One thing holding South Africa’s economy back

South Africa’s economic growth is being hampered by a deep-rooted fiscal crisis, which is resulting in higher interest rates, unsustainable debt levels, and decreased investment in the country.

This is according to the Centre for Development and Enterprise (CDE) in the third report of its AGENDA 2024 series. This series of reports sets out several catalytic actions to reverse South Africa’s decline.

The CDE said the costs of South Africa’s unsustainable fiscal position are high and rising, and failing to address it would cause enormous harm to our long-term prospects.

“In saying this, CDE is aware that there are no hard-and-fast rules that growth slows the moment a country hits a particular debt-to-GDP level,” the organisation explained. 

“It is increasingly clear, however, that the speed at which public debt levels have risen in South Africa has had very significant effects on growth.”

The CDE explained that South Africa’s fiscal crisis is chronic rather than acute. It is the consequence of structural weaknesses in fiscal policy that have become deeply embedded over time and cannot be uprooted overnight. 

“South Africa’s position is much closer to that of an insolvent business than one merely experiencing cashflow problems,” said CDE director Ann Bernstein.

“The difficulty government has in financing itself has already led it to experiment with more exotic ‘solutions’, such as prescribing that pension funds must invest in public infrastructure or deploying the Unemployment Insurance Fund’s assets to job-creation projects.” 

She said this is a form of financial repression – the generic name for policies that seek to direct funds to government or preferred sectors of the economy at the expense of other sectors – distorting capital markets and reducing their efficiency. 

Financial repression distorts and ultimately undermines the efficiency of capital markets, raising the cost of capital further.

It has also led to the drawdown of the Gold and Foreign Exchange Contingency Reserve Account and increased borrowing from international financial institutions.

Bernstein said these steps are symptomatic of fiscal weakness, not strength. She further explained that the fiscal crisis impacts growth and expected growth through many channels.

The three most important channels for this are:

• Rapidly rising debt service costs, which have grown far more quickly than nominal GDP, now absorb a fast-increasing share of tax revenues that are diverted from more productive uses 
• The very high level of real interest rates increases the cost of borrowing and reduces investment levels for the country as a whole
• A range of distortions created by misallocating resources and savings, resulting in suboptimal use of capital in the economy. Scarce savings are directed from more-productive uses to less-productive by lowering private sector investment and directing resources to low-productivity spending like bailouts in government

“These effects mean that increased government spending now would further reduce the already poor growth prospects of the country rather than improve them,” Bernstein explained. 

“It is also why high levels of deficit spending have failed to stimulate economic growth in the past 10 years.” 

She said high deficit spending levels that produce no additional growth also constrain the central bank’s capacity to use monetary policy to support aggregate demand. 

Furthermore, higher interest rates on government debt result in higher interest rates for the economy. 

This is because of the increase in demand for savings and because of the risk that the government might one day have to inflate its way out of the crisis.

High levels of government borrowing squeeze out lending to the private sector, transferring scarce savings from more productive to less productive activities.

In addition, in the absence of faster growth, high levels of debt and wide government deficits will require higher levels of taxation in the future, reducing present levels of investment because of the reduced expected after-tax returns.

The government’s high debt levels also threaten South Africa’s banks. The high debt levels distort their balance sheets as the banks accumulate high-paying sovereign debt, which exposes them to increased defaults.

“Failure to maintain a sustainable fiscal position is a symptom and evidence of poor governance, which undermines business confidence and investment,” Bernstein said.

“It is for all these reasons that empirical evidence increasingly suggests that higher levels of government consumption as a percentage of GDP have resulted in lower economic growth.”