/24, respectively. We expect that tax hikes will generally be biased towards high-income individuals, supported by government’s focus on reducing inequality as well as our view that further redistribution may be necessitated after this crisis by the likely rise in unemployment, poverty and inequality.
Ideologically, the strongest support is for a wealth-related tax increase. While policy discussions in this regard have been centred on a wealth tax per se, international literature suggests that a tax on the income derived from wealth usually achieves the same objectives but is easier to administer.
At this stage, we therefore see an increased tax rate on dividends and/or capital gains as more likely than a tax on net wealth. The tax hikes pencilled by government are quite small and can be achieved through such tax increases. Alternatively, the personal income tax burden of high-income individuals can be increased, either through fiscal drag or an increase in the top marginal income tax rate; we see the former as more likely than the latter. We expect these tax hikes pencilled in by Treasury will be revisited the MTBPS.
We don’t expect any increase in company income tax, given this administration’s focus on an investment-driven growth agenda, global competition, and SA’s company income tax rate already being high in a global context. Government has clearly signalled that it intends improving tax receipts by focussing on international taxes (particularly aggressive tax planning using transfer pricing); increasing enforcement to eliminate syndicated fraud related to VAT refunds and import valuations; expanding the use of third-party data to find non-compliant taxpayers; and improving the collection of debt due to the fiscus.
Our base case is that the VAT rate will also not be hiked again. It is possible, though unlikely, that down the line an increase in the VAT rate may be accompanied by increased pro-poor spending.
Expenditure: considerable changes promised
As expected, the reallocations to fund an additional R145 billion of Covid-19 related expenditure were quite broad-based. Net in-year suspensions of spending amounted to R100.9 billion, including R54 billion of cuts to national departments’ baselines, R20 billion of repurposing of provincial equitable shares, R13.8 billion of provincial conditional grant suspensions, and R12.6 billion of local government conditional grant cuts.
There were also more than R8 billion of cuts to the skills development levy. The remaining R36 billion is financed through an increase in the main budget deficit. The spending cuts include removing funds underspent due to delays caused by the lockdown, rescheduling projects that could be delayed to FY21/22 or later, reducing allocations to programmes with poor historical spending performance, and redirecting funds within functions. R40 billion will be drawn down from social security funds’ cash surpluses to provide wage support to vulnerable employees.
What was encouraging was the commitment government displayed to the planned savings on its wage bill, though obviously the execution risks persist amid the ongoing legal challenge to the proposed re-opening of the increase in the current fiscal year. Treasury indicated that the principles of zero-based budgeting, in which departmental expenses must be justified, will be followed in preparation for the October MTBPS. This seems like a promising change that may support the large spending adjustments required to meet Treasury’s longer-term fiscal objectives set out in this adjustment budget.
Debt and funding under severe pressure
The wider deficit and higher debt trajectory obviously underpin a sharp increase in government’s funding requirement in FY20/21. Treasury plans to fund the shortfall partly with around $7 billion of extraordinary borrowing from multinational institutions, including the World Bank, IMF, New Development Bank and African Development Bank. It also plans to dramatically increase its T-bill issuance, to R146 billion in FY20/21 (from R36.1 billion in FY19/20), while it plans to use a sizeable portion of its sterilisation deposits.
Government plans to increase local bond issuance to R462.5 billion in FY20/21 from R337.7 billion estimated in the February 2020 Budget. This implies that a further sizeable increase in weekly issuance levels.
The Budget Review contains very little specifics on reforms, but emphatically states that Cabinet has “endorsed” a budget process that moves toward “debt stabilisation”. In our view it holds enough promise to support ongoing purchases of local bonds by local and foreign investors amid the weak returns offered by other assets at this stage.
The bar for the MTBPS has been set quite high and our expectation remains that investors will over time become more cautious about SA’s fiscal risk unless there are decisive steps to improve the fiscal and growth prognoses, particularly when the global economic backdrop normalises. The consensus foresees a gradual normalisation of global bonds in 2021, which should (ceteris paribus) increase pressure on local bonds. In the near term, though, we still see scope for local bonds to gain.
Elna Moolman, Head: South Africa macroeconomic, fixed income and currency research at Standard Bank South Africa