The GNU’s biggest challenge

South Africa’s new Government of National Unity (GNU) will have to address the country’s rising debt levels and skyrocketing debt-servicing costs, as expenditure threatens to crowd out investment in the crucial areas of education and healthcare. 

This is feedback from Old Mutual Wealth Investment Strategist Izak Odendaal, who said forming a pro-market government could be the catalyst that unlocks the country’s potential. 

Odendaal explained that investors should realise the potential feedback loops at play. In a situation like South Africa’s, small improvements can lead to big changes over time. 

People often overestimate the short-term implications of an event like the formation of the GNU and underestimate the long-term consequences.

He said South Africa has often been on the receiving end of feedback loops with negative consequences. 

For example, over the past decade, South Africa has experienced weak economic growth, which has led to higher interest rates instead of lower interest rates, as would be the case in most countries. 

Subpar economic growth means tax revenues are insufficient to match government spending, leading to a deteriorating government creditworthiness, which is reflected in elevated bond yields. 

These fears also put downward pressure on the rand. The Reserve Bank’s big fear is that it could lead to a disorderly currency blowout. 

As a result, it has kept interest rates higher than what domestic economic conditions would warrant if there were no fiscal worries.  

To reverse this, Odendaal said the new government will have to stabilise the country’s debt-to-GDP ratio to improve its creditworthiness and reduce the yield it has to pay investors to hold its debt. 

The government can do this by significantly cutting spending and running a budget surplus or by growing the economy at a faster rate than its debt pile is growing, thereby reducing its debt-to-GDP ratio. 

However, Odendaal urged the government not to think that economic growth would cure all its problems. The state should still borrow significantly less money and avoid taking on debt to fund its expenditures and operations. 

It cannot afford a debt pile that continues to grow and consumes 20% of all tax revenue collected in the country. 

If the government borrows less, there are two important benefits. Firstly, it spends less on interest payments down the line, freeing it up to spend more elsewhere or allowing it to pay down debt even quicker. 

Secondly, the more markets gain confidence that they are successfully tackling debt levels, the less they will charge for lending to the government. In other words, bond yields will decline.

Odendaal warned that this would not be easy, as it is simple for “coalition partners to agree on feel-good economic reforms that lead to private investment and photo opportunities for hard-hat-wearing politicians.” 

“It is much more difficult to commit to being disciplined with state money when each party has its own spending priorities.” 

The aspiration of a slimmed-down value-for-money cabinet will probably be shelved to accommodate ministers from several parties in sufficient numbers. 

For similar reasons, the bloated state bureaucracy might not shrink. These two factors will continue to put upward pressure on government spending, potentially hobbling any attempts to reduce its debt pile.