Report of the Portfolio Committee on Finance on the Medium

Term Budget Policy Statement, dated 5 November 2004:

The Portfolio Committee on Finance is mandated to interrogate and report

to the National Assembly on the macro-economic issues raised in and by

annual Medium Term Budget Policy Statements. The present report refers

to the Committee’s work on the 2004 Medium Term Budget Policy

Statement (MTBPS) tabled before Parliament by the Minister of Finance

on 26 October.

In addition to studying the Minister’s speech and supporting documentation,

the Portfolio Committee, together with the NCOP Select Committee

on Finance and the Joint Budget Committee, was further briefed by the

Minister, the Director General and other officials of the National Treasury

on October 27. A further joint meeting was held on October 29 to hear the

views of a panel of commentators, including two economists linked to a

merchant bank and parastatal corporation respectively and a researcher

from IDASA’s Budget Information Service specializing on gender budget

issues.

The 2004 MTBPS is tabled against the background of a significant

improvement in the performance of the South African economy. After a

cyclical slowdown in 2003, when the growth in the real Gross Domestic

Product (GDP) fell to around 2%, GDP growth increased to an annualized

rate of 3,3% in the first half of 2004. The Medium Term Expenditure

Framework (MTEF) for 2005/6 to 2007/8 anticipates further broad based

economic expansion with real GDP growth expected to average 4% over

the three year period.

CPIX inflation remains subdued at a level of 4.4% for 2004. This is despite

a significant increase in the international price of oil. Although there

remains a risk of further significant international oil price hikes, the

MTBPS anticipates inflation remaining within the target range of between

3-6%, but is expected to rise slightly from the current level to 5.1% by

2007. The generally low inflation environment has created conditions for a

decline in interest rates taking real interest rates to their lowest level for

around 30 years.

The recent appreciation in the exchange value of the Rand (which rose by

8,2% during the first half of 2004) is seen as deriving mainly from the

weaker dollar, the favourable interest rate differential between South Africa

and its trading partners and the buoyancy of commodity prices. While the

stronger Rand has negatively affected some export and import competing

sectors, it has also contributed largely to lower inflation and cushioned the

potentially negative impact on growth of the sharp increase in the US $

price of oil. The MTBPS further reports that the combination of the

stronger currency and the improved growth prospects have led to stepped

up expenditure by local firms on equipment. Real gross capital formation

rose by 8,5% year on year in the first half of 2004.

The combination of an overall growth in imports, of certain large

contractual obligations associated with defence procurement and acquisition

of civilian aircraft, and of the rise in the oil price has led to a widening

of the deficit on the current account of the Balance of Payments to 3,8% of

GDPin the second quarter of 2004. For 2004 as a whole the current account

deficit is expected to average 2.4% of GDP. The MTEF anticipates this

annual average rising to 2.8% of GDP in 2007. However, steady financial

inflows, recorded in the capital account, have led to a surplus in the overall

Balance of Payments (BOP) this year. This has allowed the South African

Reserve Bank to build up its foreign exchange reserves, which stood at $

12,2 billion at the end of September 2004. Short term debt cover rose to

340% in the first half of 2004, compared to 126% in 2003. Import cover

now stands at 21 weeks compared to an average of 19.5 weeks between

2002 and 2003.

Some indication of a possible turnaround in employment prospects is

reported in the MTBPS. Stats SA’s labour force survey in March 2004

points to an increase in employment by 419 000 since March 2003. The

unemployment rate is reported, as a consequence, to have decreased from

31% to 28% over the same period, although the relevant underlying

statistics are subject to uncertainty.

As indicated above, gross fixed capital formation has expanded over the

past 19 quarters and grew by 8.5% year-on-year in the first half of 2004.

Investment by private businesses was the main source of this growth.

Government policy aims to increase the overall rate of capital formation

from the present level of 16% of GDP to 25% of GDP by 2014. To this end,

government itself will increase its contribution to fixed capital formation by

undertaking major investments in roads, rail and ports infrastructure,

electricity infrastructure, sporting infrastructure for 2010 soccer world cup

and several major water schemes. Investments in more efficient communication

and information technology as well as housing and community

services will also be promoted. Increasing the level of foreign direct

investment is identified as an important challenge, although the MTBPS

reports that portfolio investments are high. In the first half of 2004

non-residents acquired R17.8 billion of South Africa’s portfolio assets

while FDI decreased by R3.2 billion.

Global recovery is reported to have strengthened in the first half of 2004

reflecting the strength of upturns in both China and the United States. The

IMFsWorld Economic Outlook anticipates growth in the world economy at

5% for 2004. This has been one of the main factors underlying a

strengthening of commodity prices that has supported both the Rand’s

strength and South Africa’s economic recovery going forward.

Gross domestic expenditure (GDE) rose by 5.7% in the first half of 2004

responding to a strong Rand and falling interest rates. This is one of the

major factors contributing to an increasing current account deficit in the

first half of the year. Household consumption expenditure is also

strengthening as a result of a decline in interest rates and tax relief in the

past few years. Household consumption expenditure increased by 4.4% in

the second quarter and by 4% in the first quarter of 2004.

The MTBPS re-states government’s commitment to a policy framework

that supports economic growth and development and the same time

advances human development and reduces poverty. The improved performance

of the South African economy is seen as providing government with

an opportunity to increase expenditure in delivering public services without

undermining overall macro-economic stability.

Real growth in non-interest spending is projected to increase by 6,5% in

2005/06, and by an annual average of 4,3% over the MTEF period. The

budget deficit is expected to increase from 3,2% in the current year to reach

3,5% of GDP in 2005/06 before declining to 2,7% by 2007/8. General

government borrowing for 2004/5 rises from the budgeted 3,3% to 4,1% of

GDP. It is anticipated to rise to 4,4% in 2005/6 before falling to below 4%

in the outer two years of the MTEF.

Other key trends over the MTEF period include the following:

• The projected increase in non-interest expenditure will add R50

billion to the baseline projections for expenditure over the MTEF

period made in the 2004 budget.

• The key spending priorities over the MTEF period will include:

• Stabilizing social security grants;

• Accelerating the land restitution programme;

• Improving salaries for police and educators;

• Supporting the new programme for housing delivery;

• Providing additional resources for road infrastructure;

• Improving the quality of schooling system and realignment of

FET;

• Allocating additional funding for National Student Financial Aid

Scheme;

• Continuing the hospital revitalization programme;

• Investing in water resources infrastructure;

• Continuing support for African integration including the Pan

African Parliament;

• Re-engineering the core government services in Home Affairs.

• Social services will continues to absorb nearly 60 percent of

government expenditure, with social security spending increasing by

11,4 percent a year. In addition to the Hospital Revitalization

programme, which will see 10 of the original 27 targeted hospitals

completed over the next two years, the health sector has prepared a

plan for modernization of the tertiary sector.

• South Africa’s successful bid to host the 2010World Cup will require

provision for Government’s role in preparing for the competition,

which holds large potential benefits for the country. Government will

contribute to funding part of the stadium infrastructure requirements.

• Over the MTEF period, the government intends to increase public

sector expenditure on capital and infrastructure from the estimated

5,5% of GDP in 2004/5 to 6,5% by 2007/8. The total expenditure by

national, provincial and local governments as well as public enterprises

is projected to rise from R 73,5 billion in 2004/5 to R 113,5

billion by 2007/8. This will be financed both by budgetary allocations

and off budget operations.

Policy measures announced in the 2004 Budget and given effect in Revenue

Laws Amendment Bill (B22- 2004) include:

• Tightening of anti-avoidance measures on executive equity schemes

and hybrid arrangements;

• Tax relief for broad-based employee share ownership programmes;

• Tax relief for investments in South Africa by persons within the

Common Monetary Area.

The MTBPS indicates that tax proposal in the 2005 Budget will focus on

simplifying tax compliance for small enterprises, revised tax treatment of

health care benefits and motor vehicle allowances and amendments to

facilitate the hosting of the FIFAWorld Cup in 2010. No major personal tax

cuts are anticipated in the 2005 budget.

Revenue projections for 2004/05 are revised upward by R1,2 billion

bringing total anticipated revenue collection to R328,2 billion.

Three commentators were invited to make presentations to a joint

Committee meeting on October 29. Two were economists attached to a

private merchant bank and a parastatal respectively and one a specialist on

gender budget issues. A research institution attached to the labour

movement withdrew at a late stage.

In general the panelists agreed on the following:

1. The overall expansionary fiscal stance is both welcome and appropriate.

It is also well within parameters of sustainability and fiscal

prudence.

2. The GDP growth projections in the MTBPS are realistic and

attainable. One of the panelists, Prof. Brian Kantor, however, added

the rider that this depended on there being no major exchange rate

shock. He also expressed the view that growth as high as 5% or 6%

would be attainable if investment reached the 25% of GDP target.

3. The relaxation of foreign exchange controls announced in the MTBPS

(viz the abolition of financial limits on foreign direct investments by

South African corporates) do not pose any major risk, at least as long

as relative exchange rate stability and growth persist.

Beyond this, two of the panelists, Mr Mandla Maleka of Eskom and Ms

Penny Parenzee of Idasa, emphasized the need for expenditure programmes

more effectively to address structural problems confronting people trapped

in the ‘‘second economy’’ for whom growth in the ‘‘first economy’’, or the

economy as a whole, would not automatically translate into improved

prospects for higher incomes or sustainable livelihoods. Ms Parenzee

argued that public works programmes provided only a short term solution

and that there was a need to re-focus the debate on increasing investment

more towards investments that would promote household based production

and reproduction. She also argued for a more adequate consideration of the

gender dimensions of poverty and unemployment. Prof. Kantor, on the

other hand, emphasized increasing the growth rate largely through

activities within the ‘‘formal’’economy. He argued that for investments and

savings to reach the target of 25% of GDP, there should be a reduction in

corporate tax and a corresponding increase in expenditure taxes. There was

no consensus among the Committee on these matters.

Taking into account the above, as well as the thrust of most public

commentaries on the macro-economic dimension of the 2004 MTBPS, the

Committee concludes as follows:

• The overall expansionary fiscal stance envisaged over the MTEF

period is appropriate and necessary to give further impetus to

economic growth and development.

• The additional allocation of R50 billion over the previous baseline

estimate and the projected increase in public infrastructure spending

(from 5,5% to 6,5% of GDP) will allow important programmes to

make more of an impact. There is, however, some concern that over

the first two years of the MTEF, at least, most of the former will be on

consumption rather than capital expenditure.

• The expansionary fiscal stance is well within parameters of

sustainability and prudence: the small increase in the budget deficit

poses no serious risk.

• The growth projections underlying the MTEF are realistic and

attainable. They do not depend on unrealistic assumptions about the

performance of the world economy. Most of the risks to the growth

projections arise from potential external shocks (oil price or exchange

rate instability) which do not appear likely to have major destabilizing

effects at this stage.

• There is a need for more information on the expected impact on

employment of the projections in the MTBPS; including both the

expected impact of an increase in the growth rate to 4% and, since

much of the unemployment is structural in nature, of the projected

expanded infrastructure programme.

• While most commentators see little risk from the exchange control

relaxations announced in the MTBPS, the Committee believes that the

remaining application requirements, including demonstrating to the

Reserve Bank that a foreign direct investment has a ‘‘demonstrated

benefit to South Africa’’, must be strictly enforced. The Reserve

Bank’s reserved right to stagger any capital outflows is also important.

• The Minister’s concern that ‘‘A sustainable social security system

must balance bringing in everyone who is entitled to grants and

keeping out everyone who is not entitled to them’’, is understandable.

However, the Committee earnestly hopes that efforts to deal with

mismanagement and fraud do not inadvertently result in a raising of

the bureaucratic bar in ways that disadvantage poor households that

should be receiving grants.