By Jac Laubscher, 3 March 2016
For many people the prism through which the budget should be judged is whether it will prevent South Africa from sliding into junk status as far as foreign currency denominated government bonds are concerned. To repeat ̶ it decidedly moves government finances in the right direction to reduce the risk of such an outcome (for example, by moving much more quickly to a primary surplus as I argued in my pre-budget comments). But it would be wise to recognise that it does not completely remove the risk of a downgrade.
Firstly, it could be argued that although moving in the right direction it does not do so quickly enough and far enough. Much of the planned additional fiscal consolidation has been pushed out to the latter years of the medium-term budget framework and is therefore not a certainty. Important details of how it will happen are lacking, especially concerning the required tax changes to produce the extra revenue that has already been pencilled in, although in my opinion the Budget Review goes out of its way to prepare the ground for an increase in the VAT rate.
Secondly, the need for growth-advancing reforms still remains as before. It was of course unrealistic to expect the Minister of Finance to wave some magic wand, removing all structural impediments to economic activity, as they are overwhelmingly outside his jurisdiction. Although much can be done to improve the short-term growth prospects for the economy just by removing negatives such as policy uncertainty, the positive steps needed will take longer to be hammered out and implemented. It is therefore likely that South Africa will remain trapped in a low growth trajectory for the foreseeable future.
Thirdly, the international environment remains as challenging as before as underlined by Brazil being downgraded to junk status by Moody’s (the last of the three major rating agencies to do so) on budget day. As I said previously, for South Africa to escape the expected general wave or emerging-market downgrades over the next 12 to 18 months will require something exceptional, and I do not believe the steps announced in the budget meet this requirement.
With reference to the Brazilian downgrade mentioned above, it is perhaps useful to compare South Africa with Brazil in judging the risk that South Africa could follow suit. The table below sets out the salient numbers.
As the table shows, Brazil’s sovereign debt as a percentage of GDP is about 50% higher than that of South Africa but it has already reached its peak, inter alia courtesy of a higher primary surplus, while South Africa’s debt level has yet to stabilise. While both countries are faced with a high level of contingent liabilities, a greater part of these are related to state-owned enterprises in South Africa’s case.
In spite of South Africa’s poor growth performance it is still better than that of Brazil, which finds itself in recession for the second year running, while South Africa also enjoys the benefit of substantially lower interest rates. The result is an interest rate - growth differential that is much more conducive to the sustainability of government debt in South Africa’s case.
On the other hand, South Africa has a larger foreign financing requirement than Brazil while being more vulnerable to the withdrawal of foreign investors due to foreign holdings of South African bonds (as a percentage of total issued) being double those of Brazil.
As for political and social stability, South Africa and Brazil are faced with similar challenges of corruption involving senior politicians and connected business people, a highly unpopular president who may yet face impeachment, a finance minister who is finding it difficult to get the buy-in of other political players for fiscal consolidation (in Brazil’s case Minister Joaquim Levy resigned in December 2015 after he could not get sufficient political support for his austerity measures and stave off a sovereign downgrade to junk status), and extreme levels of unemployment, inequality and poverty (although Brazil has made more progress in recent years in addressing these challenges). South Africa of course still finds itself in the process of post-apartheid transformation.
On balance, South Africa is therefore still in a marginally better position than Brazil in meeting the requirements for an investment grade sovereign rating, but only time will tell whether it will follow Brazil into the junk universe.
Although the risk of South Africa being downgraded to junk status has served as a welcome wake-up call and recently helped to concentrate the collective mind of policymakers and other role players on what to do to avoid a downgrade, it would be wrong to hang everything on one specific event that may or may not materialise. South Africa’s credit rating is after all merely incidental to the health of its economy and the need for structural reform to get the economy onto a higher growth path is an imperative regardless of ratings decisions.
The danger is that should South Africa be downgraded to junk status in spite of the effort to avoid this, it will embolden critics of a more market- and business-friendly approach to argue that it has all been in vain and unnecessary. If there is one characteristic shared by all the different political factions in and around government it is their mutual dislike of what is broadly referred to as “neoliberalism”.
If South Africa’s foreign currency denominated sovereign bonds are indeed downgraded to sub-investment grade (junk), it will certainly make an already unfavourable growth environment even more so by raising the cost of capital. However, it will not mean the end of the ratings game and the country should subsequently focus on regaining its lost investment grade status as quickly as possible. In other words, the challenges will remain the same: addressing unemployment, poverty, and inequality through inclusive growth.
In the meantime, yields on government bonds have already increased sharply from 6,9% for the generic 10-year yield at the beginning of 2015 to its current level of 9,3%. A range of factors have played a role in this increase, some of them international and some of them local in origin. Even if South Africa should ward off a downgrade to junk status, it may yet be faced with higher borrowing costs because of the adoption of a risk-off stance by international investors.