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14 Rands and sense Achieving an Impossible balance By: Bradley Mitchell, Head of Research, Sasfin Wealth By: Mike Haworth, Investment Strategist, Sasfin Wealth By: Alec Abraham, Senior Equity Analyst, Sasfin Wealth So how about cutting back expenditure The 2017 National Budget appears to be a slightly less demanding exercise than in 2016 on signs of a moderate, but still sub potential, rebound in growth. However, it is important to note that this expected improvement in growth is being driven by factors that are out of government’s control; namely higher commodity prices and a dissipating drought. Sadly, opposing factors, many of which the government has influence, remain potential impediments to achieving and sustaining much needed higher growth. This growth imperative remains crucial to offset the deficit imbalance that continues to face pressure from increased current expenditure as a result of factors such as the growing social spending priority. The main factors that would make the task of fiscal consolidation even more of a headache for National Treasury include the following: • Sustained low growth; • Execution risk; • Policy uncertainty; and • ZAR disruption. Current Budget Position 1.3% In the latest South African Reserve Bank (SARB) monetary policy statement, a set of assumptions were provided, one of which was the estimated potential output growths. 20161.3% 20171.4% 20181.5% The concern is that these are still very low growth rates and suggest a serious erosion of South Africa’s potential output growth in the last few years. More importantly, it implies that monetary policy is not as accommodative as it appears at first glance. The potential growth rate and related output gap form an integral part of the price formation process in the South African economy. The output reflects the degree to which activities and processes in the economy are under pressure from excessive demand and thus generating inflation, or alternatively, under-performing and thereby pointing to reduced inflationary pressures. 1.4% 1.5% Estimated potential output growths for 2016 Estimated potential output growths for 2017 Estimated potential output growths for 2018 15 Rands and sense Revenue Growth The three largest components of national government revenue are personal income taxes (37% of national tax revenue), company income taxes (17% of national tax revenue) and ValueAdded Tax (VAT) (25% of national tax revenue). These three components contribute 80% of the national government revenue. Total revenue growth for the fiscal year to date to November 2016 slowed to 7.1% year on year from 11.1% in the prior comparable year. This growth was largely derived from a 9% increase in personal income and capital gains taxes, the largest contributors to total taxes, while company taxes increased by 4.1%. This suggests that the national government revenue imbalance persists. Medium Term Budget Adjustments In the MTBR, National Treasury lowered its revenue forecast for fiscal 2017, but a much lower consolidated expenditure reduction resulted in the main budget balance deficit to still increase to 3.4% of GDP. Main budget balance deficit to increase by R8.7bn to R165.0bn With this ongoing deficit, National Treasury highlighted the need to institute consolidation measures. We continue to believe that Treasury will aim to achieve this through proposed tax increases combined with expenditure cuts each year through to 2019. A concerning feature in the revenue mix is the decline in taxes on payroll and workforce due to minimal job growth and a changing job mix. Even more troubling was the very low growth in net VAT revenues up only 4.5% to R180.78bn. The fundamental growth driver for tax revenue growth is personal income taxes. As the National Treasury looks for more revenue to compensate for low company and VAT tax revenue (this year a R23bn revenue shortfall) it is planning additional tax increases each year through to 2019. These increases are over and above the R15bn announced in the Feb-2016 budget. Budget Targets In the MTBR, the expenditure ceiling was budgeted to increase by a compound rate of 7.5% per annum over the next three years. National Treasury has progressively lowered this expenditure ceiling in nominal terms. The expenditure ceiling is the non-interest spending financed from the National Revenue Fund and is one of the key metrics watched by the international rating agencies to ensure that SA maintains fiscal discipline given the low growth and changing political bias. Revenue Growth The three largest components of national government revenue are personal income taxes (37% of national tax revenue), company income taxes (17% of national tax revenue) and Value-Added Tax (VAT) (25% of national tax revenue). These three components contribute 80% of the national government revenue. Total revenue growth for the fiscal year to date to November 2016 slowed to 7.1% year on year from 11.1% in the prior comparable year. This growth was largely derived from a 9% increase in personal income and capital gains taxes, the largest contributors to total taxes, while company taxes increased by 4.1%. This suggests that the national government revenue imbalance persists. A concerning feature in the revenue mix is the decline in taxes on payroll and workforce due to minimal job growth and a changing job mix. Even more troubling was the very low growth in net VAT revenues up only 4.5% to R180.78bn. Bradley Mitchell, Head of Research, Sasfin The fundamental growth driver for tax revenue growth is personal income taxes. As the National Treasury looks for more revenue to compensate for low company and VAT tax revenue (this year a R23bn revenue shortfall) it is planning additional tax increases each year through to 2019. These increases are over and above the R15bn announced in the Feb-2016 budget. 16 Rands and sense Expenditure growth Against the background of a non-interest expenditure ceiling, which was introduced in 2015 as an overt measure of fiscal consolidation, noninterest expenditure rose 4.5% in the year to date to November 2016. The State debt cost was up 16.5% year to date to November 2016 on the back of continued rising net debt levels. Debt levels in september 2016 Fiscal consolidation Domestic debt The National Budget now allocates revenues exceeding R1 trillion per year. Yet the quality of spending needs to be improved. Too much public spending is regarded as wasteful, too much is ineffectively targeted and too little represents value for money. The Medium Term Budget Policy Statement (MTBPS) proposes to narrow the budget deficit and stabilise debt. This policy of fiscal consolidation is designed to prevent rapid capital outflows and their consequent economic disruption, which would set back transformation, and lead to higher unemployment and social distress. +R144bn to R1,963bn National Treasury is attempting to balance the consolidation between higher taxes and lower expenditure growth. Proposals include a combination of tax policy measures that will raise an additional R43 billion over the next two years, and reduce the expenditure ceiling by R26 billion. These steps compound on consolidation measures announced in the 2015 and 2016 Budgets. Social spending is still getting priority. 44.8% of GDP Foreign debt South Africa’s gross public debt stood at R2,156bn in September 2016, equivalent to 49.2% of GDP. When public sector cash balances are netted off the net public debt level was R1,954bn, equivalent to 44.6% of GDP. -R7bn to R193bn 4.4% of GDP 17 Rands and sense Expenditure over the period 2017 to 2020 Health Human settlement and municipal infrastructure +8.2% Social protection +8.0% Post school education and training +8.2% +9.0% The lowest expenditure increases are in general public services up 4.1%, agriculture, rural development and land reform up 4.8% and economic affairs up 4.9% over the period 2017 to 2020. The consolidation measures proposed in this MTBR are likely to have some dampening effect on economic activity. But the alternative over the medium term would likely be a further loss of confidence and a ratings downgrade, which could trigger higher interest rates and large capital outflows. The latter’s risks are greater risks to the economy than the likely effects of fiscal consolidation. Risks Sustained low growth Sustained low growth will force National Treasury to make more difficult allocation choices as its current payment demands overwhelm the tax revenue received. This will compromise government’s capital expenditure objectives and plans. It will also put increasing pressure on National Treasury’s budgeted main budget expenditure ceiling. Personal income tax growth is likely to come under pressure as corporate SA are likely to find it increasingly difficult to pay 8% per annum nominal wage growth when corporate gross operating surplus growth is as low as 4% per annum. We estimate the population of SA’s major urban areas to be growing at a rate around 5% per annum,made up of 1.7% population growth and the balance the urbanisation rate. With a high urban population growth rate and low economic growth, minimal employment growth can be expected. Therefore, urban social demands do not go away when there is low growth, rather the social protection needs escalate. National Treasury continues to increase personal taxes at the high end of the income spectrum and the marginal tax scale continues to steepen. Indirect taxes, rate and taxes and utilities are all set on steep sliding value and usage scales. The progressive taxation (direct and indirect) will disposable income of the higher income groups will come underpressure which will impact consumption growth. In the latest Quarterly Establishment Survey to Q3:2016, formal sector community services and personal services employment (most of which is public sector related) compensation growth was 10.4% YoY in Q3:2016, slowing to 8.5% YoY in Q3:2016. Alec Abraham, Senior Equity Analyst, Sasfin Wealth 18 Rands and sense Execution Risk The main execution risk lies in wage growth. In this regard, the expenditure ceiling has limited the hiring rate of public sector employees. This may be easier to control in general administrative positions but the growing urban population is placing greater pressure on police, security, healthcare, education and social welfare staffing. The largest inflation-linked expenditure is wage growth. The key risk therefore lies in the under estimation of inflation which could result in demand for higher wage growth. Policy Uncertainty Cabinet changes and politicking have been undermining National Treasury’s effectiveness in the last 18 months. Rumours abound that the President is about to reshuffle his cabinet again. The rumours linger that the ANC leadership want to remove the Finance Minister Pravin Gordhan. The attacks on Gordhan by the New Age and ANN7 media, calling him a “White Monopoly Capital” stooge, have intensified and have been reinforced by opinion on his attendance at Davos in January 2017. In November 2016, the deputy finance minister Mcebisi Jonas was quoted in the Public Protector’s State Capture report that he had been offered R600m by the Guptas to become Minister of Finance. Deputy Minister Jonas together with other senior politicians in the National Executive committee are likely to be replaced after the revelations in the State Capture report. This could place Finance Minister Gordhan under more pressure from a new Deputy Finance Minister and the ongoing power struggle with the Head of SARS. The continued challenge by students using the “fees must fall” campaign has already contributed significantly to unplanned expenditure and this challenge does not appear to be fading. Contingent liabilities associated with the State-owned Enterprises (SOEs) including the Road Accident Fund (RAF). Government’s major explicit contingent liabilities are its guarantees. The guarantee facilities stood at R469.9 billion at the end of 2015/16, while the total guarantee exposure was R263 billion at the end of 2015/16, since several entities had not fully used their available guarantee facilities. The largest guarantee exposure – more than R170 billion – supports Eskom’s capital investment programme. An exposure of R200 billion relates to the IPPs. The contingent liability risk is high in PRASA, SAA, SABC, RAF but looks to be reducing in the Post Office, SANRAL and the Land Bank. South Africa’s Sovereign Credit Ratings Rating Agency Current foreign rating Current domestic rating Rating Outlook Rating Outlook Moody’s Investor Service Baa2 Negative Baa2 Negative Fitch Ratings BBB- Negative BBB- Negative Standard & Poors BBB- Negative BBB Negative Investment Information Inc. BBB+ Negative A- Negative In mid-January 2017, Standard and Poors Global (SPG) warned that South Africa’s credit ratings still hang in the balance. The economic growth trajectory still looks too low. The country’s rating being one notch above sub-investment grade leaves no room for error. SPG also highlighted that 2017 looked likely to be busy politically because the African National Congress (ANC) is heading for an elective conference which could result in changes in government. Further ministerial changes and increased litigation undermines policy implementation, which elevates the risk of credit downgrading significantly. Other risks such as “fees must fail” demands, persistent contingent liabilities in State Owned Enterprises and growing social support pressures look unlikely to abate in fiscal 2018. The international credit rating agencies repeatedly cite the strength and independence of its key institutions as a key factors protecting the constitutional base of South Africa and providing a backbone to the investment grade ratings. These key institutions are: • National Treasury, • The Auditor-General, • The Reserve Bank, • The Independent Electoral Commission, • The Public Protector, and • Judiciary and the courts. 19 Rands and sense ZAR disruption The continued and intense politicking around National Treasury raises doubts about its continued independence. The Reserve Bank is seen to be independent and that monetary policy is conducted independently to maintain price stability in the context of weak growth and is not a pawn in the State political power struggle. The Public Protector’s office has a new Public Protector in Busisiwe Mkhwebane who replaced Thuli Madonsela when her tenure ended in 2016. In the new Public Prosecutor’s first 100 days she has asked the police to probe the leaking of the audio recording of Madonsela’s interview with President Jacob Zuma and shelved the former Public Protector’s State Capture report. The independence of the Public Protector’s office is now in some doubt. This is reinforced in the timing of a preliminary report by Public Protector Mkhwebane provisionally finding that the apartheid-era bank bailout of Bankorp was unlawful and Absa Bank could be forced to pay R2.25‑billion to the fiscus. Absa responded describing the preliminary report as containing “several factual and legal inaccuracies” which distort the context and hence judgement. The judiciary is increasingly being overwhelmed by South African politics which is becoming progressively more litigious. While this is substantially boosting demand for legal and court services, it is placing an increasing financial burden on government expenditure and extending the courts case backlog. Both factors are eroding the judiciary system effectiveness. The latest court battle between the Guptas and Gordhan is a further distraction for the Finance Minister. Mike Haworth, Investment Strategist, Sasfin Wealth The strengthening ZAR is driven by yield seeking foreign portfolio capital inflows is likely to be disruptive given the very slow expected real growth and static or slowing nominal GDP growth in the South African economy in 2017 and the rising risk of increasing US protectionism and its negative influence on already slowing global trade. In Summary National Treasury’s task of lowering the budget deficit and slowing the rise in public debt to GDP continues to pose a challenge, particularly in the context of weak, albeit improving, domestic economic growth and growing structural imbalances. Even though the need for fiscal discipline in South Africa remains critical, the consolidation measures are likely to have some dampening effect on economic activity. But the alternative over the medium term would likely be a further loss of confidence and a ratings downgrade, which could trigger higher interest rates and large capital outflows. The latter’s risks are greater risks to the economy than the likely effects of fiscal consolidation In conclusion, faced with a plethora of risks that could upset the potential to reduce the budget and fiscal deficits, tax payers, particularly high income earners, will be forced to carry a greater portion of the of the deficit reduction burden.