Fiscal credibility means economic agents believe what the fiscal authorities announce as their target primary budget balance, and that they will achieve it in the time frame they set. SA’s fiscal credibility has deteriorated since the financial crisis, and the risk remains that this could persist if Treasury continues to miss its budget targets.
As part of tabling a balanced and sustainable budget, the 2020 Budget Review must aim to re-establish fiscal credibility, which has huge implications whenever it is lost.
Loss of fiscal credibility has two main problems. First, bond yields remain elevated, which means the cost of borrowing by the state increases or remains high, crowding out another productive spending that could help lift economic growth, such as investment.
Second, in the context of a constant need for higher social spending in SA, loss of fiscal credibility and the resultant higher interest bill necessitate higher taxes in future to close the revenue gap.
Last week I constructed a simple picture decomposing the SA 10-year bond yield into its basic components: the US 10-year risk-free rate, SA’s sovereign risk premium and the rand risk premium.
I could have further disaggregated the sovereign risk premium into its credit risk (credit defaults spread) and country risk (the residual), but not doing so does not steal the thunder of the argument.
The US risk-free rate has moderated since the 2008 global financial crisis, while the currency risk premium has remained relatively unchanged. In contrast, the sovereign risk premium has gradually widened since the crisis, reflecting to a large extent SA’s gradual fiscal slippage and the subsequent credit ratings downgrades as the country’s credit risk increased.
In a normal functioning economy with fiscal credibility, when inflation falls bond yields also fall. Yet SA’s 10-year bond yield has remained elevated. This is because the market, which largely determines the price of government debt, has lost the belief that the goals the government announces in its budget will be met. Fiscal credibility has been lost. Bond yields remain elevated despite a significant moderation in inflation outcomes, which should have resulted in lower bond yields.
Second, given that personal income taxes and corporate tax rates are already stretched as sources of new tax revenues, administered prices become the next most obvious source of revenue.
The problem is that these types of revenue-raising mechanisms have been inflationary in the past five years. Administered prices and sin taxes, which constitute about 22% of the consumer basket, have been the main reason inflation remained elevated in SA relative to the rest of the world.
If we disaggregate the consumer price index (CPI) into public sector CPI, which is largely taxes and cannot be controlled by central bank monetary policy actions, and private sector CPI, it is obvious that public sector CPI has been the reason for sticky headline inflation outcomes, averaging close to 6% in the past five years. Private sector CPI continued to trend closer to the lower target band of 3%.
Without the loss of fiscal credibility one could argue that the interest bill would not be as large, and as a result administered prices would not have risen above the inflation target, which drove headline inflation higher. This means there is an increasing problem of fiscal dominance, where fiscal policy outcomes have a disproportionate impact on monetary policy outcomes.
In simple terms, we would have much lower headline inflation had it not been for Treasury’s need to raise taxes through administered prices. With much lower inflation, we could also have had much lower, growth-boosting interest rates.
While forecasting macroeconomic variables is inherently difficult, it is important that the Treasury sticks to the fiscal rules and targets it sets, as far as its primary budget balance, expenditure ceilings and debt targets are concerned, if it is to reclaim the fiscal credibility it had in its glory days.
• Mhlanga is chief economist of Alexander Forbes.
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