An Overshadowed Budget Speech
The 2022 Budget Speech was completely overshadowed by the tragic events in Ukraine. However, it also reflects the fact that there was little drama in the Budget this year, and frankly, that is how it should be. The Budget should be boring and predictable, and devoid of existential angst. Progress in that direction is therefore welcome.
There has been extensive commentary on the Budget already, so it is worth focusing on some of the points that received less coverage and ask how the Russian invasion thousands of miles away might impact some of the issues Finance Minister Godongwana spoke about.
The first point to make is that the government’s finances are in better shape largely thanks to a supportive global environment, particularly in the form of elevated commodity prices. Tax revenues in the fiscal year that will end soon will now likely exceed the updated October projections by R62 billion, with company tax a big (but not the only) reason.
Commodity prices have increased further over a broad front in recent days due to fears that the increased economic isolation of Russia could lead to shortages of the raw materials it exports. Russia is of course a major exporter of oil and gas, but also of wheat coal, palladium, nickel and aluminium. Ukraine is also a major exporter of agricultural commodities, and one will have to assume supply disruptions if the conflict escalates.
Higher oil prices will feed into existing global inflationary pressures and could lead to central banks raising interest rates at a faster pace. However, while the current uncertainty lasts, central banks could err on the side of caution.
Importantly, the price increases signal supply shortages while demand is expected to remain robust. This is indicative of still-solid global growth. We are not at the point where higher commodity prices and rising interest rates trigger a global recession yet.
While South African consumers are likely to pay more for food and petrol (and therefore the government did not raise the fuel levy for the first time since 1990), our own exporters should benefit from these higher prices.
Chart 1: Global commodity price indices
Source: Refinitiv Datastream
That said, the government is wisely not banking on commodity prices remaining high. It has used the current windfall to reduce debt levels and extend the R350 per month Covid-grant for another year. But any increases in the social safety net beyond next year will have to be funded by a permanent increase in tax revenues, not borrowing or hoping for high commodity prices. No significant tax increases are pencilled in for the next three years.
Chart 2: Debt-to-GDP projections
Source: National Treasury
Thanks to the revenue overshoot and reasonable discipline on the spending side, the debt-to-gross domestic product (GDP) ratio is now expected to peak earlier and at a slightly lower level than projected in the October mini-budget, namely 75.1% in 2024/25 (chart 2). By that point, the government expects to run a primary surplus, meaning that revenue will slightly exceed non-interest spending. The budget deficit will then entirely consist of interest payments in excess of R300 billion per year (chart 3).
This remains the key reason for staying on the fiscal consolidation path: interest payments are already the fastest growing item in the Budget and are crowding out other worthy areas of spending. Since South African government borrows at a high interest rate (6.2% on a weighted basis), debt service costs compound quickly.
Chart 3: Main budget balance projections
Source: National Treasury
It is not all bad news: most of this money flows back into the local economy since two-thirds of government bonds are in local hands, held by insurers, unit trusts, banks and pension funds.
The debt and deficit projections are considerably better than two years ago in the depths of the Covid-induced recession as the economy has recovered much quicker than expected. But there are risks to this outlook: the government faces considerable pressure to increase spending on all fronts from frontline service delivery to expanded social grants to public sector wages. Maintaining discipline will be tough but the commitment is currently there. However, there is no guarantee that a future government won’t take a more populist stance. The other risk is an economic slowdown that once again depresses tax revenues, for instance if the Ukraine crisis spirals out of control. Therefore, local bond yields still contain a hefty risk premium.
While South African bonds sold off as Russian troops rolled into Ukraine, the jump in yields was mild compared to other episodes of global risk aversion and emerging market panics. This reflects the better fiscal outlook, as well as expectations that inflation will remain under control even with higher fuel and food prices. The higher yields therefore offer an even better entry point.
Chart 4: Emerging market local currency bond yields
Source: Refinitiv Datastream
The biggest question for any bond investor anywhere is simply whether the borrower will default (fail to repay interest or capital). While many commentators and investors have framed default risk in terms of the rapid increase in the South African government’s debt levels over the past decade, they have missed another key part of the Budget, namely the debt-management guidelines that Treasury uses precisely to lower default risk.
There are limits on the issuance of foreign bonds and short-term debt (less than 15% of each), while there are ranges for inflation-linked bonds (20% – 25%) and a targeted average maturity for total debt (10 to 14 years). Debt crises have historically happened when a government runs out of hard currency to pay foreign lenders (in other words, it is usually as much of a balance of payments crisis as a fiscal crisis) or when large volumes of maturing debt have to be rolled over at a point in time when interest rates are very high, or market access limited (as was the case with the infamous 1998 Russian default). While the South African government’s debt levels are high, the profile of debt therefore reduces the risk of a fiscal crisis.
Beyond the headline debt and deficit numbers presented in the Budget, it is also important to look at the intent and the message. Apart from the emphasis on fiscal consolidation, there is a strong focus on economic reforms to raise the country’s long-term growth potential. Most of these reforms need to be carried out by departments other than Treasury, so it is often a case of two steps forward, one step back – or simply waiting ages for the first step to be taken. Treasury is involved in Operation Vulindlela, a joint initiative with President Ramaphosa’s office, to drive meaningful cross-cutting reforms.
We need real economic growth to increase from the 1% average of the past decade towards the longer-term (since 1960) average of 3% for the fiscal numbers to make sense in future. That is why the reforms underway are so important, and why more is needed to improve the business climate.
One such change is a continued simplification and easing back of capital controls to foster investment inflows. The Budget announced the intention is to raise the limit on offshore investment of funds to 45% plus 10% for African exposure. In other words, in contrast to a widely held view that government will move to restrict offshore investments, they’ve gone in the opposite direction and local investors will have more choice in future.
Another widely held view – and subject of much scaremongering – was the imminent imposition of prescribed assets which would force pension funds to buy government or state-owned enterprises. Instead, pension fund regulations will be amended to allow for – not force – greater investment in infrastructure projects. Infrastructure investing is likely to become a bigger feature of local pension funds, but probably not for retail investments that have daily liquidity requirements. Still, it is an exciting asset class. The problem is not convincing pension funds to do so but the lack of bankable projects.
If we are going to see higher economic growth rates, we will need to invest in infrastructure. There is no way around it. While Treasury has budgeted R812 billion for capital projects over the next three years, that is not enough to meet the country’s needs and almost half is allocated to provincial and local governments where implementation capacity is limited. Therefore, the efforts to crowd in private capital and expertise across a broad range of projects are crucial.
South Africa remains reliant on a healthy global economy – and of course there will be question marks given the Russian invasion – but we are slowly taking steps to get our house in order and raise the long-term growth potential of the economy. This is very important, since the world increasingly seems like a very uncertain place. The Budget and other recent announcements again reflect the fact that for all our challenges – and there are many – South Africa is not a failed state and the extreme pessimism over the prospects of the country and its financial markets is not warranted.
In fact, the strength of our democratic institutions contrasts very starkly against the one-man decision-making of Russia’s autocratic president Vladimir Putin that will directly influence the lives of millions of people. Russia is oil-rich, but its people aren’t wealthy. Russia’s real per capita income of $11,000 is a quarter of the UK’s, for instance. Putin is diverting valuable resources that could’ve improved the lives of Russians to destroy the lives of Ukrainians. His actions could also reshape the global economic and geopolitical order in profound but unpredictable ways.
Clearly the events in Ukraine are unsettling especially since the world is still dealing with the lingering uncertainty of the Covid pandemic. Markets have been extremely volatile, and this is likely to persist until there is more clarity. History suggests that such geopolitical events have historically had a minimal long-term impact on investment returns unless you are directly involved, and particularly if you are on the losing side. On the contrary, they have often presented investment opportunities. Investors are understandably anxious, but more damage to portfolios is often done panicking in response to big events than by the events themselves. The best course of action remains ensuring your portfolio is appropriate for your long-term investment goals – be it growth, income, or capital preservation – and then sticking to your strategy.