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New Fiscal Frontiers

26 February 2024 Old Mutual Wealth Investment Strategist, Izak Odendaal

Every year, the Budget Speech commands wall-to-wall media coverage. Most of this coverage asks something along the lines of “What does the Budget mean for the taxpayers, the economy and markets?” Increasingly, this question should also be asked in reverse. How does the state of the economy and the bond market influence the Budget?

That is not to suggest that the Budget has no impact on the bond market. It clearly does since it determines the size of government borrowing, which is to say the supply of bonds.

The Budget also has an impact on the economy. After all, the government will spend R2.3 trillion in the coming fiscal year. Spending levels have grown strongly over the past 12 years. However, while all this spending should in theory support economic activity, real GDP growth only averaged 0.8% since 2012, as the Budget pointed out.

Not multiplying
National Treasury’s internal estimates show that the so-called fiscal multiplier is below one, meaning each rand of government spending results in less than one rand’s worth of additional national income (GDP). There are two broad reasons for this. Firstly, while spending has increased in quantity, it has decreased in quality. It has often been wasteful or misallocated. Education gets the biggest allocation in the Budget for instance, but clearly the country is not producing the skills it needs. Another example is the hundreds of billions that have been poured into Kusile and Medupi, neither of which function properly despite being brand new power stations. Secondly, much of the increase in spending has been funded through borrowing. As the bond market’s assessment of government’s creditworthiness has deteriorated, borrowing costs have risen, not just for the government, but also for the private sector, acting as a drag on economic activity. In turn, the higher borrowing costs mean the government’s debt service burden has risen sharply, crowding out spending on other areas like infrastructure. Already, interest payments exceed social grants. The latter boosts consumption in the economy, the former does by much less, since 25% percent of bondholders are foreigners, while the rest are mostly domestic financial institutions.

It is the rising interest burden – brought about by higher yields on government bonds – that is forcing the government into fiscal consolidation in an election year. It recalls the famous quote of James Carville, President Clinton’s adviser: “I used to think that if there was reincarnation, I wanted to come back as the President or the Pope or as a .400 baseball hitter. But now I would want to come back as the bond market. You can intimidate everybody.” The poor state of the economy and the sceptical bond market are now in the driving seats.

Chart 1: Global government debt-to-GDP ratios with projections

Source: International Monetary Fund

Let’s put this in a global context. Government debt levels rose sharply after the Global Financial Crisis as the public sector stepped in when the private sector stepped back. However, in many cases, the fiscal response was insufficient, and austerity was imposed too quickly. When Covid hit, governments again stepped in. The combination of collapse in tax revenues and massive stimulus packages, notably in the US, saw government debt-to-GDP ratios rise further. The 2022 inflation surge reduced these ratios somewhat (if there is one thing inflation is good for, it is reducing debt burdens), but debt levels are still higher today than in 2019, as chart 1 shows.

Are these debt levels sustainable, especially with the increase in interest rates over the past two years? Very simplistically, if nominal national income growth is higher than the government’s cost of borrowing (the yield on its bonds), it should be broadly sustainable. There are other factors at play of course, but fundamentally it is this simple relationship between the growth of income (nominal GDP) and bond yields that determines whether a given level of debt is going to be stable or continue rising. Chart 2 summarises the difference between year-on-year nominal growth rates (for the last available quarter), and the latest 10-year government bond yield for a selection of large economies. We focus on nominal growth because most debt is a nominal number, as is tax revenues.

By the way, this does not mean that countries can “inflate away debt” as is often suggested. The experience of the post-2008 period shows that inflation is not something policymakers can conjure out of thin air, nor is it something they can easily control once it arrives. What they can do is keep interest rates artificially low, also known as financial repression. But remember that while central banks set short-term interest rates, they have little direct control over long bond yields.

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