Is SA Teetering on the Edge of a Fiscal Abyss?

A fiscal abyss first needs to be defined as it paints a rather dramatic picture - an abyss does indeed present a life-threatening risk! A fiscal abyss means a country's debt burden has become unbearable and that it is on the verge of defaulting, in other words it will not be able to pay either the interest on the debt or the capital in respect of bonds that have reached maturity (or both).

Financial markets are clearly not concerned about this at present.

Firstly, the main task of credit rating agencies is to continuously monitor borrowers- ability to meet their obligations and to warn investors in good time if they foresee the possibility of defaulting. Although rating agencies were previously accused of reacting too late, the criticism they faced after the global financial crisis has resulted in their being more proactive.

South Africa currently has an investment rating from all three major credit rating agencies, with a stable outlook (in other words they do not expect to have to adjust their ratings soon). South Africa would certainly not have this rating if it found itself on the edge of a fiscal abyss.

Secondly, the holders of South African government bonds are the ones who would be affected directly should South Africa fall into a fiscal abyss- they are the ones who would suffer the financial losses. And today foreign investors not only hold South African government bonds denominated in foreign currencies like the dollar, but also close to 40% of rand-denominated bonds.

Should investors be concerned about South Africa teetering on the edge of a fiscal abyss, they would naturally try to dispose of their South African bonds as quickly as possible and bond yields would skyrocket. However, as the accompanying graph shows, there is no indication of a change in trend of government bond yields - in fact, the yield on generic 10-year South African bonds have been trading around 8% since 2005.

Similarly, the difference between the yield on a 10-year SA government bond and that on a comparable American government bond (a good indication of investors-risk perceptions) is currently 526 basis points compared to an average of 542 basis points since 2009, which again does not suggest perceptions of increased risk.

Thus South Africa definitely does not find itself on the edge of a fiscal abyss, but one could say it does find itself in a fiscal morass the escape from which will require a concentrated effort. However, this is not the first time the country has faced this challenge and many lessons can be learnt from the previous period of fiscal consolidation that commenced in 1997.

In a presentation on South Africa's long-term fiscal choices at a government finance workshop in Pretoria on 5 November, Michael Sachs, head of budgeting in the National Treasury, addressed the important issues regarding South Africa's long-term fiscal outlook in view of the sustainability of the government's financial position, defined as a stable or declining government debt-to-GDP ratio.

The analysis shows inter alia that the current level of social spending is sustainable (proponents of the idea of a fiscal abyss maintain that this is exactly what will push South Africa into the abyss), provided that the existing system is not expanded. Given that the idea of a possible increase in the maximum qualifying age for child grants (currently 18 years) has already been mooted, this is obviously a sensitive assumption.

The motivation for such a step lies in the high level of unemployment among the youth, but one could argue that this has already been addressed with the implementation of the employment subsidy for workers between the ages of 18 and 29.

The National Treasury's analysis is based on a range of assumptions regarding demographic trends, economic growth and policy scenarios. The most important conclusions can be summarised as follows:

The current level of government expenditure is sustainable, provided that economic growth of 3% per annum is maintained. However, in a secular stagnation scenario it will be increasingly difficult to sustain the current spending levels (including social spending).

Without higher economic growth the debt-reduction trajectory will not be ideal and South Africa will remain vulnerable to shocks.

If implemented, new social policy initiatives as proposed in the National Development Plan, including National Health Insurance, will put significant pressure on the fiscus in the coming decades.

Fiscal sustainability requires that one (or a combination) of the following factors should accommodate future structural increases in spending: accelerated economic growth, an increase in the structural level of taxation, or the reprioritisation of government expenditure.

Compared with the previous fiscal consolidation process that started in 1997, the current environment is less supportive, especially with regard to the outlook for economic growth and therefore government revenue. It is unlikely that the average growth rate of 4% that applied from 1999 to 2007 will be repeated in the next 10 years.

Furthermore, the period from 1997 to 2007 was characterised by an increase in government revenue as a percentage of GDP in spite of repeated reductions in tax rates. This time it will require tax increases to achieve the same result, which will dampen the already low economic growth even more.

Although South Africa is not teetering on the edge of a fiscal abyss yet, it will require exceptional political discipline to gradually move away from such a possibility.

Sanlam Economic Commentary