Following an underwhelming State of the Nation Address by South African President Cyril Ramaphosa two weeks ago, market participants turn their eye to Finance Minister Tito Mboweni’s medium-term budget announcement on Wednesday 26th, before Moody’s updates their South African sovereign credit rating in March.
While Mboweni seems to be the guy with all of the good ideas, previously producing a paper on “Economic Transformation, Inclusive Growth and Competitiveness: Towards an Economic Strategy for South Africa” and more recently tweeting it’s “game over” without structural reform before the SONA, political deadlock continues to hamper the reforms proposed to flatten the government’s debt-trajectory and reignite economic growth.
Further pressure on the budget came from President Ramaphosa’s pledges during the SONA to create a sovereign wealth fund and a state bank, while fixed liabilities such as the public-service wage bill and state owned entities continue to drag on the fiscal balance.
Markets know it won’t be a quick fix and the road will continue to be bumpy for South Africa in the short-run as structural reforms are implemented, but under the current can-kicking regime patience is beginning to wane.
In an environment flush with credit and investors likely to once again be hunting for yield once risk-appetite returns, the consequences of an increase in government debt in order to embark on structural reforms will be more subdued than in normal times.
On top of this, the doomsday predictions of a Moody’s downgrade from last year have arguably been priced into South Africa’s yield curve, again muting the consequences of a swift economic response.
Inaction already elevated the debt-to-GDP trajectory in 2019 from 56.2% to 60.8%, while the latest Treasury projections predict debt levels will rise above 70% by 2023 – this is based on the current state of play without any structural reforms.
Given this, the barrier for Mbowemi to clear in order to avoid a downgrade by Moody’s looks almost unachievable.
The latest news from the last ratings agency to still hold South African debt as investment grade implies that a ratings downgrade is inevitable.
Lucie Villa, Moody’s lead sovereign analyst for South Africa, said a downgrade is likely if the nation can’t rein in spending, boost growth and improve tax compliance to stabilise debt ratios.
These reforms are almost a given, but finding the magic solution isn’t as simple as Villa’s statement suggests. Political deadlock and the unionisation of the labour market means that any overhaul in the government finances will be slow, while electricity production continues to drag on growth.
WHAT CAN WE EXPECT IN THE BUDGET?
- First and foremost, updated debt projections. The market will focus on these figures initially before diving into the details of the budget in order to gauge the depth of the problem and the likely reaction from Moody’s. This is especially the case as the ratings agency recently downgraded its 2020 growth projection from September’s forecast of 1.5% to 0.7%. This would suggest growth will fail to rebound from 2019’s forecast of 0.7% also. It is estimated that a 0.1 percentage point decrease in growth leads to a 0.7pp increase in debt-to-GDP, meaning a large upwards revision in September’s debt projections are likely.
- Further pledges to reach a neutral fiscal position by 2022-23 once adjustments for debt servicing and Eskom costs are stripped out. Such a pledge would reinforce Mboweni’s proposed saving of R150bn in the next three-years, but with public wage contracts already locked in until 2021, reducing spending and boosting revenue in the short-run will be more difficult to achieve. Many believe immediate policy action will therefore occur through a hike in sales tax, but such a move would also be counterproductive to growth conditions. Alternatives could see the energy sector opened up to renewables, along with increased support for tax collection.
- Commentary on Eskom will draw the media headlines. While recent load-shedding attempts seem credible for servicing power grids, diversifying the source of electricity and rebuilding production units owned by Eskom are key for growth to rebound in the coming years. Recent attempts to auction off electricity production have been stalled by Eskom’s inability to sign contracts promising to purchase the electricity due to budget constraints.
The budget comes at a time when risk-sentiment has soured due to coronavirus fears and as foreign investors’ patience for structural reform begins to wane.
According to JSE, foreign investors sold a net 2.55bn rand of South African bonds on February 20th. This marks the first major downturn in foreign investor appetite for higher yielding South African debt since November 2019 and comes shortly after foreign inflows into South African debt markets resumes.
For FX markets, the budget has a high threshold to reach in order prompt a rand rally back down to the 15.00 level given the current external climate. Markets are numbing to pledges by government officials that seem unachievable.
Chart: Foreign inflows into debt markets turn dramatically negative amid souring risk appetite ahead of the medium-term budget announcement. The move threatens to derail the recovery from last-year’s downtrend
With the path of inaction also proving severe for the economy, market participants need a quick, albeit small, win to reignite faith in the reform rhetoric.
Author: Simon Harvey, FX Market Analyst at Monex Canada.