The path to sustainability

South Africans are understandably concerned about the path our country is on, particularly regarding the fiscal sustainability of our debt, both in absolute and relative terms.

Apr 7, 2021

7 minutes

Peter Kent
Adam Furlan
Sisamkele Kobus
South Africans are understandably concerned about the path our country is on, particularly regarding the fiscal sustainability of our debt, both in absolute and relative terms.

Interestingly, the UK (85%), the US (91%) and Japan (250%) are not viewed with the same concern. The reason is the sustainability of the debt, both in absolute and relative terms.

However, assessing the sustainability of debt in any given country is a complex question. The Institute for International Finance and Deutsche Bank recently compiled a list of the change in debt-to-GDP ratios between the fourth quarter of 2019 and the third quarter of 2020 across 32 countries across their household, corporate and government sectors. South Africa ranked 11th from the bottom, with an increase of 17% of GDP, the bulk of which was in the government sector. In contrast the UK has seen a 33% increase in that period, again concentrated in the government. The US has seen a 43% increase spread between borrowing by the government and corporates. Japan has seen a 50% increase. In South Africa, the surging share of revenues (or borrowing) diverted to making interest payments is due to two main factors; the growing debt burden and persistently high interest rates (which in turn compound the debt burden).

The reason the UK, the US and Japan can afford massive increases in debt burdens is because their borrowing costs have plunged. If the US government borrows for 10 years at just under 1%, they can afford to support the massive amount of the money they have borrowed this year. If Japan or the UK government borrows 10-year money at slight negative interest rates, they have no problem with debt serviceability. In contrast, South Africa has no such leeway. South Africa’s interest costs are high, and the 10-year yields have shown little downward movement through this crisis:

  1. Inflation is expected to average 4.1% in 2021
    With 10-year government bond yields hovering between 9% and 10% this leaves South Africa with real interest rates in excess of 5.0%. In a world where real interest rates are negative in most developed markets, a 5%+ real interest rate stands out.
  2. The repo rate is 3.5%
    Leaving us with a term premium of over 5.5% currently when the 10-year term-premia are less than 1% in much of the world.
  3. Local banks can issue 5-year NCDs at 7%
    Whereas the government R186 is trading at 7.5%. Investors would rather lend to local banks than the South African government.
  4. South Africa’s 10-year bond historically yielded 1.5% more than the emerging market average
    This doubled to 3% when Nhlanhla Nene was fired. After trending down in subsequent years, it has headed higher in the last year, and is now at 4.5% more.

The only way out of this debt trap is to address the root of SA’s problems: weak growth. During a recent panel discussion, senior members of the fixed income team at Ninety One shared that our situation is by no means unique in the world. While further deterioration in debt profiles will ultimately become unsustainable, South Africa is not alone, with debt burdens across the developed and emerging worlds ballooning.

What, then, of the future? Ninety One believes that fiscal consolidation and structural reform can move us towards sustainability, and that investors have a role to play, by constructively engaging on pressing issues in order to make an impact.

What makes debt unsustainable?

Essentially, there are two perspectives. One is the amount of debt (measured relative to GDP) and the other is the affordability of that debt (measured by how much revenue – that is, tax - must be allocated to paying back that debt).

Figure 1: Rising debt = government bond indigestion

Rising debt = government bond indigestion

Source: Ninety One, data as 24 February 2021

The left-hand chart above tracks the level of debt incurred and how it evolves over time under different scenarios, and the amount of borrowing that translates into, in Rands per year, on average over the next 8 years. Under the MTBPS scenario in October 2020, it amounts to around triple the borrowing incurred in 2017/2018 – peaking at 95% of GDP in 2025/26. While debt/GDP is a widely used measure, it is also important in understanding sustainability whether the market can accommodate the amount the sovereign wishes to borrow. Measured by how much yields move on Tuesdays, when government comes to market, we’re on the cusp of the amount the market believes to be unsustainable. While it’s mentioned often, inflation is not the solution – nominal growth (and hence tax) might rise, but the cost of borrowing would also rise, pushing the absolute amount required per annum well north of R800bn as evidenced in the graph.

On the right-hand side above we graph the affordability of that debt, and its evolution. We expect interest to consume 22% of tax revenues every year, under the current scenario. This is a very large number, taking money away from important policy objectives such as social spending, healthcare, education or even growth-positive spending in infrastructure. This in turn creates social and political problems. However, the graphs both make it clear that there has been an improvement between the MTBPS last year and the Budget this year – to what can this be attributed? It’s down to a R100 billion overshoot in tax revenues versus low post pandemic expectations. However, it’s key that issuance now continues to be cut and spending be properly managed by the Treasury, and the overrun not be squandered.

We considered the example of Jamaica, which has similarities to us in having low levels of dollar denominated debt – but which hit 60% of tax revenues in spending on interest. Jamaica defaulted in the face of this number, unable to run the country. Other warning examples abound, such as those below.

Figure 2: Fiscal balance % GDP

Fiscal balance % GDP

Source: IMF and Ninety One

What can we then do to ensure we do not fall into the Jamaican trap? There are many options.

Figure 3: Dealing with the debt burden

Dealing with the debt burden

Source: Ninety One

Of all these options, the two that offer the most scope are reducing spending and encouraging growth, with growth the most sustainable. We’ve seen appetite from treasury to reduce and change expenditure already, towards growth-positive expenditure items. The balance of options is much less attractive, if not downright dangerous. There’s not much room in South Africa to raise taxes (and in fact Treasury has provided some tax relief), while inflation will backfire as described. Defaulting is clearly not a road we want to travel - and is one we can avoid. Financial repression (forcing the market to buy your bonds) is a spectrum depending on how onerous it is and we already have some forms of investment restriction (exchange controls being an example) here, with extensive repression abroad in the form of low rates – but we do not have the scope developed economies do to exert the necessary pressure. Funny money involves versions of expanding the balance sheet of the Reserve Bank – but the market is signaling that we have a fiscal problem, which can’t be fixed by funny money.

What are the key reforms necessary to kickstart growth?

Fortunately, confidence levels are so depressed that investor expectations of future growth prospects can be dramatically boosted by a few key actions. What can be done to boost South Africa’s growth prospects, reduce our borrowing costs and make our debt sustainable?

  1. Building state capacity is key
    For growth to be sustainable, the state must be capable of implementing growth-positive policies, otherwise they remain plans on paper. This includes all organs of state, the state-owned enterprises and municipalities. As of now, plans and policies appear to be headed in the right direction, and will be positive for labour-intensive growth. However, it is the organs of state that must implement these policies and plans. Operation Vulindlela has been launched to assist with the implementation of these policies. It is a delivery unit which sits in the offices of the Presidency and National Treasury. Its role is to make sure all bottlenecks in the implementation process are resolved timeously.
  2. Stabilise government expenditure and change the expenditure mix
    The government, through the budgeting process, has shown an appetite for this. This is evidenced in the decision to keep wages effectively flat over the medium-term, as budgeted in the February 2020 budget. However, government needs to conclude a deal with public sector unions that sees the government wage bill remain relatively flat over the coming three years. Preferably this would be by containing salary growth rather than by cutting jobs.
  3. Reform the energy sector
    Ensure that the unbundling of Eskom that will create an independent transmission company remains on track for functional separation and legal separation. This would allow the acceleration of independent power procurement, notably from renewables. This accelerated carbon transition would also allow South Africa to access cheap global financing to facilitate the transition.
  4. Inclusive growth
    Focus on agriculture, services, tourism, and network industries. These industries, particularly tourism and agriculture, will be able to create new jobs which our economy desperately needs.

Finally, engagement with stakeholders, including Treasury and SARB, is vital.

Figure 4: Our approach to proactive engagement

Dealing with the debt burden

Source: Ninety One

Download the PDF


Watch our panel discussion recording:

Authored by

Peter Kent
Co-Head of SA & Africa Fixed Income
Adam Furlan
Portfolio Manager
Sisamkele Kobus

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