Link to a video discussion on: The supplementary budget
This time is different. At least, that is what the Finance Minister would like us to believe.
The FY21 Supplementary Budget (SB) has two objectives. The first and primary focus is to adjust in-year spending to account for the impact of the Covid crisis and the government’s stimulus package. The second is to lay out, even if vague, the fiscal framework for the medium term. The Treasury positively surprised on both fronts.
Record recession leads to record revenue slump
The government made its first official mark-to-market for the Covid crisis by revising its GDP growth forecast for 2020 from 0.9% to -7.2%. While analysts have criticised this as still too optimistic, we have to acknowledge that we have all been forced to adjust our growth estimates almost week by week as new information comes through. Even the IMF has revised its projections yet again. On the day of the SB, the Fund cut SA’s growth forecast from -5.8% to -8.0%, which is broadly in line with Treasury and the SARB (at -7.0%). We expect a contraction of around 10% in 2020 based on the activity run-rate during the various levels of lockdown, so far, and the hit from the global recession.
While the bias continues to be to the downside, high-frequency data, such as electricity consumption, have improved sharply of late, suggesting a more rapid rebound in activity towards the baseline. Anecdotally, some of the global research houses have nudged their China growth estimates upwards, but this may be premature in the face of fear about a dreaded second wave of infections.
Figure 1: Record recession and record deficit
Source: SARB, National Treasury, Matrix Fund Managers
The unprecedented recession, which was brought about by government decree, is seen in the budget deficit widening from around 7%/GDP to a record 15.7% at a consolidated level. While this is an alarming number, it is broadly in line with the market’s expectations. Moreover, the pace of consolidation is much faster than expected, with the deficit narrowing towards 7.0% in the medium term. Our estimates remain somewhat more conservative, and we think it will be difficult to return to a single-digit deficit by next year.
The deterioration in the deficit is almost entirely driven by the collapse in tax revenue associated to the slump in nominal GDP. Revenues are expected to fall by 19% y/y amid a 4% nominal GDP decline. The result is a R304bn estimated revenue shortfall, of which R26bn is foregone revenue as part of the stimulus package, and another c.R10bn is due to lost revenue from the alcohol and cigarette sales bans. The bailout plan on the spending side is only an extra R36bn, with the R145bn full plan being partly funded via reprioritisation of R109bn – this will be quite a feat. The government will reallocate spending within and between departments by reducing allocations to underperforming programmes, delaying programmes where able, and foregoing the spending that would have taken place during the lockdown.
Figure 2: Lockdown leads to tax revenue collapse
Source: National Treasury
Revenue strain requires more pragmatic funding
Compared to the budget estimates, the funding requirement for FY21 balloons by R344bn to R777bn. The bond market has been wide-eyed about this for some time. The positive development in the SB is that Treasury has become more pragmatic in its funding strategy in a bid to reduce the impact on the debt levels and financing burden:
- There is a greater reliance on T-bill issuance to lower funding costs given the sharp fall in the repo rate;
- While it is not explicitly shown, there is probably also more active use of CPD deposits for short-term funding needs;
- The government will borrow c.R90bn from international financing institutions (IFIs) – in particular the $1bn facility from the New Development Bank has been confirmed, and it is almost certain that SA will use the $4.2bn in the Rapid Financing Instrument with the IMF;
- Government will issue the equivalent of $2bn in the Eurobond market; and
- Government will draw down the sterilisation deposits with the SARB.
This leaves “only” R463bn in gross issuance from the domestic bond market. While there are wide-ranging views on what this means for the weekly auction size, our estimates indicate that the current rate of issuance (R6.1bn per week in nominal terms) in the local fixed-rate bond market will be adequate, for now (under certain realistic assumptions). However, there seems to be more uncertainty and some upside risk to the size of issuance of inflation-linked bonds.
The IFI funding will be converted into rand, but this does not necessarily mean that it will flow through the market. It could entail an off-market transaction where the SARB takes up the dollars as part of its FX reserves and pays out rand to the government.
The use of the sterilisation deposits seem to be a more contentious issue. In drawing down these deposits, the government will add to liquidity, which could put pressure on the SARB’s sterilisation efforts via open market operations and increase the cost of sterilisation. Usually, excess liquidity is seen as inflationary because it lowers interest rates and reduces monetary policy effectiveness. In recent years, this has not been a constraint for the SARB, in part because the credit transmission channel has been hampered by weakening growth and a rising regulatory burden on banks and attendant cost. Using sterilisation deposits on a temporary basis while inflation is low, inflation expectations are anchored, and growth is weak makes sense.
Emphasis on SOE reform not bailouts
SOEs did not receive additional financial support, except for Landbank, which received a R3bn equity injection to redeem bridging finance linked to the entity’s rating downgrade earlier in the year. Oddly, this was shown as part of the Covid-19 relief package, which could probably be justified on the grounds that it is a development finance institution and should be kept afloat given that it accounts for a third of agricultural sector lending in the economy. SAA has not received anything above the R16.4bn in guaranteed debt payments announced in the February budget. The vote on the business rescue plan – which requires R10bn in additional funding – has been delayed from 25 June to 14 July. This process and the resolution of the impasse between the DPE and National Treasury will be key markers for the political will behind the required consolidation.
Now or never, again
Similar to the previous budget statements over the past three years, the SB sounds the alarm bells, warning of a “debt spiral” if nothing is done. To bring the message home, the Treasury has shown two scenarios: the passive scenario and the active scenario.
Figure 3: Passive and active debt scenarios
Source: National Treasury, Matrix Fund Managers
Under the passive scenario – the “do nothing” case – the debt ratio persistently escalates to 140% of GDP in FY29. It is debatable whether it would actually reach that level, as some time before then it is more likely that the government would have run into payment difficulties, the market would revolt, and/or a full IMF programme would ensue. Few, if any, emerging countries have sustainably been able to run debt ratios above 100% of GDP.
The active scenario forms the basis of the proposed medium term fiscal framework. Under this scenario the debt ratio stabilises just shy of 88% in FY24. We think this is a relatively optimistic scenario – our estimates for debt stabilisation are closer to the 95% – 100% mark. While a healthy dose of scepticism is warranted, what makes this budget different is that it explicitly states that Cabinet has endorsed the active approach. Perhaps the politicians are not yet aware of what this will entail.
So what does the active approach entail?
The active approach to fiscal consolidation and debt stabilisation relies heavily on spending cuts. There is some implicit reliance on the rebound in nominal GDP growth and the attendant revenue multipliers, but there is also provision for moderate tax increases in the medium term.
A return to normal on the revenue side is questionable in light of the potential firm closures and job losses that could stem from the lockdown, which would reduce incomes and spending and so lead to a lower revenue-to-GDP multiplier. Moreover, hiking taxes may be counterproductive given the decline in the tax base.
The tax policy adjustments equate to new taxes of c.R5bn per year over the medium term. These will be revisited in the October Medium Term Budget Policy Statement (MTBPS), and finalised for the February 2021 Budget. The February 2020 Budget tried to create space to lower corporate income taxes, hence we should rule out any additional tax load on companies. We think an upper-income personal income tax hike is more likely than a VAT rate hike in light of the consumer backlash in 2018. Alternatively, Treasury could increase taxes on income derived from wealth, such as the dividend withholding tax, transfer duties, and estate duties. There has been much media debate about an explicit wealth tax, which would be a political tool rather than a means to gain significant revenues.
The bottom line is that tax rate hikes at a time when consumers are under pressure – from lower income, job losses, and subdued asset prices (notably the strain on the housing market) – would be counterproductive. Over and above tax policy changes, the SB noted that progress in strengthening SARS should lead to additional revenue collections in the medium term.
The spending cuts – while short on detail – are ambitious. The SB maintains the need to reduce the wage bill by a cumulative R160bn. So far, the progress has been disappointing with the current year’s negotiation under arbitration. Over and above this, the government needs to reduce spending by R230bn over two years to stabilise debt and reach a primary budget surplus by FY24. Combined, the spending cuts equate to roughly 7% of GDP, which would be a substantial drag on growth, all else assumed equal. But all else will probably not be equal. An offset to lower government spending and a slower increase in the debt ratio will be reduced fiscal risk, lower funding costs, rising business confidence, a potential crowding in of the private sector, and an easier monetary policy stance.
Austerity needs reform
As bondholders, we would welcome the commitment to returning the fiscus to a sustainable path, but at the same time we have to debate the merits of austerity in the face of structurally weak growth. The key issue is what is the source of fiscal malaise and how quickly should consolidation take place.
SA’s experience over the past five years has involved sequential spending reductions and tax hikes – a slow pace of austerity. Yet this has left the economy even weaker and debt levels much higher than envisioned. Hence, the level of spending may not be the problem, but rather the composition of spending and government’s effectiveness. This links back to the dynamism and growth potential in the economy and the need for reform. Again, the SB explicitly states that cabinet supports Treasury’s reform agenda. It is now time for delivery.
The SB has given very ambitious targets that will be expounded on in the October MTBPS, but execution risks are large, as ever. In addition, the political economy is such that it is questionable that the proposed budget cuts have broad government buy-in. Credibility will be key.