By Jac Laubscher, 9 February 2016
However, as mentioned in Part 1 of this analysis, sovereign credit ratings depend on much more than countries’ fiscal positions. Research conducted by staff members of the Bank for International Settlements (BIS) concluded that “As agencies use a variety of indicators, any attempt to explain ratings based only on fiscal strength can be misleading. The direct weight of fiscal strength (regardless of how it is measured) in final ratings generally accounts for at most one third.”
In Part 1 I also had the following to say about the South African policymaking environment: “What is under scrutiny is the South African government’s capacity for analysing and understanding the country’s economic position, determining what its priorities should be, formulating the necessary economic policies to give substance to these priorities, and executing the chosen policies successfully.”
Because all policies require the necessary resources for the execution thereof, government policy is ultimately reflected in the National Budget, especially the expenditure side. The unfortunate reality is that the absence of coherent, ideologically consistent, evidence-based policymaking with clear goals and proper prioritisation since 2009 has resulted in a fiscal situation that has come about by accident rather than purpose.
This unhappy state of affairs is reflected in the sharp increase in gross government debt as a percentage of GDP from 26% in 2009 to 49% in the third quarter of 2015, with very little of lasting benefit to South Africa to show for it. The increase in debt was accompanied by an increase in the debt service burden from 8,6% of revenue in 2009 to 10,7% in 2015, indicating a deterioration in the affordability of government debt.
Because government expenditure was concentrated on current expenditure rather than on enhancing the growth potential of the economy (and thus also the tax base), we are now confronted with the need to raise taxes in a weak economy essentially in order to make the increase in current government expenditure (in particular the public sector wage bill and debt service costs) in the past seven years affordable after the event. It is absurd that the increase in the public sector wage bill, rather than increased spending on infrastructure development, was presented as anti-cyclical fiscal policy.
What is required is not merely tinkering with the budget numbers but reconfiguring government finances to support future growth and development. For example, the 2015 Medium Term Budget Policy Statement (MTBPS) projects an increase of 5,9% p.a. in nominal terms in expenditure on economic affairs over its term, compared with a rate of increase of 7,2% p.a. in total consolidated expenditure. (Industrial development and trade, in spite of being pushed as the solution to South Africa’s growth crisis, fare even worse with a rate of increase of 4,7% p.a. in expenditure.) One of the defining trends of our time is the rapid pace of technological development, yet the budget for science, technology, innovation and the environment is set to grow by a mere 5,2% p.a. These numbers illustrate the skewed priorities in government.
Normally one would recognise the constraints within which government must manoeuvre and that it can only be expected to do what is politically feasible, but I am afraid that this is a luxury South Africa can no longer afford. The boundaries of political feasibility are mostly defined by the ruling party in its guise as the government of the day through its actions and its communication with the electorate and they (the boundaries) will have to be pushed out in order to accomplish the necessary reconfiguration of government finances.
Of major concern, of course, is government’s damaged credibility. Why would one believe a government that promises greater discipline in public expenditure when only six months ago that same government flouted its own budget to grant the public service wage increases way above what had been allowed for? Regaining credibility requires strong action that can show quick results to prove government is serious about getting its fiscal house in order.
For example, it would send a strong signal that government means business if the cabinet was reduced to its pre-2009 size. Apart from the financial savings, such a step could also improve policy coordination and cohesion by reversing the proliferation of government departments.
What would also be helpful is if government was to announce a well-worked-out plan to reduce the size of its wage bill, starting with a blanket moratorium on new public sector hiring (with positions that became vacant being filled internally). However, with time it will have to make sure the right people are in the right positions to ensure improved service delivery.
It would also send a strong signal if government refused a further increase in guarantees to SAA to keep it afloat and let it face the legal and commercial consequences of its mismanagement, in spite of Minister Pravin Gordhan referring to SAA as a “national asset” during his first media conference after his appointment as Minister of Finance in December 2015 (perhaps “national liability” would have been more appropriate).
Wishful thinking? Probably yes, but that does not detract from the validity of the above suggestions. If radical steps like these are rejected because they are deemed not politically feasible, it will be to the detriment of South Africa’s chances of avoiding junk bond status.
From a debt sustainability perspective, maintaining a primary surplus (revenue less non-interest expenditure) is a basic requirement. South Africa’s short-term aim should therefore be to rapidly accelerate the movement to a primary budget surplus of 1% - 2% of GDP compared with the projections contained in the 2015 Medium Term Budget Policy Statement (MTBPS). According to the MTBPS, South Africa is projected to continue running a primary deficit of 1,2% of GDP in 2015/16, falling to 0,5% in 2016/17 and 0,2% in 2018/19.
This would require a swing of at least 1,5% of GDP in 2016/17, which could be accomplished by cutting non-interest expenditure or raising taxes or a combination thereof. Judging by public pronouncements, government is taking a hard look at containing expenditure, but some increase in taxes should be expected.
Any tax changes should of course take place within the context of the work being done by the Davis Tax Committee and should favour indirect taxes ahead of direct taxes to dampen the negative impact on growth. In a recent paper on South Africa’s tax system, researchers from the Organisation for Economic Cooperation and Development recommended that “Overall, priority should be given to reforms that broaden tax bases, as a more growth-oriented way of raising tax revenues than increasing tax rates. Bases can be broadened by selectively reducing allowances, deductions, credits and exemptions.”
Which brings me to the final conclusion to the question whether South Africa will be able to avoid junk bond status. The unfortunate reality is that the odds are firmly stacked against a favourable outcome.
Sovereign ratings are not only determined by evaluating an individual country’s economic and political position, but also in the context of how its peer group is doing. As pointed out in a recent BIS paper “The major agencies often highlight that their ratings reflect the creditworthiness of a rated entity relative to that of other rated entities rather than vis-à-vis an absolute level of default risk.”
New research by staff of the BIS reached the conclusion that since the 2008 financial crisis the global risk factor has become even stronger in determining sovereign risk premiums. To quote: “We find an old normal in which a single global risk factor drives half of the variation in returns and a new normal in which that risk factor becomes even more dominant. Surprisingly, in both the old and new normal, the way countries load on this factor depends not so much on economic fundamentals as on whether they are designated an emerging market.” The latter finding demonstrates the growing importance of index investing as a determinant of international portfolio investment flows.
And here the news is not good: the tide has turned firmly against emerging-market countries, essentially because of the rapid narrowing of the growth gap between them and the developed countries and a surge in debt levels ̶ sovereign as well as corporate hard-currency debt (China being at the heart of the problem). As a result, emerging-market countries have experienced unprecedented capital outflows in recent months that are set to continue in 2016, although possibly at a diminished rate. We are therefore likely to see a wave of credit downgrades for emerging markets in the next 12 months. For South Africa to avoid such a fate it will have to do something truly exceptional.
Unfortunately the South African economy is moving in the wrong direction with growth prospects being revised down to substantially lower levels than the last known forecasts of the rating agencies at a time when the agencies have increasingly emphasised the importance of economic growth (performance as well as potential) for fiscal sustainability. Growth is now forecast to be less than 1% in 2016 and around 1,5% in 2017, compared with the agencies’ forecasts of approximately 1,5% for 2016 and above 2% for 2017.
To this must be added the damage that has been done to confidence in South Africa’s institutions (previously one of its strengths) by the saga around the position of the finance minister. Furthermore, with rating agencies putting greater emphasis on contingent liabilities, the poor governance of state-owned enterprises has also become more important because of their repeated need for increased government guarantees to keep them going.
My conclusion is therefore that the risk of a downgrade to sub-investment grade (junk) for SA sovereign bonds in the near future is relatively high. All institutions that will be impacted by such a development should therefore analyse the consequences and put the necessary contingency plans in place.