South Africa heading for financial disaster

The interest rate the South African government pays on its debt is higher than the country’s economic growth, even in nominal terms. It is unsustainable and means the country will eventually hit a fiscal cliff. 

This is feedback from Old Mutual Wealth investment strategist Izak Odendaal, who outlined some of the financial challenges the government faces after the postponement of the Budget last week. 

Some of these challenges are hangovers from the pandemic, with supply shocks resulting in inflation and interest rates increasing rapidly to 15-year highs in South Africa. 

The stop-start shock Covid delivered to global supply chains contributed to a price surge, which was compounded by Russia’s invasion of Ukraine, another unexpected shock. 

There is no indication of a return to the pre-Covid, post-financial crisis period of ultra-low interest rates, especially not as inflation uncertainty has increased with the various tariff threats.

Concerningly, recent inflation data in the United States and the United Kingdom showed an uptick even before any tariffs took effect. 

It is too soon to ring the alarm bells, but it does mean that the US Federal Reserve is justified in pausing its rate-cutting cycle to assess how things play out. This will influence the Reserve Bank’s decision-making. 

Higher-for-longer global interest rates might be one of the pandemic’s biggest legacies. By definition, this means borrowers, including governments, need to think carefully about taking on more debt.

South Africa entered into this era with high government debt, which has only continued to increase as the state has to fund its fiscal deficit. 

Since 2008, the government has consistently run a budget deficit, meaning it spends more than it collects through tax revenue. This gap has been primarily funded through increased borrowing. 

As a result, the South African government has been saddled with a large debt burden that crossed 75% as a share of GDP in 2024.

Odendaal explained that South African interest rates are not particularly high relative to pre-pandemic levels but high relative to economic growth.  

The government borrows at an interest rate of around 9%, while nominal economic growth hovers around 5%. 

Tax revenue will grow more or less in line with nominal economic growth over time, assuming a steady tax-to-GDP ratio. 

This gap between interest rates and growth, sometimes expressed as r>g by economists, renders borrowing unsustainable since debt compounds faster than the income needed to service it.

This sits at the core of South Africa’s fiscal challenge, as debt-servicing costs are the fastest-growing expenditure item in the budget, with the government having to spend over R1 billion a day on interest payments. 

Since the government cannot directly control economic growth or the interest rate at which it borrows, determined by the bond market, it must focus on reducing its borrowing requirement. 

This is called ‘fiscal consolidation’ but is necessarily painful since it relies on some combination of higher taxes or less spending.

“Unfortunately, South Africa has no easy choices left. All we can ask for is that the difficult choices are made wisely,” Odendaal said.  

From investors’ point of view, it would have been positive if the Treasury was prepared to take the politically unpopular step of raising VAT rates by two percentage points. 

The fact that the Cabinet was not sufficiently briefed now appears clumsy, but it’s not sinister. The pushback against the VAT increase means the National Treasury must return to the drawing board. 

Importantly, however, the issue is not the principle of fiscal consolidation but rather how best to achieve it.

A VAT rate increase may or may not be in the final Budget Speech on 12 March. If not, some of the increased proposed spending – on infrastructure, social grants, education and health – would have to be trimmed back. 

Now that the market has seen the draft projected deficits, it will likely respond negatively to wider deficits in the final Budget.

If there is a VAT increase, perhaps 1% instead of 2%, the economy is at least on a sounder footing to be able to absorb it due to the significant decline in load-shedding, and lower interest rates. 

The benefit of VAT is that it is applied broadly and does not distort economic incentives the way income taxes can. The drawback is that it is a regressive tax, in the sense that rich and poor alike pay the same rate.