Budget likely to be boring yet risky

2013-02-26 09:35 - *Peter Attard Montalto
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Pravin Gordhan
Minister of Finance Pravin Gordhan.
WHILE Finance Minister Pravin Gordhan is torn between the political needs to boost jobs and increase health and education spending, rating agencies and the market also loom over his budget.

Because of this, we think the budget is likely to be relatively "boring" but not necessarily without substantial risk. We see no major tax changes before the tax commission reports announced in the state of the nation address and see underspend on capex cross-financing part of the revenue hole.

However, we expect deposit drawdown and increased issuance again to be a theme.

The 2013 budget is an unusually risky affair for the government as well as markets. It follows a series of downgrades last year and an ANC elective conference in December which seemed clearly to back additional state involvement in the economy and therefore spending.

Yet, at the same time, borrowing costs have never been as cheap with yields some 175 basis points (bp) lower than at the time of last year’s budget and almost 220bp lower than the 2011 budget.

What ties all this together, however, is the ballooning of funding costs. The total wage bill has doubled over the past four years from R60bn/FY to R120bn/FY this year, as a result of the budget’s core philosophy of being counter-cyclical within a debt-sustainability envelope and ensuring both development and intergenerational equity.

This has led over the past five or so years to the continual growth of spending while revenue slumps have been deficit funded increasing borrowing, and so even with cheaper borrowing costs the cost of funding has still increased.

It is such a model, when combined with the medium-run expenditure risks, that has raised the ire of the rating agencies and markets (though in the latter case inflows, and in particular World Government Bond Index inclusion, override these more medium-run concerns).

Hemmed in on both sides

While downgrades have been largely due to violence, protest and strike action in both the mining sector and more broadly, as well as political and policy risk uncertainty more generally, the other half of the downgrade equation has been fiscal.

The budget this week will be hemmed in on both sides. First are the rating agencies’ concerns that the end point of fiscal consolidation seems to be pushed ever further out with each mini budget or budget every six months, while the end point for debt even under current policy assumptions is seen as higher than the government forecasts and is pushing at the rating thresholds.

On the other side, however, is the National Treasury’s commitment to counter-cyclical fiscal policy and support for the developmental state and infrastructure.

While the National Treasury always seems to us to be a serious brake on political-fiscal endeavours, we should also not forget that there is an election at Easter time 2014.

However, there are a number of easy “get out” clauses for the budget.
 
First, while healthcare costs will expand significantly under National Health Insurance (NHI), as will infrastructure more generally as announced by President Zuma in his state of the national address (to total of R4 trillion), underspend in budgeted capex programmes is currently running at around 30% of the total per year.

The money will probably all be spent in the end. It is just that public sector inefficiencies (at state-owned enterprises and sub-central government levels in particular) mean it will take longer to spend it.

In each six monthly budget statement the National Treasury under-assumes the amount of underspend, perhaps hoping that in the coming period it can be spent more efficiently, but perhaps also to allow itself some wiggle room.

We see this as a kind of austerity in disguise, with spending growth less than expected. We expect the same to happen again this week, which should open up some room for manoeuvre. This could give around another R10-20bn in wiggle room.

The other get out clause is that the budget can be approved for the current fiscal year, promising additional revenue for the future without setting out what it is. The tax commission announced in the state of the nation address likely allows Gordhan to avoid making any difficult revenue decisions this side of the election.

This may well push the rating agencies to the limit, but he cannot push back and say the whole point of the commission is to fill the gap.

We see NHI funding wrappers in particular (we think a mixture of VAT increase and additional personal income tax – levied on both employees and employers) as the most likely outcome, as well as the mining super-tax that is now ANC policy (and which we always saw as the government pay-off for not taking the nationalisation route).

In any case, we think the additional NHI spending needs – even if likely to be as early as next year – will be once again put off without the funding wrapper yet known. Such a move clearly is impossible to maintain forever and raises questions about major virtual holes in the budget outlook.

However, we still expect this to be the strategy at this budget. After all, while there are white papers on NHI there is still no firm legislative plan.

All this wiggle room is necessary to fill a revenue hole in the current fiscal year of around R15-20bn (though the budget may well see only a smaller R5-10bn hole) and then a R20-25bn hole for the next two fiscal years in our forecast versus the last mini budget under current tax policy assumptions (though, again, the budget may only admit to a smaller hole).

Pet project give-aways

While those holes can be partly filled with capex underspend, we expect additional spending on broadening the NHI experimentation roll-out area for the coming year (ready for the much larger launch in the fiscal year 2014/15) as well as additional money on education in particular.

As ever, we expect a few "give aways" of a little money here and there for pet projects, though the lack of any real new news in the state of the nation address suggests the scope for meaningful surprise on the expenditure side is limited.

Any additional push on infrastructure will likely be self-funded by underspend elsewhere, while jobs fund announcements in the state of the nation address (R3bn) are already budgeted for the period ahead.

The issue we see here is that while the National Treasury (and government more broadly) wants to shift spending from current expenditure (in particular wages and administration costs) to capex, in fact inefficiencies are causing overspending on the former and underspend on the latter.

This can be seen with the forecast date for capex to reach R300bn moving out each budget from 2011 in the 2009 budget then to 2012 and now to 2014 in the last mini budget, and according to our estimates it may not occur until 2014.

This is important for both current and potential growth, but also in terms of the poor budget spending mix.

One of the key risk factors for us around the budget (outside of the policy-led risks like NHI) remains the wage bill. With a central government wage bill agreement to last for the next fiscal year, on paper at least the budget is likely to assume constrained costs on this front.

However, there are risks in terms of both that agreement falling apart under copy-cat strikes given the success of wage increases in the mining sector, and the municipality workers wage round in the middle of this year.

That could well see headlines and protest action pushing wage increases over 7.0% compared with the much lower central government worker agreement of CPI + 1pp for this year, which will be around 6.3%. Housing allowance increases could also be much more hefty than the R100/month received by central government workers last year.

Employment numbers also seem to be climbing faster than expected. All this may only see limited representation in the budget, however.

The market’s immediate reaction to a slower pace of consolidation on the funding side may be limited since underspend by parastatals will be reflected in a slower pace of growth in non-government public sector borrowing (given most capex is off the central government balance sheet).

However, by our estimates there can be only a very marginal increase in deposit drawdown without getting below what we would term prudential levels. The level of drawdown may be closer to R20bn than the current projected R18.5bn in the last mini budget.

Long-term bond issuance may well remain sticky in 2014-15 closer to the run rate of net R136bn/FY already seen in the next fiscal year, while it is less likely that the National Treasury will try to tap the foreign market in any more meaningful size.

The balance of increased central government but reduced public sector issuance should therefore, when combined with the current inflow story, in the immediate future look pretty neutral for the bond curve.

However, issuance levels getting "stuck" in the outlook at such high levels may only be temporary phenomenon until tax policy changes after the commission and with the additional revenue from mining in particular being directed to infrastructure.

We think, however, the rating agencies are more focused on current policy and will not take such a strong view on the outcome of the commission (indeed, the positive fiscal effects from the mining tax may be more than offset by the increased worry about competitiveness).

Additionally, we think that the majority of additional revenue would be spent with only a small fraction being used to reduce debt and deficit. As such, even with this policy risk later in the year, the consolidation path and funding path at this budget should still be meaningful.

Summary

The sum total of all these factors is basically a lack of significant policy change – fire-fighting instead to try to minimise the consolidation and debt path slippage. That may make the budget seem "boring", but it is that process and the credibility of the moves to try to keep the budget on track that are key.

Of course, resisting pressure from line ministries to increase spending remains a key and ongoing win for the National Treasury, but we think what is needed is a more fundamental rethink of the spending model and efficiency of the state.

Politically though, we cannot see how it is possible to stick with the last consolidation path in the 2012 mini budget. The National Treasury win on expenditure more generally does not extend to the budget as a whole, in our view.

We think there may well be a series of negative comments from the agencies after the budget on the inability to follow the existing path and the deficit path may be shifted out again.

S&P, which is probably the key marginal agency at the moment in terms of one most likely to move next, should be watched particularly closely. However, we do not think that there will be enough in the budget (on either the action, or inaction front) to prompt any immediate downgrade.

We do still think downgrades will come, but we expect them to be led by the policy choices made on the mining sector (beyond simply the tax) as well as land issues, all combined with an intensification of violence and protest action in the middle of the year.

Other factors

The budget still has the mysterious ghost of R5bn over three years of youth wage subsidy tax give back on the revenue side, which gets continually rolled over.

While the confusion in agreements in the tripartite alliance suggest policy on youth employment is coming, the youth wage subsidy as a widely backed (in the private sector and by opposition parties) revenue-side policy seems dead to us at least.

Even though at some point in the future (perhaps budget 2014) this revenue-side expense may move to the expenditure side of the balance sheet, we cannot see the National Treasury having room to do anything with it this time – or else that would be a clear mark of defeat.

The big negative for us – less about the budget specifically – is the fact that a fiscal rule is politically dead as we commented in our trip notes back in November. Nor has the report on long-run fiscal expenditure risks been forthcoming, despite being meant to be published last year and then at the start of this month.

That report surely must form part of the tax commission’s work later this year, but it seems those risks will not be highlighted with the report’s publication at this time and the current environment around ratings.

We expect no change in the monetary policy committee mandate at this budget, despite the shift in ANC resolution wording on the South African Reserve Bank in December. We expect that to come subtly over time when rating threats subside.

Nor do we expect any meaningful shift in exchange controls affecting locals at this time; the focus will likely be much more on establishing the new twin-peak model of financial regulation and oversight.

We also see no scope for any changes to exchange controls affecting foreigners – the foreigner land ownership issue is the much more pressing relevant issue on that front beyond the purview of the budget.

*Peter Attard Montalto is  a director and emerging markets economist at Nomura.

** Visit the Fin24 2013 Budget section for full coverage of Finance Minister Pravin Gordhan's National Budget speech.

 

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