South Africa in deep financial trouble

Despite the National Treasury’s fiscal consolidation efforts and much-improved investor sentiment towards South Africa, the government still borrows money at a higher interest rate than nominal economic growth. 

This is unsustainable and means that the country is on a path to hit a fiscal cliff, where the economy will simply be unable to afford the state’s debt burden. 

This is feedback from Old Mutual Wealth investment strategist Izak Odendaal, who outlined the government’s dire financial situation in a recent research note. 

Odendaal explained that South Africa is extremely vulnerable to external shocks. The country imports capital to fund the government’s deficit and exports commodities. 

This makes the country highly sensitive to events in the global economy that impact the cost of borrowing money or the demand for commodities. 

This means South Africa is buffeted by what happens in the United States due to the country’s outsized role and impact on financial markets. 

With the volatility created by a Trump presidency in the United States, South Africa’s declining risk premium is unlikely to continue its downward trend despite interest rate cuts. 

So far in its cutting cycle, the Reserve Bank has cut interest rates by a cumulative 75 basis points, supposedly easing financial constraints. 

However, this doesn’t help the government since it borrows longer-term in the bond market at much higher interest rates of around 10%. 

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 10%, while nominal economic growth hovers around 5%. Adjusted for inflation, the country’s economic growth is around 1%.

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 is 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 spending over R1 billion a day on interest payments.

Reducing South Africa’s debt burden

Odendaal said the government cannot directly control economic growth or the interest rate it borrows at, so it must focus on reducing its debt burden. 

Only over the long run can fiscal consolidation translate into investors attaching a lower premium to South African government debt, reducing the cost of borrowing. 

This means that whatever combination of government spending and revenue the country ends up with in the Budget, it is very important that overall government borrowing levels are stabilised. 

South Africa does not have as much government debt relative to national income as the US or UK, but they borrow at much lower interest rates than it does. This means that South Africa’s debt burden compounds much quicker. 

The South African government spends more on interest payments than social grants or education, and its interest burden keeps rising. It also spends more on interest than most of our peers. 

This squeezes out important spending areas and limits the room to respond to shocks. In other words, ‘fiscal consolidation’ remains crucial, Odendaal said.  

The government needs discipline on the spending side and efforts to raise the government’s tax revenue. For the latter, only faster economic growth can deliver on a sustained basis. 

There is a limit to how many tax rate increases the economy is able to absorb and taxpayers are willing to tolerate before tax increases do not raise additional revenue. 

Within an overall framework of fiscal consolidation, without borrowing more, Finance Minister Enoch Godongwana proposed additional spending. 

This additional spending is to accommodate the public sector wage increase, more infrastructure spending, above-inflation social grant increases and frontline service delivery support. 

SARS will also get an additional allocation, which should pay for itself over time by improving tax collection.

The above marks a shift after several years of spending curtailment. To fund this, the failed February Budget proposed a 2% VAT increase that other parties in the GNU shot down.

The second attempt at a Budget proposes a 0.5% increase in the VAT rate this year and next. This will ultimately raise the VAT rate to 16%. This remains a politically contentious issue. Unlike in February, there is no bracket creep relief, and also no upward adjustment of medical aid credits. 

One positive for consumers is that there is still no fuel levy increase despite the rand price of Brent crude oil falling almost 10% since the start of the year.   

The VAT increases will temporarily add to inflation. About two-thirds of the CPI basket is VATable, so the full 0.5% increase in the VAT rate will show up in inflation data. 

Some companies might even absorb the increase to avoid raising the final price to the consumer. The previous VAT rate increase in 2018 saw a very limited passthrough.