THE government has belatedly recognised the urgent need to avoid a downgrade of SA’s credit-worthiness to junk.
To do so requires the global rating agencies to believe that the government’s escalating indebtedness can be halted and reversed. This can happen only if government spending slows, tax revenues increase and the economy starts growing again.
The state of the nation address revealed welcome new emphasis on controlling government spending. The budget later this month is expected to include further painful spending cuts and tax increases.
The rating given to our debt matters for several reasons. Most importantly, it is a signal to global investors of our economic health. A downgrade would come at a very inopportune time.
Global investors are jittery. Their uncertainty has resulted in substantial volatility and growing weakness in global asset markets. Emerging markets such as SA are under extreme pressure.
A downgrade to junk would force many global investors to sell South African bonds because their mandates restrict investments to assets rated investment grade. Many large foreign investors allocate their savings according to the weighting different countries enjoy in global indices such as Citibank’s World Government Bond index. If SA loses its investment grade, it will be removed from these indices. Funds that track the indices will automatically sell their South African bonds.
As a result, borrowing by the government as well as businesses and state-owned enterprises would become more costly. Companies cannot be rated higher than their governments. So a downgrade would also trigger downgrades of South African corporate debt.
In the period 2009-13, foreigners bought more than R200bn of our domestic bonds. SA, along with other emerging markets, was more attractive than the low-interest economies of Europe and America. These purchases helped reduce the interest burden for the government in funding its deficit and provided foreign capital inflows that helped fund our large trading deficit.
Times have changed, and foreigners are now selling our bonds. In November and December last year they disposed of more than R20bn of our bonds. As a result, the interest rate the government pays on its long-term debt rose from 8.3% to 9.3% and the rand weakened sharply. A downgrade would trigger further outflows and probably even higher interest rates.
Higher interest rates increase the amount the government must allocate each year in the budget to fund its debt, leaving less to spend elsewhere. The full impact on the budget of higher interest rates will, however, take some time to be realised. This is because government debt is funded by borrowings that fall due over many years.
Initially, higher interest rates will affect only new bonds issued to fund the budget deficit and any debt now falling due. As more debt falls due in the years ahead and as the government issues new bonds to meet its repayments, the interest costs in the annual budget will become increasingly burdensome.
It is this frightening prospect that made the government recognise it must curtail spending. A major obstacle to cutting spending is the rising wage bill for a public service that has grown rapidly. This is why taxes will have to increase.
Even so, tax revenue cannot increase significantly until the economy grows faster, increasing the tax base. A growing economy depends on a thriving private sector.
Corporate SA is under huge pressure — something that the government has recognised very late in the day. It is now trying to engage positively with business. Accelerating growth will not be easy as we face unfavourable global headwinds. Reducing the budget deficit will initially weaken spending, which is negative for growth.
South Africans must brace themselves for difficult times and the government needs quickly to translate its words into resolute action if we are to weather these global and domestic economic storms.
• Keeton is with the economics department at Rhodes University