Budgeting on Moody’s

By Tumisho Grater

The run-up to the 2020 National Budget comes amid continued concerns about domestic electricity supply, fluid global political dynamics and a moderate global economic growth backdrop.

Following the 2019 Medium Term Budget Policy Statement (MTBPS), Moody’s has given the country limited time to put into action substantive steps towards implementing reforms and its economic strategy. It is expected that this should result in executing fiscal measures that would arrest or reverse the current debt trend. The following have been cited by the main credit rating agencies as factors that could lead to a sovereign’s negative rating action, namely:
  • Government’s failure to revive economic growth and fiscal strength.
  • Failure to stabilise debt and contingent liabilities risks to state owned companies (SOCs).
  • Weakened rule of law, property rights or enforcement of contracts (which ultimately undermine the investment and economic outlook).
The above factors will be among some of the key aspects that we will be looking out for in the 2020 National Budget next month. We also briefly discuss our views and our portfolio positioning ahead of this risk event

Growth and the reform agenda

In the October 2019 MTBPS, National Treasury forecast the economy to grow by just 0.5%. This was a revised figure from what was an optimistic forecast of 1.5% in the earlier February 2019 National Budget. Since 2013, as the global economy and most of our developing-country peers experienced a rebound in economic activity, South Africa’s GDP growth trend has continued to decline. This has primarily been a function of the country’s failure to implement structural reforms and improve the composition and quality of spending. For example, how we tackle the triple challenge of poverty, high uneployment and inequality could be through changes made in the procurement process of our SOEs.

The government’s status as a big buyer of goods and services through public procurement allows for this buying power to be spend on upgrading fixed assets such as buildings, vehicles, land and equipment. It is the brick and mortar type of investment that forms the backbone on which the economy functions. This can greatly improve logistics, education, connectivity, facilitates trade and attracts investment. By drawing in previously excluded designated groups into economic activity while also addressing the issues around economic transformation, this could change the role of SOE’s, from being the “problem children” to being positive agents of change.

One of the big concerns is that the deterioration of the domestic growth outlook will continue unabated, reflecting serious unaddressed structural changes.

Digitisation and climate change

Digitalisation and climate change are other ongoing structural changes that have real ramifications for economies. This has become clear with the increase in the number of extreme weather events (the fires in Australia and the drought conditions in parts of Sub-Saharan Africa are cases in point). Insufficient policy action and lack of policy direction to address climate change issues is likely to weigh on investment which can lead to significant disruptions in economic activity over the short term, and long-lasting damage to capital and land.

Trade and geopolitics

Trade and geopolitics are also moving away from the multilateral order of the 1990s and it would be a policy mistake to consider these shifts as temporary factors that can be addressed with only monetary or fiscal policy as they are structural in nature. In the absence of clear policy directions on these areas, uncertainty will continue to loom high thereby damaging growth prospects.

Growth reform interventions.


To remedy this, National Treasury has highlighted the need for reforms in specific economic sectors that could boost the country’s potential growth rate by 2-3% over a 10-year period. The illustration below attempts to quantify the impact of the proposed growth reforms and illustrates the significance of the interventions in the short, medium, and long term. For example, the cheapest form of stimulus is increasing confidence. Giving investors an acceptable degree or predictability and consistency in terms of the policy environment in which they are operating in could add as much as 0.5% to the country’ growth rate.


Although the impacts of the interventions in the short term are likely to be smaller (relative to the medium-term interventions), they lay the foundation for making the successful implementation of other reforms a success. While a potential 2-3% gain to SA’s current GDP growth expectations is not enough to absorb all the ills that plague the country, an improvement in the growth trajectory would give comfort to credit rating agencies that we are moving in the right direction.

Plugging the revenue gap

An important indicator of tax revenue performance is the tax buoyancy ratio which measures the sensitivity of tax revenues to changes in economic growth. In the past four years, the tax buoyancy in South Africa has decreased from 1.4 in 2014/15 to 1.2 in 2018/19. This signifies a lower compliance levels in a constrained economic environment. Current revenue options are limited and only allow moderate scope to boost tax revenue. The graph below illustrates the widening gap between what government spends and how much revenue it generates as a percentage of GDP. It is clear to see that there is a widening gap between revenue and expenditure, thus creating the debt burden that the government finds itself in, and that the ratings agencies find problematic.
 

The 2019 budget included R10 billion in tax increases for 2020/21 (and given the current spending demands and the need to strengthen fiscal consolidation), further tax policy measures to raise these funds are expected to be announced in the budget next month. An increase for the usual suspects, namely “sin-taxes” on alcohol and tobacco is likely to feature and even against the current backdrop of SA’s already struggling economy, income tax and VAT increases cannot be ruled out.

For the financial year ending 31 March 2019, SARS collected a nett amount of R1 287.7 billion, with Personal Income Tax (PIT), Corporate Income Tax (CIT) and VAT making up about 80% of total tax revenue collections, with PIT in 2018/19 accounting for more than 38% of total revenue. 

Corporate Income tax declining


The global financial crisis of 2008/09 had a significant impact on all tax types, but its main impact was most notable in the reduction and slow recovery of CIT. Companies struggled to return to profitability and several carried large assessed tax losses. The volatility in commodity prices, the fluctuating exchange rate and the downgrading of some major banks and insurance companies to junk status in 2017/18 had an adverse impact on CIT collections due to the lag effect.

The contribution of CIT to the net collection by SARS dropped further in the 2018/19 financial year due to contractions in some sub-sectors of the manufacturing industries which were impacted by power outages in the first quarter of 2019. The construction sector also contributed to the decline as it continues to struggle and has been impacted by the government’s (the biggest spender) budget cuts on infrastructure spending. Unfortunately, the current domestic backdrop has still not changed.

So where will the revenue come from?

With limited revenue generating options, the focus will also be on measures taken to reign in expenditure, of which a big proportion is the public sector wage bill. Between 2006/07 and 2018/19 the wage bill more than tripled, from R154 billion to R518 billion.

The chart below illustrates a breakdown of every R1 000 spent at a consolidated national and provincial government level for the 2019/2020 period. As it stands, above-inflation remuneration increases account for the largest proportion of this spending. Options that could be considered include:
  • Fixing cost-of-living adjustments at or below CPI inflation
  • Halting automatic pay progression
  • Reviewing occupation-specific dispensations for wages
Government must discuss these matters with labour. We look to the National Budget to find out what progress has been made in this regard.


Pressure points

Some of the main pressure points on the fiscus stem from the risks posed by commitments that may result in future financial obligations- in other words contingent liabilities, and by expenses that have been recorded but not yet paid. As credit rating agencies have been flagging for some time, the financial condition of SA’s major SOC’s account for most of these risks to the fiscal framework. These risks have already begun to materialise and according to National Treasury contingent liabilities are expected to exceed R1 trillion by 2021/2022.

Over the next three years, spending will total R6.3 trillion, with almost half of this amount going towards social grants, education and health. In the context of weak growth, however, revenue shortfalls and rising spending pressures are threatening government’s ability to maintain existing levels of service provision and infrastructure investment.

The chart below shows how financial payments (mostly support for state-owned companies), debt-service costs and wages are the fastest-growing areas of expenditure.


Source: National Treasury

In the past, reductions to spending growth have typically fallen primarily on goods and services – a category that includes items such as school books, and medical and food supplies – and capital budgets, which finance the construction of roads, dams, hospitals and water treatment plants. The space to reduce these budgets further is shrinking. 

Will Moody’s finally pull the trigger? 

After the MTBPS, the bond markets and the rand reacted sharply as it became evident that SA ran the risk of a full downgrade from Moody’s. The credit rating agency acknowledged that SA’s economic growth would remain slow and fiscal strength would likely continue to erode. Moody’s held the view that the country's credit profile would remain in line with those of Baa3-rated sovereigns (at the lower end of investment grade scale), with government debt projected to reach 65% of GDP by fiscal 2023 under the baseline scenario. Although SA’s government indebtedness is currently in line with Baa3-rated sovereigns, unfortunately, it is on an upward trend. The chart below illustrates the country’s Debt-to-GDP outlook as projected by the National Treasury.



The retaining of SA’s investment grade status hinges heavily on reversing this trend through implementation of structural reforms to raise potential growth and stabilise and eventually reduce the government's debt burden relative to Baa3-rated peers. However, reversing this trend will be gradual at best given that social, economic and fiscal policy objectives will remain difficult to reconcile. 

How are we positioned? 

The bond and currency markets appear to have largely priced in this risk, meaning the markets are trading at levels as if SA were a fully-downgraded country. If a full Moody’s downgrade is announced after the February Budget, SA will be removed from the World Government Bond Index, forcing investors to sell their holdings. This additional supply of bonds in the local market is likely to negatively affect bond yields.

The SA Government Bond yield curve maintained its bear-steepening bias over the past three months, and we expect this to persist as we approach the February 2020 Budget speech and the March 2020 Moody’s credit rating review. On a positive note, a comparison of SA real yields with those on offer in developed markets showed SA bonds offer decent yield pick-up and hence Value. With loose financial conditions and an accommodative monetary policy stance by developed market central banks, this meant that demand for emerging market (and SA bonds by extension) were prepped up.

Unfortunately, the budget deficit and the lack and sometimes absent action plan to tackle SA’s SOCs has counted against SA bonds. This calls for caution in managing fixed income portfolios. We will also continue to monitor risks from global factors such as emerging market flows. At this stage we hold a neutral position to domestic government bonds.