Debt Trap Looming



   By Christo Luüs, Ecoquant

At the recent presentation of the Medium Term Budget Policy Statement (MTBPS), we heard in a few frightening minutes from the new Finance Minister to what extent the state finances have practically derailed in the eight months since Minister Gordhan’s budget speech.

It was of course clear to everyone that trouble was brewing. When a country’s credit rating drops to junk status, there would naturally be consequences. Until now we have had the benefit that S&P retained our local currency denominated credit rating at investment grade, while Moody’s maintained both our domestic and foreign currency denominated credit ratings at investment grade.

Things can now drastically change with rating agencies which would probably sooner rather than later further downgrade our credit ratings. This may mean that South Africa will be dropped from the Citigroup’ s World Government Bond Index (WGBI) – only five years after we were initially included in the index. The potential capital outflow of foreign investors that must get rid of their South African government bonds, is estimated at between R80 billion and R140 billion.

The rand would naturally depreciate further which in turn would increase inflation. Downward pressure on government bond prices – which would cause an increase in long term interest rates – will almost immediately have twofold results: The state will have to pay more for its debt and the returns on and valuation of most of our pension fund assets will drop.

Minister Trevor Manual took steps in the late 1990’s to drastically improve South Africa’s fiscal position. Government debt dropped from approximately 49% of GDP to less than 22% by early 2009. This resulted in interest on government debt to drop from more than 17% of total government spending to only 6.6% by 2010. This decline in interest costs resulted in a saving (in current money terms) of approximately R120 billion per annum that could be utilised for alternative purposes – among others, social spending.

Unfortunately, the mismanagement of South Africa’s economic system has now led to a situation where we must consider once again the possibility of a debt trap.  Growing debt and an underperforming economy can very quickly lead to such a situation. Such a trap arises when the cost of government debt grows faster than the economy and causes a sudden increase in the state’s interest burden. The state will eventually have to borrow money to repay its debt which will cause government debt to deteriorate further and the interest burden to increase even more.

To resolve such a conundrum will require drastic measures. It may necessitate extensive privatisation; or require a sharp curtailment of social allowances and state pensions; or cause the retrenchment of government employees and a reduction of salaries; or lead to an increase in taxation. New taxes – like a wealth tax on assets – might be considered.

Tax increases are, however, often counterproductive as they may dampen economic growth further which would put tax income under pressure. The fiscal deficit and debt as a percentage of GDP will then rise even further.

A rule of thumb to determine whether a country is headed for a debt trap, is to deduct the average cost of government debt from its average nominal growth rate. The larger the negative differential, the higher the likelihood of a debt trap. This figure is currently approximately -1.9% as opposed to +5.8% in 2007 when our projected government debt ratio over five years amounted to only 7% of GDP.

The minister estimates that South Africa’s gross government debt will increase over the next three years to more than 61% of GDP. This will mean that interest costs on government debt will increase dramatically – probably by around R50 billion per annum. Aspects such as a national healthcare system, a national provident fund and Russian nuclear reactors will inevitably have to wait – and preferably be abandoned altogether. What the minister does not state is that if fiscal prudence is not restored, the country may very well soon be caught in a debt trap situation, and that government debt of close to 100% of GDP could be unavoidable in about 15 years from now (see table).

The table also indicates two other aspects: The year 2017 has the worst projected outcome if one takes into consideration 5-year historical intervals whilst keeping the assumptions on growth, interest rates, inflation and the primary deficit constant. Moreover, things already started to go wrong in 2012.

In my opinion the most negative aspect of the MTBPS was probably not the rather shocking figures and projections, but the equanimity with which the Minister, and by implication the government, has accepted the lapse into junk status and the end of fiscal discipline. The government debt projections have only been adjusted dramatically without any plans or even a commitment to move into the right direction in future.

There is admittedly very little that could be done in the short term to get us – once again – back from the abyss. There is also indeed – as the minister noted – no shortage of plans. And one can also add to this no lack of rules, laws and regulations. His reference to tourism as the “new gold” was in this regard quite ironic as Minister Gigaba’s visa regulations deprived the country of billions of lost tourism income.

The good news is that fast sustainable economic growth could have a much better result than any draconian tax measures. The fact that the minister was frank and did not misrepresent the true state of affairs, is also positive. One can nevertheless only hope that rational thought and action will triumph to stop the potential decay.