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On 20 January 2020 Finance Minister Tito Mboweni called on South Africans to share their tips for the country’s spending priorities and how to spur on equitable economic growth. With the 2020 National Budget Speech scheduled for 26 February, Citadel Portfolio Manager Mike van der Westhuizen believes a strong Budget will come down to simple action and hard choices taken now for the long-term benefit of the country.

“The main thing to look at, given that the Moody’s vultures are circling, is the need to rein in the budget deficit, which is starting to get even more out of control,” he says.

In the 2019 Medium Term Budget Policy Statement (MTBPS) the Treasury projected the consolidated Budget deficit at 5.9% of GDP, averaging 6.2% of GDP over the next three years.

A low growth, low inflation environment also affects the debt-to-GDP trajectory, the sustainability of which Mboweni has already warned about. As a proportion of South Africa’s GDP, the MTBPS notes a hike in gross debt from 56.7% in 2018-19, to 60.8% in 2020-2021 and 71.3% in 2022-23 if the status quo does not change, something the ratings agencies are understandably concerned about.

“These numbers show that the previous goal of fiscal consolidation is currently not going according to plan,” explains Van der Westhuizen. “Although it must be said that while Treasury appears to be doing everything in its power to stop the slow bleed, it’s coming down to a cooperation issue with the rest of government and other influential stakeholders.”

This disconnect between what needs to happen and the disinclination within government to act is likely to come through when Mboweni’s National Budget is revealed.

REVENUE UNDER PRESSURE

Distilling down the multiple issues at play, Van der Westhuizen explains that “government needs to come up with about R150 billion in savings over the medium-term expenditure framework, being the next three years. So that’s essentially R50 billion a year in savings that need to come through.”

So how can this be achieved?

The first option is to look, once again, to the taxpayer. But, says Van der Westhuizen, “Treasury has already squeezed the taxpayer, so options are increasingly limited. In prior years, we’ve seen personal income tax hikes and last year a VAT hike. Easy wins are fuel levies and sin taxes that go up every year, as well as bracket creep, i.e. not adjusting the tax brackets for inflation. Other potential tax avenues could include a new upper tax bracket, wealth tax, estate duties or even changes to capital gains tax or dividend tax. Although helpful these don’t really do the heavy lifting.”

There has been talk that the only really effective lever left to pull could be to raise VAT by one percentage point to 16%, which would inject anything from R20 billion to R35 billion in revenue. Although this would be a particularly unpopular move politically, it is an ever-increasing possibility.

EXPENDITURE IN THE CROSSHAIRS

As a result of revenue constraints, Van der Westhuizen believes all the heavy lifting should be done on the expenditure side. But, again, taking steps to contain and curb expenditure will come down to political will.

“The big line items here are public sector wages (about 34% of expenditure), debt service costs (10%) and social grants (10%). Interest payments and social grants are essentially fixed. The main lever is the wage bill, which is a bit tricky at this stage since multi-year wage negotiations are still in process and will only conclude around March 2021, so we need to see what the minister says about that,” says Van der Westhuizen. “The government tried a voluntary resignation and natural attrition approach to try and get the wage bill down, but that hasn’t been effective. Maybe the lower consumer price inflation (CPI) outlook from the Reserve Bank and pinning of inflation expectations might help in negotiating lower wages, but that is unlikely to be enough.”

Van der Westhuizen adds: “Even if government took a firm stance of CPI less 2%, which would have the trade unions barking at the feet of government, then this would only save about R105 billion over three years, leaving us about R45 billion short. The point is that even a drastic decline in wage growth doesn’t result in the necessary scaling back in spending.”

THE SOE DRAG CONTINUES

Despite this constrained picture, there is still bound to be more support doled out for state-owned enterprises (SOEs) in the Budget. The issue of SOEs will loom large over Mboweni’s speech.

“In late-January we saw the Development Bank of South Africa (DBSA) granting a loan to South African Airways (SAA) as part of their restructuring,” notes Van der Westhuizen. “That is something of a red flag in terms of the cross contamination of SOEs, with a well-performing SOE like the DBSA now having to step up and bail out a poor-performing SOE. The reason for this is that government cannot afford to use its balance sheet to rescue these SOEs, so they are doing a bit of reshuffling the deck chairs. The concern is the strain this might put on the well-performing SOEs. For now it’s not a massive issue as the DBSA does have rules in terms of how much it can lend out, but the trend isn’t pleasing.”

Eskom is likely to remain both a concern and a drain. Clearly there is a great deal of in-fighting within the parastatal and the agreements about the turnaround direction, coupled with bouts of load shedding, indicate that South Africa is certainly not out of the woods. “Eskom will again, in the Budget, be a massive issue to watch out for,” says Van der Westhuizen. “At least for the next couple of years support will have to be pencilled in for Eskom. If that number were to rise significantly or if there is further talk of taking Eskom debt on the government balance sheet then we are in deep trouble.”

What could prove a fillip for the country would be positive developments around key issues like power generation. Explains Van der Westhuizen: “There has been a lot of talk about mining companies, and other businesses, being able to generate their own electricity and for independent power producers to come onto the gird, but we are yet to see formal communication in this regard. If something concrete comes out about that, or even some compromise around public-private partnerships, then that would be very positive.”

THE D-DAY DOWNGRADE

While the state fiddles, and South Africa’s economy burns, the final nail in the country’s sovereign credit rating continues to hang over South Africa’s head. While the markets have long built this in, the continued expectation that the axe will fall is in itself creating uncertainty and tension.

On 28 January 2020 Moody’s Investors Service analysts noted that it was “a bit early” to judge the impact of both policy and structural reforms. Lucie Villa, Moody’s lead sovereign analyst for South Africa, told Bloomberg that while the data was not pointing to either a particularly positive or negative direction, that “there is nothing really to flag for the time being”. This indicates that Moody’s may well be prepared to give more rope and more leeway. Obviously, the credit ratings agency will be keeping a close eye on Mboweni’s Budget.

“Certainly, everyone expects this Budget to be poor,” says Van der Westhuizen, “but they might manage to demonstrate the will to cut expenditure and show just enough fiscal consolidation and, in that case, Moody’s might delay any decision until November, after the next MTBPS.”

That said, while government might do enough to keep Moody’s at bay for the first half of this year, it remains Citadel’s view that Moody’s will downgrade South Africa in 2020. While this would put South Africa out of the World Government Bond Index, Van der Westhuizen believes it is time for the country to take its medicine. “Foreigners would come in and sell some of our bonds on index exclusion but, with some of the most attractive yields out there, there would definitely be buyers stepping in,” he points out.

READING THE MOOD

Anyone who follows Mboweni on Twitter will be keenly aware that the finance minister is getting significant pushback and appears to be becoming increasingly despondent with the lack of progress. There appears to be considerable opposition to his plans, as laid out in the economic strategy document released in August 2019.

At this juncture, even those plans might not be sufficient. “There is no use putting a plaster on a bullet wound. Treasury knows what needs to be done, but the rest of government needs to come on board and stop this infighting, and make some tough decisions to turn the country around,” says Van der Westhuizen. Until they do, the economy will remain locked in a vicious circle of low growth.

“Without cooperation within government and getting fiscal consolidation on the right path we can’t generate growth, which puts us into this death spiral,” he says. “Structural economic policy implementation and talk around that would be positive in the Budget. We’ve had all these plans, which are brilliant on paper, but government still lags on implementation, and I think a lot of that has to do with a willingness to act.”

NAVIGATING CHOPPY WATERS

While many are trying to remain optimistic, a pragmatic and unemotional approach to the country and the fiscal state of the nation is essential at this juncture.

Stressing the role Citadel plays in safeguarding your portfolio during these uncertain times, Van der Westhuizen says: “We’ve been aware of these risks for the past few years and, in terms of portfolio positioning, have been underweight South African government bonds and overweight enhanced cash and the US dollar for a while. We will continue to search for the lowest risk route to get to the other side of the junk divide.”