Heading off disaster

Ann Bernstein says Tito Mboweni needs to find a way to curtail govt's debt explosion

Tito Mboweni is, by now, putting the finishing touches to his budget, one that is being prepared in exceptionally constrained circumstances. South Africa’s economy is barely growing, while its citizens and businesses already hand over large proportions of their incomes to government and state-owned entities (SOEs), doing so with increasing levels of reluctance. At the same time, pressures to spend more money – to alleviate poverty, to provide essential goods and services, to make good on commitments made to public servants, university students, etc – are more intense than ever.

The challenges are greatly magnified by the explosive trajectory of government’s debt. SA’s debt sucks up a larger and larger proportion of government’s revenues, slows economic growth and ensures that what growth we do have is less inclusive. Unless this is turned around, and the fiscal consolidation that does this is accompanied by growth-enhancing structural reforms, SA will never get out from under the growing mountain of debt.

Between 1992 and 2018, SA’s public sector debt (i.e. the debt of both the state and its SOEs) rose 15-fold, from around R200 billion to over R3 trillion. Most of this rise occurred after 2008, with the nominal value of debt tripling in the past 10 years (figure 1).

Figure 1: Gross debt of national govt and non-financial public entities (SARB data)

Over the same period the value of SA’s GDP has also increased, of course, making any given level of debt that much more affordable. But including GDP in the calculation brings only limited comfort. The impressive progress made between 1994 and 2008 has been undone by the vast borrowings of the past decade which have seen the ratio of debt to GDP double from about 30% to about 60% (figure 2).

Figure 2: Gross debt as a % of GDP (SARB data)

The principal cause of all this is the large gap between spending and revenue that opened up in government’s budget after the global financial crisis 10 years ago, and which has never been closed (figure 3). This widening gap between revenue and expenditure is made worse by SOE quasi-deficits. In combination, the public sector’s net borrowing requirement has averaged more than R150 billion a year since 2009, and now exceeds R200 billion.

Figure 3: Revenue and expenditure of national and provincial government (SARB data)

The rapid rate at which SA’s debt is now increasing – much faster than the value of GDP – creates the possibility of truly awful outcomes – default, financial crises, even hyper-inflation. Such disastrous outcomes are not inevitable and some risks are remote, but their mere presence reflects the weakness of our public finances. Our future is now much more uncertain, which inevitably means slower long-term growth.

Along with the sheer volume of borrowing, these risks have raised the cost of capital, making it harder for firms and households to borrow, thus slowing growth. A larger and larger share of national income is also being consumed by payments for loans by government, households and firms, making everyone poorer.

The debt explosion means that growth will be both slower and less inclusive because more and more of our income flows from borrowers to lenders. Although this was not precisely what Thomas Picketty meant when he used the phrase, but South Africans now live in a world in which past borrowings are consuming the future.

There are a handful of variables determining whether the level of debt as a proportion of GDP will rise or fall: the size of existing debt as a percentage of GDP; the gap between the growth rate and the rate of interest government pays on its borrowings; and whether or not the public sector borrows more than the cost of its debt service costs.

In determining whether policy will lead to ever-higher levels of debt, these are the only variables that matter. And, as things stand, the trends are all pointing in the wrong direction. Existing debt levels are high, the rate of growth is significantly lower than the real interest rate, and we are running a large primary deficit (especially if one includes the SOEs’ quasi-deficits).

In the absence of faster growth, the only way government can tackle the deficit directly is by raising taxes (and other revenues such as electricity prices) or reducing spending.

As we have seen in recent years, however, raising taxes in a weak economy can be self-defeating, with less aggregate revenue generated as higher tax rates slow economic growth. Add the effects of higher rates on tax-payers’ willingness to comply, and it seems unlikely that pushing up taxes would actually increase revenues.

A much more plausible case can be made for slowing expenditure growth.

Over the past decade, government spending has grown faster than the economy as a whole. This will have to be reversed, if only because it is mathematically impossible for this to go on forever. Given the poor quality of public spending as a result of much-reduced standards of governance and performance in the public sector, the case for slowing spending growth to close the primary deficit is overwhelming.

Care must be taken to minimise the effects of slowing government spending on short-term growth, but unless government adopts a more aggressive approach to cutting spending, long-term growth rates will continue to fall as risks rise and the cost of capital climbs.

Slowing expenditure growth significantly can be achieved. We now have overwhelming evidence that corruption costs government a great deal. Savings can also be achieved by rethinking procurement rules: we have raised costs, inefficiencies and corruption in the procurement process through state incapacity and through the addition of numerous social and economic objectives to procurement processes. Critically, however, government also needs to reverse the long-term trend in payroll costs both in government and in SOEs, which have seen very significant real growth over the last decade.

Tackling rising government and SOE expenditure would go a long way to defusing SA’s debt bomb. It would be far better to do it now than to wait for some kind of funding crisis that would force policy-makers to make faster, deeper, more disruptive and more painful cuts.

If our public finances are to become sustainable it is absolutely critical that growth-enhancing reforms are implemented at the same time. Such reforms would emphasise the exposure and destruction of the networks of corruption that have insinuated themselves into the state; fundamental change in appointment processes towards a professional state; restructuring SOEs and liberalising the industries and markets in which they operate.

South Africa cannot return to fiscal health unless we raise our growth rate. The economy is in desperate need of a range of reforms to increase productivity, foster employment growth, and raise its long-run rate of growth. These reforms, which span everything from education, immigration reform, encouragement of labour intensive manufacturing and tourism to more effective urban management and improving the business climate including labour relations, are critical for long-term prosperity and transformation.

In the short-term government cannot shy away from the urgent tasks of fiscal consolidation. Absent this, there is little prospect other than tragic and unnecessary national decline.

Ann Bernstein, executive director Centre for Development and Enterprise. See forthcoming CDE report on SA’s fiscal crisis and growth.

Figure 1: Gross debt of national govt and non-financial public entities (SARB data)