SOUTH AFRICA: FINANCE MINISTER SPELLS OUT

UNCLAS SECTION 01 OF 06 PRETORIA 005007 SIPDIS SENSITIVE BUT UNCLASSIFIED DEPT FOR AF/S; AF/EPS; EB/IFD/OMA USDOC FOR 4510/ITA/MAC/AME/OA/DIEMOND TREASURY FOR OAISA/BARBER/WALKER/JEWELL USTR FOR COLEMAN LONDON FOR GURNEY; PARIS FOR NEARY E.O. 12958: N/A TAGS: ECON EINV EFIN ETRD SF SUBJECT: SOUTH AFRICA: FINANCE MINISTER SPELLS OUT PRIORITIES REF: A. PRETORIA 4879 ¶B. PRETORIA 4809 Sensitive But Unclassified; Protect Accordingly ¶1. (U) Summary. Finance Minister Trevor Manuel addressed Parliament on October 26 to table the Medium Term Policy Statement, an appropriations adjustment bill, and a tax amendment. He presented a detailed overview of the government's development priorities over the next three years and economic outlook. Manuel said that sound fiscal management and successful inflation targeting meant that the government could now focus more on growing the economy "to create employment, and to generate resources to plow into education, health care, social security, fighting crime, and reducing poverty." He predicted growth would average 4% over the next three years and flatly declared that the government's goal was to increase the rate of gross fixed capital formation from 16% of GDP to 25% by 2014. While acknowledging that private sector investment would be responsible for most of this increase, he focused most of his discussion on what the public sector needed to do. Manuel warned that public sector borrowing would rise as state-owned enterprises borrowed from capital markets to fund a large proportion of their infrastructure investment. ¶2. (U) Manuel departed from political convention on several occasions. He commented that the ownership criteria in some draft Black Economic Empowerment (BEE) charters were self defeating, leading to unnecessarily complex and risky financing structures. Just as critical, he thought, was building the economy, increasing production, creating jobs, developing young black managers, and investing in social development. Manuel conceded that immigrant skills could be critical to growth, since it would take time before education and training programs yielded substantial returns to the economy. Manuel admitted that the social security net was under severe strain, and should be removed from the provinces and consolidated under a new national social welfare agency that would be able to stem the flow of grants to people who did not warrant them. Finally, he said that the Cabinet wanted to introduce an index to monitor government administered prices in electricity, water, transport, education, and health sectors -- all of which seemed to be growing faster than inflation. End Summary. ¶3. (U) Finance Minister Trevor Manuel addressed Parliament on October 26 to table the Cabinet's Medium Term Policy Statement, the Adjustments Appropriations Bill, and the Revenue Laws Amendment Bill. Manuel's speech reflected the government's growing confidence in its ability to manage the economy. Manuel made the point that sound fiscal policy and inflation targeting had contributed to lower interest rates and buoyant consumer demand. This, in concert with high commodity prices and a strong international economy, had fomented greater local business confidence. He said that trade reforms of the 1990s had caused South African business to become internationally competitive and more able to penetrate new markets. The result was that domestic investment was evident across a wide range of sectors -- particularly construction, services, and manufacturing -- and more balanced growth. Moreover, strong capital inflows meant that the country could finance a higher current account deficit and use that deficit to grow faster. Manuel concluded that the reforms of the last ten years were now bearing fruit. State of the Economy -------------- ¶4. (U) While the South African economy grew just under 3% per year since 1994, Manuel said that government projections suggested that the economy would now grow faster. Manuel confirmed the government's forecast at least 2.9% growth in ¶2004. However, continued fiscal stimulus, firm commodity prices, and a more competitive real exchange rate (assumed in the future) along with low interest rates and rising income would support an average of 4% growth over the next three years. At this point, Manuel broke from his prepared text to say that he, personally, felt 4% was a conservative estimate; actual growth might be closer to 5%. ¶5. (U) Manuel reaffirmed his commitment to inflation targeting, predicting that CPIX (consumer inflation less mortgage costs) would remain firmly within the 3-6% target range over next three years. He pointed out that sticking to the target thus far had successfully lowered inflation expectations. While high oil prices posed risks to both global growth and domestic inflation, projected inflation for 2004, at 4.4%, would still fall within the target range. Administered prices, on the other hand, had become a subject of Cabinet attention. Manuel noted that the Cabinet wanted to introduce an index to monitor administered prices in electricity, water, transport, education, and health sectors -- all of which seemed to be growing faster than inflation. While administered prices still needed to balance price stability, capital requirements, and service delivery objectives, the Cabinet also felt that there was room to improve the price setting process. ¶6. (U) Manuel was mindful of the current strength of the rand, particularly vis-a-vis the dollar. He acknowledged that there were adjustment problems for industry at R6 to the dollar and equally important problems at R10 to the dollar, especially with oil prices at record highs. On the bright side, he thought that business confidence in the face of a strong rand revealed South African resiliency and improved competitiveness, and also reflected the general perception that doing business in South Africa now carried lower risk. Priorities -------------- ¶7. (U) Manuel reminded Parliament of President Mbeki's three challenges: 1) to encourage the growth and development of the First Economy to increase employment; 2) to address the challenges of the Second Economy; and 3) to build a social security net to alleviate poverty. With these in mind, Manuel said that the government could now focus more on growing the economy "to create employment, and to generate resources to plow into education, health care, social security, fighting crime, and reducing poverty." He said that for the first time in ten years, there was evidence that growth was resulting in employment gains. Between March 2003 and 2004, South Africa gained 400,000 new jobs, causing the official unemployment rate to fall by 3.4%. ¶8. (U) Manuel outlined the government's short and long-term approaches to growth. In the short-term, targeted incentives and public works programs would accelerate investment and job creation. In addition, the government would take measures to make the distribution and pricing of water and energy resources more efficient. Manuel conceded that immigrant skills could be critical in the short-term, since it would take time before education and training programs yielded substantial returns to the economy. In the long-term, Manuel said that the government had to pay attention to investment in economic infrastructure (including electricity supply and rail service),regional development policy reform, and more effective competition policy. ¶9. (U) During this discussion, Manuel highlighted sequencing and coordination issues in social policy. Housing programs could be accelerated, he said, but needed to be aligned with regional development plans, job creation, and community services. Social health insurance was a long-term goal that needed to be preceded by the modernization of public hospitals. Land redistribution and BEE agricultural development needed to move forward, but not until the restitution program was completed and needed bureaucratic resources freed. The First Economy -------------- ¶10. (U) Manuel flatly declared that the Government's goal was to increase the rate of gross fixed capital formation from 16% of GDP to 25% by 2014. To do this, the Government would pursue a supportive investment environment which included moderate inflation, low real interest rates, a stable and competitive currency, and implementation of certain microeconomic reforms. Manuel was encouraged by 7% private sector investment growth in 2003 and 7.6% in the first half of 2004. While acknowledging that most investment in the economy would have to come from the private sector, he then spent more time talking about what the public sector would do. This included employing public-private partnerships to overhaul the country's public transport systems, investing in ports, and renewing the country's rolling stock. Other public sector priorities included investment in health and education infrastructure, roads, housing, as well as expanding water and electricity services to the poor. ¶11. (U) In a departure from past ministerial statements, Manuel admitted that the ownership criteria in some draft BEE charters were not realistic, leading to unnecessarily complex and risky financing structures. This was self-defeating, he said. While increasing the level of ownership of black people in corporate South Africa remained critical, just as critical was building the economy, increasing production, creating jobs, developing young black managers, and investing in social development. At the same time, Manuel lauded the Financial Services BEE Charter for providing the impetus behind the launch of the low-cost Mzansi bank account that was designed to attract millions to the formal banking system. The Second Economy -------------- ¶12. (U) To foster development of the country's "Second Economy," Manuel said that the government would have to balance direct income support with investing in human capital. This covered a wide spectrum of programs, including expanded public works programs to create jobs and infrastructure, housing and municipal grants, micro-enterprise development, skills development, land restitution, land reform, and agricultural support programs. Manuel also promised that the 2005 budget would further raise teacher salaries. He said that the renewal of the primary school nutrition program under the education departments of the provinces was already in progress. The provinces would receive additional funding to cover increases in social grants, higher personnel costs, greater infrastructure spending, and the consolidation of spending programs in education and health. Social Security Net -------------- ¶13. (U) Manuel admitted that the social security net was under severe strain. Social welfare services were unable to respond adequately to the range of needs and distress that confronted them. In particular, the rapid growth in disability and foster care grant applications indicated both rising income support needs and deficiencies in administrative systems. He added that the caseloads in public hospitals and clinics reflected large numbers of victims of crime, road accidents, and disease -- especially HIV/AIDS and tuberculosis. Manuel stated that the government believed that a single Social Security Agency would be better able to target and deliver social welfare grant programs. A national agency would to tighten procedures, develop clear qualifications for the grants, and reduce the number of welfare grants going to people who did not warrant them. ¶14. (U) Manuel explained that the administration of social security grants would shift to the new national agency once it was up and running. In the interim, the provinces would continue to deliver social welfare grants under the conditional funding category from the national budget instead of equitable share funding as was now the case. The provincial equitable share formula would be adjusted to take this shift into account as well as 2001 census data. He said that the restructured equitable share formula would have a larger education and health components and no longer contingent on social welfare payments taking priority over other categories of expenditures. This change would allow for a more stable budgeting process for education and health. In addition, he said that the housing grant would receive a substantial boost, and a new housing strategy, focusing more on the creation of whole communities, would be phased in over the next three years, together with the expanded provision of basic household services. Fiscal Policy -------------- ¶15. (U) Manuel said that after a concerted effort to reduce the budget deficit between 1996-2001, the government was now able to increase public expenditure in real terms through borrowing at lower interest rates and managing a higher budget deficit. He said that in 2003/4 the government recorded a budget deficit of 2.4%, a bit higher than predicted because revenue fell a bit below expectations. Revenues should be above expectations in 2004, but greater spending on social security grants and wages (government workers successfully went on strike recently for an above inflation wage increase) should result in a budget deficit of 3.2% of GDP as compared to the 3.1% expected. Manuel predicted that for 2005, rising corporate profits, continued strength in VAT and personal income tax receipts, and further broadening of the tax base would result in a moderate increase in overall revenue. He said that the budget deficit was expected to widen to 3.5% of GDP next year, bringing net borrowing to its highest level relative to GDP since 1997/8. Nonetheless, he projected that the deficit in 2007/8 should fall to 2.7% and that debt service costs should stabilize at about 3.6% of GDP. ¶16. (U) Manuel added that R50 billion in extra spending would be added to the budget estimates. Of this, about R21 billion would finance growth in disability and foster care grants. Over the next two years, the rest would go to fund recently agreed salary increases for government workers, the land restitution program, social welfare grants, and increased salary payments from increased government hiring. In third year, additional allocations would be required for infrastructure, education and training, and municipal services. ¶17. (U) Manuel warned that public sector borrowing would rise as state-owned enterprises borrowed from capital markets to fund a large proportion of their investment in infrastructure. New borrowing to finance provincial and municipal government spending on infrastructure projects would also contribute to the growth in public sector debt. The Treasury expected public sector borrowing to reach 4.6% of GDP in 2007. Since the debt would be directed toward improving the country's economic infrastructure, it would be supportive of growth. ¶18. (U) Manuel said that revenue was R5.1 billion short in 2003 mainly because of lower profits in resources sector. However, he expected revenue to exceed its target for 2004. In 2005, the contribution from the resources sector would likely remain below target, but should be offset by a recovery in VAT and personal income tax receipts. Tax Policy -------------- ¶19. (U) Manuel said that tax relief would not be a prominent feature in the 2005 budget. However, efforts to simplify the income tax system and reduce the compliance burden on small businesses would continue, as would consideration of easing taxes related to health insurance. ¶20. (U) One of the purposes of Manuel's presentation to Parliament was to introduce the 2004 Revenue Laws Amendment Bill. He explained that the amendment contained measures to encourage foreign investment and improve South Africa's position as a regional economic center. These included the elimination of the existing tax on interest-bearing investments by residents from Swaziland, Namibia, and Lesotho, changes to the VAT to support South Africa's position as a freight distribution hub, and allowing companies to distribute shares valued up to R9000 to employees over a three-year period without any tax consequences under certain conditions. On the other hand, Manuel said that tax benefits from share options for high-income earners would be subject to more stringent limitations. ¶21. (U) Manuel also said that the Treasury was undertaking reviews of the South African pension fund industry from both a regulatory and a tax perspective to derive a regulatory framework that had more transparent disclosure rules regarding costs and benefits, encouraged the preservation of built-up reserves and discourage early withdrawals, and improved competition in the industry by providing incentives for portability. Manuel said that a discussion paper on the regulatory aspects of pension funds would be released for comment later this year. It would be followed by a tax policy discussion paper that dealt with existing shortcomings of the pension fund tax regime and proposing changes that would align South Africa's taxes in this area with international best practices. He explained that the central aim was to protect and promote individual savings for retirement. ¶22. (U) With respect to the mining industry, Manuel stated that the 2003 Mineral and Petroleum Royalty Bill would have to be revised to address outstanding issues such as the differentiation of royalty rates, marginal mine treatment, the elimination of the double royalty risk, and transitional matters. He said that Treasury would undertake a holistic review of the mining sector that would include the low effective tax rates that mining companies paid, recommendations relating to the gold mining tax formula, the appropriateness and international comparability of the current mining investment allowances, and the consideration of special allowances for exploration and mining rehabilitation programs. Possible tax measures to assist the small-scale mining sector would also be considered. ¶23. (U) Manuel recalled the exchange control amnesty announced in 2003. He reported that the government had adjudicated 16,033 of 43,000 applications received -- yielding a total of R826 million in tax revenue from newly declared income on foreign assets. The Treasury estimated that the value of declared foreign assets would reach about R65 billion, yielding a total of R2.2 billion in additional annual tax revenue. Foreign Exchange Liberalization -------------- ¶24. (U) Manuel announced that, following discussions with SARB Governor Mboweni, the Treasury was proposing abolishing exchange control limits on new outward foreign direct investment by South African corporations. He added that demonstrated benefit to South Africa would still be a criterion for SARB Exchange Control Department approval. In addition, Manuel said that South African corporations would now be allowed to retain foreign dividends offshore, and transfer any dividends repatriated to South Africa at any time for any reason. To position South Africa as a financial center for the rest of Africa, Manuel restated the government's February announcement that foreign companies, governments, and institutions would be able to list on South Africa's bond and securities exchanges. Manuel said that in November, Aquarius Platinum (an Australian mining company) would be the first company to take a secondary listing in South Africa. Manuel stated that all investment restrictions in such companies would be eliminated for South Africans. Explaining that the sequencing of reforms was critical to liberalizing exchange controls, Manuel added that the government's end goal was to abolish exchange controls altogether and put in place a set of prudent financial benchmarks that protected the institutional savings of working people. Comment -------------- ¶25. (SBU) Manuel's presentation covered all major issues of concern with clarity and purpose. His recurring message was that since the economic fundamentals were good, job-creating growth could now be the central aim of economic policy. The government's growth plan grants a new lease on life to South Africa's huge parastatals, as their role now will be to raise and manage the lion's share of public sector investment. Manuel is convinced that the impact on the national budget will be limited because considerable funding will be sourced from the country's deepening bond market at relatively low domestic interest rates (i.e., when compared to recent years). Moreover, parastatals will be expected to contract or enter into joint ventures with private sector firms to accomplish their dual objectives of turning around their operations and building the nation's infrastructure. The result will be greater public sector debt, but Manuel clearly believes that the markets can supply it. He also believes that the resulting increase in government expenditures, especially on economic infrastructure, will kick start faster growth for the rest of the economy. The onus, of course, will be on the parastatals, provinces, and municipalities to manage public sector investments well. This may be the Achilles heel of the grand scheme as their record on this has been mixed. Manuel's warnings about social welfare grants, recognition of the value to an economy that skilled immigrants bring, and criticism of BEE ownership requirements reflect his concern that strict adherence to achieving certain social goals as originally set out can be self defeating and perhaps hinder growth. FRAZER