Tito Mboweni's special budget analysis

Nicky Weimar, Nedbank’s Chief Economist, provides a considered interpretation of the supplementary budget review presented by the Minister of Finance on 24 June.

Tito Mboweni painted a very dismal picture yesterday - we are heading towards a fiscal reckoning. Over an extended period of time, we’ve had relatively poor fiscal management, ministers with their own agendas, high rates of corruption and state capture throughout the public sector. Confidence within the private sector has diminished, fixed investment has started to decline, resulting in a shrinking private sector. Government is really the only ’show in town’ but doesn’t create wealth and lives off tax revenue generated by the real economy, which is shrinking.

Revenue/expenditure gap

South Africa was in a technical recession in the second half of 2019 and the economy, pre-COVID 19, probably shrank in Q1 2020 and Q2 will be even worse. Mboweni referred to a situation where the ‘hippo’s jaws are opening wide’ with budget expenditure as a percentage of the economy increasing because the rest of the economy is shrinking. Government’s share of the economy is rising but the rest of the economy is in trouble with budget revenues heading south. The gap between revenue and expenditure has to be financed through borrowing, resulting in an accumulation of debt.

A slow journey to growth deterioration

It’s taken us many years to get here and government has been in control  right from the start. It started with Zuma’s tenure when we saw the rise of corruption and deliberate attempts to misdirect state funds to benefit and enrich a few at the expense of the whole nation. This spilled over into SOEs, very poor governance and discipline and, within government, very little control over public sector wages, which accounts for almost 46% of government’s revenue, crowding out the expenditure needed to make the economy grow. At the same time we’ve had an uncertain policy environment. All these uncertainties, inefficiencies, poor government delivery, no effective investment in infrastructure, especially in power, has led us to a situation where growth has continued to deteriorate. On top of our weak environment we had COVID-19 and level 5 lockdown from 27 March with virtually no economic activity. 

A new budget

National Treasury now faces a situation where revenues are collapsing and they needed to put together a new budget. In February 2020, government was looking at GDP growth of 0.9%, which was yesterday adjusted down to a contraction of -7.2% followed by growth of 2.6% in 2021, without having recouped the losses of 2020. The GDP forecast for 2022 and 2023 are back to the weak growth trend of 1.5%. Revenue goes from almost 26% of GDP to 23% of GDP. Mboweni made it clear that it would take seven years for government revenue to return to pre-crisis levels, which were not fantastic to start with. Budget expenditure will increase in the short term with a concerted effort to bring it down over the following two years. Debt service costs continue to rise and by 2023, R300 billion will go to interest on debt, which means there will be a lot less money to spend on things that matter to the economy, such as investing in building infrastructure, improving the education system, etc. The consolidated budget deficit is predicted to soar to 15.7% of GDP from 6.8% in February 2020. For the next three years, we will be living on the edge of the cliff with a massive debt battle.

Tax revenue implosion

We’ve had tax shortfalls nearly every fiscal year since 2014/15 where growth fell short of expectations and expenditure remained at high levels. We are now facing a shortfall in tax revenue of R304 billion this fiscal year. Value added tax has collapsed as domestic spending plunged during lockdown and the picture is similar with personal income taxes.  All the pressure is now on expenditure. National Treasury has managed to contain the increase in spending to just over 2% from February’s budget by changing the budget share allocation to different functions, such as increasing the allocation to social development and health while decreasing allocations to all other functions. From an economic classification, transfer payments increased by 2.3% while everything else has been reduced, including a 1.3% cut in the public wage bill. 

Despite this effort, the outcome is still soaring public debt. The path the government has taken sees debt levels reaching a high of 87.4% of GDP in 2023/24, gradually reducing over the following years through long-term expenditure constraint and improved tax revenue collection. We will have to boost economic growth to deal with the problem.

Financing the debt explosion

The government will, in addition to February’s funding estimates, raise R9.7 billion in short-term loans, R150.9 billion in long-term (7-10 year) loans and R16.4 billion in foreign loans. South Africa currently faces one of the steepest yield curves in the emerging market universe. South Africa has cut interest rates by 275 bps since the beginning of the year and, among the other emerging markets, has undertaken some of the most significant cuts on the shorter end of the curve. At the long end of the curve, we’ve seen yields increase. If global risk appetite returns, then South Africa does offer a very attractive yield, but the risks are enormous. Looking at the 3-year Credit Default Swop spreads, South Africa is looking more risky than both Brazil and Russia. Foreigners have been selling out of our equity market for quite some time and with the COVID-19 panic also sold out of the bond market. Foreigners are wary of our government debt situation with any money that has come in, going to government bonds.

Government steps to stabilise public debt

Revenue will be increased by:

• Undertaking measures to boost long-term economic growth
• Improving tax collection through greater enforcement
• Focusing on international taxes, especially the use of transfer pricing
• Eliminating syndicated fraud on VAT refunds and import valuations
• Using 3rd party data to find non-compliant taxpayers
• Improving collection of debt owed to the fiscus
• No tax hikes this year, but additional tax measures in the next two years
• Reforming SOEs to limit reliance on public funds

Expenditure will be reduced by:

• Removing funds underspent due to lockdown delays
• Suspending allocations for capital and other departmental projects that are not urgent
• Suspending allocations for programmes with poor performance history
• Redirecting funds towards COVID-19 efforts
• Cutting the public sector wage bill by 1.3% in 2020/21
• Long-term spending constraint, using zero budgeting

Faster economic growth and job creation are the only silver bullets

Government has to create a legislative and regulatory environment that supports business. It must deal with the Eskom issue and the lack of power capacity in the economy. National Treasury has proposed, but without timelines or details on whether they have been accepted, to lower the cost of doing business by reducing red tape dramatically; support industries with high job creation potential like agriculture and tourism; facilitate regional trade; reduce the skills deficit by attracting skilled immigrants; improve the skills framework through reforms to basic education and post-school training;  reform SOEs by finalising an electricity plan, unbundling Eskom, open the energy market to private players, modernise the port and rail infrastructure and license spectrum. If we can achieve this it will make us a more productive and efficient economy where high levels of growth and job creation could be achieved. The problem is that there is no record of delivering on these promises. While this will be an uphill battle, National Treasury appears to be determined, but they will need to get everyone to buy into this effort. Already the unions have indicated that they are ready for the battle and will not accept the public sector pay cut.

Nothing is clear, but the proposals they’ve suggested is the correct path to follow.

To listen to this conversation, go to Nedgroup Investments Insights on Apple Podcast, Google Podcast and Spotify. 

Nicky did not have time to answer all of the questions posted on the forum during her presentation. Please see below her written responses to a selection from the many questions tabled:

1. Do you Expect a reaction by markets? It has been muted thus far.

True, it has been muted. I think that part of the reason is that the markets were prepared for the bad news (Minister Mboweni’s tweet), so although it was slightly worse than expected, it was not a surprise.  Our own forecast for the budget deficit was 14.1% of GDP.  So everyone was around that range. However, over time the enormity of challenge may sink deeper into the collective minds of the markets and then we may see some pressure on the rand.  I think at this stage; the market seems comfortable with the pricing.

2. What in your estimation is "fair value" for long term bonds?

We do not calculate ‘fair value’ for the bond market in the same way bond analysts do.  I will refer your questions to our bond analysts and hopefully return with an answer that makes sense. My sense is that beyond 10-year maturities, yields of around 10% is probably a fair compensation for the risk investors are taking.

3. A steep yield curve often means growth. Could our steep curve be signalling growth?

I don’t think so. The drivers of a steepening yield curve that points to stronger growth are very different from the conditions on the ground in SA.  Under such circumstances the yield curve would steepen because of accelerating economic growth and the emergence of inflation as a result of rising demand pressure on prices. The markets would then start to price in the possibility of rising interest rates over the longer-term to address the overheating of the economy.  In our case, the steepening of the yield curve reflects heightened risk of default given the country’s exceptionally precarious fiscal position and the resultant surge in issuance amid timid demand for bonds.

4. What is the worst-case scenario for holders of longer-dated ZAR bonds assuming the government will print to redeem?

The risk is that inflation soars & the rand becomes worthless.  Bond yields will therefore soar even though theoretically government will meet its redemption commitments through newly printed funds.  There will come a point where government will no longer be able to attract funding through the market and will ultimately run out of new funding because the paper will be worthless based in an equally worthless currency.

5. If the foreigners are still net sellers then what would you attribute to the relative bond and currency strength or resilience since the trough?

In the bond market, there has been an increase in foreign buying around 5- to 7-year maturities, but the rise has been marginal compared to previous periods. This increase in foreign purchases at the margin, increased holding by local banks and the SARB’s active purchases have contributed to the improvements we have seen around certain maturities.  As for the currency, it also reflects the trickle of increased foreign buying, but more than anything else it reflects the downward movement of the US dollar over the past two weeks. The Bank of International Settlement indicated that the demand for US$s through the Fed’s swap facility has eased noticeably over the past two weeks.

6. Based on the current Fiscal situation in SA would you now propose greater exposure to Global assets rather than South African?

Absolutely. Hard-currency assets are a good bet. Some care is needed in choosing asset classes and specific investments within the various asset classes, as it is probably fair to stay the recent correction in equities is probably overdone relative to the underlying economic fundamentals, which remains extremely uncertain.

7. How do you think foreign investors will view this "update". Another false promise or the real deal this time?

I think foreigners will remain sceptical, until government can deliver some results.  As Minister Mboweni said himself, SA has lost its fiscal credibility and it needs to be restored. SA will however be a speculative bet for those searching for higher yields.  We are indeed being treated increasingly like an Argentina.

8. The R200b government loan scheme seems to be failing. Is this a saving to government as far as funding goes? Or just a delay?

The uptake on the loan scheme has been relatively slow, but applications are starting to flow in.  Under the scheme government would have been responsible for any loan which ultimately defaults, so this is a liability that would only fall on government shoulders in about 3 years’ time.  It is not an immediate concern.

9. How aggressive do you believe the active path really is? i.e. Assuming the expenditure cutting is the best-case scenario then a further revenue miss throws it further into the drain. It appears that this scenario is way too optimistic and most likely unrealistic.

You are right, the outcome you sketch above is a very real possibility.  History suggests that government is more likely to miss their revenue target than to meet it.  We approach the numbers with caution and have decided to take a wait and see approach.

10. Will Government place the burden of the budget deficit on the few SA tax payers? No tax increases - all this funded by debt. What areas could we see tax increases hitting?

It is quite clear from the Supplementary Budget that tax increases are coming.  I think you will probably see continued heavy reliance on the fuel levy, excise duties especially on luxury products.  I know that an estate tax and ‘wealth’ taxes are being seriously considered.  Again how such wealth taxes will differ from capital gains tax is unclear.  What is not unclear is that they will not yield much in revenue.  Capital gains tax is not an efficient tax, and I doubt a ‘wealth’ tax will be either. I think government will be hesitant to push company taxes too high, fearing the impact it may have on the little fixed investment we do have.  This brings us back to personal income taxes.  Here too, of course, National Treasury knows it has become counter-productive to increase personal income taxes even further, but I think in the end it will be a political decision and we are likely to see some action on personal income taxes.

11. What will the private sector have to do to support Government efforts?

Exploit those opportunities for growth that present themselves, improve relationships with their labour force, aggressively upskill workers and employees, no more Steinhoff’s, undertake as much as possible advocacy on economic policies, to ensure that the whole of government understands what elements of its regulation & legislation is destructive and why it is necessary to alter these towards a much more business-friendly version.

12. What spending has been “crowded out” in this reorganization and cutting of spend? What are the longer-term consequences of this?

The biggest cuts are planned for the public sector wage bill. Within this the largest reductions will occur in learning & education.  However, education has long received the biggest allocation in the expenditure budget.  There is plenty of inefficiency and waste.  The extension of the cuts is therefore not really severe.  Education still has sufficient capacity and resources to improve outcomes.  The most damaging reduction is that to capital expenditure.  This downward trend started long before COVID-19 and the lockdowns. The implication is simply that SA will continue to operate with inadequate social and economic infrastructure, which raises the cost of production, disrupts actual operations (load-shedding) and undermines our international price competitiveness.  Over time it raises the hurdle rates to fixed investment (we are already at this point), fixed investment contracts, economic growth slows and unemployment remains high and worsens.

13. How much can be saved by zero based budgeting?

Not sure.  Those estimates have not been made available.  I imagine plenty.  It would also be a way to picking up corrupt and wasteful spending quickly.

14. COVID has highlighted inequality in SA. Might this affect the fiscal budget and allocations radically? What happens to the proposals National Health Scheme?

It has highlighted inequality and the failure of government to improve access to good health care facilities for the poor.  It increases the pressure to fast-tract the NHI. However, it is simply impossible right now and for many years to come.  The money is gone. One positive is that COVID-19 has brought the public and private health care system closer together.  Perhaps future partnerships are the answer to improving quality health care for all.

15. Please elaborate on SOE funding and bailout, and the impact of this?

No further information was made available.  The battle at SAA continues.  Eskom is apparently working towards deregulation.  Only the Land Bank was supported in the Supplementary Budget.  SAA or parts of SAA may still be closed down.  Eskom already received an additional gigantic bailout in February.  Results from Eskom suggests that their finances remain vulnerable, hurt by the drop in economic activity under lockdown.  We have been told anecdotally that operationally capacity has been improved, but again we remain cautious of these messages. We do not believe load-shedding is a thing of the past.

Minister Mboweni is quite right, the only solution to our energy woes is to encourage private sector participation in electricity generation.

16. Another problem is management at SOEs. How are they going to address that?

I honestly don’t know.  My suggestion would be candidates need to be selected and interviewed by professional firms completely outside government and free of political influence. Even this process can be manipulated or at best prove flawed. 

17. What was blatantly NOT said in the budget yesterday that was expected? Prescribed assets for pension funds?

Yes, apparently it was meant to have been addressed.  What is clear is that government knows this a very sensitive subject (rightly so).  So it seems they want more time to prepare a carefully considered proposal.  It will come though, of this I am relatively certain.

18. Government Wage Bill reduction – will the unions revolt?

Yes. Government will have to stand firm!

19. Whilst we realise how grave the situation in SA public finances, how do we compare with other EMs?

It depends on the EM.  They are a diverse bunch.  We still look good compared to Argentina (just a mountain of debt and a history of default), Brazil (highly corrupt & destructive economic policies) and Turkey (huge private sector $-denominated debt & extremely disruptive government policies), but we are in a much more fragile position than most other EMs (worse than Chile, Peru, Colombia, Mexico, Hungary, Poland, Taiwan, Malaysia, Indonesia and even Philippines). Some EMs have higher debt burdens than us, but they have been moving in the right direction, chipping away at their debt year after year. We however have been moving in the wrong direction with considerable speed.