Hidden threat to South Africa’s finances

South Africa’s biggest financial problem is the combination of low economic growth and high interest rates the government has to pay on its debt. 

This combination has resulted in the government paying around 10% in interest on its debt while its income has only grown by 6% as tax revenue correlates closely with economic growth. 

Old Mutual Wealth investment strategist Izak Odendaal explained the severity of this problem in his latest investment note covering the Medium-Term Budget Policy Statement (MTBPS). 

While the MTBPS is often dismissed as a ‘mini-budget’ that offers little in terms of policy, Odendaal said it plays a vital role in ensuring that South Africa is aware of threats to its financial health. 

Budget projections are done on a three-year forward basis, allowing for transparency and a clear projection of where the government’s finances are headed. 

This not only sends signals to rating agencies that things are on the right track but also ensures that while there are problems with the government’s financial health, at least it is aware of them. 

Though government debt levels have increased rapidly since 2009, debt itself is not necessarily the biggest problem, Odendaal said. 

Rather, it is the disastrous combination of low economic growth and high interest rates. Put simply, the government is borrowing at around 10%, but since growth in tax revenues correlates with nominal economic growth, its income has only been growing by 6% per annum. 

Odendaal said this gap started widening about a decade ago as the county’s economic growth slowed.  

Before then, the nominal economic growth rate was higher than the government’s borrowing costs, and debt levels were sustainable. 

As growth slowed, the market was increasingly concerned about South Africa’s fiscal sustainability, pushing up bond yields.

Higher borrowing costs, in turn, put downward pressure on economic activity as more money was required to pay the interest on the government’s debt burden.  

This created a vicious cycle that has played out over the last decade and has finally shown signs of reversing. 

The government’s nominal GDP growth in comparison to the interest charged on its debt is shown in the graph below. 

Odendaal thinks South Africa is in the early stages of reversing this cycle as bond yields have declined since the election, and growth prospects are higher. 

He did warn that nothing should be taken for granted, with the MTBPS somewhat disappointing markets by projecting a wider-than-expected deficit for the current year at 4.7% of GDP. 

This is mainly due to tax revenues undershooting by R22 billion, but, importantly,  the commitment to fiscal consolidation remains. 

The National Treasury expects to run a primary surplus this year and over the next few years, meaning tax revenues will exceed non-interest spending. This is projected to result in the debt-to-GDP ratio peaking at 75% in the next fiscal year. 

The main risks to this turnaround are the public sector wage bill, potential further support for Transnet and other SOEs, and municipal debt to various utilities. 

A looming threat is the implementation of the National Health Insurance (NHI) scheme, but the Treasury appears to be clear in its stance that there are no funds for it. 

The other side of the equation requires sustained economic growth through reform in key sectors of the economy. 

This has been driven by Operation Vulindlela, which has successfully tackled obstacles to faster growth, notably in restructuring the electricity market. 

Its second phase will now focus on local government, addressing spatial inequality, and advancing digital government.  

The other big area where reforms are underway is the infrastructure development framework, including mechanisms to encourage the private sector to invest in major projects. 

Despite the economic reforms, the Treasury’s economic growth assumptions are conservative. It forecasts real GDP growth rising from 1.1% this year to 1.9% in 2027. 

South Africa’s improving financial health is shown in the graph below.