AS FINANCE Minister Nhlanhla Nene prepares to present his first medium-term budget in Parliament on Wednesday, he might be looking back rather wistfully at his predecessor Pravin Gordhan’s first budget five years ago. "This is indeed a difficult time," said Gordhan in October 2009 in the midst of the global downturn that pitched SA into recession and led to a R70-billion shortfall in tax revenues.

But if it was difficult then, it is immeasurably more so now. SA had gone into the downturn with a budget surplus and low government debt, so Gordhan had the space to increase spending and let the deficit grow to stimulate the economy and try to prevent the worst of the recession.

Five years on, that space is long gone and Nene is faced with a faltering economy, a revenue shortfall of R15-billion or so, some big spending pressures and ever-rising government debt. Faced with a growth rate much lower than anyone would have expected a year ago, he does not have the space to run up the deficit to support growth. Indeed, he is supposed to be doing quite the opposite: SA was meant to be bringing the deficit down over the next three years to a level at which the government-debt ratios would start stabilising. The February budget projected that the deficit would fall to 4% this year and to less than 3% in two years’ time. But that assumed the economy would grow 2.7% this year, and more than 3% in the next couple of years.

That is clearly not going to happen.

Nene’s credibility will depend in part on his economic growth forecast, and while it may not be as low as the 1.4% the International Monetary Fund (IMF) has predicted, it is unlikely to be much higher. That means much lower than expected tax revenues, and a higher deficit, not just this year, but in the next three years. And that in turns means government debt, which was a modest 27% of GDP going into the downturn, will rise to levels nearer double that, raising questions about SA’s ability to sustain and finance that debt.

Looming over this budget is the threat of further downgrades from international credit rating agencies, causing a steep rise in borrowing costs and large outflows of capital.

All indications are that this is going to be a very tight budget — probably even more austere than the market expects.

How Nene has managed to pull this off politically is an intriguing question. But it is not only the rating agencies that the government would be worried about. Nor is SA alone in its plight. "Fiscal risks are on the rise in most countries," the IMF says in its latest Fiscal Monitor. It talks of the need to rebuild fiscal buffers that were used during the crisis. And it points to three risks in middle-income emerging market economies — lower potential growth, prospects of tighter financing and rising contingent liabilities. All are highly pertinent to SA’s case.

Looming over this budget is the threat of further downgrades from international credit rating agencies, causing a steep rise in borrowing costs and large outflows of capital.

First, growth. The real problem is not just that growth is going to fall short. It is that SA may be looking at permanently lower growth. That has major implications for fiscal policy. The economy’s potential growth rate — the average it can sustain over the longer term — is about 3%-3.5%. But after years of poor growth and constraints such as infrastructure and skills, that is being revised down, with the IMF now estimating SA’s potential growth rate at closer to 2%-2.5%.

That is key to fiscal ratios. It suggests tax revenues may not perform as they have in the past. And, in theory, as long as you are running deficits faster than the potential growth rate, the debt-to-GDP ratio keeps increasing. Which is why the "neutral" target for SA has been 3%. Not only are we not getting down to that, but the target may be too high, and the chances of reaching it worse than before.

Second is financing. As government debt has increased, so has the cost of financing it. Borrowing costs are now the fastest-growing item of government spending. That "crowds out" other spending, leaving less space for the government to invest in infrastructure or buy textbooks or medicine. It also risks getting SA back into the kind of rising debt spiral it worked so hard to escape in the 1990s.

Borrowing costs are going up globally as interest rates start to normalise in advanced countries and to rise in SA. The really big risk, though, is how vulnerable SA’s debt burden makes it to bouts of global market turmoil. SA’s "twin deficits", fiscal and the current account, leave it particularly exposed to negative sentiment towards emerging markets.

The threat of a ratings downgrade adds huge risk to it all — and not only in relation to the government’s debt burden, but to that of state-owned entities, particularly Eskom.

This touches on the IMF’s third set of fiscal risks — rising contingent liabilities. Nene is faced with demands for support from an increasingly lengthy list of public entities that are in trouble — from Eskom, to South African Airways and from the South African Post Office to the Road Accident Fund.

The government has already provided more than R466-billion in guarantees, mainly to Eskom. Add these "off balance sheet" liabilities to the debt on the government’s balance sheet and the fiscal position is stretched. And in Eskom’s case, the government has promised an equity injection of about R50-billion, as well as guarantees. It has said it will find the cash through the sale of nonstrategic assets. This week’s budget will be closely watched to see if Nene is serious about asset sales.

The fiscal constraints certainly suggest the government should be looking to the private sector for more funding of and participation in public services such as education and health as well as in the provision of public infrastructure. But Nene’s most urgent task will be to address the deficit and debt issues. He is likely to do so by curbing spending and increasing taxes. The government imposed a spending ceiling two years ago, limiting real growth to just less than 2%, and Nene is likely to reduce that further.

That will mean little support from the fiscus to boost growth or job creation. Nene may make cuts, and the markets and the rating agencies may welcome that. But his priorities and what he cuts matter a great deal. Already, the composition of the budget is far too biased towards current spending, particularly on social grants, which can’t be cut, and on public servants’ pay, which makes up more than a third of spending.

A tight budget will mean the wage bill, social grants and borrowing costs are a big chunk of spending, while textbooks or clinics or bridges are relatively less of it than before. That might work in the short term but the damage will be felt to the fabric of the economy and to public services and public infrastructure in the longer term.

But perhaps in crafting his budget, Nene might have looked at the first medium term budget to be tabled in Parliament, in 1998. That was also in the midst of a global crisis. The tight budgets of the late 1990s were the crucial first steps in creating the fiscal space that helped SA weather the 2009 recession and in building its credibility in international markets and its investment grade rating. But the legacy of deep cuts to skills and infrastructure spending is arguably still being felt. So, as much as markets might welcome austerity, they should be looking carefully at whether it is the right kind of austerity.

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