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Press Offices > Investment Managers

Sanlam Investment Management
Press Office Feature : All about debt stabilisation and a social compact

Company: Sanlam Investment Management
Author:Arthur Kamp
Email:[email protected]
Posted:25 Feb 2016

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Will we avert sub-investment grade status on our sovereign debt?

This Budget was always going to boil down to the implementation of measures to show a credible path back to debt stabilisation.

As far as the top-line numbers go the decline in the consolidated government budget deficit to 2.4% of GDP by 2018/19 from a deficit of 3.9% of GDP in 2015/16 is a positive development.

Concomitantly, the Main Budget deficit declines from 4.2% of GDP in 2015/16 to a deficit of 2.9% of GDP by 2018/19.

This is pleasing since these deficits are significantly smaller than those projected a year ago, despite a weaker real GDP growth outlook. Fiscal consolidation is also no longer back-ended to later years.

Equally encouraging is that the Main Budget primary deficit (revenue less non-interest spending) continues to improve to a surplus of 0.5% of GDP by 2018/19 from a deficit of 1.1% of GDP in 2015/16 in 2015/16.

Accordingly, government’s gross loan debt ratio is projected to stabilise at 51.0% of GDP in 2017/18, before declining a notch to 50.5% of GDP in 2018/19. Concomitantly, the net loan debt ratio stabilises at 46.2% of GDP by 2017/18.

As a result, the Main Budget borrowing requirement declines to R156.3 billion in 2016/17 and further to R151.3 billion in 2018/19, from R172.8 billion in 2015/16. The total public sector borrowing requirement declines to R201.6 billion (3.9% of GD) by 2018/19, from R254.6 billion (6.2% of GDP) in 2015/16. 

The detail does leave some questions though. The Treasury’s GDP growth numbers look a bit optimistic. GDP in current prices expanded just 4.5% in the year to 3Q2015.

Although inflation is expected to lift, the National Treasury’s projected nominal GDP growth of 7.8% in calendar year 2016, followed by increases in excess of 8% in the following two calendar years, are materially higher than the current trend.

Leading up to the Budget South Africa’s government finances were in an unsustainable position, requiring fiscal consolidation. Ideally, the required adjustment should occur through total expenditure cuts, but not of infrastructure expenditure.

Also, revenue should be raised through increased efficiency. But, given an unemployment rate of 25% and palpably weak GDP growth it is difficult to implement the ideal solution.

To start, growth is simply too weak to rely on increases in tax collection efficiency alone (for example, by protecting the corporate income tax base).

In the end, the Minister went for tax increases upfront in 2016/17 (amounting to an additional R18bn relative to baseline) followed by further tax increases amounting to R15bn in both 2017/18 and 2018/19.

Main Budget revenue increases to 26.9% of GDP by 2018/19, from 25.1% of GDP in 2014/15, which is a material increase. The comparison with 2014/15 is more relevant than a comparison with 2015/16 when the revenue take, which amounted to 26.4% of GDP, was boosted by the sale of assets. 

Meanwhile, the expenditure ceiling for 2016/17, set out in the Budget Review of 2015, was maintained, while “new” expenditure cuts were back-ended to 2017/18 (-R10bn) and 2018/19 (-R15bn).

The “new” expenditure cuts emphasise restraint on government compensation through, amongst other measures, restraints in hiring. The focus on constraining compensation, the largest government consumption expenditure item, is important, but the jury is out.

Consolidated non-interest spending growth is budgeted to increase by 5.1% in 2016/17 in current prices. This is less than expected inflation, but the base of 2015/16 is inflated by extraordinary payments (to Eskom and the Development Bank).

This is followed by commendable, constrained increases in non-interest spending in 2017/18 and 2018/19 of close to 1% and 1.5% respectively.

Also, total Main Budget expenditure remains high, declining only slightly to 29.8% of GDP by 2018/19, from 30.6% of GDP in 2015/16. This is important considering the additional potential expenditure projected for National Health Insurance over the longer term. 

The Minister has an array of tax options open to him

What the Budget did illustrate is that the Minister has an array of options to increase revenue at his disposal, raising the R18 billion relative to the baseline for 2016/17 without resorting, as yet, to increases in top marginal tax rates or VAT.

Rather, the Minister plugged the gap through a combination of increases in excise duties, the general fuel levy and other environmental taxes (+R9.5 billion), an increase in capital gains tax and transfer duty (+R2 billion) and limited relief for fiscal drag (+R7.6 billion), while giving back R1.1 billion in medical scheme tax credits.

For reference, full relief for fiscal drag in 2016/17 would have amounted to R13.1 billion.

Further, the Treasury has moved to make the tax system more equitable and progressive (although it is arguably already quite progressive).

Tax harmonisation reform implies higher income earners’ tax deductions will be constrained, while the after-tax take-home pay of low and middle income earners will increase due to lower deductions.

Overall, these changes satisfy the conditions of making the tax system simpler, more equitable and more progressive.

The interest bill continues to climb, almost matching total social protection spending

The importance of stabilising the debt ratio is underlined by the size of debt service cost on government debt, which is budgeted to amount to R147.7 billion in 2016/17.

This is not too far off the R167.5 billion budgeted for total social protection (which includes the old age grant, child support grant, disability grant, provincial social development, policy oversight and grant administration and other grants).

Accordingly, debt servicing cost is expected to climb to 11.6% of GDP by 2018/19, from 10.4% of GDP in 2015/16. This illustrates the importance of stabilising the debt ratio.

NHI – the elephant in the room

The elephant in the room is National Health Insurance (NHI). In its current form, according to the NHI White Paper, published in December 2015, the funding plan is to use a mandatory prepayment system and to raise general taxes, although Minister Gordhan indicated the funding plan is still being considered.

For illustration, the NHI White Paper includes a projection showing total NHI spending at R256 billion (2010 prices) so that spending on healthcare by the public sector increases from around 4% of GDP currently to 6.2% of GDP in 2025/26, but only if the economy grows at 3.5% in real terms.

This reflects a funding shortfall of R72 billion (2010 prices).

The Reserve Bank, however, argues that potential growth is currently below 2%. Of course, potential growth may lift, but should this not be the case the NHI White Paper includes projection, which indicates a R108 billion funding shortfall in 2025/26 (2010 prices) if the economy grows at just 2%.

That would leave public sector spending on health at closer to 7% of GDP. That would be an especially onerous gap to fill. Clarity is needed on this issue.

Will we avert sub-investment grade status on our sovereign debt?

Finally, the real concern appears to be focused on South Africa’s growth potential, since the fiscal numbers do not add up if growth does not lift.

Promising initiatives are under way to promote stronger long-term economic growth, including planned initiatives that encompass co-operation between government, business and labour.

Although these are clearly welcome, it will take time for the results to show up.

The Budget makes it clear that getting growth going hinges on the success of the social compact between government, labour and business called upon by the Minister.

Within this there is renewed scope for the private sector to partner with government in promoting investment and growth.

The Budget Review strongly emphasises the important role State Owned Enterprises have to play in creating an enabling environment for growth.

It provides a sobering assessment of the financial condition of some SOEs (including reference to the ongoing insolvent position of the Road Accident Fund and the technical insolvency of SAA), pointing to declining profitability, poor governance and weak balance sheets.

The Review further notes that government is exposed through guarantees.

Importantly, however, the Treasury indicated support for / capitalisation of SOEs would remain Main Budget deficit neutral.

Further, the Budget opens the door for private sector participation in improving governance and allowing competition in sectors where SOEs have monopolies.

Moreover, the Budget also highlighted the success of the Renewable Energy Independent Power Producer programme and announced the expansion of partnerships with the private sector to include electricity from coal (3126MW) and a gas-to-power programme.

Importantly, the Presidential Review Commission recommendations on SOEs are to be implemented.

Ultimately, the debt stabilisation trajectory shown is a welcome development. As is, it should reduce the downgrade risk. But, that said, the risk of a further downgrade is not nil.

Ultimately, the likely outcome of the ratings agencies’ decisions on this is unknowable. Only time will tell.

But at least financial markets have, to a significant extent, already priced in the possibility of a downgrade to sub-investment grade.

Another mitigating factor is that most of the South African government’s debt is denominated in domestic currency, which carries a higher rating than for its foreign currency denominated debt, which amounts to a relatively low 10% of total government debt.

Arthur Kamp is the Sanlam Investments Economist 

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