SA heading for fiscal cliff: Flags are going up, Don’t wait for a crisis urges Kevin Lings

South Africa’s Finance Minister, Enoch Godwongdwana, is set to present the medium-term budget policy statement, bringing updates on economic forecasts, budget adjustments, and necessary spending changes. However, Stanlib’s Chief Economist, Kevin Lings, warns that the upcoming mid-term budget won’t bring good news. In an interview with BizNews, Lings highlights a significant deterioration in South Africa’s fiscal health since the February budget. He believes that the initial projections were overly optimistic, and government spending remains unchecked. Lings anticipates a R60 billion revenue shortfall and approximately R25 billion in overspending. He expresses scepticism about the government’s ability to enact substantial changes to regain investors’ trust. Lings rules out staff or salary cuts in the government and believes social payments won’t be reduced during an election year. South Africa, he said, is heading in the direction of a fiscal cliff. Flags are going up and he urged the government not to wait for a crisis, as it did with Eskom, but to act proactively. Ling said the market is already concerned about these deteriorating fiscal parameters and the lagging tax revenue. If South Africa, however can enhance its growth rate and eliminate load shedding, the country can attract substantial foreign investment, he said. – Linda van Tilburg

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Relevant timestamps from the interview

00:24 – Introductions
00:44 – Kevin Lings on Budgets bleak outlook
06:24 – Any cuts in expenditure?
09:31 – How far have we gone off the tracks
14:14 – Is SA approaching a fiscal crises
16:59 – How are the markets going to react
19:31 – The rands rally earlier this week
21:50 – Conclusions

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Excerpts from the Interview. Budget coverage was made possible thanks to BrightRock, the first ever needs-matched life insurance.

Gloomy outlook for the mid-term budget

No, I don’t think it’s going to be good news. Clearly, there has been a significant deterioration in South Africa’s fiscal parameters. We’ve witnessed this unfolding over the past year, especially when the minister presented the budget back in February. There were genuine concerns that the ambitions outlined in the budget were overly optimistic.

It’s important to note that you certainly want the government to try and achieve something to improve the situation. We certainly want to see efforts in that direction. However, the goals set, especially regarding tax revenue, were undeniably too ambitious. Over the previous two years, company taxes had exceeded the budget by a significant margin. Unfortunately, the government made two imprudent decisions in response. Firstly, they spent a substantial portion of the surplus, committing to ongoing expenditure without certainty that the tax revenue would continue at such high levels. This was problematic because it created future financial commitments without a reliable revenue source.

Secondly, instead of using the surplus to reduce the national debt, they only made partial efforts in that direction. A more substantial debt reduction could have been achieved. As a result, we now find ourselves in a situation where company tax revenues fall short of expectations.

Adding to the challenges, commodity prices have also declined, and Transnet’s difficulties in exporting and port operations have impacted mining companies’ profitability. This has further contributed to the significant shortfall in tax revenue.

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Mounting fiscal challenges with R80-85 billion deficit and limited recourse

There have been instances where we’ve observed a slippage in tax collections. This has resulted in an estimated revenue shortfall of approximately R60 billion. In the South African context, this may not be considered catastrophic, but it does put significant pressure on the financial landscape. The fiscal parameters outlined in the February budget become unattainable.

Furthermore, expenditure has exceeded the budget due to the approval of salary increases beyond the initially allocated budget. Initially, it was stated that any additional spending on salaries would be compensated by reductions in other areas. However, the government has not taken these compensatory measures, resulting in higher salary-related costs and an increased cost of debt. Internationally, bond yields have risen, placing additional financial strain on the country.

Consequently, the total overspending is estimated to be around R25 billion. When you couple this with the R60 billion tax revenue shortfall, it leads to a deficit in the range of 80-85 billion Rand. Unfortunately, there are limited options available to address this situation. This expanded deficit signifies a higher debt level.

Most importantly, it signifies a deterioration in fiscal parameters. The budget deficit is now projected to increase by one to one and a half percent, and the debt level will rise as well. This is in contrast to the promises made in February, where the commitment was to improve South Africa’s fiscal position and pursue fiscal consolidation.

Now, we are compelled to revisit those promises. It becomes necessary to acknowledge the further deterioration and attempt to regain trust. Past experiences have shown ambitious targets, failure to achieve them, acknowledgment of the shortfall, and renewed promises for improvement. The credibility of such promises may be met with scepticism.

Government expected to offer limited clarity on Transnet and Post Office

Unfortunately, as we enter an election year, I’m not convinced that the government will be able to implement significant changes that would satisfy the investor community and demonstrate that they are on the right track. This could lead to unfulfilled promises.

To compound the challenges, Transnet requires a substantial infusion of funds, as does the Post Office, along with other state-owned enterprises (SOEs), all of which are in need of financial support. The sources of this funding remain uncertain. I understand the necessity of restructuring Transnet to enhance its efficiency, similar to the needs of Eskom in the past. Transnet’s excessive debt must be addressed through restructuring, but it also requires an injection of capital and liquidity.

I’m not entirely convinced that the minister is currently inclined to provide this financial support willingly. However, circumstances may force him to do so. It’s possible that he will announce plans for restructuring and financial support in due course, but he might delay disclosing the details, given the concerns about further deterioration in fiscal parameters.

Government staff and salary cuts unlikely in election year

When it comes to managing expenditures, the situation is quite challenging. Many of the potential cuts have already been implemented. To elaborate, typically, when governments face financial pressure, they consider reducing infrastructure spending. They may delay or put certain projects on hold, effectively deferring expenditure to save money. However, in our case, the government has already taken this approach, and our infrastructure spending has been significantly reduced over the years. Completely eliminating such spending is not a sensible solution and could lead to even more significant issues. Therefore, there are limitations to what can be done in this area.

Our two major expense categories are salaries and staff. Recently, the government granted larger-than-expected salary increases. It’s improbable that they will cut salaries or reduce staff in an election year. The best course of action might involve allowing for natural attrition. Approximately 5% of the government workforce retires or resigns each year, and one approach could be to refrain from automatically replacing those positions. This has been the government’s policy so far, but analysing the data, it hasn’t had a substantial impact. Tightening this policy and being more selective when replacing departing employees could be considered, perhaps reserving replacements for critical positions.

Social grant to stay in election year, other budget cuts unlikely

The second aspect to consider is social payments, which have grown significantly over time. We have the social relief of distress grant, the R350. Could it be cut? In theory, yes, it could be, but is it realistic to do so in an election year? The president recently emphasised the importance of the R350 on national television. Cutting it at this juncture is highly unlikely and would likely lead to a substantial backlash during an election year. What could be considered is refraining from increasing it. There is pressure on the government to adjust the R350 to account for inflation, so holding off on that adjustment might be a more feasible option. However, outright cutting is improbable.

This leaves us with smaller areas to potentially cut, such as travel expenses and conference expenditures. It’s possible to attempt to reduce these costs. Nevertheless, it’s worth noting that the government has claimed to be making such efforts already, and we still see an additional expenditure of R25 billion. Given the circumstances, there may be limited options. The minister may announce the intention to exercise fiscal discipline and control these parameters. He may present figures indicating that things will improve from this point onward. He does express concern about credit rating agencies possibly downgrading us, but it’s doubtful that any significant, meaningful changes can be implemented.

Uncertainty surrounds SA Government’s commitment to fiscal discipline

The current fiscal situation isn’t a disaster; we’ve weathered worse periods in the past. For instance, if we examine the fiscal deficit, the projection was around minus 4% of GDP, indicating that the government would overspend by approximately 4% of GDP. Now, it appears that the overspending might be closer to 5% or even 5.5% of GDP.

This translates to an increase of one to one and a half percent of GDP. Can we manage it? Is it something we can handle? Certainly, yes. Looking at the debt level, it’s now over 70% of GDP. Previously, there were indications that debt would decrease over time. However, the new reality suggests that debt is on an upward trajectory. Financing Transnet will likely push the debt up by a few more percentage points of GDP. Instead of demonstrating a decline and aiming to get the debt below 70%, it will be necessary to acknowledge that the debt will remain above 70%. Consequently, the key fiscal parameters are set to worsen.

Why is this significant? The parameters are already out of alignment and present existing challenges. They have even led to credit rating downgrades. The government’s longstanding message, going back to when Tito was the Minister of Finance, has been that the fiscal position would be brought under control. Efforts were made, and there was a period when tax revenue exceeded budget expectations, mainly due to high mining company revenues. However, this was an external windfall, not a result of their own actions, being largely influenced by international commodity prices. When you remove this windfall, you realise that genuine progress wasn’t made; in fact, the situation deteriorated.

When investors and credit rating agencies scrutinise the budget, they will recognise that without the windfall from mining companies, our fiscal position would have been significantly worse. Consequently, they will raise questions about the political will and commitment to achieving a healthier fiscal position. The key concern is not just the percentages; it’s the direction we’re heading in and the absence of improvement. This leads to a paramount and overriding conclusion.

There is not substitute for economic growth to address challenges

There is no substitute for better economic growth. When we assess the challenges that the government is grappling with, the only viable solution is to boost economic growth and employment. Once these two aspects are on the right track, the economy will expand more rapidly, more jobs will be created, and tax revenues will naturally increase. With this, many of these challenges can be tackled more effectively, preventing further fiscal deterioration.

Consider what the government is attempting to achieve: managing social grants, a large workforce, and handling entities like Transnet and Eskom, all while operating in an environment with less than 1% GDP growth. It’s an insurmountable task. The tax base is inadequate, and there isn’t enough tax revenue to make it work. In essence, the primary focus must be on accelerating the growth rate.

Realistically, I don’t believe the government will abruptly decide to downsize significantly in response to economic needs. However, that’s what may ultimately be necessary to sustain a 1% growth rate. If you’re growing at 1%, you can’t justify the size of the government as it stands now. It’s too extensive for the available tax base, which also cannot support the state-owned enterprises in their current form. These are the tough choices the government must confront. They might not fully comprehend the situation in such stark terms, but essentially, these are the challenges we are confronting.”

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South Africa is heading in the direction of a fiscal cliff

We are indeed heading in that direction. Some may describe it as a fiscal crisis, but in reality, we’re not at the brink of a fiscal crisis, default, or the need for substantial IMF support. If you look at countries that have reached such a dire point, historically, Venezuela and Argentina, things have deteriorated much further than our current situation to necessitate significant assistance.

Fortunately, we’re not in that position primarily because our foreign debt remains relatively low. This is a crucial factor working in our favour. Countries in distress often struggle with a heavy burden of foreign debt. When trouble arises, their currency weakens, making foreign debt payments significantly more expensive and unsustainable. We are not as vulnerable in that regard.

The path we are on doesn’t immediately lead to an outright fiscal crisis or a complete fiscal collapse. However, it’s undeniably the direction in which we are headed. It’s important to recall that we moved in this precarious direction during the era of state capture. While we made some efforts to reverse that trend and achieved some progress, thanks in part to the substantial tax revenue generated by mining companies, we are now regressing back into that perilous territory.

Flags are going up – don’t wait for a crisis to jump into action

The flags are indeed going up, and the warnings are getting more pronounced. The message is unequivocal: if the current course continues without effectively managing the state-owned enterprises (SOEs), providing necessary bailouts and restructuring, and stimulating economic growth, we are heading towards a precarious path that could culminate in a fiscal crisis. South Africa has unfortunately developed a habit of waiting for crises to materialise.

We’ve seen this with electricity, where warnings were sounded but action was delayed until the crisis hit. The same pattern repeated with Transnet: warnings were issued, but we hesitated, resulting in the current transportation crisis for commodities. Issues related to water and sanitation have followed a similar pattern, where we tend to wait until we are on the verge of collapse before addressing the problem. This approach should not be adopted with fiscal parameters because once they spiral out of control, it can be exceedingly challenging to rein them in, and the situation may become unsalvageable.

In such dire circumstances, substantial economic and fiscal restructuring may be required, potentially necessitating external assistance, such as an IMF support program.

Markets stay wary, bond markets will remain nervous

The markets have been showing concerns, and if we examine the behaviour of bond yields, it’s evident that these concerns have been lingering for a while. This apprehension has unfolded as the year progressed. Initially, the numbers appeared promising, with tax revenue benefiting from mining companies. However, as more data became available, the markets had to adjust to a different reality. Simultaneously, we were contending with relatively high inflation, elevated interest rates, and disappointing economic growth, which gave the markets ample reasons to worry. Additionally, global interest rates were on the rise, adding to the pressure on international markets. This pressure has certainly had an impact on our bond market.

Now, the question that arises is whether the bond market has already factored in this bad news. The answer is probably yes. This deterioration is not a hidden mystery; it’s well-documented, with the government regularly publishing these data points. The market can systematically adapt to such information. It is well aware of Transnet’s financial needs, the tax revenue shortfall, and government overspending.

The market acknowledges that fiscal parameters have deteriorated, and it’s also cognizant of the fact that tax revenue is falling short of the budget, and expenditures are running ahead of budget. The awareness of Transnet’s need for additional funds is also prevalent. Thus, one could argue that much of this is already reflected in the market price, which is a fair assessment.

Looking ahead, the market needs to see concrete efforts to bring these fiscal parameters back under control. However, it’s uncertain whether the government is in a position to do this during an election year. As a result, we can expect our bond market to remain somewhat apprehensive. Nevertheless, the prospect of lower interest rates and controlled inflation in the coming year may make government bonds an attractive investment option. This isn’t solely due to the state of government finances but is more linked to the expected downward trend in interest rates both internationally and locally. Assuming that most of the negative news is already factored into the prices, it might present a reasonable opportunity to invest in government bonds.

Improvements in loadshedding and growth could attract foreign investment

When we examine international trends, there’s a somewhat optimistic sentiment, with the expectation that the US won’t further increase interest rates. Their meeting is scheduled for today, and we anticipate no change in interest rates. Additionally, it’s becoming evident that the European Central Bank (ECB) will likely maintain its interest rates at current levels, and a similar stance is expected from the Bank of England. The message is clear: we’re likely at the peak of the global interest rate cycle, and moving forward, although interest rates will remain relatively high, there will be a systematic reduction. Some emerging markets have also started to lower their interest rates, contributing to a growing sense of optimism among investors.

While this trend may not be significant or substantial at this point, it does create room for some strengthening of the rand.

In the event that South Africa can successfully address a number of key parameters next year, such as eliminating load shedding and improving the growth rate, it’s plausible that foreign investment could flow into the country. South Africa would then represent a compelling investment opportunity, offering value to investors. Under these circumstances, the rand might experience a rally.

While it’s a possibility worth noting, I would refrain from immediately investing in a short-term rally as there’s a lot of market noise. However, it’s an interesting dynamic  if South Africa can make significant improvements in these parameters over the course of the next year.

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