Why our budget deficit might not be such a good idea after all.

Treasury's decision to spend aggressively this year in an effort to stave off recession could have longer-term implications for the country's debt markets.

On Wednesday Finance Minister Trevor Manuel, said the country would rack up a budget deficit of 3,8% in 2009 as it spends R834bn on, among other things infrastructure and expanded public works and added that most of the money borrowed would come from the local debt markets.

Apart from the strain that might be placed on the local debt market, the ambitious spending programme, while economically correct, will stretch governments institutional capacity over the next three years says Chris Hamman, fixed interest strategist and Sanlam Investment Management.

According to Hamman, the increase in spending means that the amount government needs to borrow on a net basis now exceeds the interest amount payable to existing bond holders by R7bn.

This is important because in many cases investors in the bond market use the money they receive in interest to buy new bonds. But, in 2009/10, in order to take up all the bonds issued by government, they will have to find other sources of funding to make up the R7bn shortfall, which could put pressure on the market.

Also, for the first time in a number of years, government is going to have a primary deficit (when spending excluding interest payments to existing bond holders exceeds revenue collected) which may suggest that some of the proceeds from new issues will be used to pay the interest due to existing bond holders. This situation may have a negative impact on fiscal sustainability and thus government's ability to spend on discretionary items if left unchecked.

The primary balance is important, Hamman says, but it should also be seen in the context of the growth outlook and the expected real interest rate payable on government debt.

Jeff Gable, head of research at Absa Capital, told SAFM Market Update with Moneyweb, that the 1,2% growth number put out by government Wednesday is a little optimistic.

"Our own forecasts, for instance, are that the economy actually shrunk in the fourth quarter, on the back of data like we received from the manufacturing sector."

He added, "As growth surprises on the downside, you end up with difficulties on revenue, just as we saw in the budget for the current fiscal year. We've seen a downward revision of their revenue forecasts and, as a consequence the deficit for 2008/9 looks about 1% of GDP. That I would say is a clear risk as we look at the 2009/10 budget as well."

The increase in spending has also sounded warning bells at the rating agencies.

According to Kristin Lindow, a credit analyst at Moody's, the Budget forecasts are broadly in line with expectations.

"Moody's positive outlook on the government's foreign currency rating has been in place for about 18 months, however, upward pressure on the rating has diminished. In particular, Moody's is becoming concerned about how the deterioration in the external environment has affected the quality of the capital account of the balance of payments and the cost of new financing," she says.

Write to Geoff Candy: geoff@moneyweb.co.za

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