Medium Term Budget Policy Statement: Economists' Responses

Meeting report

FINANCE PORTFOLIO COMMITTEE
2 November 2007
MEDIUM TERM BUDGET POLICY STATEMENT: ECONOMISTS' RESPONSES

Chairperson: Mr N Nene (ANC)

Documents handed out:
Sanlam Group Economist presentation "The 2007 MTBPS: Short on detail"
Industrial Development Corporation: Inflation developments presentation
Rand Merchant Bank oral presentation only

Audio recording of meeting

SUMMARY
Economists from Sanlam, Industrial Development Corporation and Rand Merchant Bank briefed the Committee on their responses to the Medium Term Budget Policy Statement. The economist from Industrial Development Corporation pointed out that South Africa was following a prudent policy, but he was concerned that the policy was responding counter-cyclically, with high borrowing costs, and thought perhaps greater flexibility was needed. Inflation would be high for several years. He would caution that there were downsides to increased global competition. The State had not fulfilled promises to the poor in providing efficient transport, and was having to import some food.  He wondered whether it was correct for South Africa to keep using the interest rate to curb inflation. There was a need for more structural investment. Although inflation targets were important, he thought the 6% band was too narrow.

The economist from Sanlam noted that the statement had failed to address some issues. The objectives remained the same, but it was clearly up to other arms of government to implement policies and improve service. Structural policy issues were important. There must be a sound fiscal position and a surplus.  Consumption expenditure must be disciplined to create room for investment spending. He had predicted higher rates of inflation. He did not believe that the 6% inflation would last for as long as IDC had suggested, but that it would come down. He did not agree with the argument that one should not raise interest rates, because food and energy inflation were beyond the Reserve Bank’s control. The Reserve Bank’s approach was consistent. He agreed there must be emphasis on structural reform. There was a need for caution on the government wage bill. Increased costs would result from the introduction of the National Social Security System, and he would have liked to see more statements on this, on the industrial policy, more on inflation targeting, exchange controls and Eskom.

Rand Merchant Bank’s economist was pleased to note that the deficit had been reduced, and there were better credit ratings. There was better management of the economy. However, part of this better turnaround was simply good fortune, not only good management. South Africa was still running a large current account deficit. He did not agree with critics of the Reserve Bank, who said that the interest rates were too high, and he would support the raising of interest rates to ensure that growth was sustained. One of the problems was the shortage of skills. To maintain the better budget balance numbers, it was necessary to have the ratio of revenue to GDP rise sharply. The pace of spending, although slowed down, was perhaps not yet sufficient.
He outlined that in fact the rand was weak in comparative terms, and it would not be correct to try to manipulate the level down through cutting interest rates.

Members asked questions on trends in steel and cement, the impact of the international situation, how best to contain inflation, without using interest rates, the main drivers of food production, infrastructure financing, particularly for Eskom, and how the Committee should look at food pricing strategies. Further questions related to biofuels, growing and persistent imbalances, whether South Africa could be run as a socialist state, how government should encourage investment, tariffs in agriculture, the current account deficit, unproductive spend, the wisdom of spending the surplus, and the desirability of an inflation target.

MINUTES
Industrial Development Corporation (IDC): Briefing
Mr Lumkile Mondi, Chief Economist, IDC, briefed the Committee on inflation developments pointed out that South African had a prudent fiscal policy, with high levels of confidence, economic growth and investment. More importantly, these were symptomatic of gross domestic product (GDP) per capita growth, showing a huge improvement generally in living standards of South Africans. On the investment side, the Capex spending should drive the economy to high levels in the next six years. Companies were exploiting resources, and there had been investment in companies like Eskom and Transet. However, there was also much concern that the monetary policy was responding counter-cyclically, with high borrowing costs. Many blacks trying to come into the economic cycle were finding themselves disadvantaged. Many countries had experienced rapid decline of inflation, which benefited the poor. He contended that perhaps in periods such as the present worldwide climate, some flexibility was needed.

Commodity prices such as oil were globally of concern. The concentration on bio-fuels meant that food prices were rising. In South Africa there was huge pressure to create capacity, because the current capacity could not sustain a growth above 6%. Much was still being imported because local producers could not meet demand due to under-investment in capacity Food was globally the biggest concern, and inflation in this sector had risen across the world. In emerging markets, the poor spent most of their income on food and transport. In USA there were high levels of producer price inflation. He believed that inflation was here to stay, for several years. China, which had recently put in funding into South Africa, was probably a better country for comparative purposes, as it was similar to South Africa, with a large population, with a first world economy in the cities, but many poor people. Its inflation was following similar paths to South Africa.

In South Africa prices had risen sharply over the past two years at the manufacturing level. On the positive side, the rand had been quite robust, which was good for inflation, but bad for exporters. This raised several issues. The Minister of Finance had spoken of trade, but this was more complex than free trade, and covered also protection of own interests. In practice, all economies must look after the national interest. He would caution against getting over excited about increased competitiveness.

At present, the poor were under much pressure just in terms of gaining access to food. The State had failed the poor in providing efficient transport, forcing many to borrow. He tabled a slide showing comparative prices in milk, meat, fats and oils and food, noting that South Africa was already having to import milk products.  The import demand for mineral products had increased. Over the first nine months of this year, the value of imported mineral products had already increased by 40%. Less hectares were planted under maize, and the emphasis on bio-fuels meant that less land was put to food production.

Mr Mondi pointed out that National Treasury had indicated that inflation would come down. He believed that the target of 6% was not attainable as yet. He questioned whether it was correct for South Africa to keep using the interest rate to curb inflation. He noted that South Africa had already been experiencing power outages, and there was a need, in his view, for more structural investment. He pointed out that the Consumer Price index (CPIX) had been higher than the predicted 6% ceiling for the last months.

Mr Mondi concluded that inflation would have a huge impact on investment. There was still temptation to keep prices high, which he thought was the wrong decision. His argument was summarised that the use of inflation targets was very important for South Africa. However, the 6% band may be too narrow. Low inflation was good for the poor, but the global events were beyond the Reserve Bank and Minister's control. If the fixed investment programme was to be supported, then monetary and fiscal policy must be aligned. He urged Treasury to increase the range up to 8% and the Minister to emphasis outward growth as well as employment. Halving of employment would require massive investment. This would only be possible if the policies were aligned.

Sanlam Economist's Briefing
Mr Jac Laubscher, Group Economist, Sanlam, noted that he would be touching also on the issues Mr Mondi had raised, including the inflation target. Firstly, he noted that this was the first Medium Term Budget Policy Statement (MTBPS), which went beyond the current government, with entry of the new government in 2009. The 2010/2011 budget would be influenced heavily if the national social security system were to proceed in 2010, and that meant that the budget numbers would be substantially altered.

Mr Laubscher was often asked by investors in South Africa and abroad about the changeover in the Presidency. He said that the critical question was whether there would be continuity in economic policy. There was no reason to think that this would not happen. The acid test was continuity in fiscal policy and the MTBPS played an important role in cementing the perceptions around fiscal policy.

Mr Laubscher was a little disappointed in the statement, not so much in what it said, but what it had not addressed. He had the impression that perhaps it had been scaled down; the presentation related largely to tax numbers, not policy. This was of course not a mini-budget.

There were a number of overriding themes, and the objectives remained the same. He had the sense that fiscal policy had done its part, and there was little additional it could do now to achieve the objectives, so that it was now up to the other policy arms of government in terms of policies and better execution. Structural policy issues were equally important.  He had the impression that the gains over the last ten years - reducing debt ratios and deficits - must be preserved for the sake of continuity. The statement had emphasised economic imbalances and risks, and emphasis should be on sustainability of the fiscal position. If there was a large current account deficit, then potentially there was the risk of a currency crisis, and the best way to counter that was to have a sound fiscal policy, and a surplus. Fiscal policy must also support monetary policy, and this was a further theme that came through.

Mr Laubscher noted that the revised macro-economic forecast, when compared to the budget forecast, had risen with inflation, which implied higher interest rates. The theme of growth being rebalanced, and consumption expenditure playing less of a role than investment implied that consumption expenditure must be disciplined to create room for investment spending. The current account deficit was quite high, but this was projected quite far into the future. He tabled a comparative of the budget, the MTBPS and the forecast of Sanlam. In 2008,the MTBPS saw a lower level for inflation than Sanlam was forecasting. He did not believe that the 6% would last for as long as Mr Mondi had suggested, but that it would come down. Sanlam was predicting slower growth next year, and a drop in inflation in 2009.

The MTBPS had emphasised the growing and persistent imbalances in the economy. Core inflation excluded fresh produce, and had a lower level than CPIX inflation, but the trend was the same. If one excluded energy prices also, the trends would still remain the same. So, in terms of the monetary policy response, excluding the international influences, there would still be the same conclusion that the policy must be tightened. He did not agree with the argument that one should not raise interest rates because food and energy inflation were beyond the Reserve Banks' control. If this argument were to be taken through to its logical conclusion, then food prices would have to fall. He felt that the Reserve Bank approach was consistent. The international situation would always be uncertain, although he agreed that currently the international crises were exacerbating the situation. All forecasts were suggesting that economic growth would slow down, from 5.2% this year to 4.8% next year. He suggested that this must be looked at over the next two years and there were risks lying ahead. Slow down in growth was coupled with higher inflation. Growth was important for capital flow to emerging markets, and if growth slowed down those countries with current account deficits would be worst at risk. There were only a few countries, including South Africa, Turkey and Hungary, with large deficits. Caution was required, monetary policy must be supported, and tighter fiscal policy would reduce the need for higher inflation. He had believed the tax relief for individuals had been inappropriate, which he said had contributed by increasing disposable income. He agreed there must be emphasis on structural reform.

In response to the risks, the Government had now introduced the concept of a structural budget balance, joining other countries in the concept. This had been necessary and useful. This emphasised that high commodity prices and improvement in trade terms had given a windfall. There was a reverse in the declining trends over the past ten to fifteen years. From Treasury's perspective, the economy was growing above potential. Sustainability required conservatism. He described this as a "soft" concept, as it would depend on various assumptions. It was often difficult to separate cyclical and structural change. The upward trend since 2000 had followed after a fifteen-year downward trend. He thought at least part of the current situation arose from structural change, making it difficult to predict the long-term trend. Treasury had suggested 4.6% output. This was recognised methodology, but was rather mechanical. Output was a moving target that was difficult to predict. Sanlam welcomed this information, but felt that the principles were more important than the numbers.

Mr Laubscher noted that the upward revision to gross tax revenue was more than most people expected. Perhaps SARS was moving to a more accurate figure. He noted that almost half of the upward revision was allocated to public corporations.

He noted that the projected growth in revenue was increased in spite of reduced growth forecasts. He was surprised at this, and asked whether this was to do with introduction of the structural balance, that encouraged government to be more bold than conservative, rather than give the best forecast and counter this by asking how much was of a cyclical nature. He noted rising expenditure and rising cash balances. He noted the need for caution on the government wage bill, which had in real terms increased 1.8% per year and was intended to increase substantially more up to 2010. This was part of the responsibility of government, but should be watched to ensure it did not get out of hand. The tax burden also pointed to a broadening in the tax base that had not been fully passed on in terms of lower tax rates, and this policy must be borne in mind for later.

Further matters to note were the national social security system (NSSS) and the wage subsidy. He accepted that there were ongoing discussions and Government was not yet clear on its position. There were differences of opinion between National Treasury and the Department of Social Development. The wage subsidy did not necessary have to go with the social security system. He would have liked to see a progress report on this.

He thought the industrial policy was also vague. The policy announced in July had a programme of action, and there were some deadlines, many of them being December 2007 through to March 2008. The MTBPS had not said how Treasury was intending to engage with the industrial policy framework approved by Cabinet. Hw though a public debate was needed

There was little on the tax policy, particularly on the tax administration burden on small business. Nothing had been said on inflation targeting. He noted that keeping quiet could be a way of answering something. However, this was not something that could be ignored. He supported the position that there should be no change to the inflation targets at this stage. The credibility of the whole policy regime would start to be questioned. However, he did not think it was appropriate to brush it off. Specifically, he noted that the different types of employment and the role of monetary policy. Cyclical unemployment would result from changes, but structural unemployment was long term. USA had also stated that it must ensure full employment, and their unemployment was around 4.7%. South Africa would not address structural unemployment by not raining interest rates when inflation went up. It was more of a structural question for the economy to deal with, than for the money policy.

He further noted that nothing had been said on exchange controls; South Africa must bear in mind that China’s investment meant that Standard Bank would be paying dividends out of the country, and he was also concerned that they were buying into an exiting revenue stream, part of which was siphoned offshore. He would prefer to see buying into a new revenue stream. He thought he foreign liability asset position must be borne in mind. Entering a negative foreign liability situation would raise question marks on sustainability.

There were finally two references to how the public corporations would finance their spending. Nothing had been said about Eskom, and the impression was given that Government did not intent to make any capital injection. A few years ago it had been said that the public corporations should be handled on a commercial  basis. The government, as the shareholder in Eskom, would benefit from returns on increased investment and he felt there should be an investment into the business. The only other sources would be increased tariffs but customers could not be asked to put equity into the business. If Eskom was to borrow heavily it would mean deterioration in its finances, particularly if there were capping of tariff increases. The matter of dividend flow from Eskom to Treasury should be clarified. It would to his mind be inappropriate for a dividend flow at present. It was not a question of affordability; but he thought that Eskom was being treated differently from other levels of government. There was a statement in the MTPBS that support would be available to public corporations, but there was no mention of energy , and he felt that this was an important national interest. The tariffs were too low, but there could not be a shock increase. Government would have to adjust.

The accelerating growth would be retained, which was fine. Improving sustainability would contribute to national statements. It removed infrastructure bottlenecks, created employment, accelerated growth, and contributed to industrial and trade reform, where treasury also had a role to play. The proposed wage subsidy would also protect take-home pay of lowly paid workers when they had to contribute to NSSS. The reduction of poverty and inequality was happening, with creation of employment, safety net, a social wage, ongoing redistribution and increased allocations to health, education and training and their access to the economy via infrastructure.

Rand Merchant  Bank : Response to MTBPS
Mr Rudolf Gouws, Chief Economist, Rand Merchant Bank, said he would be focusing on the economic background to the MTBPS. He was pleased to note the budget deficit had been reduced, and South Africa was now in a surplus situation. The ratio of national debt to GDP had declined, but this was no longer hiding the problem through inflation. This was a genuine decline as a result of the budget deficit. South Africa had managed to reverse the long-term upturn in the ratio of the interest to spending. This meant that there was more money available for things other than "passive" spending on interest. Mr Gouws noted that South Africa now had better credit ratings, meaning that foreigners were more willing to fund current account deficits. This was positive.

Mr Gouws said that South Africa had been fortunate in that commodity prices had risen as sharply as they had, and that the terms of the trade were improved. South Africa could purchase more from abroad for every unit that it produced locally. Not only had income risen, but interest rates had fallen. There was major capital inflow, so on three fronts there were boosts to the domestic economy. This provided the basis for the strong growth recently. There was better management of the economy. However, part of this better turnaround was simply good fortune, not only good management. There had also been the ability to afford the large current account deficits that ha recently developed. A current account deficit was the difference between imports and exports, the difference between what it spent and what it generated as income, and the difference between savings and investment.

An important point noted candidly by the Minister noted that despite rising terms of trade, South Africa was running a large current account deficit. In asking how the deficit developed, one must look to fiscal and monetary policy. Growth in demand (the sum of government, investment and consumption spending) was 8% whereas growth in Gross Domestic Product (GDP), or output, was 5%.The gap was an explanation for the current account deficit. This was where he did not agree with critics of the Reserve Bank, who said that the interest rates were too high.. The prime overdraft rate, in the period of falling interest rates, encouraged spending, and the interest rate cuts of 2004/05 were decided upon to try to increase growth. At the time there had not been recognition that there were constraints through skill shortages, and this led to bottlenecks, as domestic demand grew. Cutting interest rates did not result in more skilled people, nor more infrastructure. He would support the raising of interest rates to ensure that growth was sustained.

Mr Gouws suggested that the fiscal policy must be looked at in the same framework. There was a budget balance. The rapid growth was partly an explanation why the deficit was reduced. He was glad that matters had evolved as they had, for both fiscal policy and the effect of interest rate cuts on monetary policy. Comparing South Africa with other emerging markets, it sat was at the bottom in the sense that it was living beyond its means, and had inflation double that of the countries that were running surpluses. With the exclusion of Russia and Venezuela (both of whom were oil exporters but had high inflation) other countries running surpluses, including China, had low inflation rates. The deficits in South Africa did not result from growing so rapidly. Mr Laubscher had made a valid point. All capital inflows were portfolio type flows, and if the Ministry stressed the need for a countervailing fiscal policy it should have  the support of parliament. The Reserve Bank deserved support rather than criticism. Printing more money would not give jobs.

Finally, he was concerned by the trend in government spending. To maintain the better budget balance numbers, it was necessary to have the ratio of revenue to GDP rise sharply. The pace of spending, although slowed down, was perhaps not yet sufficient.

Mr Gouws noted that there was a popular misconception around the strength of the rand. The Japanese exchange rate had fallen sharply, because of inflation. He tabled statistics from other countries and noted that the rand was at the bottom of the league in terms of its value. None of the currencies had been weaker than South Africa in real effective terms, despite being similar in their commodity export basis.

He tabled nominal exchange rates, plotted against the rand. The rand was exactly the same as it was in 2000 against the Philippine currency, and had fallen 40% since 2006. As against the Indian currency it was 10% lower. Against the Korean it was 5% lower, and against the Chinese currency was 20% lower against this than it was in 2000. It would not be correct to try to manipulate the level down through cutting interest rates. An abolition of exchange controls may lead the rand to weaken but it could have a more market-determined rate and would therefore be useful.

Discussion
Mr K Moloto (ANC) asked if there had been monitoring of trends in steel and cement production, and mining, and if there had been significant investment in those sectors in terms of their capacity. He referred to the international situation and queried its recent developments and impacts. He asked the IDC what would be the best route to contain inflation, without using interest rates. Finally, he asked what were the main drivers in maize production.

Mr N Singh (IFP) asked Mr Laubscher about Eskom financing, noting that the Minister had implied that if all was going well, matters should be left alone. There had been no request from Eskom for infrastructure funding.

Mr Singh agreed with Mr Laubscher that perhaps there was a need to meet with the Portfolio Committee on Trade to speak of incentivisation, particularly in rural areas. Urban renewal was happening but perhaps the policies of the past, even though they were not the best, might give pointers to how to accelerate industrial development.

Mr Singh noted that there had been a long debate on the effect of food prices on inflation. The Minister had circulated comparative figures on food inflation, and he noted that food in some countries was accounting for 75% towards inflation. He asked for Mr Mondi's views on how the Committee should look at food pricing strategies. He wondered if some countries were artificially increasing prices and thereby their own profits.

Mr Singh asked Mr Mondi to expand upon the bio-fuels industry and the impact it was having on food production.

Mr M Johnson (ANC) spoke of administrative prices. He said that interesting statements were made about the support to other public corporations, save for Eskom. He asked if the economists were saying anything to government about this particular entity, whether it was able to sustain itself and its business. There had been statements that some State Owned Entities were "bottomless pits"

Mr Johnson asked if the raising of prices in Eskom would happen if it had a monopoly. Government had agreed on private investors coming into the energy sector, but this would a long-term strategy. At the moment Eskom was in a similar position to where Telkom had been.

Mr Johnson said a statement was made about not expecting fiscal policy to cover all ills. He asked the presenters to expand on this, and to suggest what else should be done. He commented on the policy background mentioned by Mr Laubscher on growing and persistent imbalances. He asked if South Africa would ever reach the ideals of socialism.

Each of the economists gave general answers to the numerous points raised.

Mr Mondi commented that one of the largest challenges in South Africa was around the social contract. Government had made it clear what it would be doing in public investment into the infrastructure. When IDC engaged with business, it had had input as to what the Department of Public Enterprises wanted to do. The major players, being Eskom and Telkom, said that capacity filling was "pie in the sky". Some of the companies, between 1992 and 1994, had expected a black government to care for people through full implementation of the Reconstruction and Development Programme (RDP) programme. Many of the companies had therefore undertaken huge CAPEX investment, including new production capacity in the steel sector. However in 1994, the government pursued a conservative and prudent fiscal polity, with the result that many newly-hired workers were retrenched, and went to England and Dubai. The businesses that had responded to the expected GDP growth could now not meet the demand and South Africa was at the moment operating at full manufacturing capacity. Metasteel, Lafarge and other construction companies were now trying to respond, but the global demand and prices were huge. This was the reason for his comment on continued increase in costs. Eskom was about 60th in the world queue for turbines. Capacity constraints were continuing to bite. There was commitment from the private sector, and in his view all sectors must work together to get credibility on investment plans and the way forward. The vision was not shared by everyone so there was a lagging.

Mr Mondi said that milk prices had been too low, and many dairy farmers went out of business. Therefore they had switched to other areas, horticulture, or high cash crops, and South Africa was caught short, and was now short of dairy products. Globally, there were  few dairy farms hence the high prices.

Mr Mondi responded to Mr Singh that the situation around food inflation was interesting. He was looking forward to Competition Commission making a ruling on some of the big players. He had no proof, but based on what he was hearing from the poor (who had to buy in volumes as they were the biggest consumers) it seemed that the sector was not competitive. There should not be a situation where every December bread prices were allowed to rise and not come down again. 

Mr Mondi commented that the IDC was involved in bio-fuels. His personal view was that in Southern Africa drought and food security were huge issues. He was concerned about the energy strategy in terms of bio-fuels. There were partnerships between South Africa, Brazil and India, and he was a little concerned about such heavy emphasis on bio fuels to the detriment of food security issues. 

Mr Laubscher noted that the starting point of the effects of the international situation was probably the USA’s declining property market. The USA economy’s third-quarter growth numbers gave hugely different results depending upon whether the construction sector was included or not. Housing sector problems were causing a problem in their economy, and USA property prices were 4% lower than they were a year ago, which caused additional problems for the borrowers, some of whom were in negative equity. South Africa’s National Credit Act was appropriate to many of the problems that had arisen in the USA market. The question was whether there would be similar problems in other countries. There had been rises in property in all countries, including South Africa, over the last few years If housing prices were to decline, this would affect consumer confidence and spending, and hamper economic growth. Banks would be reluctant to lend money to risky borrowers, not only in the housing but also business and corporate bond markets. This would result in tightening of monetary policy, with less credit available on more expensive terms. The indications were that USA would slow down until the end of next year. USA represented about a quarter of world economy, and if it spent less, he was not sure if the rest of the world would be able to “de-couple” and not feel the effects. In the emerging market world, new economies would be protected by structural investment. They had become more dependent on domestic economy and there was room to encourage that further. Chinese growth had come from investment spending and exports. It had potential and needed to expand the consumer side of its economy. Some factors, he felt, would still impact.

Mr Laubscher noted that South Africa benefited from global growth in exports and commodity prices. If these increased less rapidly, it would have an impact on South Africa. He commented that people tended to accept risk when growth was strong. All economies were risky but emerging economies were more at risk. Less capital going to more risky assets would include our markets and then the current account deficit would become larger. He had been warning about this for some time. The economists had to ask if something had changed, so that South Africa should be less pessimistic about risks from the emerging world. The problem was that the answer to that would not be available from some years. He wondered how South Africa should be working differently. He did not think that there would be more risks by running the current account deficit as it was.

Food inflation was an international phenomenon. ECD inflation was also higher than expected, because of food and fuel. In the emerging world food took a higher percentage of the basket of spending, and impacted more. The biggest factor was wheat prices, which had risen internationally, because of the drought in Australia. South Africa, being an importer, could not escape, and that impacted on the bread prices. He thought further increases in bread prices were unavoidable. Bread had a high rating in the food basket. Unless food inflation and prices were to subside internationally there would be no drop locally.

On the issue of administrative prices, he noted that this applied to all sectors. The CPIX numbers were an unpleasant surprise because of wage increases for domestic workers; the minimum wage had increased more than people were expecting. The administrative prices were reigned in about two years ago, and there were limits to costs being announced. He had the impression that was being pushed to the background. He wondered about sustainability of some of those public corporations, whether the businesses were sound and that was a question for government to answer. It could not continue to put money into a bottomless hole.

Mr Laubscher noted that in respect of the comments on Eskom, the private investors were not queuing up to get involved. If it was not viable for Eskom to increase capacity without increasing tariffs, then it would also not be viable for private investors. They would not invest if the business case was not sound.

Mr Laubscher felt that all aspects of the monetary and fiscal policy must all be improved. It was correct to continue to talk but results were also needed.

Mr Laubscher said that no economy would ever be fully in balance, as that would imply zero unemployment inflation and so on. That would never be achieved. There was no ideal economic system anywhere in the world. All had imbalances and policy had to manage them as they rose, and the economy had to adjust to work out of the system. To his mind a market or mixed economy that was biased towards the market system was the most flexible one to deal with imbalances.

Mr Gouws said that his comments would also be general, but wished to comment in particular upon the question on socialism. If South Africa was the only country in the world to adopt socialism it would not attract skills, technology or capital to itself, and would no doubt find its existing skills base and capital fleeing. Two examples of socialist states were North Korea and Cuba. China was a capitalist economy in all but name. Private property was now being entrenched as a concept in China. No one would take the risk of investing if they did not have ownership of the means of production. It was not a debate that was really happening elsewhere in the world. The question was how to accommodate the legacies of apartheid and what was the role of the State. He felt that the ideals of a socialist economy would remain a dream.

Mr Moloto asked about manufacturing, and whether the depreciation allowances were sufficient to encourage investment, or what more could government still do on tax policy side to encourage investment.

Mr Moloto asked if South Africa had lowered tariffs in agriculture beyond the norm, and whether the lowering of tariffs would increase competitiveness. 

Mr Moloto asked Mr Gouws to clarify his point that even if interest rates were increased, this would not have addressed the inflation.

Mr Gouws responded that South Africa was running a large current account deficit. The growth was the sum of various types of spending and spending was running ahead. However, the constraints at the moment were limiting the growth. If the bottlenecks were removed, the potential growth could rise. Domestic demand was rising ahead of domestic output and the difference between export and import had appeared on his graphs. He argued that there was good reason for the Reserve bank’s current policy on interest rates.

Mr Johnson said Mr Gouws had mentioned the unproductive spend, the fact that Treasury were speaking of privatising spend, and reducing the debt costs. He asked if that was what was being referred to as unproductive spend on interest rate. He asked what alternatives there were for the surplus.

Mr Gouws responded that the point was that the more that was borrowed, the more interest would have to be paid. If South Africa attracted foreign capital, it must remember that nothing came for free. Foreigners buying shares or bonds would have to be paid outside. That became a limitation on the current account deficit. By the end of the 1990s South Africa was spending R1 in R5 merely to pay interest. Mr Manuel had then sold the idea of smaller deficits to his government, and that had been useful. Wasteful spending, on the other hand, was the sort of unjustified duplication that had happened in the apartheid years, with separate development

Mr Johnson said that some believed the debt should be reduced, to release more funding. Another view was that the surplus should be spent. He asked for comment.

Mr Gouws responded that from 1983, a large portion of spending by the then-government was on urgent non-capital spending and the deficits rose. It was effectively borrowing money to pay civil servants’ salaries. This dis-saving (borrowing to repay current expenditure) was whittled away until last year the recurrent expenditure did not have to be funded though borrowing. Government began to become a saver and put this into to the budget deficit. Part of the reason was outside factors, but other reasons resulted from the policies adopted. South Africa had a windfall, but spending it now would create a major problem down the line. The MTBPS warranted total support.

Mr M Mbili (ANC) looking at escalation of oil and food prices, believed this could not be left to the market to address. A developmental state like South Africa would, in his view, need to do something to address the fundamental issues.

Mr Laubscher said that the CPIX was calculated by weighting the different income groups on their spending. The high income groups spent more. A new basket would be introduced next year and Stats SA would change their measurement tools, to say that the "basket' should be reflective of the majority of households, rather than total spend. The new CPIX measure would have a  bigger weighting as to how the poor experienced inflation. He had suggested that subsidies would not necessarily be the way to go; but there were some plans to expand school feeding, and the Minister had spoken about compensating pensioners for rising food prices. There would also be an increase in the social grant. That created the perception that in February next year, the increase might be higher than general CPIX because food inflation was running at 12%. Compensating social grant beneficiaries meant that their increases would have to be higher. That was not stated specifically but he was reading between the lines.

Mr Mbili asked for comment on the proposed 18% hike by Eskom in the tariff. Energy in South Africa was cheap, but he was of the view that electricity was one of the scarce commodities for the poorest of the poor. He asked against who was being gauged as "low". An increase of 18% was very high, and he asked what would that do to create more jobs and affect investment.

Mr Laubscher said Eskom's claim was not only about financing expansion but also high coal prices. Coal powered stations were a large percentage of their total cost. Coal was correlated with oil, being fossil fuels. In Eskom's case, it had long term contracts for supply of coal for some of the electricity generation and would have to pay market price. The average coal price had increased 14%, compared to the tariff increase of about 6%.Perhaps they were not completely out of order in suggesting this had to be taken into account. Their costs were not driven by CPIX inflation but by other factors. Even without capital expenditure there must be a higher tariff increase to allow for the cost of coal. Reserve Bank did not assume a zero increase.

Mr Johnson noted that there had been talk about the inflation target of 3% to 6%.He asked if there were targets in place anywhere else, and what was the average elsewhere. He understood that this was dictated by various economies and levels.

Mr Laubscher said between 30 and 40 countries did have inflation targets. Those in the developed and emerging world had adopted them, and inflation had increased. US Federal Reserve had not had one, but had appointed a technical committee to look at this. It was accepted internationally by monetary policy as best practice. New Zealand, United Kingdom and Canada all had targets. Only in the last five years had emerging markets also had targets, and generally there were tighter ranges, and lower caps than 6%. Brazil had an upper end of 7% but a central point of 4.5%,and they managed their policy with a view to the 4.5%. Another country, that he could not recall offhand, was higher. The inflation target was intended mostly to gain credibility for monetary policy and to manage inflationary expectations. He though inflation targeting was not the most important point. Economists felt there should be a debate about whether it was the best policy regime. To break away from internationally regarded best practice would be difficult.

Mr Moloto noted that Mr Laubscher had not compared the JSC with the emerging market, and asked for clarity on the slides giving USA / South Africa comparisons.

Mr Laubscher responded that the graphs had been intended just to indicate that capital inflows had been mostly portfolio capital, and were dependent on the financial markets' performance. These showed that South African performance in equity and bond markets was in line with what had been happening  with emerging markets in general. If the emerging markets were to hold South Africa would be fine.

Mr Mondi commented in general that the conclusion was that as long as there was commitment to containing inflation, it did not really matter how it was done, as the same result would be reached. Clear targets were needed. He agreed that there should be dialogue on how to move forward. He said that the focus of the MTBPS was not clear. Everyone assumed that there would be a certain peak, and then costs would come down. He thought that South Africa could live with that. However, his argument stressed the need for sustained structural change, so that South Africa could achieve the objective of a better life for all.  Leadership required a long term vision and thinking out of the box. The better life for all meant that all anchors must support it together. He was still worried that things were being done piecemeal to satisfy certain interests. In answer to Mr Moloto he made the points that many of the industrial processes were old, working with old equipment, and not investing in new technology because of the focus on reducing the deficit.  The point was how best to maximise capital expenditure into new infrastructure and new technology. Industrial financing was critical. He did not think incentives would work. Business would do certain things for incentives, but partnerships with financing must be created.  IDC was an instrument of the State to try to create capacity. There was still some disjuncture as how best to work, rather than merely using a subsidy.

Mr Mondi added that the State must respond to high fuel and food prices in part through land policy. A development state would say a person had access to land for three years and if it was not used, it would be lost, and redistributed back to the people who would benefit. There was no developmental state at present, but it was perhaps something to consider. Where there was arable land, he thought that partnerships should be encouraged between the formal sector and emerging farmers and this was used usefully recently in citrus farms in the Eastern Cape. 

Mr Mondi said that 50% of fuel came locally through state investment in conversion of coal and gas to liquid. The crude oil price was used as a basis, without looking at the cost of production. This entity had huge ambition, as fuel was a national security issue. A developmental state should work to create those capabilities. He wondered if using the crude price was correct.

Mr Mondi said that in relation to Eskom at last the Cabinet had come to the party around alternative energy sources. This was a huge opportunity for communities. Much electricity went towards geysers and appliances other than lighting. Government policy should be geared to make alternative sources attractive. There should be exploitation of fossil fuel and biomass was being used as a source of energy, although the output was less. He would encourage Parliament to think in terms of the New Economic Partnership for African Development (NEPAD, and  to work with Congolese partners to a sustainable future.

The meeting was adjourned.