SUNDAY TIMES - Gordhan's medicine will not go down well
Sunday Times News By CAROL PATON, 2016-02-21 00:00:00.0

Gordhan's medicine will not go down well

Pravin Gordhan
Image: Matthew Lloyd Bloomberg

On Wednesday, Finance Minister Pravin Gordhan will carry the nation on his shoulders. What is said and done in this year's budget will decide whether South Africa becomes "junk" or if we can keep investment-grade status.

It's a cruel and unjust truth that just three organisations based in New York have the power to decide this for us.

Credit ratings agencies Moody's, Standard & Poor's and Fitch have, via the mysterious workings of global capitalism, established themselves as the judge and jury on who is creditworthy and who isn't. Using an inscrutable system of A's, B's, pluses and minuses and the likely outlook, the agencies rate a debtor's ability to repay debt by making timely interest payments and the likelihood of default.

Those who are less trusted must pay more to borrow. Right now, all three are viewing South Africa with a great deal of scepticism. Two have South Africa on the edge of junk and one just two rungs away. All three are negative in outlook, an indication that they expect things to deteriorate.

But Gordhan's and the ANC's problem is that many of the possible remedies are ones that ANC members, workers and voters won't like.

Cutting government spending, reducing the number of government jobs, privatising state-owned enterprises and raising taxes are now all squarely on the agenda.

In short, the pressure is for the government to take a hard-right turn and do the things necessary to improve the investor environment. At the same time, the ANC has committed itself to implementing new programmes that will cost even more. These include funding a national health insurance scheme and putting more money into higher education. There is also the urgent problem of drought relief and the promise of a minimum wage, which won't affect government costs but will raise costs for businesses and will be viewed negatively by investors.

Higher general taxes such as VAT, lower spending on government services and higher costs for basic services hurt poor people the most. Job cuts, privatisation and putting the brakes on a minimum wage and national health insurance are politically risky.

In the context of a harsher economic environment over the next year, all this opens the ANC up to attack from the EFF.

The most effective way to get more money would be to raise VAT. A 1% rise would bring in R20-billion

The EFF has made strides since the last elections by poking holes in the ANC's radical socioeconomic change story.

On Wednesday, Gordhan faces not just one perfect storm but two: an economic storm unparalleled since the mid-'90s and a political storm as voters run out of patience.

Junk status will mean that much less money, especially foreign currencies, will be invested in government bonds as well as shares and other investments. This is because many asset managers and pension funds are not allowed to invest in subinvestment-grade entities. But South Africa needs this money for its current account deficit which must be financed in order to pay for goods and services from the rest of the world.

For the government and state-owned companies such as Eskom, it means the cost of borrowing rises and capital markets increase their rates in line with risk. This goes for companies too.

If the government has less money to spend on goods and services, citizens, especially poor ones, suffer. Companies invest less when money is expensive. The prospects of economic growth diminish.

There are three main reasons why we got into this situation.

Trade unions that organise the 1.3million people the government employs have won great improvements for their members. Between 2008 and 2014, spending on wages of public servants in the departments that employ large numbers of people doubled. Last year, spending on wages consumed 40% of all government spending. Although the government planned to increase salaries by 7% last year, generous increases in housing and medical aid allowances meant salaries rose 10%. This will be compounded in the years ahead.

South Africa borrowed heavily to fund infrastructure and stimulate the economy, and now the cost of servicing the debt is out of control. Debt-servicing costs are the fastest-rising item of government expenditure. As the credit rating has deteriorated, the cost of borrowing money has risen.

Eskom, Transnet, SAA and other state-owned companies also borrowed expansively to fund new infrastructure. The government is often required to guarantee this debt. The result is that gross debt, which includes borrowing and guarantees to state-owned entities, has risen at an alarming rate. In 2008, gross debt as a percentage of GDP was 32%. In 2015, it reached 57.3%. The government has a self-imposed gross debt ceiling of 60%

As a result, the ratings agencies are concerned . When Gordhan stands up in parliament, they want to hear, above all else, that the government will get spending and debt under control. To show this, it must stick to its plan to cut the budget deficit before borrowing to 3% of GDP by 2017-18. This means cutting spending or raising taxes, or both.

They also want to see a change in spending: a reduction in the share spent on wages; a plan to reduce the debt of state-owned enterprises, perhaps by privatising; and a plan to get economic growth going. This would lead to greater income from taxes and allow important spending, such as on infrastructure.

To meet the 3% deficit target, it's estimated that the government needs to find an extra R30-billion a year on average over the next three years.

Economists estimate that a 5% cut in spending on goods and services would raise only R10-billion a year. Increasing taxes also brings in surprisingly little. Raising the top tax rate to 43% for those who earn more than R1-million and to 50% for those who earn more than R2-million sounds like a good idea politically. But it would bring in only R6.8-billion more.

The most effective way to get more money would be to raise VAT. A 1% rise would bring in R20-billion a year. But this is the least palatable of all options politically.

Growth prospects for 2016 look miserable, with estimates of less than 1%. Without igniting growth, tax revenues can't rise and the government can't spend to meet social needs. The easiest way out of the political trap is to cut spending on infrastructure. But doing so will choke growth. It is the least palatable of the options economically.