South Africa’s 2004/05 government Budget, set for release on Wednesday, should reveal a “go for growth” strategy, tolerating an increase in the Budget deficit in the coming years, according to international investment bank Lehman Brothers.
While this might put pressure on the bond market by the second half of 2004 — causing yields to rise and the yield curve to steepen — as bond issuance reaches its highest level in 10 years, this expansionary fiscal policy could prove to be crucial to sustain economic growth in 2004 and beyond, Lehman Brothers economist Tolga Ediz writes in a Budget preview.
Overall, Ediz believes there will be little near-term market reaction to the announcement of the government’s 2004/05 Budget, as much of the government’s approach has been signalled in the November 2003 medium-term Budget policy statement (MTBPS), which updates both current-year progress and expectations for the next three financial years.
However, he projects there is likely to be a bigger-than-expected shortfall in government revenue for the current 2003/04 financial year, of about 0,4% of gross national product (GNP), thanks to a sharp decline in corporate tax, as profitability took a major hit from the economic slowdown and the strength of the rand.
Combined with the anticipated strong rise in public spending, Ediz says this should lead to a higher Budget deficit than the government’s estimate of 2,6% of GNP, to about 3,2% of GNP.
Deficit targets for the out-years should be adjusted higher by similar amounts, pushing the deficit target to 3,6% of GNP for the 2004/05 financial year compared with the government’s original forecast of 3,2%.
“Clearly, the government is willing to tolerate a higher Budget deficit to bolster growth,” Ediz writes. “Within that, further tax cuts are off the agenda: the MTBPS has tax revenues as a proportion of GDP [gross domestic product] remaining constant in the coming years. The government is instead looking to increase non-interest spending … projecting a further 0,6% of GNP increase in non-interest spending in 2004/05, remaining at that higher level for the following years.
“Any corrective measures on tax or spending (from the MTBPS) are unlikely. We expect the government to target a real-terms increase in non-interest spending of 6% in 2004/05, falling to about 4,5% in the following years, in line with previous plans.”
The government’s higher-growth Budget is likely to be bad news for the bond market, believes Ediz, coming under a “fair amount” of supply pressure in the coming years after having benefited from several years of net redemptions. Lehman Brothers estimates that more than R50-billion in domestic bonds will be issued in 2004/05, meaning a net new issuance of about R30-billion — the highest level in almost 10 years.
“We don’t expect bond markets to be spooked by the budget in the near term,” he hastens to add. “And bond yields could fall in the near term, with the South African Reserve Bank possibly pushing for a surprise interest-rate cut in two weeks’ time.
“But supply pressures could eventually tell. The trouble is that the financial system is not in fantastic shape to absorb the additional supply. Neither the pension industry nor banking system is growing in real terms. The yield on the 10-year R153 is likely to reach 10% by year-end from 9,2% currently, and the yield curve is likely to steepen in the second half of 2004.”
The economist goes on to note that the key worry for the South African economy in 2004 is rand weakness.
“The currency is vulnerable to a sharp widening of the current account deficit and a major pickup in domestic demand,” he writes. “We expect 2004 to be a much better year in terms of growth performance, with GDP rising by 3,5% versus 1,2% in 2003.
“But such an increase in growth will boost imports, leading to a widening of the trade deficit and a rising current account deficit that is likely to reach 3% of GDP. We are also pessimistic on the export outlook, because the rand is not competitive enough to take advantage of improving world trade.”
Their forecast is for the rand to weaken from the second half of the year, trading at about 7,5% against the United States dollar in 12 months’ time, a 15% fall from current levels. Consumer inflation, meanwhile, is expected to start rising from mid-2004 due to rising labour costs, higher consumer spending and a weaker rand, but CPIX (headline consumer inflation less mortgage costs, targeted by the South African Reserve Bank) is not expected to exceed the 3% to 6% target range in 2004.
Ediz says Lehman Brothers expects the Reserve Bank to lower interest rates by 50 basis points at its next monetary policy committee meeting on February 25 and 26, but thereafter monetary policy would be on hold. Bond yields were likely to begin rising in the second half of 2004 as the market started to discount expected interest rate hikes and higher inflation going into 2005, however. — I-Net Bridge
Budget could bring positive surprise