Category: Fiscal Policy

Introduction

In my pre-Budget comments I had argued that SA could only hope to for SA to escape its debt and slow growth trap by ensuring that government spending and revenues grow no faster than the real economy. I asked whether the SA government would be able to grasp this nettle? Given its long term trend of rising real levels of government spending and taxing – with taxes playing a growth suffocating catch up with spending – and government debt ever increasing as a ratio to GDP and spending of interest rising to over 20% of all spending the danger is that SA will resort to its central bank for funding and the inflation, to inevitably follow, will push up interest rates that will reduce the value of long-term RSA bonds outstanding and weaken the rand. Default through inflation becomes more likely and so lenders demand compensation in the form of higher initial yields and risk spreads. That make borrowing more expensive and a debt trap ever more likely. The earlier pre budget comment is available here.

An emphatic response Spending growing at a slower rate than GDP

The short post-Budget answer is that the government has delivered a Budget that would take fiscal policy on a very different and very necessary path. For all the good reasons made very clear in the Budget Review. Almost to the point that the Treasury presents itself as an alternative and highly critical government agency. It is a top-down plan that deserves full support and for which the governments to come should be held fully accountable.

Between 2024/5 and 27/28, GDP in current prices is predicted to grow by 25% – or at an average rate of 5.9% p.a. All government spending is planned to increase by 21%, by 27/28 or an average 5% p.a. while taxes will grow faster by 24% or an average 5.2% a year over the same period. Government spending, excluding interest payments is more heavily constrained to grow at well below the growth in GDP, at a very demanding mere 4.2% a year. The payroll for the 216000 government officials employed by the central government, at an average R470000 a year, is expected to increase at 4.2% a year until 1927/28 with minimal increases in the numbers employed, and well below inflation expected.

All this genuine austerity would mean reducing the real burden of government spending (exp/GDP) and to a lesser degree the real burden on taxpayers (Rev/GDP) and allow the debt to GDP ratios to stabilise and decline. Especially should these very different long-term trends impress investors in SA enough to have them supply extra capital to reduce the risk premium and the interest they demand of the RSA and to factor in less persistent weakness of the rand Vs the major currencies. As is very much the Treasury intention.

The thoughts that have moved the Treasury are well illustrated by the following extract from the Budget Review. They are enough to warm the cockles of a heart sympathetic to a market led economy. Even more warming were the intention and practice to pass the incentives to add and maintain the infrastructure to the private sector.

Are the plans credible? The market remains unconvinced

One could perhaps argue and judge that these austere budget plans are too ambitious and hence not credible.   The Budget proposals have however not received any positive reactions in the currency or bond markets. Long term interest rates have not declined nor has the risk spreads between RSA and US Treasury Bond Yields declined. They remain at highly elevated levels. So far not so good for the SA economy.

The rand has weakened marginally against the EM currency basket since the Budget. A minor degree of extra SA specific risk rather than the strong dollar is to be held responsible. (see below)

Taking of reducing the inflation targets has not been well received- for good reasons.

Perhaps the post budget suggestion by the Treasury that they would welcome a reduction in the inflation target has muddied the waters. How would lower inflation be realised without a stronger rand? A rand that could, with a more favourable view of fiscal policy, be expected to depreciate at less than the current 5.5% p.a. rate – which clearly adds to prices charged and inflation expected. Absent a stronger rand, a lower target for inflation would imply even more restrictive and growth and tax revenue defeating than current monetary policy settings. It is not something to be welcomed by investors.

The Treasury would be well advised to wait for the approval of their policy intentions as and when registered in the bond and money markets, in the form of lower interest rates and a stronger rand – before they explicitly aim at lower inflation. The Treasury may well be getting ahead of itself.

The National Budget to be presented next Wednesday may well be the last under the full control of the ANC led government. The ANC may need support the from other parties to govern after the elections to set Budgets. And these other parties should have different and perhaps even better ideas about taxes and government expenditure. They might even mirabile dictu insist that continuing to award comparatively well paid and well cossetted public sector officials well above inflation increases in their compensation is not the best way to utilize tax revenues. That employing more doctors, nurses, teachers and prosecutors, unable for want of a large enough budget to break into public sector employment, might be a much better idea than paying the establishment more. They may understand that ever rising tax revenues are a major drag on economic growth and that the country therefore cannot afford to increase government expenditure at the rate it has been increasing over many years now. It has meant an ever-growing interest bill that crowds out other spending and threatens fiscal sustainability and brings very high borrowing costs in its wake.

Though the major threat to the Budget outcomes this year has been the lack of revenue. The weak economy and its negative impact on company earnings and taxes has taken a heavy toll on revenues. They are expected to fall some R80b below year ago estimates- about a 4 % miss. Weaker prices for our metal and mineral exports have dragged on mining revenues and earnings. It will all mean more borrowing, perhaps also some drawing down on Treasury cash and foreign exchange reserves to reduce debt issuance. But this will but paper over the cracks. Something very different is called for.

Higher tax rates will seem counter productive and expenditure growth will have to be constrained even in an election year. Though it is surely hard to argue that the SA economy has suffered for want of government spending. The opposite must be argued – that the economy has suffered from too much and too much unproductive government spending and hence too heavy a burden of taxes.

Ever since the recession of 2009 government spending and tax collected at national level have grown at a rapid clip – ahead of inflation and nominal GDP. With the growth in expenditure slightly faster than the growth in revenues and the consistent shortfalls made up with much extra borrowing.  You can describe it, up to a point, as conservative budgeting. Necessarily so in the circumstances, but surely economic policy must hope to do better than slowly strangle an economy.  Being re-elected demands no less.

If we base our fiscal history on 2010 levels, National Government Expenditure is up 2.9 times, Revenue up 2.8 times, compensation of public officials up 2.7 times while interest paid is 3.39 times higher than it was in 2010 and runs at about R28 billion a month- a heavy price to pay for the mere right to borrow more. The CPI is up a mere 2 times since 2010. And the ratio of revenue to GDP is up from about 22% to 26%. These are the unimpressive statistics that damage growth and make losing elections inevitable.

A Fiscal Summary

Key Fiscal Statistics (2010=100)

South African fiscal policy settings have been seen by investors in RSA bonds and bills as a slow-moving train wreck. They have demanded high interest rate premiums to overcome the risks to fiscal sustainability undermined fundamentally by slow growth and insufficiently restrined spending and taxing. And to satisfy their expectation that the rand will weaken consistently and inflation stay at high levels and eat into their rand incomes in real or USD dollar equivalents. It will take a much different fiscal path to reverse such expectations and lift growth rates. That is in short for government spending and revenues to grow no faster than the real economy. Will the next SA government be able to grasp this nettle?

The short fall in government revenues of R56.8 billion reported in the Budget Review of 2023 came as no surprise to observers of the monthly tax returns. It represented a moderate miss in volatile circumstances – equivalent to 3.1% of the revenues expected in the February 2023 Budget of R1787.5 billion. A very large number and equivalent to 25% of GDP. This real tax burden (Taxes/GDP) is not expected to change over the next few years. Underestimated company tax, lower by R35.8b and net revenues from VAT down by R25.6b, accounted for much of the revenue shortfall. Weaker metal prices and massive investments in alternatives to Eskom power were largely responsible for both declines. Personal Income Tax grew as expected by 7% in line with some growth in real wages and salaries for those employed in the formal sector.  The shortfall will be fully covered by raising additional loans of about R54b.

The higher ratio of national government expenditure to GDP, currently 29.1%, is estimated to decline to about 28% of GDP over the next three years. Still leaving scope for a positive Primary Balance of 0.3% of GDP this year and 1% next year. Raising revenues to exceed expenditures, net of borrowing expenses, is the first and necessary step to reducing the burden of National Debt to GDP-now about 74%, though predicted to decline to about 71% of GDP in three years. National government expenditure, is estimated to increase by an average 4.6% p.a. over the next three years, including servicing our debts, currently over 20% of all revenue that will cost the taxpayers about R400 billion this year. That would represent a decline after inflation.

The SA government is still practicing fiscal conservatism despite persistently slow growth that weighs so heavily on revenue.  And inhibits expenditure. And raises persistent doubts about fiscal sustainability. That is the willingness of the government to avoid money creation, that is a heavy reliance on its central and private banks to fund its expenditure over the long run. Which raises the risks of more inflation and is already well reflected in high borrowing costs.  Risks incidentally that have not trended higher in the run up to the Budget Review. Encouragingly the debt and currency markets reacted positively to the statement itself. The rand strengthened to improve the outlook for inflation and long bond yields declined by about 15 b.p.to help reduce debt service costs.

Source; Bloomberg

South Africa; Risk Spreads- Differences in borrowing costs. RSA-USA

Source; Bloomberg, Investec Wealth and Investment

In reading the Budget Review and listening to the Minister one is struck by how deeply dissatisfied the government  is with its own performance. The statement is a catalogue of government failure.

To quote the statement

The case for reconfiguring government, as it is put, is vigorously argued by the government itself. It will however need its own genuine champions informed by events rather than a stale ideology. It will have quite simply to put the private sector and private sector incentives in control of much of the activities so badly performed by the SOE’s and government departments generally, that could be outsourced. It can be called private public partnerships rather than privatization, but the essential reforms required will be to incentivize operating managers on the bottom line and return on capital- as the private sector does – to thrive and survive.  The upside is incalculable.

And as far as funding a reformed public sector, the place to start would be to dispose of key underperforming assets on the best possible terms. Selling assets or leasing them over the long term would be equivalent methods for raising capital and reducing government debt. The leases can be sold to funders (foreign and local) who would be very keen to provide finance on favourable terms, given credible operators. The Transnet iron-ore line from Sishen to Saldanha would be an obvious candidate for sale or lease. There will be many other such projects made much more valuable under different operating control. For the mines to lease and operate their essential gateways to the market would add many billions to their values and taxable incomes.

An unexpected shortfall in SA government revenues, has provoked something of a fiscal contretemps. R60b less revenue than was estimated in the February Budget has followed an even larger windfall in 2021 linked to the post Covid inflation of metal prices. The recent pull back in metal prices and in mining company profits has seen government revenues falling back sharply from peak growth rates of 25% in late 2021 to zero growth. Government expenditure has stayed on an essentially modest growth tack of about 5% p.a.

Recent Trends in SA National Government Revenues and Expenditure. Growth smoothed Y/Y

Source; SA Reserve Bank and Investec Wealth and Investment

Less revenue means more borrowing. South African taxpayers are already paying a high price for our highly compromised credit-rating. We pay an extra 2.7% p.a. more than Uncle Sam to borrow US dollars for five years.  And a rand denominated RSA five-year bond offers investors 5.5% p.a. more than a US Treasury of the same duration (9.89-4.39) The spread on a ten-year RSA over the US Treasury yield is even higher, over 7.3 % p.a. (11.57-4.25). The reason for such expensive, after expected inflation, borrowing costs and risk spreads is the persistent skepticism of potential investors in SA bonds, local and foreign, about the willingness and consequences of South Africa having to live within the limits of government revenue- heavily constrained as it is expected to be – by very slow growing GDP. The further forward lenders are asked to judge our growth prospects and fiscal policy settings, the wider have been the risk spreads and the higher the cost of issuing long dated debt.

RSA and USA 10 year bond yields and risk spread.

Source; Bloomberg and Investec Wealth and Investment

Yet if it is a crisis in the bond market (not immediately obvious given modest recent interest rate movements)  the heavy burdens of raising debt for the SA taxpayer has been a long time in the making.  SA national government revenues have consistently lagged government spending- by a per cent or two each year ever since the recession of 2010. And the Covid lockdowns were naturally much harder on revenues than government expenditure. These difference between revenue and expenditure have had to be covered by large extra volumes of additional government borrowing. The share of interest paid by the national government in revenues and expenditure has been rising sharply, doubling since 2014. Interest paid in serving the national debt is now 20% of all national government revenues and about 16% of all expenditures. It is not the kind of expenditure that helps win elections.

SA Government Revenue, Expenditure and Debt

Source; SA Reserve Bank and Investec Wealth and Investment

Share of Interest Payments in National Government Revenue and Expenditure

Source; SA Reserve Bank and Investec Wealth and Investment

The share of RSA debt of more than ten years to maturity rose strikingly from 30 to over 70 per cent of all national government debt between 2008 and 2020 – at inevitably much higher rates. The government could immediately relieve part of the burden of high interest rates by reducing the extraordinarily long duration of RSA debt.  As indeed it has been doing since 2018.

The extended duration of RSA debt. Long dated debt as share of total debt and average duration of all debt in years (Monthly data)

Source; SA Reserve Bank and Investec Wealth and Investment

RSA Bond yield differences- by duration of debt

Source; Iress and Investec Wealth and Investment

It was a form of hubris to think that lenders would be willing to take a twenty year and longer view on the fiscal outlook for SA on reasonable terms. The long-term lender is highly exposed to inflation and default through inflation, that the short-term lender largely avoids. The benefits of borrowing long are apparently that it avoids the risks that rolling over short-term debt that may prove to be difficult at inconvenient moments in the money markets. But this makes even less sense when the SA Treasury was building its cash reserves at the Reserve Bank from R70 billion in early 2010 to R183 billion by January 2023.

Managing the interest burden of national debt can play a small part in solving the problem of slow growth for the SA government. Even should government and private spending in real terms remain as deeply and unpopularly constrained as it is likely to be this year and next. Only faster growth can avoid the interest rate trap as interest paid/all government spending should rise further. Absent growth the burden of paying interest, rather than undertaking other forms of spending, is very likely to make a resort to money creation, as an alternative to more borrowing, irresistible. The growth enhancing choices for economic policy should be obvious. There is really no other way.

South Africa needs a plan to reduce the national debt and interest bill

The national debt and the interest bill for SA taxpayers have grown sharply since 2010 – the national debt grew by over R200bn before the Covid-19 lockdowns and by over R400bn in 2021. This year, taxpayers’ interest bill will be of the order of R300bn, compared with R57bn in 2008, while the national debt will approach R4 trillion, equivalent to about 60% of GDP – from a mere 18% in 2008. This is a dangerous trend that needs to be reversed.

In 2008, the interest bill accounted for 8% of all government spending but has since doubled to 16%. At an average 8% yield on the debt, every 1% increase in the average cost of funding the debt adds about R32bn to the interest bill. As the real national debt increases, taxpayers and voters may become unwilling to keep paying this overwhelming interest bill.  Destruction of wealth through inflation of the value of the outstanding local currency-denominated debt will then follow. These types of developments do not come as a surprise to investors. History has made them aware of the dangers of default and they demand compensation for the risks of funding national debts, in the form of higher interest rates paid for upfront.

SA government growth in expenditure, revenue and national debt

Source: SA Reserve Bank and Investec Wealth & Investment, 10/11/2022

In this context, South Africa has been penalised for its presumed inability to reverse course on its fiscal trajectory. High interest rates paid by the government and then passed on to businesses have compensated lenders for expected inflation and the expected accompanying weakness of its currency. The expected weaker rand detracts significantly from the expected returns of foreign investors earning rand incomes when converted to US dollars at some future point in time.

Government interest paid (R billions – LHS) and the ratio of interest paid to total debt (RHS)

Source: SA Reserve Bank and Investec Wealth & Investment, 10/11/2022

Looking closer at the cause of the rise in the national debt and interest bill, the chief culprit was government spending, which was sustained at a generous rate relative to real GDP after the recession of 2009 and 2010, while the revenue growth lagged. This problem was exacerbated by the lockdowns of 2021. Between 2008 and 2021, government spending after inflation grew by an average of 4% a year, while growth in real revenues increased by an average of 1.2% a year. Real revenues declined by 10% in 2010 and by 16% in 2021. The recession was bad news for the Treasury and higher tax rates were bad news for the economy.

Real growth in national government expenditure and revenue

Source: SA Reserve Bank and Investec Wealth & Investment, 10/11/2022

Much of the extra borrowing undertaken by the government since 2008 has been used to fund consumption spending rather than capital expenditure, a situation that is not helpful for growth. Real spending on compensation for government employees grew by about 30% between 2010 and 2018. Real capex by the government fell away sharply after 2015 and is now 25% below 2015 levels. The numbers employed in government have not increased meaningfully – it is average real employment benefits that have. An expensive patronage system seems to be at work.

Real general government spending on employee compensation and capital expenditure (2010=100, LHS) and the ratio of compensation to capex (RHS)

Source: SA Reserve Bank (Production and income accounts) and Investec Wealth & Investment, 10/11/2022

The call for fiscal sustainability made by Minister of Finance Enoch Godongwana in his recent mid-term Budget update is founded on the principle of restraining government spending on employee benefits. This is a restraint that is essential for promoting the long-term interests of all South Africans in economic development, including those who now work for or hope to work for the government.

Fiscal reform will be needed to achieve this sustainability. For example, it could extend beyond the objective of reducing the gap between government expenditure and revenue. The government could publish a capital budget and commit to raising national debt only to fund capex. This would help to permanently close the gap between government borrowing and government capex that was allowed to open up after 2008. Honest procurement of well-selected cost-of-capital beating projects should not be regarded as an impossible task.

Growth in national debt and capital expenditure by government

Source: SA Reserve Bank and Investec Wealth & Investment, 10/11/2022

A most extraordinary feature of the SA economy is how large a proportion of the adult population, some 58% or over 22 million of working age in early 2020, reported no income earned from employment. These estimates are abnormally high when compared to other similarly undeveloped economies. The adult population has been growing faster than the numbers employed and the participation rate in the economy has accordingly declined.  A large number of South Africans including the great majority of those reporting no income, are also objectively poor. South Africa has an employment and a poverty problem. It is only when you reach the upper end of the third quintile of the income distribution that income from work becomes significant. The SA economy has served those in employment well enough in what is a dual labour market of insiders and outsiders who struggle to break in. It has failed to absorb vast numbers of potential workers into employment. A consequence but also a primary cause of slow growth.

It may be asked – how do so many survive- merely survive – with no income? The answer is mostly in the support received from the SA government or rather its taxpayers in the form of benefits in kind- education, health care, housing water and electricity and in form of cash grants for those over 60 and mothers with dependent children and for the disabled on a means or asset tested basis.  

Some 50% of all government spending, currently 1.1 trillion rands, is the welfare bill of which a roughly a quarter is distributed as cash. These cash grants now include monthly payments of R350 to able bodied adults as Covid relief for which 9 million applications were made and are bound to continue indefinitely. The intention is to extend meaningfully these benefits for able bodied adults in the form of a Basic Income Grant. (BIG) The bigger the BIG in terms of benefits and coverage the more negative however will be the impact on the willingness to work of low skilled low paid workers. It will mean fewer jobs sought and provided and widen the income and cultural gaps between the fully employed skilled and, the more or less permanently, not employed.

Improved welfare benefits raise the reservation wage of all potential workers. That is the rewards required to make work a sensible choice, especially for those with limited skills or capabilities. The improved income rewards sought and realized by better welfare endowed potential workers – with limited productivity – makes them less attractive to employ. They lack the skills and training to justify higher rewards sought from understandably cost-conscious employers. Capabilities that their expensive education (provided by taxpayers) has failed to provide them with. Employers are also reluctant to stand accused of paying “starvation” wages. Who therefore prefer to employ better paid, more productive workers and hence fewer of them.

The South Africa has chosen improved welfare rather than work to relieve poverty – and has failed to do so – for want of the economic growth that would have provided a larger tax base.  For which the higher tax rates needed to fund the welfare budgets are in part responsible. We should recognize the full causes of the failure to exercise our economic potential employing more workers. Ideally, with private sector involvement, we could reform education and training to deliver better qualified entrants to the labour market.  And we could subsidise their employment more heavily.

Any significant increase in the tax burden to improve welfare or subsidise employment would however have to borne by formal sector workers in the form of a significant social security tax – that is a by a proportional sacrifice of their wages and salaries.  There will be no other realistic place to look for additional tax revenue. It is therefore unlikely to be popular with the formally employed, the insiders whose interests, well supported by their Trade Unions, that have dominated the regulation of the demand for labour, adding further to the sacrifice of employment opportunities.

The Competition Commission has prohibited Grand Parade (GP), a JSE listed company, from selling its assets and obligations in the Burger King franchise to a private equity company. The reason why the transaction was prohibited was, to quote the media release,  “ …the Commission is concerned that the proposed merger will have a substantial negative effect on the promotion of greater spread of ownership, in particular to increase the levels of ownership by historically disadvantaged persons in firms in the market as contemplated in section 12A(3)(e) of the Competition Act. Thus, the proposed merger cannot be justified on substantial public interest grounds” Grand Parade has a large 68% historically disadvantaged body of shareholders (HDP’s) , ECP Africa Fund IV has none.

The qualification substantial public interest grounds, not just prohibited on an unqualified and damaged public interest is revealing. The problem with public interest arguments is that the public is inevitably made up of a variety of private interests some of whom will benefit from a particular agreement and others who may be harmed.  For examples common to the modus operandi of the competition authorities in SA, one can refer to cases of M&A activity that are only approved, subject to the acquirer not reducing the numbers employed in the merged operations. Clearly a restriction in the limited private interest of those who would not lose their jobs that they might otherwise have done. But one that makes the merged operation less efficient and competitive than it would otherwise have been, given the cost saving synergies of a merger, which would be its essential justification in the broad public interest.

Any lack of efficiency is clearly not in the interest of many consumers who may have benefitted from lower prices or better quality or more convenient locations that a more competitive business might have offered its many customers. Suppliers of goods services or credit to the less efficient operation and their employees would also have been compromised by a less capable business to engage with. And  restrictions on cost savings would be obviously unhelpful to its shareholders who may be many and include historically disadvantaged persons (HDP’s) who are quite likely to be members of collective investment schemes with widely spread ownership claims increasingly exercised by HDP’s through retirement plans. Does the competition commission look through to the members of pension and other collective investment schemes to establish their racial composition?  Or are the only empowerment interests recognised by them and the government more widely, are those held directly? Which is to conveniently understate the numbers of beneficial owners of SA businesses of all races and open-up the opportunity to do more deals to empowerment entrepreneurs, who are small in number, influential and politically important, but hardly representative of the public at large.

The winners and losers in this deal prohibited by the commission are obvious enough. The losers are the owners of GP, heavily and genuinely empowered, who are prohibited from realising part of their risky investment in GP. Their shares lost 60 cents on the news and with 430 million shares in issue this was a damaging loss to them of the order R300m. Surely not a sacrifice they would willingly make in some vague public interest. Another case of expropriation without compensation through regulation. The chances of their realising the same value with another deal, with a company similarly broadly enough empowered to satisfy the commission, is surely remote.

As indicated by the commission there are very few if any such broadly constituted and empowered groups of shareholders around. The shareholders and managers of GP are in effect compelled to do nothing but hold on to their investment in Burger King which may well end up destroying all of their investment.

But are such sacrifices forced on the shareholders of GP likely to promote similar such widely owned enterprise in the public interest? Denying risk taking investors the fruits of their risk taking, or the ability to mitigate their losses, which is the case with this transaction, is surely setting a very discouraging precedent for further broad-based empowerment. It suggests that HDP’s can take the risk of investing their savings in a broadly based and empowered venture but you are prohibited from cashing in on its success or from reducing your potential losses. Hardly an enticing prospect.

Because you will only be allowed to sell assets or the company to a very restricted number of buyers- presumably then at a knockdown price.  Surely not a restriction any business with current or prospective empowerment credentials would welcome.

The logic of the competition commission therefore defies me. Even if such interventions in agreements willingly reached, by parties fully capable of recognising their own self-interests that have no implications for competition, can ever be against the public interest – which I seriously doubt. The commission should protect competition and efficiency and the genuine public interest in well-functioning markets they are set up to protect. The public interest in competitive markets is not the same as a political interest interfering in them. One that is usually narrowly defined to supporters and sponsors of a party and best left to the politicians and the voters to pursue.

Only the arrival of inflation is likely to put an end to the biggest round of government spending seen in in times of peace.

The extent of the surge in government spending and borrowing and money creation currently under way, especially in the richer nations, has no precedent in peacetime. Perhaps that’s because we are not really at peace. We are at war with a virus and, as in most wars, this is accompanied by warlike amounts of impenetrable fog, multiple chaotic situations and much wealth destruction.

Yet there is no sign of any taxpayer revolt to the spending propensities of governments. The current spat between Republicans and Democrats over additional spending is by no means asymptomatic. As I write these words, Congress and the President have already approved extra spending of US$3.2 trillion. The Democrats have now proposed an extra US$3.4 trillion of relief divided up their way. The Republican offer is of an extra US$1.1 trillion spent very differently. For a US$20 trillion economy, either set of spending proposals is formidable.

The global outlook for government debt is truly astonishing. The US fiscal deficit is predicted to approach 25% of GDP shortly, much larger than it has ever been, but for World War 2. In the UK, the debt/GDP ratio was below 60% in 2015 and forecast by the Office for Responsible Budget to fall marginally by 2050. The latest forecast is for a debt/GDP ratio, currently at 100%, to double by 2030. Managing government debt with the aid of central banks and their power to create money, usually the cheapest non-interest bearing form of government debt, is characteristic of all funding arrangements in and after wartime. But if this is war, then it is one without more inflation, either now or expected in the future. 90% of all developed market debt now yields less than 1% a year, of which 10% offers negative returns. It is therefore an inexpensive war for taxpayers to fund.

The recent growth in the size of developed market central banks is equally and consistently awesome. Or is it awful? It could not have happened without them. And there is every prospect of further growth in their assets to come. The balance sheets of four of the largest economies (US, Japan, the European Union and the UK) have increased by the equivalent of US$5.7 trillion (16% of GDP) since February, in other words, by about 30% in five months. Further purchases of securities, mostly issued by their governments, combined with support for extra private bank lending, can be expected to take their balance sheets to about US$27 trillion by 2021, the equivalent of 67% of GDP.

They have similarly increased their liabilities, in the form of extra deposits held by private sector banks at the central bank. These and other central banks have been exchanging their cash for government and other debt on a scale that has made them completely dominant in the market for government debt. They dominate over all maturities that are the benchmarks for all other yields, including earnings and dividend yields in the share market.

The US Fed will soon own 25% of US debt. The number was 10% in 2009. The Bank of Japan has grown its share of government debt from 5% in 2012 to over 40%. The European Central Bank held no European government debt in 2015. It now holds 25% of such debt. The Bank of England now holds 27% of UK government debt. Thus it would be incorrect to describe the low rates of interest on debt as market determined. The flat slope of the yield curve is under central bank control and they are likely to want to keep it that way, because there is no inflation or higher interest rates in sight. Economic revival is their priority.

When will the splurge of (always popular) spending end, while it can still be financed so cheaply? Only when and if inflation rears its ugly head again. And politicians and central banks may then do what their electorates have demanded in the past from post-war regimes: bring inflation down by raising interest rates and reducing money and credit growth (especially by governments) to better balance supply and demand in the economy. Inflation therefore will have to rise, surprisingly and sustainably so, before interest rates do, as the Fed has clearly indicated this week. Asset price inflation in such circumstances should not come as a surprise.

The history of the Corona virus catastrophe will come to be written. The costs as well as the benefits of lock downs will be calculated as best they can. The benefits and costs of not locking down as in Sweden or Brazil, will provide useful comparisons.

The benefits will be measured in infections avoided and in lives saved. The future incomes of those spared to continue productive working lives will be measured as part of the economic benefits realised. As should all the collateral damage from other medical threats to survival not adequately dealt with because of the attention focused so heavily on the victims of Corona virus. On the positive side of the cost benefit equation, damage avoided from fewer fatalities and injuries on the roads or in the factories and mines will be part of the calculation. The costs of the lock down will be calculated, much less controversially as the value of incomes and output sacrificed in the lock downs.

The history lessons learnt may teach us about how best to cope with a future pandemic of inevitably uncertain cause, effects and consequences. And where the appropriate policy responses can never be obvious before the spread of the disease. The relationship between the economic costs and medical benefits of any policy responses to an epidemic deserve the most careful consideration. We are not at all sure they have been properly calibrated.

The case for governments building a large and yet very expensive reserve of medical capacity will have been greatly strengthened by what has happened. If only to allow for more time for leaders and their advisors to assess any new unknown pandemic threat to the community. A reserve that would allow more time for science to come to the rescue, before hospital facilities are overwhelmed, and so perhaps avoid the highly expensive lock downs.

What the lock downs will have cost their economies before economic life returns to something like normal will be measured with some degree of accuracy after the event. It will be the difference between all that might have been produced or earned (that is measured by gross domestic product (GDP) had economies not been shut down to a lesser or greater degree, and what has been produced and earned despite the lock downs.

It is possible to forecast potential GDP by extrapolating the underlying trend in outputs and incomes before the crisis. A more complicated econometric model could attempt the same forecasts. The difference between this potential GDP and the GDP delivered over the two or three years, post the crisis, will give us an accurate enough estimate of the costs of the lock down.

We have estimated a GDP loss ratio for SA under lock down. We have made a broad-brush estimate of how much of potential GDP will be produced each quarter in SA. It is assumed in Q1 2020 that SA GDP will run at 90% of its potential, then in Q2, when the knock down impact will be at its most severe, we judge that the GDP will then run at 75% of what have been delivered without the crisis. Thereafter each quarter, the loss of output ratio reduces by 5% per quarter. That is GDP will rise to 80% of potential GDP to be produced in Q3, 90% in Q4, 95% in Q1 2021 and then back to 100% in Q2 2021.

This would mean a V shaped recovery bringing the economy back to its potential by mid-2021. This might be an optimistic scenario. But even so the loss in GDP each quarter on these assumptions could amount to a large over R1 trillion by Q2 2021.  Whatever the more precise measure of actual GDP over the next few years, there are undoubtedly very large opportunity costs in the form of sacrificed output and incomes that South Africans will be bearing.

It would be a loss equal to about 25% of GDP delivered in 2019. And may be compared with the extra R500b rand the government plans to spend or provided tax relief to assist an economic recovery. Though not all of this R500 billion spending or tax relief programme will represent extra spending by government that will have to funded one way or another. Some of it will be covered by re-allocating some of the previous budget. Is the government plan generous enough? Such a judgment would depend upon on the estimate of its economic costs and benefits -rather than a narrow view of its financial implications. It can be funded with extra money created for the purpose. It does not have to rely on issuing extra interest-bearing debt raised that would be a burden on future taxpayers.

The less reliant the government is on funding the spending with expensive debt, the better it will be for future taxpayers. The case for funding a temporary increase in government sending with a temporary increase in the money supply, as well as with the almost free money provided by the IMF and World Bank, is surely the right way to budget. There is nothing ever to stop a sovereign as for example SA with its own currency, issuing more money to pay for goods and services that none would refuse. Issuing non-interest bearing central bank money is not normally used as an alternative to taxes or genuine borrowing to fund government spending because if pushed to excess, beyond the willingness of those who receive money in  exchange to hold that money, it leads to inflation. Prices would tend to rise when the surplus money held by economic agents, including banks, is exchanged for goods and services and financial securities of all kinds including bank overdrafts. But in current crisis circumstances, when demand for goods and services is so depressed higher inflation, runaway inflation, is a distant threat. And one that can be removed by taking money out of circulation when the state of the economy is strong enough.

The sacrifices of income and output will not be shared equally by all South Africans. Many will lose jobs that will be difficult to replace. Others will lose their jobs and the businesses that self- employed them. Some businesses will survive better than others in the new world of business after Corona virus. Many will see the value of the pensions and retirement plans, their hard earned savings,  painfully reduced.

Businesses to survive will need a reserve of working capital to start up again. The banking system, with assistance from the government and its central bank, as is the intention,  can help those with viable businesses, but without the means to start them up again without additional bank credit. It would only be fair for the government that has so damaged the value of these enterprises, to help the banks do so- by creating money for the banks to deploy in the form of extra bank credit. And overspending to mitigate the damage caused would be better than underspending- especially if the charge to future taxpayers can be limited by money creation. At times like these traditional parsimony is not called for.

Would it be unfair to point out that those in SA who are employed by the government at all levels, will lose neither incomes nor the pension benefits the SA taxpayer has guaranteed them on retirement. Their willingness to accept a wage and salary freeze to help our fiscus when the economy returns to normal might seem a proper form of reciprocation.

The extra spending or tax relief offered by governments in response to the lock down, might add not only to demand for goods and services over the next two years, but can also encourage more output of goods and services. This stimulus to the supply side of the economy, as it is allowed to revive, will reduce the net loss of income and output. If this is the case such extra expenditure can in a real sense pay for itself. More demand that leads to more supply avoids any opportunity costs, the trade-offs that normally apply when resources are fully employed.

The actual GDP numbers over the next two years will be closely watched and used to update our GDP loss ratio in order to gauge the shape of the recovery. It will hopefully be a V shaped recovery as we have estimated – it could be a less helpful more prolonged  U shaped recovery, with an extended bottom to the U should the economy struggle to revive its spirits and confidence. The economic recovery might worse even take a double u (W) course. That is a brief recovery followed by a further decline and then only later a recovery.

The economic growth rates as they unfold will not mean what they usually do. And therefore should be treated with great care over the next few years. GDP growth rates are most often presented as annual percentage growth from quarter to quarter, when the GDP has been adjusted for seasonal influences and converted to an annual equivalent That is growth from one quarter in seasonally adjusted GDP to the next quarter is then raised to the power of 4 to provide an annualized growth rate. This is the growth rate that attracts headlines.

Two consecutive negative growth rates measured this way are regarded as indicating a ‘technical recession’. The implication of this annual equivalent growth rate is that quarterly growth is expected to continue at that pace for the next year. Clearly under the influence of lock downs growth, so measured, is likely to become even more variable than it usually is.

This will be especially true of Q2 2020 when the impact of the lock down will be at its most severe, perhaps  reducing  growth in GDP to a truly shocking negative rate of  minus 50% p.a or thereabouts.

Estimating growth on this quarter to quarter basis over the next few years will be a very poor guide to the underlying growth trends. Following our estimates of the loss ratio and GDP, as an example, would show a very sharp contraction in Q2 2020, to be followed by positive growth of 40% p.a. in Q3 and Q4, 10% in Q4 and then as much as 50% again in  Q2 2021. The recession will seemingly have been avoided and the economy will soon be recording boom time growth rates. This would present a highly misleading account of what has been going on with the economy.

If GDP is compared to the same quarter a year before we will get a much smoother series of growth rates. It is likely to  show negative growth throughout 2020, (down by as much as -20% p.a in Q2) with strongly positive growth of 30% resuming in Q2 2021 when measured off the highly depressed base of Q2 2020, when the lock down was at its most severe.

The better way to calculate the impact of the lock down in terms of growth rates would be to calculate the simple percentage change in GDP from quarter to quarter (not seasonally adjusted or annualized)  as the impact of the lock down unfolds and gradually, we should hope, dissipates. The worst quarters measured this way will be Q2 and Q3 2020 after which quarter to quarter growth in percentage terms will become positive. See the figure below that turns our estimates of quarterly GDP in current prices over the next few years into the alternative measures of growth rates.

Estimated Quarterly Growth rates between 2020 and 2022 under alternative conventions.

Source; SA Reserve Bank and Investec Wealth and Investment

The upshot is that growth rates will not be able to tell what has happened to an economy when subject to a severe supply side shock – that is temporary in nature. Measuring in absolute terms, in money of the day GDP sacrificed each quarter, as we have attempted to estimate, will tell the full tale of economic destruction under way after the events.

Monetary and fiscal policy should be fully engaged avoiding such disappointments. Much lower short-term interest rates, combined with a degree of money creation by the Reserve Bank, to assist the banks and other lenders to take up the extra short dated and low yielding Bills to be issued by the Treasury, will be necessary to the purpose. A mixture of significantly more government spending, hopefully well directed, and  funded as cheaply as possible is called for to help revive the SA economy when it is given the opportunity to do so. Moreover there should be no sense of improper fiscal or monetary conduct acting this way.

It would be the right thing to do, and to do it openly without any sense of equivocation. As right a set of economic policy measures as they are being adopted in all the developed world whose economies are subject to similar proportionate losses of income and output. The developing world and South Africa does not deserve to be held to a different fiscal and monetary policy standard in circumstances like these. The time to resume sensible fiscal conservatism is when the economy is back to something like normal.

January 9th 2019

If you could borrow as much as might wish at close to zero rates of interest for ten or more years you would surely do so. There would be no lack of projects that promised wealth generating returns of at least one per cent p.a. Of course such funding opportunities are not readily available to any ordinary business or household.  Lenders would demand a premium to cover risks of default and would raise the prospective returns potential investors would have to achieve.

But such considerations do not apply to the German, Japanese, Netherlands or even the Brexit stressed UK government or the Swiss that can borrow at negative rates of interest. Lenders pay for the privilege of funding the Swiss government – for ten years and more. These governments can borrow as much as they might wish at very low rates.

Surely an extra bridge or highway, port or pipeline or even a dyke helping to create a productive polder can promise a one per cent per annum return? Governments with such favourable credit ratings  neither have to undertake the construction nor the management of such low return projects that can be leased to private operators- who win competitive tenders to do so. And if governments would exercise such opportunities to borrow more at invitingly low rates – also, heaven forbid,  to cut income and expenditure tax rates – aggregate demand for goods and services would be stimulated. And businesses would add to their productive capacities, including their work forces. And depressed rates of growth of GDP and accompanying incomes would accelerate.

Demands for credit especially bank credit would be encouraged, bank balance sheets would strengthen, while the national savings rates declined and interest rates could rise for very good reasons. Because demands for capital to invest would be rising rise faster than supplies of savings.

The failure to respond to respond sensibly to an extraordinary level of savings and the accompanying low interest rates is the essential European economic problem. The rate at which the Germans have saved has increased dramatically since 2000, while the rate at which they have added to their stock of capital fell away.

Germans in 1995 saved about 22% of their incomes- a very high rate for a developed economy. They are now saving 28% of their very large GDP that is forecast to rise further.They add to their capital stock at a 20 per cent of GDP rate. This has meant dramatically larger flows of capital out of Germany into global capital markets. In 2018 outflows of about 400 billion dollars were estimated.

Savings and Capital Formation ratios to GDP in Germany. Annual data

Source; IMF World Economic Outlook 2018 and Investec Wealth and Investment

The Dutch are now saving a similarly high proportion of their incomes and the Japanese are a further major source of global savings. The Chinese save at an even higher rate, over 40% of GDP, though the rate at which savings are made and capital formed has been falling. China is no longer a significant contributor to the global savings pool. A fact that may well inhibit its ability to stimulate its economy.

China – saving and capital formation to GDP ratios. Annual data

Source; IMF World Economic Outlook 2018 and Investec Wealth and Investment

Contribution to global capital markets. The combined surpluses of Germany, Japan and China (US dollar billions)

Source; IMF World Economic Outlook 2018 and Investec Wealth and Investment

The contribution in 2007 to the global savings pool from China, Germany and Japan amounted to nearly a trillion US dollars – compared to about a mere $100b seven years before. It is now about $600b.

The borrowers to absorb these surpluses at low interest rates were naturally found in the credit hungry US. Inflows of capital to the US expanded dramatically after 1995 – much of it funding houses that had to be abandoned by their owners after 2008. The average US home lost 30% of its pre-global financial crisis value. No mortgage based financial system could hope to survive a collapse in asset values of this magnitude- without a bail out.

US capital inflows 1980- 2023 – A tale of growing dependence.

Source; IMF World Economic Outlook 2018 and Investec Wealth and Investment

Less not more austerity is urgently called for in northern Europe- to help save the euro and the European project. The Italian and other populists are on the right track while the German fiscal conservatives perversely continue down a dead end.

When our newly minted Minister of Finance, Tito Mboweni, presents his update on the finances of the state later this month he will little alternative but to look through the rear view mirror. Total output and incomes (GDP) and the balance of payments – crucial information for the budget – will have been estimated only up to June 2018 and will be revised. The coinciding business cycle, which is a good proxy for GDP, calculated and published on a monthly basis by the SA Reserve Bank (SARB) is as out of date as the GDP.

The CPI for September will also be released on the 24^th October. He must hope that the misanthropes at his old Reserve Bank do not regard possibly higher inflation, in the wake of the weaker rand and the higher petrol price, very obvious negative supply side shocks to economic growth, as reason to hike interest rates. That would further depress growth in spending and GDP and tax collections without altering the path of inflation in any predictable way.

Mr.Mboweni can take consolation from the market reaction to his appointment. The rand immediately strengthened on the news – not only against the US dollar – but by a per cent or two against the currencies of our emerging market peers. Alas global economic developments a day after his appointment later  – pessimism about global and especially emerging market economic prospects- weakened the rand against the US dollar and undid the good news.

A stronger rand can clearly reduce inflation and, if it is sustained, reduce the compensation for inflation, and accompanying expected rand weakness, priced into the high interest rates the RSA has to pay. Inflation expected is of the stubborn order of about six per cent per annum.

Our new Minister will hopefully recognize that raising tax rates to close the gap between government expenditure and revenue is a large part of the problem of, rather than the solution to South Africa’s stagnation. Perhaps he will report progress being made in private-public partnerships, (alias privatization) in taking assets and liabilities (actual and contingent) and interest payments off the Budget- now running at over 11% of all government expenditure and likely to increase further.

I can offer the Minister a little consolation derived from some very up to date indicators of the current (September 2018) state of the economy. That is from new vehicle sales in South Africa and the supply of cash issued by the Reserve Bank in September 2018. These are actual hard numbers and do not depend on sample surveys that take time to collect and collate. These two hard numbers are combined to provide a Hard Number Indicator (HNI) of the state of the economy. It does a very good job anticipating the turning points in the SA business cycle. (see figure 1 below)

Fig. 1; The Investec Hard Number Indicator (to September 2018) and the Reserve Bank Coinciding Business Cycle Indicator (to June 2018) (2015=100)

Source; Stats SA, SA Reserve Bank, Naamsa and Investec Wealth and Investment

If current trends in new vehicle sales and the demand and supply of cash persist, the HNI is pointing to positive real GDP growth of what would be a very surprising possibly 3%, over the next twelve months.

Fig.2; Growth in the Hard Number Indicator and the Reserve Bank Business Cycle Indicator

Source; Stats SA, SA Reserve Bank, Naamsa and Investec Wealth and Investment

Current sales of new vehicles are running at an annual rate of 551,000 new units sold, forecast to rise modestly to an annual equivalent of 570,000 units in twelve months. The demand for cash is however suggesting more impetus for growth. It is recovering quite strongly and is expected to grow at a 7% rate in 2019 and when adjusted for consumer prices to rise to at a near 4% real rate in 2019. (see figure 3 below

Fig.3; The components of the Hard Number Indicator. Smoothed annual growth rates

Source; Stats SA, SA Reserve Bank, Naamsa and Investec Wealth and Investment

What moreover does this growing demand for old fashioned notes and coin say about the SA economy given all the electronic alternatives to cash? It suggests that much economic activity is not being recorded in GDP. Raising the contribution made by the unrecorded economy to the GDP is long overdue. It would improve all the critical ratios by which our economy is judged.

We economy watchers and the Treasury must hope that this growth in the demand for and supply of cash– so indicative of spending growth – continues to run ahead of inflation.

The Budget statement and speech on Wednesday badly disappointed the market in the rand and in RSA bonds. Since the Budget statement, the rand has lost about 3.3% of its US dollar value and was nearly 4% weaker against other emerging market exchange rates. This indicates that rand weakness and additional SA specific risks are at work.

The government’s cost of raising funds for 10 years has risen by about 22 basis points (0.22 percentage points), while five year money has since become a quarter of a percent more expensive for the SA tax payer. The spread investors receive as compensation for the risk that SA may default on its US dollar-denominated debt has increased by approximately 13 basis points.

Given that SA, to the 2020/21 fiscal year, will have to raise about R1 trillion to fund the growing deficit and to roll over maturing debt, the Budget statement has been a very expensive failure for the SA taxpayer. Furthermore, by weakening the rand, widening the risks to our credit ratings and to the rand and by adding to the inflation rate, the prospects for faster economic growth have deteriorated.

Yet one has difficulty in understanding why the statement was so poorly received. The statement continues to commit the government to fiscal conservatism. That taxes collected were a very large R50bn less than estimated in the February Budget, was widely signaled, as was the breach of the spending ceilings incurred to keep SAA alive. Furthermore, the decision to increase the Budget deficit and the borrowing requirement, rather than raise tax rates, makes good sense in such dire circumstances.

The Treasury may be implicitly conceding that raising the income tax rates in February proved counterproductive. Higher tax rates have not increased revenues and have in all probability discouraged growth. Raising income tax rates in the near future may well have become less likely.

Strictly controlling government spending while selling government assets is the only way out of the debt and interest trap. But privatisation on any scale appears as unlikely after the Budget statement as it was before.

What then are the steps the SA government could immediately take that might raise confidence in the prospects for the economy, enough to encourage households to spend more of their incomes and for firms to add jobs and capacity to meet their extra demands? Confidence enough to lift growth rates closer to a highly feasible 3% rather than 1% a year?

What is essential is no less than a confidence boosting conviction that the SA government is capable of ridding the economy of those individuals who have gained destructive control of the commanding heights of the SA economy. It therefore takes more than a statement to improve the outlook for the SA economy and to escape the stagnation that makes sound budgeting so difficult. 27 October 2017

South Africans will soon learn how much more of their disposable incomes and wealth will be extracted to sustain the nation’s credit rating. They have been forewarned, though they do not appear forearmed, to resist the incoming tide of still more tax and less income to dispose of.

They will be told, correctly, why limiting the borrowing requirements of government (the fiscal deficit) is essential for holding down interest rates and the cost to taxpayers of servicing the debt (old and new) incurred on their behalf.

What will not receive much attention from the Minister of Finance is a recognition of the influence of taxes and tax rates on the ability of economically active South Africans to pay these taxes – so that tax rates have to rise even as the economy continues to flirt with recession.

Evidence of policy failure, in the form of persistently dismal growth in SA incomes, is there for all to recognise. The rating agencies have identified the lack of economic growth in SA and so of its tax base, as the long term threat to the solvency of SA government debt.

It is not good economic policy to tax some goods and services at a much higher rate than others. Nor does it help to subsidise more favoured (by politicians and officials) sources of income. The economy needs less of both taxation and subsidisation that can significantly alter the patterns of consumption and production; interventions that prevent prices and output from revealing the economic value of the resources used in production and distribution. Transport and energy costs, including the particularly adverse taxes on fuel and energy, have a large influence on the prices of everything consumed and produced in SA.

It is a mystery why South Africans appear so complacent about the ever higher specific taxes levied on their demands for transport and energy, yet are so defensive of the inviolate 14% VAT rate with all its significant, hard to justify exemptions that in reality help the better off more than the poor.

The Treasury is now looking to a tax on sugar added to soft drinks. It’s looking to add as much as 20% to the price of a litre of the offending liquid and also, not co-incidentally, hopes to produce significant additional revenue. This focus on extra revenue will deflect attention from the full, perhaps unintended, consequences of such penal taxes: that is not only less sugar consumed but added incentives for producers to avoid taxation, not just the sugar tax but also all the other taxes, VAT and income taxes that accompany the legal production of soft drinks. This has been the case with cigarettes, where highly penal tax rates have driven much of their production and distribution underground. When the price of a cigarette is cheaper on the street than in the supermarket, the practical limits of the ability to tax and also to influence the prices charged, have been exceeded.

The way forward is for the government to spend less, especially on the benefits provided to the nannies employed by an increasingly nanny state, who thrive on an ever-growing but largely dispensable tide of regulation that inhibits production and employment. The full costs, as well as the often marginal benefits of a regulation, need to be better recognised.

The government also needs to recognise the cost savings, were the private sector allowed to deliver more of the services that taxpayers fund, including education and hospital services as well as electricity and transport. And it should look to sell off the assets of these superfluous state-owned enterprises (SOEs) in order to reduce government debt and interest payments that the SOEs have been so assiduously adding to, given their poor operating results.

South Africans should fully recognise that ever-higher tax rates are not helpful to their economic prospects. They should be calling loudly for less government, less spending and interventions by government. This would lead to lower tax rates, faster growth and indeed more revenue collected. 3 February 2017