S.A: Beyond the 2017 Budget

By now everyone has had some time to digest the Budget Speech, and specifically how the R28 billion increase in the tax burden that largely falls on individuals will impact us. The new top marginal tax bracket of 45% only applies to 103 000 taxpayers, who will on average pay R3 500 per month more in income tax. There are 7.4 million registered individual taxpayers in South Africa, but  6.5 million fall below the threshold income and don’t pay income tax.

The immediate market reaction to the Budget was fairly positive, but South African markets are so closely connected to global markets that it is often difficult to disentangle domestic from foreign drivers. Ultimately, one wouldn’t expect a big market reaction because the October mini-Budget already gave clear direction; last week was just a case of giving us the details.

Commitment to narrow the deficit

The 2017 Budget retains a commitment to narrowing the budget deficit to an internationally acceptable level of 2.6% of GDP over the medium term and stabilising the government debt to GDP ratio. Fortunately, unlike the previous four years, the global climate is more favourable this year. Global economic activity is speeding up, especially in Europe where economic growth has reached its fastest rate in six years and positive business and consumer sentiment suggests that it will be maintained.

Similarly, Japan is enjoying decent growth (by its standards). US economic growth is strong enough for the Federal Reserve to consider an interest rate increase soon. Commodity prices have firmed up substantially over the past year, and investor sentiment towards emerging markets has improved, reversing the sustained capital outflows of the previous five years. When Minister Gordhan delivered the Budget Speech last year – soon after he was parachuted into the position – the rand was at R15.26 against the US dollar. Last week, it closed at R12.94.

South Africa benefits from all these trends, and the local economic outlook has therefore improved. In the short term, fiscal consolidation is a drag on economic growth, but should not derail this recovery. Whereas the economy barely grew in real terms last year, Treasury expects growth to rise to 2.2% over the next three years. These numbers represent an improvement off a low base, however, and will not dent the unemployment rate.

Perhaps the biggest criticism of the Budget was the lack of reform announcements and measures to stimulate growth. But it is important to remember that the Minister of Finance and the National Treasury control Government’s finances and not economic policy and implementation.

Hurdles for a ratings reprieve

Consider the ratings outlook, for instance. In a recent panel discussion, S&P Global’s local representative reiterated that South Africa’s ratings hinge on three issues. Firstly, expectations for improvement in economic growth and fiscal performance. Secondly, signs of weakening institutions would put downward pressure on ratings since it could lead to a deteriorating investment climate. Thirdly, risks posed to Government’s finances by the State Owned Enterprises (SOEs).

Of the above, the Minister only has direct control over the fiscal performance, and even there not as much as he would like. To begin with, the overall thrust of fiscal policy is a Cabinet decision, not Treasury’s alone. But the actual outcome of fiscal policy is dependent on the performance of the economy. The problem over the past four years has precisely been that the weak economy has put tax revenue under pressure. Complicating matters somewhat is that the economy responds to fiscal policy too. For instance, sharp tax hikes could choke off the nascent recovery. On the other hand, tax incentives can encourage growth and job creation in targeted sectors, as the World Bank recently pointed out.

South Africa’s institutional strength was stress-tested last year. When flimsy charges were brought against Pravin Gordhan, the combination of media freedom, a vibrant civil society and independent courts prevailed. And our central bank was willing to hike rates to maintain its inflation-fighting credentials even though there was an election around the corner. The election itself and the subsequent peaceful transfer of power in key metros also demonstrated the strength of our institutions. Few, however, doubt that 2017 will see further strains as we gear up for the ruling party’s elective conference at year-end. Major policy shifts before the conference are unlikely.

In terms of the SOEs, there is some control by Treasury, since Treasury signs the guarantees that make up Government’s contingent liabilities of around 10% of GDP. But the overall structure, objectives and governance of the SOEs rests with Cabinet, not with Treasury. The financial underperformance of the large SOEs – the return on equity of the 16 largest SOEs in the 2015/16 fiscal year was only 0.8%, well below any reasonable estimate of the cost of capital – is not only a drag on the fiscus, it can also hamper economic growth.

It is also important not to lose sight of South Africa’s ratings strengths. These include world-class financial markets and a well-capitalised banking sector. Government is therefore not dependent on borrowing in fickle foreign markets, exposing it to currency swings (foreign debt is only 10% of the R2 trillion total).

As long as economic growth improves in the short term, and provided there is no institutional deterioration, South Africa can hold on to its investment grade rating. This would be a positive surprise, given that global market pricing places us in the same camp as other “junk” economies like Russia and Brazil.

Structural reform needed

Faster economic growth over the longer term is not only important for job creation, it is also necessary for fiscal sustainability as it will lead to growing tax revenues for Government, which can be spent on welfare, education and health without resorting to additional borrowing. Structural reforms to lift the long-term growth rate include lowering barriers of entry to increase competition between firms, providing young people with easier access to the job market, ensuring fewer strikes, improving transport infrastructure, attracting skilled immigrants until such time as our own people are better equipped, effective land reform and greater regulatory certainty, especially in capital-intensive industries like mining.

The first chapter of the Budget Review highlights that 2016 was the first year private fixed investment contracted since global recession, a sign of rock-bottom confidence. It then lists a number of items on Government’s to-do list that could lift investment (including finalising mining regulation, expanding the independent power programme, and concluding analogue to digital migration) where responsibility rests with other departments within Government. Unsaid, of course, is the lack of certainty around the position of the Finance Minister, which has drained business and investor confidence over the past 14 months.


Chart 1: Rand-dollar exchange rate

 Old Mutual Chart 1 27 Feb 2017

Source: Datastream


Chart 2: Projected consolidated budget deficits

Old Mutual Chart 2 27 Feb 2017


Source: National Treasury

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