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The Emergency Budget and the markets

16 July 2020 Bernard Drotschie, Chief Investment Officer at Melville Douglas

South Africa faces the real risk of further sovereign downgrades and a potential funding crisis, in perhaps the not too distant future following the bleak picture of government’s debt profile painted by Finance Minister Tito Mboweni’s Supplementary Budget.

The country has reached a crossroads where difficult decisions about improving our growth outlook and/or fiscal austerity measures can no longer be deferred. The Minister has assured the public and investors that cabinet has agreed to follow the “narrow-road” through the implementation of growth reforms and initiatives to stabilise government’s debt profile and that more information will be provided at the Medium-Term Budget Policy Statement.

The impact of COVID-19 and related lockdown measures enforced by government have been extremely costly to an economy that was already experiencing an economic downturn prior to the outbreak of the pandemic. As a result of the slowdown in economic activity, the local bond market experienced severe liquidity challenges due to concerns around debt sustainability and the fiscal position of the country.

In response, the South African Reserve Bank (SARB) cut interest rates aggressively by a cumulative 275 basis points including in a surprise inter schedule meeting on April 14 2020 and intervened in the secondary market by buying bonds. Government also responded to the crisis by announcing a R500 billion rescue package to soften the economic and social impact of the lockdown. This announcement by President Cyril Ramaphosa required the tabling of the Supplementary Budget in Parliament on 24 June 2020.

The Supplementary Budget was much anticipated by the market and of concern was the issue of mandatory targeted investments (prescribed assets) as speculation was rife that this would feature. In tabling the budget, the Minister did not mince his words on the fiscal and debt challenges facing the country. He likened our fiscal position to that of a wide-open hippopotamus’ mouth that “threatens to eat our children’s inheritance” and indicated the administration’s determination to “close the mouth of the hippo” and stabilise public debt.

The Minister painted two scenarios to debt stabilisation; a passive approach where debt is left to spiral out of control and an active approach where the fiscus is managed prudently and debt is brought under control. Government has adopted the latter and under this approach has highlighted the following:

• Cabinet has endorsed the target of a primary surplus by 2023/24, meaning revenue will exceed non-interest expenditure.
• Spending reductions and revenue adjustments amounting to approximately R250 billion over the next two years.
• National Treasury will introduce zero-based budgeting from the October MTBPS under which all spending programmes will have to be re-justified and reconsidered with each iteration of the fiscal plan.
• Main budget expenditure is now projected to increase to 37.2% of GDP in 2020/21, relative to the 2020 Budget estimate of 32.5%. This reflects the response to COVID-19 and higher debt-service costs.

We envisage political headwinds to the bold policy reforms and public sector wage reduction plans remain unclear. The Minister jokingly alluded to the difficulties faced by government in negotiating this expenditure item down. Given skills and capacity constraints of the State, execution risk and capacity to deliver always lingers.
With the risks highlighted above, we believe bond yields will remain range bound and that the MTBPS in October will be a key determining factor to bond yields and currency trajectory.

The South African bond yield curve remains very steep, (meaning the gap in bond yields between the long and short end remains wide). The expected selloff of long bond yields because of funding concerns should be muted due to supply demand dynamics as government plans to issue mainly in the belly of the curve (7 – 12 year). The belly of the curve remains the most liquid and extra issuance in this area will enhance this sector’s liquidity. Consequently, we expect this area to be best performing going forward and funding concerns to continue being expressed in the long end of the curve.

The SARB, despite its aggressive and deep cuts so far this year, has indicated its willingness to give further monetary policy support to the economy should the need arise. This could very well be offset by fiscal austerity measures as government tries to arrest the rising public debt. We however believe the interest rate cutting cycle is getting close to bottoming.

South Africa’s fortunes, in line with many other emerging economies, is very much linked to global developments and the pace and sustainability of the cyclical recovery in the global economy. In the near term, this should provide some underpin to the manufacturing and export industries as global trade and the supply chains normalise, but this won’t be enough in the long term to save the country from a continued decline in GDP per capita, run-away unemployment and social unrest.

In line with global trends, the South African government and Reserve Bank have stepped in to alleviate some of the pain inflicted by the crisis, as individuals and companies were starved from income. We will only know in time how successful these interventions have been but suffice to say, given government’s restricted balance sheet, its ability to support the economy will be severely restricted.

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