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Solving the fiscal puzzle

| Investments

By Carmen Nel at Matrix Fund Managers

 

Mission impossible. That is certainly the way most commentators would describe the daunting task of solving South Africa’s fiscal puzzle. To be sure, no one envies Minister Mboweni’s job, certainly not during a pandemic crisis amid governing party factionalism and elevated global uncertainty. Encouragingly, the National Treasury has become more explicit in its acknowledgement that we are on an unsustainable fiscal path and that time is of the essence.

How did we get here?

South Africa has been heading towards a fiscal cliff for some time now, due to the culmination of various local and global dynamics, many of them structural. Six broad factors have contributed to serial fiscal slippage and the unceasing rise in the debt burden.

1.Structurally lower trend growth: Notwithstanding the rebound in growth and commodity prices in the wake of the 2008/2009 Global Financial Crisis (GFC), the trend in growth reset to a lower path (Figure 1). The GFC triggered a balance sheet recession that was exacerbated by the Eurozone sovereign debt crisis of 2010-2012, while the change in China’s global growth model – from investment and export orientated to being more domestically and consumption led – resulted in less commodity-intensive growth. Domestically, the economy faced a higher regulatory burden, most notably the implementation of Basel III, as well as severe energy constraints.

Figure 1: Sharply lower GDP growth over the last decade

 

 

Source: iress, Matrix Fund Managers

2.Lower inflation: Inflation is often seen as a mitigating factor when it comes to tax revenue growth and fiscal ratios, but since 2017 South Africa’s inflation rate has steadily declined. This is not only due to persistently weak GDP growth, but also to the South African Reserve Bank (SARB)’s success in anchoring inflation expectations. This led to nominal GDP growth also undershooting official forecast, resulting in a smaller than expected tax base.

3.Government’s remuneration policy: The wage agreement of 2009-2010 between the government and trade unions resulted in the implementation of occupation specific dispensation (OSD) that restructured and defined remuneration across the various categories of employees in the civil service. This included pay grades and automatic pay progression (APP). The impact was not only a substantial adjustment in the real wage bill at that time, but it also entrenched excess real wage gains year after year (Figure 2). Over the last five years, the nominal pay per worker in the civil service has risen by 7.5% per year on average, compared to 4.8% in the private sector. The Treasury reiterates that it is not so much the size of the government work force that is the concern, but that growth in the compensation per employee has become unsustainable.

Figure 2: Compensation spending increases per year by component

 

 

Source: National Treasury, Matrix Fund Managers

4.SOE support: Financial and operational mismanagement has put significant pressure on state-owned entities (SOEs) over the past decade. The most prominent example is Eskom, which has received R133bn in shareholder support (a euphemism for a bailout) over the past 12 years, and is set to receive a further R112bn over the next three years. After a series of turnaround plans, SAA is now in business rescue, which requires R14bn to implement amid the pandemic headwinds to the avian industry. In aggregate, the major SOEs have sapped R162bn out of government’s coffers since 2008.

5.The composition of spending: The combination of very generous pay hikes and ideological support for flailing parastatals has required serial adjustments to the government’s expenditure ceiling. Yet, what is often underappreciated is that tighter departmental budgets with higher wage bills result in aggressive spending cuts to goods and services, as well as capex programmes. The net effect is a further lowering of potential GDP growth, as well as a reduced ability to deliver services.

6.Counterproductive tax rate increases: Serial tax rate hikes since 2015 have put notable strain on a shrinking individual tax base. Cumulatively, the estimated direct tax drain from the various policy measures – such as direct personal income tax rate hikes, the 2018 value-added tax rate hike, and the sub-inflation bracket adjustments – have taken R90bn out of consumers’ pockets. Various analyses conclude that further personal income tax increases will be counterproductive. To be sure, while the registered number of taxpayers has been increasing, the number of individuals assessed and actually taxed has been falling (Figure 3). Anecdotally, it would seem that tax morality is declining and that the tax base is shrinking (thanks to emigration and a stagnant jobs market).

Figure 3: Number of individuals registered and assessed for tax

 

Source: SARS, Matrix Fund Managers

What do we need to do?

Government policies need to address the rapid increase in the debt burden, the attendant sharp escalation in debt service costs, as well as the sustainability of fiscal expenditures. In broad terms, for every R1 generated in tax revenues in the current fiscal year, almost 60c will go towards the wage bill and 20c will be paid to creditors. This leaves only 20c for other spending, which means an ever-growing reliance on borrowings. As a result, the higher debt service cost is crowding out other spending, and the high government bond yield is raising the cost of borrowing across a large part of the economy.

The Budget update released in June this year showed two scenarios: the passive scenario, which is the ‘do nothing’ option where debt rises to 140% of GDP, and the active scenario, which requires rapid reform and spending restraint to stabilise the debt ratio below 90% of GDP. The October Budget update showed a somewhat more realistic middle-way, where the debt ratio reaches 95% of GDP. Yet even this more pessimistic outlook still requires notable expenditure cuts, as well as stronger real GDP growth.

Figure 4: Government debt projections – active, passive, and realistic

 

Source: National Treasury, Matrix Fund Managers

In this regard, the October Budget proposed the correct strategy, which is addressing the structurally high wage bill with a three-year nominal wage freeze. This is anathema to the unions, and given the sharp deterioration in the private sector labour market due to the lockdown, the unions should be on the back foot. Yet this has not stopped Cosatu from reportedly threatening to withdraw election support for the governing party in next year’s local elections in protest to this proposal. A key marker for progress is the Labour Court’s hearing on this year’s wage dispute in early December.

In addition to wage restraint, the government must start implementing long overdue reforms. National Treasury’s multi-year analysis indicates that effectively implemented reforms could boost potential GDP growth by as much as 2% per year over the longer term. The recently released Economic Reconstruction and Recovery Plan (ERRP) prioritises infrastructure, energy security, employment, and localisation. While scepticism is reasonable based on the new administration’s track record – recall the Ramaphoria of 2018 – the ERRP does give broad timelines for specific interventions. The short-term focus is on the release of additional spectrum, as well as stabilising the electricity system. These are markers for the early success, or not, of the ERRP. The spectrum auction deadline is set for March 2021, while the Department of Mineral Resources and Energy must issue its request for proposals for additional generation capacity, including bid window 5 of the renewable energy programme, by January 2021.

There’s a way, but is there the will?

Numerous research analyses from across National Treasury, Business for South Africa, and the private sector have shown ‘the way’. The question now is whether the government has the will to do what is needed. This is particularly challenging when it will require depleting political capital amid the ongoing Covid-19 crisis and as we head into local government elections and the ANC National General Council in 2021. Moreover, reforms are often costly in the short term as they disrupt the status quo, but pay off in the long term. Yet, there are various tailwinds that policy makers can use to assist the transition to a more productive economy. These include substantial fiscal stimulus in the developed world, record low monetary policy rates across most countries, a positive terms of trade boost, and a weaker dollar, which is usually a boon for emerging markets. In addition, we should not underestimate the confidence boost that will come from clear evidence that we are turning a corner on corruption and the fiscus.

While solving the fiscal puzzle is no easy task, investors should be cautiously optimistic and not ignore the potential upside in domestic markets.

 

Disclaimer

Matrix Fund Managers (Pty) Ltd is regulated by the South African Financial Sector Conduct Authority as an authorised Financial Services Provider with a Category I, II and IIA license, issued in terms of the Financial Advisory and Intermediary Services Act, 2004 (FSP 44663). 

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