Medium Term Budget Policy Statement: Comments by Economists

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Finance Standing Committee

16 November 2003
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FINANCE PORTFOLIO COMMITTEE
17 November 2003
MEDIUM TERM BUDGET POLICY STATEMENT: COMMENTS BY ECONOMISTS

Chairperson:
Ms B Hogan (ANC)

Relevant documents
Submission by Prof Ben Smit
Submission by Mr Mandla Maleka
Submission by Mr Dennis Dykes

SUMMARY
Three economists were invited to provide their input on the MTBPS. During the discussion on the three submissions, Members sought clarity on the reasons for the strengthening of the Rand in recent times, the impact of the stimulatory fiscal policy and the tax cuts in recent years and whether micro-enterprises should not be invested in on a large scale instead of the short-term Public Works Programme. The economists were requested to indicate whether they believed the current economic policy would be able to absorb the 40% unemployment rate, whether government's efforts should not instead be focused on ensuring a stable and predictable currency rather than a strong Rand and whether the emergence of a relatively low interest environment would create a "property bubble" in the South African mortgage market.

MINUTES
Introduction by Chairperson
The Chair stated that the Committee would hear all three submissions on the Medium Term Budget Policy Statement (MTBPS) and then engage the economists in a question and answer session.

Submission by Prof Smit
Prof Ben Smit, Director: Stellenbosch University Bureau for Economic Research, addressed the Committee in his private capacity as an economist. His submission (document attached) outlined the macro-economic forecasts and the macro-economic policy aspects for the MTBPS.

Submission by Mr Dykes
Mr Dennis Dykes, Chief Economist: NEDCOR Group Economic Unit, addressed the Committee in his private capacity as an economist. He welcomed the reduction of the interest rate bill, and the increased emphasis placed on capital spending as this would build the economy's capacity. The focus placed on job creation and poverty alleviation in the MTBPS was good, and it was appropriate that the fruits of fiscal discipline could now be enjoyed. Mr Dykes cautioned against potential problems if revenue totals disappointed due to weak global situation and the reversal in the performance of the Rand, and he welcomed the extension of the tax amnesty. He contended that the inflation targeting figures were easier to understand but might be difficult to reach.

In his submission (document attached) which provided a brief economic background, the government's macroeconomic assumptions, the budget arithmetic and the overall fiscal stance and the assessment of fiscal policy to direction.

Submission by Mr Maleka
Mr Mandla Maleka, Chief Economist: Eskom Treasury, addressed the Committee in his private capacity as an economist. He congratulated the Minister on the combination of prudent management of the fiscal policy and similar management of the monetary policy that enabled the recovery of the Rand. Mr Maleka believed that it was correct to introduce large spending increases in the social services sector in recognition of growing incidence of unemployment and the HIV Aids pandemic. It was not too concerned by the rise in the budget deficit but cautioned against any significant break-away from low deficit ratios.

Mr Maleka's submission outlined the social expenditure component, a revision of the growth, budget deficit and inflation target figures, Black Economic Empowerment (BEE) allocations and the tax reforms in the MTBPS.

Discussion
Mr L Zita (ANC) sought clarity on the reasons for the strengthening of the Rand in recent times.

Mr Dykes responded that the Rand has benefited from an improvement in South Africa's fundamentals. South Africa had been marked higher in the international scoreboards and credit ratings, after it had come through an emerging market crisis very well, and having maintained fiscal monetary discipline etc. The second factor was very much a global factor because, as the American Dollar had continued to fall, people have sought out currency with limited downward potential and with good interest return. South Africa has fitted the bill on both scored perfectly, because it was a sophisticated market which allowed people to move in and out very easily and, consequently, it has been the home for short term funds in recent times in line with other fairly highly-yielding currencies.

It was not necessarily a solution to the problem to slash interest rates, because it would initially prop up the currency as people would recognise the opportunity for even further capital gain. This would be the case because a cut in interest rates would increase bond prices, and would decrease bond yields and would ironically actually attract more funds in the very short-term. Ultimately the South African interest rate should decrease and resemble the favourable interest rates of other countries, but the volatility of the global currencies would also have to stabilize.

Prof Smit stated that the other factor that affected the Net Forward Open Position (NFOP) was the local factor. He stated that it concerned him that the perception amongst many exporters that government in a sense supported an output oriented approach, whereas the case now appeared to encourage them to merely contain their costs. This occurred especially in the manufacturing industry. These were the advantages of a strong currency but, unfortunately, some people did feel let down. This was however the reality of the market experience.

Mr Zita sought clarity as to whether specific industries were affected by the "squeezing of profits", or whether this occurred generally.

Mr Dykes replied that the marginal mines industry was affected, the textiles and clothing manufacturing industries have also come under significant pressure as well as the motor vehicle component parts industry, to a certain degree.

Prof Smit stated that companies that compete with imports have also experienced this. He stated that some of the BER surveys contained a breakdown of the manufacturing industry in 19 different sectors.

Mr Zita asked whether it would not be more prudent to invest the funds that were currently allocated to short-term Public Works programme into asset formation and land reform initiatives as well as large scale investments in small-scale businesses, as these would provide more sustainable livelihoods.

Mr Maleka responded that this was a valid concern, but it must be remembered that the extensive Public Works programme served to at least empower the unemployed to be introduced into the real economy. This would provide them with a sense of worth and would allow them to uplift themselves, and seek something more from the real economy. This was not a sustainable programme, but it could operate as an intervening strategy in the medium-term to at least alleviate abject poverty.

Prof Smith stated the relative assignment of funds to the Public Works programme was reasonable, given the particular priorities of government to this aspect at the moment.

The Chair contended that this was an interesting issue, but could probably not be fully discussed in this meeting. It was particularly interesting with regard to its impact on SMMEs (Small Medium Micro Enterprises), because there did not appear to be visible enough support for SMMEs and their growth.

Mr Zita sought clarity on the impact of the stimulatory fiscal policy in recent years, and the past tax cuts.

Prof Smith replied that it must be remembered that much of the R15b tax cut announced by Minister Manuel would actually be clawed back as a result of the progressiveness of the tax. This would however deal with the inflationary impact on the rise in the rate that would have occurred otherwise, or the fiscal drag, and then some. He stated that his impression was that the tax cuts did certainly contribute to the stimulating of demand, and it also affected consumer demand. Thus the macro-impact of government's decision would have stimulated both the lower taxes and the expenditure.

The question which then must be answered was whether it would in fact be possible to stimulate the economy over a long period of time going forward by spending. A stronger growing economy could be created if the spending were focused on infrastructure and capital goods investment.

Dr P Rabie (DA) requested Prof Smit to further clarify the statement in his submission that "the Rand should be less talked up".

Mr Dykes responded to these two statements by stating that it would be a negative development if Ministers were to say that the Rand was really too strong and should fall significantly, because the markets would tend to give in to it very quickly. It was a much more difficult task to keep a currency propped up and to prevent it from depreciating. The general consensus in the market would be that there should be a lack of commentary altogether, and the trading activities of players in the market should thus be interpreted as the commentators and analysts see fit.

Prof Smit stated that the "taking up" has come primarily from the South African Reserve Bank (SARB) and the Treasury has been much more cautious in its approach, and it was important that they do not "talk down". In 2001 the opposite occurred, and it did at times contribute to an extent to the depreciation of the Rand.

Mr M Tarr (ANC) requested Prof Smit to provide clarity on the "expanding education and training" aspect mentioned in the submission, because it has been contended that there was a mismatch between what educational institutions were producing and what the economy actually needed.

Prof Smit replied that he was not best placed to answer this question, but stated that it was clearly an area that needed attention. Approximately 6-7% of the GDP was allocated to education and training, which was rather high by international standards, yet South Africa was still in a position to claim that it had the best education system in the world. The recent trend amongst Stellenbosch University students has been a much greater entrepreneurial awareness, as students were much more focused not only on receiving training but rather on receiving an education that would guarantee them a good job.

Mr Tarr requested Prof Smit to respond to the proposition that South Africa would be able to "survive very happily" on a strong Rand in the absence of any tariffs imposed on exports, if this were possible.

Prof Smit responded that the lowering of domestic tariffs encouraged more foreign competition, and actually resulted in a slightly weaker Rand. The changes effected to South Africa's trade policies in the early 1990's was instrumental in bringing down inflation, perhaps more so than the efforts of SARB. The introduction of- and the large role played by foreign competition in South Africa was an important part of that change from 14% inflation down to the 8% rate. He agreed with Mr Tarr that the exchange rate would have to reflect the substantial reduction and simplification of the South African tariff structure. This would however require a somewhat weaker currency than would otherwise be the case.

Dr G Koornhof (ANC) stated that the International Monetary Fund (IMF) projected average GDP growth for other African countries was substantially higher than the South African countries, even though South Africa was one of the leading economies on the continent. He asked Mr Dykes to explain the reasons for South Africa's low projected GDP growth.

Mr Dykes replied that the comparisons were difficult to make because many African economies were just coming out of recovery situations, and were thus starting at a very low base. The South African economy has gone through a period of very strong structural change, from an economic as well as a politico-social view, and these matters do take some time before dividends could be reaped. He stated that these dividends were definitely bearing fruit now especially in terms of the South African fiscal policy, but in recent years South Africa definitely had contractionary fiscal and monetary policies which government had resolved. The chances were definitely that South Africa could move to a higher structural growth rate in future, once all these issues were in place. There was thus no reason why South Africa should permanently remain at a 3,5% growth rate.

Dr Koornhof stated that the micro-enterprises and SMME's sector did not necessarily need financial assistance, but rather managerial and skills needs. He asked the presenters to indicate whether they were of the opinion that government should in future concentrate instead on the micro-enterprises within the SMME sector.

Mr Maleka responded that it would be a difficult exercise to require the foregoing of support to SMME's and to redirect that funding to micro-enterprises, and it would be preferable if both could thrive in the same environment. South Africa had a fairly thin-stretched skills base due to the structural imbalances of the past, as the State did not have the entrepreneurial culture to immediately divert from SMME's to micro-enterprises.

The war against unemployment would be won much easier if investments were focused on SMME's rather that micro-enterprises, and a vast investment in micro-enterprises was needed. The micro-enterprises often involved just an individual, and the financial mechanism of that structure could prove somewhat complex. Yet an SMME could involve a small group of individuals, and this structure could be managed much better. The strategy should thus focus on both SMME's and micro-enterprises concurrently, without biasing either.

Prof Smit agreed that the broad SMME sector should be focused on, with specific recognition of the micro-enterprises.

Mr K Moloto (ANC) asked Mr Dykes to explain the factors that he believed would be playing a much larger role in reaching the estimated growth figure of 3,6% for 2006, as contained in the submission.

Mr Dykes replied that this would partly be due to the structural change he referred to earlier, as the gains from all the changes affected would only realised now. By 2006 a much more benign global view of the situation would be pencilled in than was expected for 2005. The breakdown contained in the submission indicated that NEDCOR was confident that fixed investment trends over the next couple of years would be very strong, and there seemed to be no reason for the consumer spending to drop below the 3-4% levels.

The new wave of BEE initiatives that will come through over the next couple of years will also have a stimulatory effect in the short term, and the beneficial effects would possibly even come through more strongly by 2006. There were thus a number of good initiatives which laid the foundation for growth. South Africa could easily have a 3,5% growth rate in 2004, if the International Monetary Fund (IMF) forecasts were correct.

Mr N Nene (ANC) contended that the opposite view was held by Prof Smit in his submission, as he forecast a 2,4% growth rate in 2004. He requested Prof Smit to explain the reasons for the difference of opinion.

Prof Smit responded that the particular reason why the BER forecast a reduced growth rate was that part of its forecast ran to 2008, and by that stage the current account on the balance of payments for the previous years would become such a problem and also had such an impact on inflation that government would have to increase interest rates. This was the cyclical theory and the reasoning behind the 2,4% forecast. According to this scenario there would be a technical slowdown in 2008, and after that year the growth rate would return to 3,5%. It was however very difficult to forecast exactly how the market would perform in 2006.

Ms C Botha (DA) [NCOP] stated that despite the rosy forecasts for the growth rates predicted, this did not appear to solve the problem with unemployment. She stated that Prof Smit indicated that salary and wage increases until 2006 would remain at 5%, and suggested that the increased reliance placed by families on their wage earners would place pressure on the wage increases.

Prof Smit replied that the figures contained in the submission were compiled by government, and stated that it would be interesting to note whether government would be able to get away with a 5% wage increase if inflation remained at 5%. He suggested that the more accurate figure would probably be closer to 6,5-7%, in terms of normal experience.

South Africa had many single wage earners and extended families, and government should not use wages and salaries to attempt to eradicate poverty and other problems. It should instead provide broadly for the conditions in which South Africans could look after themselves, find employment and also create the conditions under which employment could actually be created. Government's role in creating this was limited and the sustainable answer to the unemployment problem lay in the vibrant operation of the private sector, which included SMME's and micro-enterprises.

Dr G Woods (IFP) requested Prof Smit to clarify the tax ratio versus the revenue ratio as a percentage of GDP as reflected in the submission, because expected the total revenue figure to be larger than the tax figure in this regard.

Prof Smith responded that he had used the national accounts numbers for general government, with both the direct and indirect taxes as a percentage of GDP. The figure of 27% indicted in the slide entitled "Taxes: total tax burden" reflected the national account figures from the personal income account of the South African Reserve Bank. The figure of 24,8% indicated on the slide entitled "2003 MTBPS projections" referred to the main budget figures, and the revenue would clearly have to include the taxes. He stated that this matter involved two different basis of calculating the figures. Treasury would be best placed to provide an answer to this matter.

A representative from Treasury agreed with Prof Smit that there were two different basis on which these were calculated. One was calculated at general government level and the other at main budget national government level. This was reflected in the difference between the two.

Dr Woods asked the presenters to indicate whether the degree of expansionism in the MTBPS was appropriate.

Prof Smith replied that he was not of the opinion that the economy was being over-stimulated in the process, as his submission instead focused on the long-term structural impact of that. The question would however arise as to whether over-stimulation was occurring in the shorter term. He stated that he would not be concerned at this stage, given the extent of the capacity available in the economy especially in the production sectors to deliver on the demands. He stated that he would however be concerned about the position with the result that the balance of payments, because over-stimulation of demand would simply result in increased imports because of the strong Rand, and this was the risk that would be run.

This risk was not only due specifically to the budgetary policy, but instead was due to broader concerns such as the continued strength of the Rand or whether interests rates should be cut further beyond the December 2003 expectation. It may even happen that the current account on the balance of payments could deteriorate very quickly, even more so than the current expectations. Under these circumstances government would then be able to retrospectively evaluate whether the expenditure increases from Treasury's side were excessive.

The Chair asked how the beginning of the emergence of a relatively low interest environment would impact on the consumption expenditure by consumers, especially with regard to property prices and mortgage bonds. The creation of a low interest environment in the United States resulted in a virtual "property bubble", and a significant degree of debt was carried by the mortgage market. She asked the presenters to indicate whether they expected similar reactions in South Africa.

Mr Dykes responded that the United States, United Kingdom, Australia and a number of other economies did experience a property bubble. This was one of the reasons that informed the Australian Reserve Bank's decision to raise interest rates, because the property bubble had gone too far. During the whole of the 1990's there was a strong secular downtrend in interest rates. The rates did not simply fluctuate over several years but in fact moved from fairly high interest rates to practically zero, in some instances. In the housing market this typically became an affordability factor, because the more the interest rate dropped the higher the property prices.

There would be some effect in the local market, and this has in fact already occurred. There was no question that the housing market over the last few months has responded to the interest rate cuts, and would probably continue in that trend over the next few months as well as mortgage finance would increase quite significantly. Thus, to some extent, as soon as people could afford more, the prices would increase. He stated that he was of the opinion that that pattern would repeat itself.

The question then as to whether South Africa was following suite would depend on whether inflation was beaten permanently, or whether it was simply ""knocked in the head because of the Rand" and whether it would then bounce back up. NEDCOR Group was of the view that a 6% inflation figure was expected on a long term structural view, but SARB disagreed and suggested that there was no reason that inflation figures should not settle at lower levels. If it did settle at 6% it could be argued that there would be limited further downward potential for interest rates, and this would only bode well for the housing market.

Prof Smit stated that a colleague of his observed that there appeared to be an increase in the purchasing of property, and was interesting as it suggested that people have become more confident about property. It also reflected their disillusionment with the returns received in other asset classes. He suggested that South Africa appeared to be returning to the situation in 1983, as far as real house prices were concerned. The creation of a "property bubble" was some distance away although the house prices have increased quite substantially, but it was largely been in a "catch up" fashion.

He suggested that there was a broad concern among economists that excessive reduction of interest rates, together with the continued strength of the Rand, the current situation low growth in the production sectors and continued strong demand in consumption and to some extent investment, would create a problem.

Dr Woods asked whether it was generally agreed that the MTBPS did mark a discernable shift in emphasis from growth stimulation to social welfare.

Mr Maleka replied that over the last decade exhibited a stabilisation of the South African economic front, which was very necessary. Government could not adopt a very expansionary approach in supporting a welfare agenda, given the high interest and inflation environments, and it was generally a government prone to increasing debt as well. As a result of this, government first had to stabilise that position to allow it to begin welfare programmes. This did not mean that government did not invest in welfare over the last decade, as there has been substantial amalgamation and collapse of inefficient structures. The result was that government could today reap the benefits of that stabilisation mechanism and move with speed "to begin to satisfy the huge welfare appetite". He stated that he was thus not of the opinion that there was a vast shift from growth orientation to welfare, and sufficient expenditure on welfare would be recovered via VAT.

Ms S Nqodi (ANC) sought the opinion of the presenters on the success of the labour intensive Public Works Programme, in view of the challenges of globalisation and the effects of trade liberalisation. She sought specific clarity on the effects thereof on BEE, as the small and emerging organisations would struggle to compete with the long established big businesses in the corporate world.

Mr Maleka responded that it was clear that, since the early 1990's, South Africa had to break away from structures that were reliant on tariffs and a protectionist economy, and begin to at least align South Africa with the international demands of retiring some of its tariffs and protection. On the other hand it was impossible to ignore some of the South African realities, such as unemployment, which was a very pressing social imperative. This problem would necessitate a short-term interventionist strategy to at least alleviate this, and the labour intensive Public Works Programme was appropriate here. The long-term would have to entail very sustainable structural inputs, such as the development of the education pool to compete globally. South Africa would inevitably have to align its trade policy with the regulations and requirements of the World Trade Organisation (WTO) in the long-term.

Mr Dykes stated the one area in which there were labour intensive jobs that were globally competitive was the services industry, and a good example here would be the tourism sector. In this sector an increase in number and demand necessitated an increase in numbers employed, as that was the reality of the matter in that sector. The unemployment rate was very large and there were a large number of people that would have to be employed. It was not a hopeless task because it had been successfully turned around in other countries.

Mr Zita requested the presenters to explain whether, in their opinion, the current economic project of the country would ever absorb the 40% unemployment rate.

Mr Dykes replied that it must be remembered that the unemployment problem was a legacy, but it could also be regarded as a huge amount of potential that was not currently being used and which could contribute to growth significantly in future years.

Prof Smit stated that this problem was undeniable, and there were no "magic answers" as to how it could be solved as quickly as possible. He suggested that it would take a number of generations to solve this problem, and government had set itself a target to cut the current unemployment rate by half by 2014. The best solution would be found in identifying means by which government could empower people to care for themselves, and this was clearly evident in government's plans.

Mr Jaya Josie, Financial and Fiscal Commission Deputy Chairperson, stated that economists appeared to focus on the strength or weakness of the Rand and questioned whether it was not more important to have a stable currency rather than a strong currency. It was his opinion that the stability of the currency did, at least for a period of time, provide the kind of certainty and predictability in which government could then its monetary and inflationary targets.

He asked whether it would be possible to establish a five year period within which the inflation rate could be stabilised. He asked whether the balance of payments could have such a negative effect on the stability of the inflation and interest targets, because of the global economy, that South Africa would not be able to sustain a predictable and certain level of targeting in government's policy.

Mr Dykes responded that a certain amount of flexibility in the exchange rate was desirable. It was one of the important price mechanisms, particularly in a situation in which other prices could not move up and down as easily, and it did provide a safety valve in the economy. He stated that no-one would disagree with Mr Josie that a more stable currency would be desirable.

It was fortunate that the conditions for a more stable currency were beginning to fall into place. One of the big factors in 2001 which placed the currency under so much pressure was the reduction of the very significant NFOP. The other very technical factors that were also plaguing the currency have now largely been taken out of the market. A further technical position would be the size of the country's reserves and its liquidity position and, again, South Africa was basically building up this liquidity. He suggested that there was thus a chance that the economy would see more stability, going forward.

South Africa could decide to fix the exchange rate, but this could also result in a host of other problems as was the case in Argentina, and Thailand to a lesser extent a few years ago. Those countries experienced "hopeless over-evaluation" and massive increases in inflation. He contended that South Africa has lived through this period of volatility and it could now hopefully look forward to something better, going forward. Any attempts to change the entire system would not be desirable.

Mr Maleka stated that a stable South African currency would definitely be supported. There were a range of other developments that were beyond the control of the country, especially factors such as oil crises or political tensions in the Middle East which could have an affect on the South African currency.

The economy has however reaped the benefits of those development which it could control. These include the elimination of sources of Rand weaknesses, be it in the NFOP or over-reliance on commodities, and there has been a gradual shift away from these factors. The result was a strengthening Rand, and it might become more stable going forward. There has thus been a stabilisation of these kinds of sources of weakness on the currency.

Prof Smit agreed. The problem was that the entire system would have to be changed if stability was sought. If efforts were made to generate stability in the exchange rate, which was in itself very difficult to do, this would probably generate substantial instability in other areas. In 1998 government sought to control this problem via the interest rates, and the huge increase in interest rates had quite a negative impact on the economy.

There were unfortunately no easy options here, but South Africa's experience has been quite exceptional. He agreed with Mr Dykes that an increased stability going forward, barring major shocks, was hoped for.

The Chair thanked the presenters for their very valuable input. The meeting was adjourned.

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