South Africa: time to deliver on reforms

Stronger than expected revenues and a commitment to aggressively cut expenditure over the medium term enabled South Africa to announce markedly improved fiscal projections in its annual budget. These aim to stabilise government debt, currently among the highest in the emerging markets, to below 90% of GDP by the fiscal year 2025/26.

Financial markets reacted positively to the news but the government will need to hit its targets if markets are to continue to perform well over the medium term. Social transfers will decline as the Covid-19 pandemic is dealt with and the economy reopens. But there are question marks over the ability of the government to deliver efficiency gains and real terms cuts in public sector spending as the 2024 general election draws nearer. These would be widely unpopular and drag on the economic recovery.

Delivering macroeconomic reforms to boost economic growth through higher investment would be a more sustainable way of improving the public finances in the longer term. The government reiterated its laundry list of reforms during the budget - now it is time to deliver.

What was announced?

Finance Minister, Tito Mboweni, delivered an upbeat annual budget to parliament last week. The government still expects its budget deficit to more than double in the current 2020/21 fiscal year, to 14% of GDP from 5.7% of GDP in 2019/20. However, the new estimate is smaller than the 14.6% of GDP deficit that was envisaged in the October supplementary budget.

While the prolonged impact of the Covid-19 pandemic on South Africa’s economy means that the government had to revise up its expenditure figures for both this fiscal year and last, higher spending was more than offset by surprisingly strong revenues; a result of stronger commodity prices and a modest recovery in consumption.   

There was even better news on the medium-term outlook. The government expects to more than halve its budget deficit to 6.3% of GDP with a primary deficit, which excludes interest costs, are added, of just 0.8% of GDP by 2023/24. This is anticipated to be enough to stabilise the debt ratio at around 90% of GDP by 2025/26 before starting to bring it down thereafter. While this is still very high, it is significantly lower than the peak of over 95% of GDP that was projected just four months ago.

How should investors interpret the budget?

The announcements were received positively by the market during Mr Mboweni’s speech. At one point, the rand was up by more than 1% against the US dollar and 10-year bond yields moved lower; albeit those gains were later given up as South Africa was caught up in a bit of a risk-off move as the yields of US Treasuries continued to climb amid concerns about the outlook for inflation and US Federal Reserve policy.

In the longer term, the impact of the budget on the performance of financial markets in South Africa will hinge on the government’s ability to deliver on its ambitious targets. The macroeconomic assumptions appear to be reasonable and avoid the usual trap of being too optimistic. Indeed, the government’s projections for GDP growth of 3.3% this year and 2.2% in 2022 are broadly in line with consensus. Expectations for inflation to average about 4% through to 2023 are similarly sensible.

The main question marks come from the fiscal projections themselves. The government has ditched plans to raise taxes to avoid putting undue pressure on the economy as it recovers, meaning that revenues are expected to rise by just 1% of GDP by 2023/24. Instead, the government expects to achieve almost all of the fiscal consolidation through an aggressive, near 7%, reduction in expenditure between the current fiscal year and 2023/24. Some of this will of course occur naturally as a re-opening of the economy reduces the need for social transfers.

However, the budget relies on real-term cuts in spending on public sector wages and services in the medium term and efficiency gains from streamlining public sector activities. Efficiency gains are almost never achieved in those emerging markets that rely on them to deliver austerity. And while the government has stood up to growing discontent at restraint on spending in areas such as public sector wages, it will be increasingly difficult to ignore concerns further ahead as the next general election expected in mid-2024 comes onto the horizon.

Why reform delivery is crucial

A more sustainable way to improve the public finances would be for the government to press ahead with macroeconomic reforms to raise economic growth by tackling South Africa’s long-standing problems of low national savings and investment rates.

A relatively small pool of savings means that there is not much capital available to invest. The low investment rate means that the supply side of the economy struggles to keep pace with demand, leading to structurally high inflation and low real GDP growth. Moreover, the need to supplement domestic savings with borrowing from abroad in order to raise investment means that South Africa has structurally high interest rates and a tendency to run current account deficits, which result in external vulnerabilities and volatility in the rand.

As the chart below shows, South Africa has one of the lowest national savings and investment rates in the emerging world, which is a key reason why it has relatively weak economic growth, high interest rates and volatile currency.

The government reiterated its long list of structural reforms to boost economic growth by investment in infrastructure and improving the business environment amongst other things. Reform momentum has understandably stalled during the crisis, but it is crucial that the government gets on with the job if there is to be a long-lasting improvement in the economy and public finances that would deliver a sustained period of strong returns from South African assets.