SA must pursue fiscal reform to prevent a dire debt trap
The country knows what to do, and should not shy away from approaching the IMF
Within a short period the coronavirus pandemic has become the greatest economic shock for at least a century. Lockdowns motivated by public health considerations have caused a shock of uniquely adverse depth and reach in SA and elsewhere.
On the economy’s demand side, that shock is devastating, with gross domestic expenditure forecast by the Bureau for Economic Research (BER) at Stellenbosch University to decline 9.9% in 2020. The effect of this demand shock is worsened by the supply side effect of the lockdown, which has shrunk the effective labour force, severed supply chains and frozen large sectors of the economy.
A large proportion of firms face liquidity and even solvency risk, while millions of South Africans face unemployment. The situation calls for strong and appropriate government action, with all the tools at the government’s disposal: fiscal and monetary policies, as well as industrial and labour policies. Our concern in this article is with fiscal policy.
The government recently announced a large fiscal intervention of R500bn, about 10% of GDP. Many other countries have launched similar or even larger fiscal packages. However, in the SA case, this intervention will be made against a background of a precarious state for government finances. During the 2020 budget, the finance minister reported that gross national debt would be 65% of GDP this fiscal year, and without strong fiscal intervention was not expected to stabilise over the medium term.
This debt ratio results from the interplay of three factors: the primary budget deficit (which excludes spending on interest payments), the growth of the tax base, and the real interest rate on government debt. A decade of large primary deficits is one of the major causes of the country’s rising debt ratio, along with weak real economic growth that constrained the tax base over the same period.
To an important extent, the bond market prevented an earlier escalation of SA’s fiscal difficulties by keeping the real interest on bonds relatively low over this period. This has now changed: having traded in a 8%-9% range for most of the past five years, yields soared in March as global investors’ $100bn flight from high-risk emerging-market debt collided with SA’s loss of investment-grade status by all three major ratings agencies.
While these yields have since pulled back from panic-driven highs in excess of 13%, the new normal will almost certainly involve higher debt-servicing costs, with 10-year bond yields in excess of 10%. With low inflation, this means the government will have to finance new debt (and refinance old debt) at real interest rates of 5%-6%. If the tax base grows at a slower rate than the real interest rate, the debt ratio will rise without other compensating factors. The BER now expects real GDP to contract 9.5% in 2020, a macro proxy for the tax base, which is sure to decline sharply as well.
The compensating factor that could stabilise the debt ratio despite the unfavourable balance between real growth and the real interest rate is the government budget balance, specifically the primary balance (net of interest payments). The finance minister expected a primary deficit of 2.6% in 2020 and a headline deficit of 6.8%. These numbers are no longer attainable: if real GDP contracts by about 10% in 2020, the headline deficit will rise to about 15% of GDP. SA’s debt ratio could now rise to 80% of GDP in 2021 and conceivably 90% the year after.
The sustainability of this public debt stock is more easily judged by looking at the interest bill the government has to pay annually. The government expected interest payments to rise from 4.2% of GDP this fiscal year — 16% of government revenue — to 4.7% in two years. That would have been difficult enough to finance, but prospects are now much worse. With the adverse shocks to the tax base, the rise in real interest rates and higher budget deficits, the government’s interest bill could, in theory, reach 30% of government income within two years. We say “in theory” because it is usually not practically possible for countries to spend up to 30% of its income servicing debt, especially not given the rigidities of the SA budget due to the public sector wage bill and increased social grant expenditure, which leaves little scope for easy reprioritisation.
Well before debt servicing costs reach such levels, the bond market intervenes or countries choose from various versions of default: they restructure debt unilaterally, raid their pension and saving funds, inflate away their debts, or crash their currencies; they get shut out of the capital markets, unable to roll over their debts, even at exorbitant costs. Or they dramatically and painfully cut spending — either with or without assistance and conditions from the IMF. Alternative policies that will harm SA’s access to the bond market for years to come, such as unilateral interest holidays, capital controls and prescribed assets, should be avoided as a cure worse than the disease.
We hope SA chooses the path of fiscal reform, as was done with great success 25 years ago. This will not be easy, but the required steps are known and have been mapped out in recent budgets. Of course, spending on public sector wages and ailing state-owned entities will need to be reduced, significantly. So too will spending on much-needed infrastructure and even socially sensitive areas such as education. These priorities are crucial to the country’s long-term growth prospects, but the government will have to identify efficiency gains and learn to do better with less.
In addition to these budgetary steps, the government should prioritise its financial policy, that is the management of the structure and duration of its debt, to curtail the rising interest bill as much as possible. Again, this was an important part of preventing fiscal collapse 25 years ago. The Reserve Bank’s balance sheet is another potentially important complement to the required financial policy, to ensure the continued smooth functioning of capital markets as part of the Bank’s mandate for financial stability.
The IMF plays a potentially important role in this financial policy, starting with the loans from its emergency facilities that are available at short notice and come without conditions, other than they have to be repaid with (very low) interest. This may not be enough though, and the government may well have to approach the IMF for a much larger package, colloquially known as a “programme”. A programme would provide credit on concessional terms that are more attractive and predictable than those associated with the bond market.
Constructive engagement with the IMF will also signal to the market SA’s commitment to policy and structural reforms required to restore fiscal sustainability (and would be a condition of an IMF programme). This, in turn, would likely have the virtuous effect of reducing yields on government bonds, thus lowering the servicing cost on non-IMF government debt.
The conditions attached to an IMF programme would align with the structural reforms and spending cuts the Treasury would need to initiate anyway under a go-it-alone approach. For this reason there appears to be little reason — other than fear of political cheap shots — not to engage with the IMF.
• Du Plessis is COO and professor of economics at Stellenbosch University. Dr Rietveld is an independent economist.
Correction: May 14 2020
An earlier version of the headline of this article incorrectly said SA’s interest repayments could reach 30% of GDP. The article suggests interest could reach 30% of government income.