Ratings downgrades on the horizon

The Medium Term Budget Policy Statement (MTBPS) 2017 reflects an unsustainable fiscal position amidst a persistent deterioration in government net worth.

Finance Minister Malusi Gigaba, in his maiden Medium-Term Budget Policy Statement (MTBPS), laid bare the extent of South Africa’s fiscal woes. Gigaba was quoted as saying that government cannot sugar-coat the state of our economy and the challenges we are facing, but at the same time offered no foreseeable turnaround plan. With no solution in sight, further credit ratings downgrades by year-end are a strong possibility, says Arthur Kamp, investment economist for Sanlam Investments.

In short, the key take-outs from his announcement are:

• Economic growth projections have been revised downwards from 1.3% to 0.7% for 2017, 1.1% in 2018 and 1.5% in 2019.
• The consolidated budget deficit is to widen to 4.3% of GDP in 2017/18, up from 3.1% projected in February.
• Revenue shortfall forecasts are as follows:
  • R50.8 billion 2017/18
  • R69.3 billion 2018/19
  • R89.4 billion 2019/20
• Gross national debt is to increase to 61% of GDP by 2022 with debt-service costs approaching 15% of main budget revenue by 2020/21.

In order to stabilise gross debt to below 60% of GDP over the coming decade, government will have to cut costs or increase taxes to the tune of 0.8% of GDP. Over the next three years, consolidated spending will increase by an annual average of 7.3%, from R1.6 trillion in 2017/18 to R1.9 trillion in 2020/2021.

At face value it appears that the Budget numbers no longer reveal the previous intent to stabilise the debt ratio.

New spending priorities and NHI

The MTBPS also makes it clear that new spending priorities (which could include National Health Insurance, fee-free higher education, improved early childhood development, accelerated land reform and infrastructure spending) should be financed by structural increases in revenue and reprioritisation of existing expenditure. Hopefully, that implies faster growth and efficient tax collection, rather than new taxes. Treasury could also turn to reducing tax expenditure. For example, it is considering adjustments to the medical tax credit to help fund NHI. These credits resulted in tax expenditure of R18.5 billion in 2014/15, but are effective in supporting lower income earners.

Markets react

The markets reacted to Gigaba’s worrying confirmation that fiscal deterioration is worse than expected and that all metrics related to fiscal consolidation have also deteriorated. The notable lack of commitment to fiscal consolidation, absence of meaningful expenditure cuts, no stabilisation in debt ratios as well as no indication as to how the revenue shortfall would be plugged, was not well received and the rand promptly fell to its lowest level against the dollar in ten months while dollar bonds issued by government came under pressure.

Says Kamp, a return to a sustainable fiscal path would require less consumption spending and increased capital expenditure, protection of the government’s balance sheet and alignment of the tax structure with the growth objective. None of this is evident in the Budget and is reflected in the persistent decline in government’s net worth – a key indicator of an unsustainable fiscal path.

Domestic currency ratings at risk

Ratings agencies typically have a two-year horizon, so the macro view for the next two years is critical, says Kamp.

Given what we currently know about SA’s two-year macro outlook, we believe S&P’s long-term foreign currency debt rating for South Africa at BB+ (sub-investment grade) is fair for now, although in the current environment nothing is certain. The risk, of course, says Kamp, is that if the outlook changes within this two-year window (and that could be anytime), the S&P may then move to adjust their foreign currency rating within the next two years. Kamp explains that S&P are the only agency of the three that allows a one to two notch difference between the foreign currency rating and the domestic currency rating. But, in this instance, we believe the uncertainty around the budget may push them to close the gap, says Kamp.

But, the domestic currency ratings are more at risk in the absence of additional fiscal consolidation measures.

S&P have cited two key drivers to their SA rating. Firstly, they need to see evidence of fiscal consolidation over the medium term. Unfortunately the MTBPS produces no evidence of this, as debt to GDP continues to rise over the medium-term. Secondly, they want comfort that state-owned enterprises do not present a major risk to the sovereign balance sheet. So decisive action will be needed with regard to the increase in the expenditure ceiling caused by the SAA bail-out.

Moody’s also cites two key drivers to their SA rating: Firstly, adherence to the expenditure ceiling, which has now been breached, and the need to see a solid growth plan. Hopefully, the MTBPS will spur some much-needed action in the area.

Read together, the Medium-Term Budget Policy Statement and Minister Gigaba’s Budget Speech plainly lay out the tough choices South Africa faces. Without hard political decisions, South Africa’s gross-debt-to-GDP will breach 60% in four years. Net debt-to-GDP will breach 55% in three years. Add in guarantees to net debt, and the total is over 60% in two years.

We cannot predict if and when ratings agencies will act, says Kamp, but with no additional fiscal consolidation measures in place, there is a risk that ratings agencies could revise South Africa’s long-term domestic currency debt ratings down from above investment grade to sub-investment grade. If both Moody’s and S&P take this step, South Africa will be excluded from the World Government Bond Index, concludes Kamp.