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South African Medium Term Budget: What to expect

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For any successful economy, a spirit of mutual respect and teamwork between Government and the private sector must exist. In South Africa, business confidence is at its lowest level since 2009, which, unsurprisingly, coincides with low GDP.

With his upcoming mid-term budget announcement, the finance minister has an opportunity to instil confidence in the business community by demonstrating that Government is serious about working with them. He will also need to display his commitment to dealing with State Capture, stamping out corruption and curtailing spending excesses at state-owned enterprises.

Furthermore, the minister must convince the market and the ratings agencies that he has Government expenditure under control. He has very few tools available to him to stimulate growth and needs to pay very careful attention to perceptions as the market will be watching closely, with little patience for ambiguity.

This paper provides an economic overview and addresses the situation Gigaba currently finds himself in while providing some insight into the outcomes JCRA expect to see from the announcement, and what the South African economy needs to jump-start itself.

Download the full report here.

Economic overview
Government debt is above 50%

The ratio of South African government debt to GDP is growing, and is now above 50%: an alltime high. However, the International Monetary Fund (IMF) has forecast that it will continue to grow in the future. The amount of debt the government builds up has direct consequences for business confidence and investment levels. Rating agencies have become increasingly concerned about the government’s ability to raise enough tax revenue to cover spending, and this contributed to the sovereign credit rating being cut to junk status by two agencies earlier in 20171. While business confidence fell to its lowest level since 2009 in the second quarter of 2017 as a result, it has since picked up.
Figure 1: Debt/GDP
Source: IMF

2017 recession and low economic growth

In the first quarter of 2017, South Africa’s economy entered a technical recession2, a blow for the newly appointed Finance Minister, Malusi Gigaba. The news of this recession stimulated the creation of the government’s 14 point Inclusive Growth Action Plan in June3. Upon the announcement of this plan, which outlines various structural reforms to support both business and consumer confidence, the Finance Minister promised to more comprehensively speak to [the] economic outlook and growth prospects in the medium-term budget policy statement.
Since the release of the action plan, economic growth has picked up again and South Africa broke out of its technical recession in the second quarter of 2017, with GDP rising at an annual rate of 2.5%. However, Figure 2 shows that GDP has been volatile for the past few years, so another bout of negative growth in the coming quarters is not unlikely.

The World Bank revised their South African GDP forecasts up to 2019 in September4. They now expect GDP to grow 0.6% in 2017, which is low compared to the figure of 1.3% the Treasury estimated in the February budget. The World Bank expects 1.1% growth in 2018 and 1.7% in 2019 respectively. In contrast, the February budget forecasts were 2.0% and 2.3% for these years.

Figure 2: GDP annual growth


Source: Statistics South Africa

Unemployment remains high

Weak GDP growth is underpinned by high levels of unemployment and subdued productivity. Unemployment reached 27.7% in the second quarter of 2017, its highest point since 2003. Only 16 million people5 - or 28% of South Africa’s rapidly growing population - were employed in the second quarter. This low employment figure reflects the fact that the long term unemployed often cease trying to gain employment, and so drop out of the unemployment statistics. If they were included in those statistics, the unemployment rate would increase considerably.

Youth unemployment also reached 52% in 2016, up from 46% in 2008, showing that South African unemployment is concentrated in the country’s younger population6. The World Bank South Africa Economic Update highlights that South Africa is falling behind other countries in terms of productivity (which declined by 2% during the first quarter of 2017) especially in the technology sector. This can be attributed to a low level of innovation and a loss of skills caused by professionals moving to other OECD countries. The World Bank also cited low productivity as a reason for slashing their 2017 South African growth outlook from 1.1% to 0.6%.

Finance Ministers: Gigaba and Gordhan
How they compare
Pravin Gordhan was Finance Minister until the end of March 2017. His infrastructure plan and aim to limit spending won over investors and calmed markets. Prior to his appointment in 2015, the rand was at an all-time low, but it gradually recovered during his appointment as Minister. Gordhan prioritised infrastructure spending in his 2017 budget, allocating R195.8 billion for infrastructure and local development in the 2017/2018 financial year.
Gordhan also had a strong anti-corruption stance that helped build trust and confidence. There have been corruption charges against the new Finance Minister, Malusi Gigaba since his appointment, especially relating to his relationship with the Guptas7; however so far none of these have resulted in charges8.
In Gordhan’s February budget, he estimated that the spending for this financial year will be R1.56 trillion, and that tax revenue will be R1.41 trillion, with a budget deficit of R149 billion9. One of the most important tests for the new Finance Minister will be sticking to this budget, especially by keeping spending down. 
The dismissal of Gordhan by South Africa’s President Jacob Zuma in March resulted in a wave of credit rating downgrades and a reduction in business confidence. Fitch downgraded both the foreign and local currency rating to junk, while S&P reduced the foreign-currency rating to noninvestment grade, keeping the local currency rating at investment grade. Around 64% of government bonds were owned by domestic investors in 201610, meaning that the local-currency rating is more significant for the majority of investors. However, the share of foreign investors increased between 2015 and 2016 from 32.4% to 36.0%11. Moody’s also downgraded South African government bonds in June, but both foreign and local currency-ratings remained at investment grade. 
Despite the initial strong response (rating downgrades and bond disinvestment) to the appointment of Gigaba, bond yields and the rand have stabilised since, and Gigaba quickly announced his commitment to Gordhan’s February budget. Investment in South African long term bonds has remained healthy and they are still attractive compared to those of other emerging economies. However, yields remain high compared to the time when Gordhan was minister, reflecting the higher perceived risk.
Figure 3: Government bond credit rating relative to junk (August 2017)


Source: Bloomberg, Fitch, S&P, Moody’s
Gigaba: his performance so far
The biggest challenge for current Minister of Finance, Gigaba so far has been limiting government expenditure and preventing fiscal slippage (deviations from what was promised in the 2017 budget). If the level of spending exceeds tax revenues by too much, then the risk of public debt distress will increase, which is likely to fuel further rating downgrades.

In July, the South African government paid R2.3 billion to South African Airlines (SAA) in order for them to settle a loan from Standard Chartered. On 29 September, they were permitted another R3 billion to repay a Citibank loan. In addition, SAA have asked the government for R13 billion in order to recapitalise12, which Gigaba is expected to address in the upcoming medium term budget. However, he is facing increasing pressure to come up with the funds that have already been given to SAA and so further spending on SAA is likely to prove unpopular.

Gigaba also has to manage the government’s contingent liabilities (commitments to take responsibility for state owned enterprise (SOE) loans in the event of a default), of which Eskom, independent power producers and the Road Accident Fund make up the majority. Eskom poses a particular risk to the economy, with requirements for R413 billion in interest and debt payments over the next five years13. They also face corruption allegations relating to the Gupta family.

Gigaba has given limited information to the public so far in describing how he will raise the funds for the government to cover the pay-outs to SOEs. There have been reports that the Treasury may request the Public Investment Corporation (PIC, manager of the Government Employees Pension Fund) to buy the government’s R12 billion stake in Telkom (a wireline and wireless telecommunications provider) to fund some of the SAA bailout. PIC has about R1.86 trillion in assets, and is one of the country’s best performing companies. However, Gigaba has stressed that no formal or informal request has been made to PIC. Gordhan has also criticised the idea of using PIC funds to bail out SOEs, suggesting that they need to correct the cause of the financial distress before handing over more money14.

Reports also speculate that the Treasury might sell its 39% stake in landline provider Telkom to fund the SAA bailout. Gigaba told parliament in early August that they would not be selling the Telkom stake to fund bailouts. Therefore, if he chooses to go back on his word on this matter market confidence in Gigaba is likely to weaken.

Since his appointment, Gigaba has also spoken about the importance of raising employment in South Africa, which at present creates a large restraint on economic growth. The 14 point Inclusive Growth Action Plan released in July aims to create complementary government funds aimed at financing SMMEs (small, medium and micro enterprises) in their start-up phase which may aid employment increases.
Medium term budget policy statement
What the economy needs
Although the economy has emerged from recession, the annual growth rate for 2017 is expected to be low, due to weak productivity and employment as well as drought, electricity shortages and logistical constraints and Gigaba needs to address these concerns, while keeping in mind that possible spending is constrained by the size of the economy’s debt.
The World Bank have published a report15 outlining ways for the South African government to improve the economic outlook. The report highlights that productivity needs to increase, which can be done through innovation. This can create new opportunities for employment and economic growth. Policy uncertainty, red tape (excessive regulation) and limited competition in key product markets restrain the entry and growth of small firms. Therefore, if Gigaba addresses these issues by engaging with businesses and reducing bureaucracy as well as promoting research and development, he can create more potential for economic growth. South Africa already has clusters of innovation in a few of the largest cities, but these advancements need to be spread to other regions.
Another issue Gigaba needs to address is economic competition. Competition is low in South Africa which means that demand for capital and labour are below their potential, and living costs for the poor are higher than necessary, perpetuating the poverty problem. Competition can also stimulate innovation, and thus further create economic growth. 
The National Development Plan16, says that infrastructure investment as a fraction of GDP needs to grow to 30% by 2030 in order to reach a sustained and inclusive growth path. In the February 2017 budget, Gordhan proposed a new facility to finance large infrastructure projects which requires funding or other state support, such as sovereign guarantees. Although this may require significant government investment, if Gigaba implements this plan, it will stimulate productivity and growth increases which will benefit the economy. 
What to expect
In terms of spending, Gigaba is in a difficult position. If he raises too little tax revenue, there is likely to be another round of rating downgrades, since rating agencies are concerned by the risk of public debt distress. This is a likely scenario since revenue collection is already substantially below budget, with some economists suggesting a shortfall for the year of as much as R50 billion17. Another credit rating downgrade could result in a reduction in investors’ appetite for South African government bonds. A reduction in investment will slow economic growth, which makes it harder for the government to raise tax revenue (because people are earning and spending less). Therefore, a vicious circle may emerge, and Gigaba should do his best to avoid it.
Gigaba needs to reassure investors that government spending is being limited to a minimum in order to avoid a downgrade. Although, the large SOE contingent liabilities make this difficult.
In the medium term budget policy statement he will also have to address questions on how he will cover the cost of the SAA bailout and which assets he has identified for sale. If he decides to sell Telkom shares then he will have to provide strong reasoning for this, since he has previously stated that he wouldn’t do so. 
Many are expecting rating downgrades to come. Despite strong expectations that the central bank would reduce the base rate to stimulate growth on 21 September, they chose to keep rates steady. The South African Reserve Bank cited the possibility of rating downgrades in the near term as a cause of concern, since they could pose a danger to the rand18.
If the budget announcement does not satisfy rating agencies, we can expect further downgrades of domestic and foreign-currency bonds. This is likely to cause the rand to depreciate against the dollar, as was the case after previous rating downgrades. Furthermore, the central bank may feel the need to raise interest rates again, since a depreciation means that imports will be more expensive, and so could trigger inflation. However, increasing the base rate again may limit economic growth.

In February, President Zuma announced his plan for a radical economic transformation. Some of his main concerns are the persistent economic inequality and the underrepresentation of black South Africans at top management levels. Gigaba is likely to address the ongoing high level of inequality in the medium term budget, and will feel pressure to allocate funds towards achieving higher equality, due to Zuma’s promise to "utilise to the maximum, the strategic levers that are available to the state"19.
In light of the World Bank’s growth outlook reduction for 2017 to 0.6%, there is a strong likelihood that Gigaba will cut his forecast to a similar level. Indeed, at the Tax Indaba on 11 September, he said that the 1.3% growth forecast provided in the February budget was unlikely to be realised in 2017. It would be best to accompany a reduction of growth expectations with an update on methods of increasing growth in the future, but this will be difficult to do given the importance of keeping spending low.

A poor mid-term budget carries the potential for increased volatility in respect of the Rand and the forward rates curve. It will almost certainly set the scene for further downgrades in ratings and may result in substantial portfolio outflows, putting the Rand under pressure and negatively influencing the trajectory of JIBAR and swap rates.
These risks together with the Fed balance sheet unwind, ECB tapering, rating agency decisions, and Nersa’s opining on Eskom’s request for ever higher tariffs, resulted in the MPC, against market expectations, deciding to hold off on the next rate cut pending more clarity. Eskom’s balance sheet and refinancing needs are also posing significant negative risks to the economy, as is the ANC elective conference.
In light of all this, it would be prudent to consider hedging for both currency and interest rate exposure and explore the services of an independent hedging advisor to assist you in choosing a strategy that works for you at the best possible price. In a volatile and uncertain economic environment, hedging can help to mitigate market risk and provide confidence in the budgetary process by ensuring that future cash flows are not subject to wild fluctuations.
JCRA has over 28 years of experience advising on market risks to corporates, project companies, funds and the property sector. We are a global business with significant experience in markets around the world including South Africa where we, together with key staff, have been involved in driving bespoke hedging solutions to large corporate and infrastructure deals since 2004.
Please get in touch if you would like to learn more about services we provide and what we can do to help keep your organisation one step ahead.
1  https://www.ft.com/content/5b8e083c-1b91-11e7-bcac-6d03d067f81f
2  A technical recession is defined as two consecutive quarters of GDP contraction
3  National Treasury of South Africa: Government’s Inclusive Growth Action Plan (2017)
4  World Bank: South Africa Economic Update: Innovation for Productivity and Inclusiveness (2017)
5  Statistics South Africa
6  World Bank, World Development Indicators, youth unemployment
7  A wealthy business family in South Africa whose strong ties to President Jacob Zuma have led to claims of corruption, undue influence and of state capture
8  https://qz.com/1002519/south-african-finance-minister-malusi-gigaba-faces-corruption-allegations-over-gupta-family  connections/
9  South Africa National Treasury: Budget Review 2017
10 South Africa National Treasury: Budget Review 2017
11  South Africa National Treasury: Budget Review 2017
12 https://www.reuters.com/article/us-safrica-economy/south-africa-considering-1-billion-bailout-for-national-airline-idUSKBN1AK0UU
13 https://www.bloomberg.com/news/articles/2017-09-22/goldman-sachs-sees-eskom-as-biggest-risk-to-s-african-economy
14 http://ewn.co.za/2017/09/26/gordhan-soes-must-clear-out-rot-before-requesting-bailouts
15 World Bank: South Africa Economic Update: Innovation for Productivity and Inclusiveness (2017)
16 Republic of South Africa: National Development Plan 2030 (2012)
17 https://www.businesslive.co.za/bd/economy/2017-08-21-downgrade-alarm-as-revenue-shortfall-could-hit-r50bn/
18 MPC Statement September 21, 2017
19 http://www.sanews.gov.za/south-africa/president-announces-radical-economic-transformation​



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