Investors have had a day to digest Finance Minister Mboweni’s make-or-break Medium Term Budget Policy Statement (MTBPS).
According to the market reaction and news headlines, the mini-Budget (as the MTBPS is often referred to) fell woefully short of already pessimistic expectations.
As in the prior two years the market did not react well to the MTBPS with the rand and local bonds selling off based on this news.
By now, we all know the headline numbers:
- The consolidated budget deficit is projected to widen from 5.9%/GDP in FY20 to 6.5% in FY21, versus the forecast for 4.3% in the February Budget;
- The debt-to-GDP ratio rises from 60.8% in FY19 to 80.9% in FY28, while the February budget thought it would peak at 60.2% in FY24; and
- Eskom is set to receive a total bailout of R112bn over the next three years to help redeem guaranteed debt, but there is no explicit debt transfer onto the government’s balance sheet.
Yet the message that accompanied the updated forecasts is that we should not view the MTBPS as the proposed fiscal stance, but rather that it is a warning about the potential trajectory that will transpire if government does not make the difficult decisions. In our view, this is a change in the way the MTBPS is used as a signalling tool. Prior to 2017, the MTBPS would have (realistic) fiscal proposals incorporated in the numbers, even if not all of these proposals ultimately end up in the final budget in the February of the following year. Since 2017, the MTBPS has shown the numbers with minimal policy adjustments, leaving the message conveyed in the document and the Minister’s speech as the true policy focus.
The MTBPS is seen as a redux of the Gigaba mini-Budget of 2017 that aimed to catalyse the then Zuma-administration into action. The dire fiscal situation in the absence of a plan is meant to be a clear message from the technocrats in the National Treasury to the politicians in Cabinet to take action. So far the market reaction has been similar to the 2017 episode, although there are currently mitigating factors: this MTBPS was delivered by a credible policymaker (Finance Minister Mboweni) who reports to a popular reform-minded president (President Ramaphosa), and global bond yields are much lower now than they were then.
Eskom is partly to blame for our dire fiscal position, not only because of the serial bailouts it now needs, but also because of the impact it has had on growth. The lack of reliable electricity provision over the last six years has been an opportunity cost to the economy by investment that did not take place and jobs that weren’t created. Yet a bigger structural factor in the level of government spending is the wage bill.
The sharp moderation in real GDP growth and lower inflation may be structural, reducing the revenue-generating ability of the South African economy. Combined with the upward adjustment in government expenditure, largely due to the public sector wage settlement in 2010 – 2011, this has resulted in an unsustainably large gap between tax receipts and spending. The key risk factors to the fiscal position are persistently low growth and the attendant negative spillovers to employment creation and migration, as well as significant spending pressures – the size and growth of the wage bill, Eskom support, and the pending implementation of the NHI.
It is not all doom and gloom, as there are some positive aspects in the MTBPS. Treasury has allocated more funding to the National Prosecuting Authority and to the South African Revenue Service (SARS). The latter’s rehabilitation is an upside risk to revenue collections down the line as systems are rebuilt, capacity is enhanced, and confidence improves tax morality.
Alongside the nominal expenditure ceiling (which has been in place since 2012), Treasury proposes a fiscal target of a balanced main budget primary position (excluding Eskom support) in FY23. To achieve this, government will have to cut spending, raise taxes, and sell non-core assets. On the tax front, options may be more limited, but we cannot rule out indirect tax increases (fuel, tobacco, alcohol) or bracket creep (not adjusting tax brackets for inflation). While we think it will be tough to put through another VAT hike, it seems that this is not entirely off the table. Yesterday’s message might just be loud enough to raise it further. After all, of all the major tax tools, VAT is spread the widest and is arguably the least distortive.
Spending cuts are proving more difficult. Earlier this year, Treasury issued a directive for departments to lower their spending by 5% – 7%, but the MTBPS pencils in 2% reductions in limited areas, at best. A concern is that some of the reductions must come from transfers and conditional grants to provinces and local governments. This means fewer resources for maintenance and even more upward pressure on local government rates, tariffs, and fees to make up the shortfall.
Treasury will be the first to acknowledge that absent a curtailment of the wage bill, rapidly rising debt will mean that it is failing in its objectives of intergenerational equity and counter-cyclicality, while posing a direct threat to service delivery on the ground. This is what happens when interest costs crowd out other spending priorities – the government is borrowing to pay interest on borrowings!
So what does this mean for markets? It depends on what spending cuts and reforms the government can implement between now and February.
If we take these numbers at face value, then the bond market will face even higher weekly issuance, and a severe bout of supply indigestion. This will raise the hurdle for a meaningful rally in bond yields, even against a backdrop of low global yields. However, if we give the government the benefit of the doubt, then the current weekly auction will be sufficient.
From a SARB perspective, we think the MTBPS and market reaction will delay but not prevent further monetary policy easing. After all, potential growth has fallen, while inflation remains contained. This will give the MPC room to move down the line.
Importantly, the extent of the deterioration in the fiscal outlook has caused renewed concern in the market about a credit rating downgrade by Moody’s. The risk of a downgrade has surely increased, but it is highly unlikely to occur this week. Moody’s is set to publish a review of South Africa’s sovereign credit rating today, 1 November. At best, they will reiterate the rating at Baa3/stable outlook. At worst, they could put the rating under review for a downgrade pending the release of the main budget in February. At that time they will have to resolve the review by either downgrading the rating (to Ba1) or renewing the rating at Baa3 (the outlook could then move to negative, but it is not a given). Our base case is in between: we expect Moody’s to revise the outlook to negative, which is less onerous on the timeline. An outlook is usually resolved within 12 to 18 months. Hence, we do not think that investors should be concerned about an imminent rating downgrade and forced selling of South Africa’s government bonds. Moreover, a negative outlook might be just what is needed to amplify Mboweni’s call to action.
Is the MTBPS a bold gamble that will pay off with focused minds in Cabinet collectively making the tough choices? Or is this a sign of weakness in the face of vested interests? These are crucial questions as the February Budget is potentially the final fork in the road.