Budget should focus on sustainability of government's debt position

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This is according to Izak Odendaal, Investment Strategist at Old Mutual Wealth.

"The International Monetary Fund (IMF) defines debt sustainability as 'a situation in which a borrower is expected to be able to continue servicing its debts without an unrealistically large correction to the balance of income and expenditure'. In other words, sustainability means that it should not be necessary to effect drastic budget cuts or tax increases to find the money to pay the interest owed on debt and roll over maturing bonds," explains Odendaal.

He says the harsh austerity measures imposed on Greece as a condition of receiving bail-out money is a good example of such an 'unrealistic' adjustment. "Ultimately, the market decides what is sustainable and what is not. And if the market turns against you, skyrocketing borrowing costs can quickly turn sustainable into unsustainable as issuing new debt becomes unaffordable. Again, Greece is the pertinent example. What is the likelihood of South Africa going down this path? There are a number of factors that will determine whether a country's government debt level is sustainable."

Odendaal says the seven issues that should be watched closely during this year's budget are:

1. What is the level and the path of the government debt-to-GDP ratio?

"Many countries have settled on 60% as a ceiling for the government's gross debt-to-gross domestic product (GDP) ratio or, simply, the debt ratio, including Eurozone members. SA's debt ratio is below this, but has increased substantially over the past six years. Compared to our emerging market peer group, South Africa had a low ratio prior to the 2008 global recession. This ratio is now broadly in line with our peer group. The problem is the sharp increase in the debt ratio over the past eight years. The market tends to be more forgiving towards a country with a higher ratio, but a falling debt path," says Odendaal.

2. What is the gross financing requirement?

Governments have to turn to the market to fund new borrowing - the budget deficit - and to roll over maturing debt, says Odendaal.
"It is risky going to the market with a huge borrowing requirement at any given time. While SA's budget deficit is on the high side close to 4% of GDP, it is projected to decline over the coming years. Meanwhile, the maturity profile of the government's debt is smooth, avoiding the risk of a large amount of debt coming due in a given year and long-term in nature (on average around 13 years). In recent years, government has been able to borrow longer-term and the maturity profile for outstanding debt has increased significantly. The gross financing requirement looks perfectly manageable, provided the deficit reduces as projected."

3. What is the composition of government debt?

Apart from roll-over risk, governments also face currency risk and interest rate risk. Currency risk arises when borrowing is done in a foreign currency.

"South Africa's deep and liquid local capital markets mean government can do most of its borrowing (about 90%) in rand. Therefore, any sharp fall in the rand will not threaten government's ability to service its outstanding debt. Interest rate risk can be passed on to lenders by issuing fixed rate bonds, rather than floating rate bonds. Most of South Africa's government debt is at fixed rates, so the interest rate risk the government faces is also relatively small. Government debt management certainly contributes towards fiscal sustainability."

4. What drives new borrowing?

The split between current spending and capital spending is important, says Odendaal. "Current spending is mainly on salaries, and government's wage bill has ballooned over the past six years. Borrowing to fund such current spending is usually unsustainable. Capital or investment spending not only supports economic activity immediately, but also facilitates it over the long term, increasing the tax base and therefore enhancing the ability to service debt.

"South Africa fares poorly on both on the mix of spending and on the quality of its current spending. The upcoming public sector wage negotiations are an opportunity to demonstrate a willingness to reverse the trend."

Odendaal notes that government's exposure to loss-making state-owned enterprises (SOEs) is also a concern. "While the SOEs are meant to be national assets, and form the centre piece of government's 'developmental state' policy, the fact that many continue to require bailouts is of grave concern. The Finance Minister noted last year that any further assistance to SOEs would be deficit-neutral. Sticking to this commitment is vital to support fiscal sustainability."

5. What are the long-term fiscal pressures?

Unlike many developed countries, South Africa's sizable Government Employees Pension Fund is fully funded. The three social security funds (Road Accident Fund, Unemployment Insurance Fund and the Compensation Fund) have a combined surplus, though the RAF has a deficit.

"Social welfare payments are funded out of national revenue, and are thus completely 'on balance sheet' - again unlike some developed countries - while South Africa also does not face the demographic crunch of a large segment of the workforce on the verge of retirement," says Odendaal.

But South Africa has a large social welfare bill by developing country standards. "The National Treasury has done modelling on the long-term affordability of social spending. It expects the take up of social grants, which is partly a function of demographics, to ease over time. The National Health Insurance is a daunting challenge, and if fully implemented, could see public health spending double as a percentage of GDP over the next 15 years.

"Crucially, Treasury's sustainability models assume a baseline GDP growth rate of 3% per year, while the IMF and the Reserve Bank have recently cut SA's long-term potential growth range from around 3.5%-4% before 2008 to less than 3%. Disappointing growth over the next few years could very quickly render social spending growth unsustainable and see the debt ratio deteriorate. We need to get our long-term growth rate back up above 3%."

6. How credible is fiscal policy?

On the positive side, actual budget deficits were usually smaller than projected by the government over the past 20 years - except during the 2008/9 recession, says Odendaal. "So budget projections are generally trusted by the market. The government has committed itself to fiscal consolidation, and the markets and ratings agencies have given it the benefit of the doubt. But failure to walk the talk will dent the credibility of these promises.

"Government introduced an expenditure ceiling in the 2012/13 fiscal year, placing a limit on the rand amount of spending it can undertake in a given year. It has managed to keep spending under the ceiling, and last year also lowered the ceiling for the next three years. If spending breached this limit, government would lose credibility since it ultimately has a lot more control over the spending side than the revenue side of its budget. It is vital to illustrate continued discipline to support fiscal sustainability."

7. What is market risk appetite?

"You are only solvent when the market says you are solvent," says Odendaal. "Since the Global Financial Crisis and particularly the Eurozone fiscal crisis, the appetite of the market to fund large deficits and rising debt ratios has waned significantly. Running large deficits and rising debt ratios can easily lead to difficulties in funding new debt at affordable interest rates and rolling over maturing debt. Foreign investors own about 40% of our government debt and the Minister needs to take that into consideration in his budget."

Considering whether South Africa's government debt is sustainable, Odendaal notes that debt management has been good in terms of currency exposure, maturities, and interest rate risks.

"But the emphasis on current spending over investment spending is a worry, and government will also need to limit the potential financial pressure from SOEs. South Africa requires a higher and sustainable economic growth rate to support long-term social spending needs. The government must also be mindful of the shifting goal posts in terms of what international investors regard as fiscally sustainable."

Higher growth rate is vital

Odendaal says that to stabilise the debt ratio, one needs nominal GDP growth to exceed the average interest rate government pays on existing debt, and for tax revenues to exceed non-interest payments (i.e. for the government to run a primary budget surplus).

"Getting our growth rate up is vital, and to do that requires implementing the kind of reforms outlined in the National Development Plan. The longer fiscal consolidation is postponed, the more urgent it becomes, and the bigger is the primary surplus required to stabilise the debt ratio (i.e. the harsher the economic austerity)."

Odendaal says that a recent IMF working paper suggested that 60% should be considered the maximum debt-to-GDP ratio for South Africa, but that, given our economic volatility, adopting 50% as a debt-to-GDP ceiling was more prudent.

"We are still slightly below that level, but we cannot be complacent. The Finance Minister needs to outline the steps necessary to turn the primary deficit into a surplus and reverse the rising trend of the debt ratio. The government managed to do this in the late 1990s, and it can do so again."