MTBPS 2016: The different shades of junk

By investment economist Arthur Kamp

The 2016 Medium Term Budget Policy Statement (MTBPS) illustrates the South African National Treasury’s intent to continue following a path of fiscal consolidation as it aims to stabilise government’s debt ratio and ensure long-term fiscal sustainability.

We have entered a period of marked belt tightening

Individual budgets often appear relatively benign in their impact. However, the effect of fiscal consolidation is clearly visible when viewed over time. In aggregate, announced fiscal consolidation measures (including both expenditure cuts and tax increases) amount to a cumulative R154 billion for the period 2015/16 to 2018/19.

Treasury has stuck to its targets

The Treasury has diligently stuck to its expenditure targets. Real Main Budget non-interest spending per capita (excluding financial transactions per capita such as the capital injection into Eskom in fiscal year 2015/16) has been flat since the beginning of the current decade. In addition, tax revenue growth has exceeded nominal GDP growth, increasing from around 25% of GDP in 2008 to an expected 27.7% of GDP by 2019/20.

Given the weakness in income growth it is commendable that fiscal slippage relative to the initial Budget is expected to be contained at 0.2% of GDP for government’s Main Budget in 2016/17, which is now expected to improve from a deficit of 3.8% of GDP in the current fiscal year to a deficit of 3.1% of GDP in 2019/20. At the same time the Main Budget primary balance is projected to improve to a surplus of 0.5% of GDP by 2019/20 from a deficit of just 0.4% of GDP this year (1.0% of GDP in 2015/16). This is expected to stabilise government’s debt ratio over the medium term.

Increasing debt is a threat

But, it is evident the sustained underperformance of the economy is beginning to weigh, making it increasingly difficult for the Treasury to meet its goal. Despite the National Treasury’s sterling effort in implementing fiscal consolidation, the government’s gross loan debt ratio continues to increase, although at a slower pace.

And, yet, the track record for debt consolidation relative to announced targets since the recession falls short. In February 2009, the Treasury projected gross loan debt would increase to 31.1% of GDP by end March 2012, from an estimated 27.3% of GDP at end March 2009.  By end March 2012, total gross loan debt amounted to 42.4% of GDP. It has persistently increased since then and reached 50.5% of GDP at end June 2016. It is now projected to increase to 53.0% of GDP by 2018/19, before declining a notch to 52.3% of GDP in 2019/20. Fortunately, given government’s cash balances its total net debt ratio is significantly lower at 44.7% of GDP. Still, net debt has also recorded a sharp increase from 22.6% of GDP at end March 2009. It is expected to stabilise at 47.9% of GDP in 2019/20.

The continued increase in the debt level speaks to the sustained underperformance of the South African economy.  We know this is a concern to ratings agencies. Even though the agencies look to “see through the cycle” they also emphasise potential growth, which in South Africa’s case is exceedingly low for an emerging market country at around 1.5% to 1.75% currently.

A downgrade is very possible

Based on observable real economy, fiscal accounts and external data, a current rating of BBB- (negative outlook) on South Africa’s foreign currency debt by Standard and Poor’s seems appropriate. The negative outlook is an indication that a BB+ rating is a strong possibility.

The swing factor is the subjective element implied in ratings. In South Africa’s case this speaks to the importance of structural economic reform, including the need to improve the efficiency and financial accounts of state-owned companies. The Budget does not add up over the medium term unless economic growth lifts.

Further, uncertainty lingers regarding the long-term potential impact of National Health Insurance on the Budget and whether additional guarantees will need to be extended to state-owned companies. Ratings agencies pay specific attention to the level of these guarantees.

All of this implies the risk of a ratings downgrade remains high despite the National Treasury’s commendable adherence to fiscal consolidation.

Junk status is not necessarily devastating

But, here’s the thing. Although near-term volatility would be expected if South Africa were to be downgraded, junk status is not necessarily devastating. A downgrade due to underperformance of the economy amid a continued drive towards fiscal consolidation and prudent monetary policy (which anchors inflation expectations) is one thing. In Brazil’s case, for example, a downgrade to BB+ from BBB- by Standard and Poor’s in September last year, rapidly followed by a further downgrade to BB in February this year, was followed by a strong rally in government bonds. This partly reflects a better inflation outlook and expectations of improved fiscal performance.  Another consideration is the external environment. Brazil was downgraded against a background of exceedingly loose monetary policy in developed economies, which kept global bond yields low.

Roughly, South Africa appears to be in a similar situation to Brazil. We do not know whether South Africa will be downgraded this year. But, what we can argue is that a downgrade appears to be largely priced into the domestic bond market.

But, there are different shades of junk. A downgrade due to continued overspending, a lack of will to stabilise the debt situation and loose monetary policy (which worsens the inflation outlook) is a completely different thing. It is this far more damaging scenario South Africa must continue avoiding, even though it implies the continued implementation of restrictive macro-economic policy.