What to Expect from the South African Medium Term Budget

Whitepaper What to Expect from the South African Medium Term Budget

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Contents

Executive summary 1

Economic overview 2

Government debt is above 50% 2

2017 recession and low economic growth 2

Unemployment remains high 3

Finance Ministers: Gigaba and Gordhan 4

How they compare 4

Gigaba: his performance so far 5

Medium term budget policy statement 6

What the economy needs 6

What to expect 7

Conclusions 8

Whitepaper 1 What to Expect from the South African Medium Term Budget

Executive summary: For any successful economy, a spirit of mutual respect and teamwork between Government and the private sector must exist. In South Africa, business confidence is at its lowest level since 2009, which, unsurprisingly, coincides with low GDP.

With his upcoming mid-term budget announcement, the finance minister has an opportunity to instil confidence in the business community by demonstrating that Government is serious about working with them. He will also need to display his commitment to dealing with State Capture, stamping out corruption and curtailing spending excesses at state-owned enterprises.

Furthermore, the minister must convince the market and the ratings agencies that he has Government expenditure under control. He has very few tools available to him to stimulate growth and needs to pay very careful attention to perceptions as the market will be watching closely, with little patience for ambiguity.

This paper provides an economic overview and addresses the situation Gigaba currently finds himself in while providing some insight into the outcomes JCRA expect to see from the announcement, and what the South African economy needs to jump-start itself. 2 Whitepaper What to Expect from the South African Medium Term Budget

The amount of debt the Economic overview 2017 recession and low economic growth government builds up In the first quarter of 2017, South Africa’s 2 has direct consequences Government debt is above 50% economy entered a technical recession , a The ratio of South African government debt to blow for the newly appointed Finance Minister, for business confidence GDP is growing, and is now above 50%: an all- Malusi Gigaba. The news of this recession and investment levels. time high. However, the International Monetary stimulated the creation of the government’s 14 Fund (IMF) has forecast that it will continue point Inclusive Growth Action Plan in June3. Upon to grow in the future. The amount of debt the the announcement of this plan, which outlines government builds up has direct consequences various structural reforms to support both for business confidence and investment levels. business and consumer confidence, the Finance Rating agencies have become increasingly Minister promised to more comprehensively concerned about the government’s ability to raise speak to [the] economic outlook and growth enough tax revenue to cover spending, and this prospects in the medium-term budget policy contributed to the sovereign credit rating being statement . cut to junk status by two agencies earlier in 20171. While business confidence fell to its lowest level since 2009 in the second quarter of 2017 as a result, it has since picked up.

Figure 1: Debt/GDP

% 30

0 2000 2005 2010 2015 2020

Debt/GDP Debt/GDP forecast Source: IMF

1 https://www.ft.com/content/5b8e083c-1b91-11e7-bcac-6d03d067f81f 2 A technical recession is defined as two consecutive quarters of GDP contraction 3 National Treasury of South Africa: Government’s Inclusive Growth Action Plan (2017) Whitepaper 3 What to Expect from the South African Medium Term Budget

Unemployment Figure 2: GDP annual growth reached 27.7% in the 10 second quarter of 2017, 8 its highest point since 6 2003. 4

2 % 0 2000 2002 2005 2008 2010 2013 2016 -2

-4

-6

-8

GDP growth

Source: Statistics South Africa

Since the release of the action plan, economic Youth unemployment also reached 52% in 2016, growth has picked up again and South Africa up from 46% in 2008, showing that South African broke out of its technical recession in the second unemployment is concentrated in the country’s quarter of 2017, with GDP rising at an annual rate younger population6. of 2.5%. However, Figure 2 shows that GDP has The World Bank South Africa Economic Update been volatile for the past few years, so another highlights that South Africa is falling behind bout of negative growth in the coming quarters is other countries in terms of productivity (which not unlikely. declined by 2% during the first quarter of 2017) The World Bank revised their South African especially in the technology sector. This can be GDP forecasts up to 2019 in September4. They attributed to a low level of innovation and a loss now expect GDP to grow 0.6% in 2017, which is of skills caused by professionals moving to other low compared to the figure of 1.3% the Treasury OECD countries. The World Bank also cited low estimated in the February budget. The World productivity as a reason for slashing their 2017 Bank expects 1.1% growth in 2018 and 1.7% in 2019 South African growth outlook from 1.1% to 0.6%. respectively. In contrast, the February budget forecasts were 2.0% and 2.3% for these years. Unemployment remains high Weak GDP growth is underpinned by high levels of unemployment and subdued productivity. Unemployment reached 27.7% in the second quarter of 2017, its highest point since 2003. Only 16 million people5 - or 28% of South Africa’s rapidly growing population - were employed in the second quarter. This low employment figure reflects the fact that the long term unemployed often cease trying to gain employment, and so drop out of the unemployment statistics. If they were included in those statistics, the unemployment rate would increase considerably.

4 World Bank: South Africa Economic Update: Innovation for Productivity and Inclusiveness (2017) 5 Statistics South Africa 6 World Bank, World Development Indicators, youth unemployment 4 Whitepaper What to Expect from the South African Medium Term Budget

Investment in South Finance Ministers: Gigaba and The dismissal of Gordhan by South Africa’s African long term bonds Gordhan President Jacob Zuma in March resulted in a wave has remained healthy of credit rating downgrades and a reduction in How they compare business confidence. Fitch downgraded both the and they are still Pravin Gordhan was Finance Minister until the foreign and local currency rating to junk, while attractive compared to end of March 2017. His infrastructure plan and aim S&P reduced the foreign-currency rating to non- those of other emerging to limit spending won over investors and calmed investment grade, keeping the local currency rating economies. However, markets. Prior to his appointment in 2015, the rand at investment grade. Around 64% of government 10 yields remain high was at an all-time low, but it gradually recovered bonds were owned by domestic investors in 2016 , meaning that the local-currency rating is more compared to the time during his appointment as Minister. Gordhan prioritised infrastructure spending in his 2017 significant for the majority of investors. However, when Gordhan was budget, allocating R195.8 billion for infrastructure the share of foreign investors increased between minister, reflecting the and local development in the 2017/2018 financial 2015 and 2016 from 32.4% to 36.0%11. Moody’s also higher perceived risk. year. downgraded South African government bonds in June, but both foreign and local currency-ratings Gordhan also had a strong anti-corruption stance remained at investment grade. that helped build trust and confidence. There have been corruption charges against the new Finance Despite the initial strong response (rating Minister, Malusi Gigaba since his appointment, downgrades and bond disinvestment) to the especially relating to his relationship with the appointment of Gigaba, bond yields and the Guptas7; however so far none of these have rand have stabilised since, and Gigaba quickly resulted in charges8. announced his commitment to Gordhan’s February budget. Investment in South African In Gordhan’s February budget, he estimated that long term bonds has remained healthy and they the spending for this financial year will be R1.56 are still attractive compared to those of other trillion, and that tax revenue will be R1.41 trillion, emerging economies. However, yields remain high 9 with a budget deficit of R149 billion . One of the compared to the time when Gordhan was minister, most important tests for the new Finance Minister reflecting the higher perceived risk. will be sticking to this budget, especially by keeping spending down.

Figure 3: Government bond credit rating relative to junk (August 2017)

0 Level relative to junk

-1 Fitch Standard & Poor's Moody's Foreign-Currency Rating Domestic-Currency Rating Source: Bloomberg, Fitch, S&P, Moody’s

7 A wealthy business family in South Africa whose strong ties to President Jacob Zuma have led to claims of corruption, undue influence and of state capture 8 https://qz.com/1002519/south-african-finance-minister-malusi-gigaba-faces-corruption-allegations-over-gupta-family- connections/ 9 South Africa National Treasury: Budget Review 2017 10 South Africa National Treasury: Budget Review 2017 11 South Africa National Treasury: Budget Review 2017 Whitepaper 5 What to Expect from the South African Medium Term Budget

Eskom poses a Gigaba: his performance so far Reports also speculate that the Treasury might sell particular risk to the The biggest challenge for current Minister its 39% stake in landline provider Telkom to fund economy, with of Finance, Gigaba so far has been limiting the SAA bailout. Gigaba told parliament in early government expenditure and preventing fiscal August that they would not be selling the Telkom requirements for R413 slippage (deviations from what was promised in stake to fund bailouts. Therefore, if he chooses billion in interest and the 2017 budget). If the level of spending exceeds to go back on his word on this matter market debt payments over the tax revenues by too much, then the risk of public confidence in Gigaba is likely to weaken. debt distress will increase, which is likely to fuel next five years. Since his appointment, Gigaba has also spoken further rating downgrades. about the importance of raising employment In July, the South African government paid R2.3 in South Africa, which at present creates a large billion to South African Airlines (SAA) in order for restraint on economic growth. The 14 point them to settle a loan from Standard Chartered. Inclusive Growth Action Plan released in July aims On 29 September, they were permitted another to create complementary government funds R3 billion to repay a Citibank loan. In addition, aimed at financing SMMEs (small, medium and SAA have asked the government for R13 billion in micro enterprises) in their start-up phase which order to recapitalise12, which Gigaba is expected to may aid employment increases. address in the upcoming medium term budget. However, he is facing increasing pressure to come up with the funds that have already been given to SAA and so further spending on SAA is likely to prove unpopular. Gigaba also has to manage the government’s contingent liabilities (commitments to take responsibility for state owned enterprise (SOE) loans in the event of a default), of which Eskom, independent power producers and the Road Accident Fund make up the majority. Eskom poses a particular risk to the economy, with requirements for R413 billion in interest and debt payments over the next five years13. They also face corruption allegations relating to the Gupta family. Gigaba has given limited information to the public so far in describing how he will raise the funds for the government to cover the pay-outs to SOEs. There have been reports that the Treasury may request the Public Investment Corporation (PIC, manager of the Government Employees Pension Fund) to buy the government’s R12 billion stake in Telkom (a wireline and wireless telecommunications provider) to fund some of the SAA bailout. PIC has about R1.86 trillion in assets, and is one of the country’s best performing companies. However, Gigaba has stressed that no formal or informal request has been made to PIC. Gordhan has also criticised the idea of using PIC funds to bail out SOEs, suggesting that they need to correct the cause of the financial distress before handing over more money14.

12 https://www.reuters.com/article/us-safrica-economy/south-africa-considering-1-billion-bailout-for-national-airline-idUSKB- N1AK0UU 13 https://www.bloomberg.com/news/articles/2017-09-22/goldman-sachs-sees-eskom-as-biggest-risk-to-s-african-economy 14 http://ewn.co.za/2017/09/26/gordhan-soes-must-clear-out-rot-before-requesting-bailouts 6 Whitepaper What to Expect from the South African Medium Term Budget

Competition is low in Medium term budget policy statement South Africa which means that demand for What the economy needs capital and labour are Although the economy has emerged from recession, the annual growth rate for 2017 is below their potential, expected to be low, due to weak productivity and living costs for the and employment as well as drought, electricity poor are higher than shortages and logistical constraints and Gigaba necessary, perpetuating needs to address these concerns, while keeping in the poverty problem. mind that possible spending is constrained by the size of the economy’s debt. The World Bank have published a report15 outlining ways for the South African government to improve the economic outlook. The report highlights that productivity needs to increase, which can be done through innovation. This can create new opportunities for employment and economic growth. Policy uncertainty, red tape (excessive regulation) and limited competition in key product markets restrain the entry and growth of small firms. Therefore, if Gigaba addresses these issues by engaging with businesses and reducing bureaucracy as well as promoting research and development, he can create more potential for economic growth. South Africa already has clusters of innovation in a few of the largest cities, but these advancements need to be spread to other regions. Another issue Gigaba needs to address is economic competition. Competition is low in South Africa which means that demand for capital and labour are below their potential, and living costs for the poor are higher than necessary, perpetuating the poverty problem. Competition can also stimulate innovation, and thus further create economic growth. The National Development Plan16, says that infrastructure investment as a fraction of GDP needs to grow to 30% by 2030 in order to reach a sustained and inclusive growth path. In the February 2017 budget, Gordhan proposed a new facility to finance large infrastructure projects which requires funding or other state support, such as sovereign guarantees. Although this may require significant government investment, if Gigaba implements this plan, it will stimulate productivity and growth increases which will benefit the economy.

15 World Bank: South Africa Economic Update: Innovation for Productivity and Inclusiveness (2017) 16 Republic of South Africa: National Development Plan 2030 (2012) 17 https://www.businesslive.co.za/bd/economy/2017-08-21-downgrade-alarm-as-revenue-shortfall-could-hit-r50bn/ Whitepaper 7 What to Expect from the South African Medium Term Budget

If the budget What to expect In February, President Zuma announced his plan announcement does not In terms of spending, Gigaba is in a difficult for a radical economic transformation. Some of satisfy rating agencies, position. If he raises too little tax revenue, there is his main concerns are the persistent economic likely to be another round of rating downgrades, inequality and the underrepresentation of black we can expect further since rating agencies are concerned by the risk South Africans at top management levels. Gigaba downgrades of domestic of public debt distress. This is a likely scenario is likely to address the ongoing high level of and foreign-currency since revenue collection is already substantially inequality in the medium term budget, and will bonds. This is likely to below budget, with some economists suggesting feel pressure to allocate funds towards achieving cause the rand to a shortfall for the year of as much as R50 billion17. higher equality, due to Zuma’s promise to "utilise depreciate against the Another credit rating downgrade could result in a to the maximum, the strategic levers that are reduction in investors’ appetite for South African available to the state"19. dollar, as was the case government bonds. A reduction in investment will In light of the World Bank’s growth outlook after previous rating slow economic growth, which makes it harder reduction for 2017 to 0.6%, there is a strong for the government to raise tax revenue (because downgrades. likelihood that Gigaba will cut his forecast to people are earning and spending less). Therefore, a similar level. Indeed, at the Tax Indaba on 11 a vicious circle may emerge, and Gigaba should do September, he said that the 1.3% growth forecast his best to avoid it. provided in the February budget was unlikely to be Gigaba needs to reassure investors that realised in 2017. It would be best to accompany a government spending is being limited to a reduction of growth expectations with an update minimum in order to avoid a downgrade. Although, on methods of increasing growth in the future, but the large SOE contingent liabilities make this this will be difficult to do given the importance of difficult. keeping spending low. In the medium term budget policy statement he will also have to address questions on how he will cover the cost of the SAA bailout and which assets he has identified for sale. If he decides to sell Telkom shares then he will have to provide strong reasoning for this, since he has previously stated that he wouldn’t do so. Many are expecting rating downgrades to come. Despite strong expectations that the central bank would reduce the base rate to stimulate growth on 21 September, they chose to keep rates steady. The South African Reserve Bank cited the possibility of rating downgrades in the near term as a cause of concern, since they could pose a danger to the rand18. If the budget announcement does not satisfy rating agencies, we can expect further downgrades of domestic and foreign-currency bonds. This is likely to cause the rand to depreciate against the dollar, as was the case after previous rating downgrades. Furthermore, the central bank may feel the need to raise interest rates again, since a depreciation means that imports will be more expensive, and so could trigger inflation. However, increasing the base rate again may limit economic growth.

18 MPC Statement September 21, 2017 19 http://www.sanews.gov.za/south-africa/president-announces-radical-economic-transformation 8 Whitepaper What to Expect from the South African Medium Term Budget

In a volatile and Conclusion uncertain economic A poor mid-term budget carries the potential for environment, hedging increased volatility in respect of the Rand and the can help to mitigate forward rates curve. It will almost certainly set the market risk and provide scene for further downgrades in ratings and may confidence in the result in substantial portfolio outflows, putting the Rand under pressure and negatively influencing budgetary process by the trajectory of JIBAR and swap rates. ensuring that future cash flows are not These risks together with the Fed balance sheet unwind, ECB tapering, rating agency decisions, subject to wild and Nersa’s opining on Eskom’s request for ever fluctuations. higher tariffs, resulted in the MPC, against market expectations, deciding to hold off on the next rate cut pending more clarity. Eskom’s balance sheet and refinancing needs are also posing significant negative risks to the economy, as is the ANC elective conference. In light of all this, it would be prudent to consider hedging for both currency and interest rate exposure and explore the services of an independent hedging advisor to assist you in choosing a strategy that works for you at the best possible price. In a volatile and uncertain economic environment, hedging can help to mitigate market risk and provide confidence in the budgetary process by ensuring that future cash flows are not subject to wild fluctuations. JCRA has over 28 years of experience advising on market risks to corporates, project companies, funds and the property sector. We are a global business with significant experience in markets around the world including South Africa where we, together with key staff, have been involved in driving bespoke hedging solutions to large corporate and infrastructure deals since 2004. Please get in touch if you would like to learn more about services we provide and what we can do to help keep your organisation one step ahead. Whitepaper 9 What to Expect from the South African Medium Term Budget

About JCRA About Cebr JCRA are independent financial risk advisors with Centre for Economics and Business research over 25 years’ experience in providing tailored (Cebr) is an independent consultancy with a hedging solutions for large-scale infrastructure reputation for sound business advice based on projects. We create transparency by thorough and insightful research. Since 1992, benchmarking pricing and managing the hedge Cebr has been at the forefront of business and execution process so that our clients understand public interest research. They provide analysis, the true cost of their project. forecasts and strategic advice to major UK and multinational companies, financial institutions, Carrying a number of mandates for infrastructure government departments and agencies and and renewable energy clients in South Africa and trade bodies. sub-Saharan Africa, our current projects total ZAR 18 billion, and we are now targeting a further For further information about Cebr please visit ZAR 24 billion. With a global reach and experience www.cebr.com advising on projects across the UK, Europe, North America, Australasia and Africa, the JCRA team have the expertise to help you and your project stay one-step ahead. jcragroup.com For more information, or to discuss this whitepaper, please contact:

Lionel Kruger, Ian MacFarlane, Director, sub-Saharan Africa Director, Project Finance T: +44 (0)207 493 3310 T: +44 (0)207 493 3310 E: [email protected] E: [email protected]

This whitepaper is fifth in a series, previous whitepapers can be downloaded @ jcragroup.com

Issue 1 Issue 2 Issue 3 Issue 4 Issue 5 10 Whitepaper What to Expect from the South African Medium Term Budget

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