How to fund 2021’s R500bn deficit

In June, Finance Minister Tito Mboweni told us that South Africa would experience a R305bn shortfall in tax revenues in the current financial year. This was in addition to the R368bn budget deficit that was forecast in the February 2020 budget. As a result, South Africa needs to borrow almost R710bn in the year ended 31 March 2021.

Fortunately, this has been taken care of. The massive funding gap is being met by a combination of borrowing from multilateral organisations, including the IMF, the African Development Bank, the New Development Bank and the World Bank, and increased local issuance. The problem is how do we fund next year’s deficit?

Despite a moderate expected bounce back in GDP output next year and a plan to cut expenditure by R45bn, the main budget deficit is still expected to be R495bn in the fiscal year ending 31 March 2022. That is a great deal of money. If financed entirely locally, that would result in a local issuance of R10bn per week.

In the year to date, the bulk of the new issuance has been taken up by local South African banks. Their ability to buy government debt is fast eroding. South Africa needs another plan for next year.

The bond market does not believe the current situation is sustainable. There are several measures that highlight the fiscal risks the bond market is pricing in:

1. Inflation is expected to average 2.8%-3.2% over the next nine months. This leaves South Africa with real interest rates of at least 6%. In a world where real interest rates are negative in most developed markets, a 6% 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 is less than 1% in much of the world.

3. Local banks can issue 5-year NCDs at 6%, whereas the government R186 is trading at 7.2%. 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 as Finance Minister. After trending down in subsequent years, it has headed higher in the last year, and is now at 4.4%.

All these measures demonstrate the high cost investors are demanding to fund South Africa’s deficit. Ultimately, the problem can be distilled by comparing 2021’s nominal GDP growth expectation of 6.5% with the 10-year borrowing rate of 9.2%. Interest costs need to fall sharply to make the situation sustainable.

A long time ago, when we were at UCT, we had a finance professor who talked about how South Africa was in danger of falling into a debt trap. A debt trap is when you borrow to make interest payments on a permanent basis.

South Africa has been borrowing to make interest payments for several years now. Interest consumed 15.2% of total revenue in the year ended 31 March 2020. This is projected to rise to 21.5% in the year ended 31 March 2021.

If no actions are taken to rein in spending and boost growth, one-third of all revenue will be used to make interest payments within five years.

The solution is to dramatically boost investor expectations of future growth. Confidence levels are extremely depressed in South Africa. Years of corruption, regulatory uncertainty and the hollowing out of public sector capacity have resulted in a government whose default is to do nothing.

We are five months into the COVID crisis and there has yet to be any progress in policy initiatives from the government. COSATU has produced a plan. Business for South Africa has produced another plan. The government has yet to produce a plan.

To be honest, at this point we don’t need another plan from government. We simply need government to grab hold of Treasury’s plan that was produced a year ago and implement at least three initiatives before the February 2021 Budget.

One of those areas of progress needs to involve stabilising the supply of electricity by accelerating private sector provision of electricity, unbundling Eskom and taking advantage of the Green Transition to restructure Eskom’s debt.

Beyond electricity, government can prioritise any two of a host of initiatives, including auctioning spectrum, establishing Special Economic Zones for export processing, accelerating the infrastructure pipeline including container terminals for ports, dramatically improve government’s online services, specifically for municipalities to reduce the burden on small businesses, resolve the persistent visa issues for tourists and highly skilled workers and reduce the regulatory uncertainty in the mining sector.

That leaves the government with six months to make tangible progress. No-one believes that is possible. South African government bond yields do not believe this is possible.

Therefore, tangible progress on a few key issues will boost confidence markedly – both for businesses considering capital expenditure, but also for local and international bond market investors. In a world where interest rates are likely to remain low for an extended period of time, South Africa’s bond yields would become very attractive if investors do not have to factor in a reasonably high probability of an eventual default.

Without progress to boost growth, South Africa will struggle to fund the budget deficit next year. The good news is that the solution is clear. The bad news is we do not know if there is sufficient understanding within government of the need to act with urgency.

While we would hope that the government understands the need to execute on reforms, the need for funding will keep bonds attractive as an investment proposition. Either movement on reforms will reduce the fiscal risks, and thus the decline in yields (and rise in price) will be offset by lower risks. Alternatively, without clear positive economic momentum the only way National Treasury can attract sufficient capital to fund their issuance is by remaining the cheapest on the block.

From a portfolio perspective the key is to balance this valuation attractiveness with the obvious fiscal risks – so extracting a decent income by owning some SA government bonds s is best balanced with some offshore exposure and downside protection in case one of the many local fiscal risk materialise.

ENDS