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Economist View

By Arthur Kamp, 21 February 2019

The core message from Budget 2019 is that non-performing state owned companies (SOCs) have become such a drag on the fiscus that it is difficult to place South Africa's government finances on a sustainable path.

This situation is compounded by an underperforming economy, which, following a revenue shortfall of R15 billion in 2018/2019, necessitates continued tax increases.

More Tax Increases in the 2019/2020 and 2021/22 Budgets

New revenue raising measures amount to R15 billion in 2019/20, mainly by not compensating for bracket creep, which effectively raises personal income tax and produces an additional R12.8 billion. Meanwhile, medical tax credits are not increased, which nets an additional R1 billion in tax revenue. Changes in the general fuel levy, the road accident fund levy and the introduction of a carbon tax on fuel result in a net increase of 29c per litre in the total fuel levy. Apart from increases in excise duties (which raise revenue by R1 billion) and the "sugar" tax, additional zero rating of VAT items reduces revenue by R1.1 billion. An additional R10 billion in revenue raising measures will be announced in the 2020/21 budget.

Overall, main budget revenue increases from 25.4% of GDP in 2018/19 to 25.9% in 2019/20. Consolidated revenue increases from 28.8% of GDP to 29.3% of GDP over the same period.

Main budget balances

Source: SA National Treasury

Note, in tandem with improvements in tax administration the revenue raising measures announced result in an increase in tax buoyancy (growth in tax revenue relative to GDP growth) from 0.98 in 2018/19 to 1.31 in 2019/20. But, tax buoyancy has surprised on the low side in recent years, suggesting an element of risk, especially if tax administration does not improve.

Expenditure Saving Measures Overwhelmed by Assistance to SOCs

The Treasury directly addresses one of the main expenditure pressure points by cutting the national and provincial wage bill by R27 billion over the next three years. Additional expenditure cuts over and above this imply a total cut in spending of R50.3 billion over the medium term.

However, R23 billion is to be injected into Eskom per year, while the contingency reserve is boosted to R13 billion in 2019/20 due to "possible requests for financial supports" by SOCs. As a result, the expenditure ceiling lifts R16 billion over the medium term, despite support for SOCs in 2019/20 being funded by the sale of assets.

Overall, main budget spending increases to 30.6% in 2019/20 from 29.8% of GDP in 2018/19. Consolidated expenditure increases from 32.9% of GDP to 33.7% of GDP over the same period.

Support for State Owned Companies Stymies Fiscal Consolidation

Disappointingly, there is material fiscal slippage relative to the Budget initially read in February 2018. A main budget deficit of -4.4% of GDP is projected for 2018/19, compared with the initial estimate of -3.8% of GDP. The deficit increases to -4.7% of GDP in 2019/20. This compares with an estimated deficit of -3.8% of GDP for 2019/20 projected in February last year.

Following fiscal year 2019/20, the deficit does decline a little, but remains wide at -4.55 of GDP in 2020/21 and -4.3% of GDP in 2021/22.

The consolidated budget deficit also remains wide, increasing to 4.5% of GDP in 2019/20 from 4.2% of GDP in 2018/19, before easing to 4.0% of GDP by 2021/22.

Also, after accounting for the borrowing requirement of SOCs and municipalities the total public sector borrowing requirement is 6.5% of GDP in 2018/19, which declines in 2021/22, but remains elevated at 5.5% of GDP.

Worryingly, the main budget primary deficit (revenue less non-interest spending) increases to -1.0% of GDP in 2019/20 from -0,8% in 2018/19 and remains in deficit over the medium term. Accordingly, the government's debt ratio continues to increase.

Specifically, the gross loan debt is projected to increase to 56.2% of GDP at end 2019/20 from 55.6% of GDP at end 2018/19. Note that the government's borrowing requirement in 2019/20 is partially funded by running down its cash balances by R71.6 billion. Hence, its net debt ratio (gross loan debt less cash balances) increases faster than the gross loan debt ratio - from 49.9% of GDP at end 2018/19 to 52.3% of GDP at end 2019/20.

Ultimately, the gross loan debt ratio only stabilises in 2023/24 at a projected level of close to 60% of GDP.

Government gross loan debt

Source: SA Reserve Bank, SA National Treasury

The debt level, in itself is not especially high relative to GDP. However, given persistent sovereign debt rating downgrades the real interest rate government pays on new debt is high relative to GDP. Hence, in the absence of a substantial improvement in the primary budget balance, the debt level can only be stabilised over time should the real interest rate on debt decline relative to the real GDP growth rate.

But, at present, the ratio of debt servicing cost to main budget revenue continues to increase – from an already high 14.2% of revenue in 2018/19 to 15.2% of revenue in 2021/22.

The clearest path to changing this unsustainable path would be to improve South Africa's sovereign debt ratings or to lift real GDP growth. The former is hardly likely under current conditions, while the latter is difficult given high real interest rates and a situation in which the government is absorbing a large share of available savings to fund itself.

It should be noted that the support for state owned companies is (almost) deficit neutral. But, the point is this support is preventing expenditure saving measures elsewhere from lowering the budget deficit and constraining the level of borrowing. The build-up in off-balance sheet contingent liabilities and the accompanying deterioration in the public sector's balance sheet are now preventing the National Treasury from sticking to its fiscal consolidation path.

Government guarantees to public institutions amount to R483.1 billion of which current exposure amounts to R372.4 billion. Eskom's guarantees amount to R350 billion (with an exposure of R294.7 billion).

Other contingent liabilities include post-retirement medical assistance to government employees (an estimated present value of R69.9 billion), legal claims against government departments (R28.7 billion) and obligations for the Road Accident Fund (which increased by R76.9 billion to R216.1 billion in 2018/19).

The Plan to Stabilise the Government's Finances

It must be noted there is a lot that's good in Budget 2019, including the determined effort to boost capital expenditure relative to consumption expenditure (by cutting the public sector wage bill and accelerating public sector infrastructure investment), the firm stance on the need to improve the operational and financial performance of state owned companies, recognition of the need to strengthen the delivery capacity of the state and the renewed focus on the functionality of municipalities.

Indeed, Minister Mboweni indicated the time is approaching when hard decisions need to be taken, including whether or not the central government should issue guarantees for the operational expenditure of SOCs (in aggregate SOCs are increasingly borrowing to fund operational expenditure and interest payments), as well as consideration of equity partners where necessary.

As regards SANRAL specifically, the Minister emphasised the importance of applying the user pays principle.

Further, the willingness to engage the private sector in infrastructure investment is welcome. The infrastructure fund aims to accelerate R526 billion on-budget projects by involving the private sector and development finance institutions. The former is expected to participate in the design, build and operation of "key" infrastructure assets.

Overall, the Treasury's intent is to stabilise the debt ratio and return South Africa's government finances to a sustainable path.

But, that said, the track record of recent years is not good and the weakness of the public sector's balance sheet raises questions over South Africa's fiscal consolidation effort. Net government loan debt plus its exposure to contingent liabilities (in the form of government guarantees alone) amounts to 55% of GDP and is projected to increase to more than 60% of GDP over the next three years.

It is not known whether Moody's rating agency will give the government the benefit of the doubt as regards the state's difficult reform strategy. But, given the above, it is clear that the risk of a downgrade of South Africa's government debt rating to sub-investment grade by Moody's has increased, given the absence of fiscal consolidation and an

ever increasing debt ratio – although the first step would likely be a change in the outlook from stable to negative, rather than an immediate downgrade.

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