SOUTH AFRICA: THE NEED AND PROSPECT FOR GROWTH

UNCLAS SECTION 01 OF 04 PRETORIA 002977

SIPDIS

DEPT PASS TO USTR, USAID
DEPT FOR E, EB/IFD, AF/EPS, AF/S
DEPT FOR AF/S/AMBASSADOR FRAZER
TREASURY FOR OIA/OAN/JRALYEA, BCUSHMAN

SENSITIVE

E.O. 12958: N/A
TAGS: ECON EAID KMCA EFIN EINV SF
SUBJECT: SOUTH AFRICA: THE NEED AND PROSPECT FOR GROWTH

REF: A) Pretoria 1998 B) Pretoria 2161 C) Pretoria 2343

D) Pretoria 2621 E) Pretoria 2971 F) 04 Pretoria 171
G) 04 Pretoria 4809 H) 04 Pretoria 5007


1. (SBU) Summary: Fiscal and budgetary reforms of the
past decade have built a firm foundation upon which the
South African economy can build, but life for many South
Africans has not improved much since the transition to
majority rule in 1994. Widespread unemployment, rapid
urbanization, and disease make South Africa home to one
of the most impoverished populations in the world. The
government knows that it cannot meet this challenge on
the back of transfer payments alone. Last year, the
executive branch decided that the way to achieve higher
growth was through fiscal expansion and investment in
infrastructure. It reserved a starring role for state
owned enterprises and public-private partnerships. The
hitch is that implementation hinges on improving the
capacity and effectiveness of the public sector. The
right kind of development assistance could help South
Africa get the most bang for its buck, or a bigger bang
from more bucks. End Summary.

Gauging Strengths .
--------------


2. (U) Most economists would argue that the fiscal and
budgetary reforms of the past decade have built a firm
foundation upon which the South African economy can
build. The government has reduced and then stabilized
its fiscal balance, brought inflation under control,
modernized its tax structure, adopted policy-consistent
planning and budgeting systems, deepened its credit
markets, dismantled many exchange controls, lowered
import tariffs, reduced non-tariff barriers, and
redirected public spending in an effort to redress the
inequality and poverty caused by the country's racially
skewed past. There are clear signs that the economy is
on the right track. The country has experienced its
longest period of continuous growth in its recorded
economic history, averaging 3.0% between 1994 and 2004.
For 2004, interest rates reached their lowest levels in
20 years, inflation reached its lowest level since 1959,
and the rate of GDP growth picked up to 3.7%.

and Weaknesses.
--------------


3. (U) While the ANC government can congratulate itself
on having restructured the economy and achieved modest,
but steady growth, life for many South Africans has not
improved much since the transition to majority rule in

1994. Widespread unemployment, rapid urbanization, and
disease make South Africa home to one of the most
impoverished populations in the world. Fifty-seven
percent of the population lives below the poverty line
[defined here as a family of four living on less than
$215 per month]. Though 2 million net jobs have been
created over the last decade, a rapidly growing labor
force has resulted in the rate of unemployment almost
doubling during this period, disproportionately affecting
blacks and "coloureds." About 2.8 million households, a
quarter of the population, are still situated in
impoverished settlements originally designed to warehouse
a non-white population under apartheid. A rampaging
HIV/AIDS epidemic has reduced life expectancy to 46 years
in 2004 - down from 63 years in 1992 and well below the
69-year average for other lower middle-income countries.
The precipitous decline in life expectancy has caused
South Africa's to fall to 119 out of 177 countries in the
2004 Human Development Index. (Ref E)


4. (U) The government knows that if high unemployment
persists, political discontent will be difficult to
contain because unemployment is dramatically skewed along
racial lines. Since 1994, scores of unemployed black
South Africans and "coloureds" have migrated to cities in
search of work, creating huge shantytowns on the
periphery. Some of these shantytowns have already become
political powderkegs for municipal governments that have
failed to deliver on the many promises of national
government (Ref D). Economists and politicians
increasingly refer to the broad measure of unemployment,
which estimates unemployment to be 41%. Using this broad
measure, almost 48% of black Africans and over 30% of
"coloureds" are unemployed -- two racial categories that
comprise 88% of the population (Refs E, F).

The Need for Growth
--------------

5. (U) The government faces formidable medium and long-
term challenges to reduce unemployment, alleviate
poverty, and eliminate the racial divisions that plague
South African society. In 2004, policy makers concluded
that that, while much had been accomplished to provide
housing, electricity, water, and other services to the
poor, the government could not overcome poverty through
transfer payments alone. The government now spends 4.5%
of GDP on child support, disability, and foster care
grants - constituting one of the largest non-contributory
income redistribution programs in the world. Further
increases in transfer payments risk creating dependencies
on government and attitudes of entitlement among the
general population that will ultimately buckle the
country's relatively small, modern economy. To eliminate
extreme poverty and open employment paths to the modern
economy, policy makers concluded that higher growth was
needed, of a kind that generated employment opportunities
for the poor and unskilled. Without faster economic
growth, the country had little chance of alleviating
poverty and virtually no chance of reaching the
government's goal of halving unemployment by 2014.


6. (U) In his paper entitled, "The State Must Review
Priorities and Step Up Performance" published in mid
2004, President Mbeki's Chief Economic Advisor Alan
Hirsch argued that the major reason for South Africa's
relatively modest growth compared to other emerging
economies was South Africa's low level of fixed
investment, which had fallen from 28% of GDP in the early
1980s to only 17% of GDP in early 2005. Hirsch noted
that, over the last decade, the government and state-
owned enterprises, such as Eskom (the electric utility)
and Transnet (port, rail, and air transportation
services),had actually consumed more capital than they
had contributed. The result was the gradual
deterioration of the nation's infrastructure, greater
inefficiency embedded in the economy and, in some cases,
a loss of international competitiveness for South African
businesses. Hirsch argued that South Africa needed to
raise the level of fixed investment to 20-25% of GDP
(similar to South Korea and Australia) to drive the kind
of growth the country needed to successfully reduce
unemployment and alleviate poverty. As it stood, public
sector fixed investment had declined from a peak of about
16% of GDP in the late 1970s to 4% in early 2004. While
domestic private sector investment was holding its own --
even growing at a healthy rate -- it would not be
sufficient to spawn rapid growth in the near term without
increases in foreign direct and/or public sector
investment. (Ref G)

If You Build It, They Will Come
--------------


7. (U) Hirsch observed that, with the exception of mining
and manufacturing, South Africa had not been able to
attract the level of foreign direct investment (FDI) as
had its peer countries. In 2003, South Africa attracted
just $820 million in FDI, much less than Poland and
Chile, which attracted over $4 billion and $3 billion,
respectively. Often cited reasons have been the high
degree of concentration of ownership in some sectors in
South Africa, labor market rigidities, affirmative action
policies, a volatile exchange rate, a high crime rate,
relatively high interest rates, the low rate of domestic
growth, social inequality and the perceived will and
capacity of government to deal its many problems. While
policy makers, including Hirsch, recognized that
"microeconomic reforms" would be needed to address some
of these issues, they generally concluded that foreign
investors would come to South Africa once domestic growth
picked up.

The Plan for Growth
--------------


8. (U) Given this analysis, policy makers concluded that
the government should pursue a policy of fiscal expansion
to promote faster economic growth through greater public
sector investment. The ensuing plan was clearly
articulated by Manuel in his Medium Term Budget Policy
Statement in October 2004. Manuel declared that the
government's goal was to increase the rate of fixed
investment from 16% of GDP to 25% by 2014 in an effort to
produce a 6% rate of growth. Most of the increase in
fixed investment would come from state-owned enterprises
and public-private partnerships. State-owned enterprise
investment would expand by at least 20% over the next
five years. General government would expand fixed
investment by about 7% a year over the next three years.
An "Expanded Public Works Program" would create one
million temporary jobs in a range of sectors over the
next five years. Public sector borrowing would increase
from under 1% of GDP in 2002 to 4.6% in 2007; interest on
public debt would ultimately stabilize at around 4.5% of
GDP. (Ref H)


9. (U) Manuel reserved a starring role for Eskom and
Transnet, state owned enterprises that the government
would spare from privatization for the time being. Eskom
would spend up to $16 billion on new power plants and the
expansion of its transmission network. Transnet would
spend up to $7 billion in port projects and almost $1
billion on the refurbishment of 24,000 freight rail
wagons. These investments would create jobs, stimulate
economic growth, and raise the competitiveness of export
related industries. (Ref B)


10. (U) Manuel also reserved a starring role for
national, provincial, and municipal government to entice
the private sector to invest alongside government through
an extensive program of public-private partnerships.
Guidelines were issued and a unit created in Treasury to
govern the process. Treasury projected an increase in
capital spending associated with public-private
partnerships, from about $300 million in 2003 to about
$800 million in 2007. (Ref A)

Challenges
--------------


11. (U) A successful public sector-led growth strategy
will hinge on the ability of government and state owned
enterprise to implement it. President Mbeki has readily
conceded that the "Achilles heel" of his effort to
transform South Africa is the shortage of skilled persons
to carry out needed reforms and implement government
programs. In June, Minister of Provincial and Local
Government Sydney Mufamadi admitted to Parliament that
136 of 284 municipalities were "under performing."
[Note: The exact definition of "under-performing has not
been made public, but is likely to include the inability
to deliver basic services, shrink the housing backlog,
disburse funds, and file reports to provincial and
national government in accordance with the Municipal
Financial Management Act. End Note.] State owned
enterprises have had their own management difficulties,
making Minister of Public Enterprises Alec Erwin's
central mission to ensure that these enterprises are
strong enough to accomplish government's objectives (Refs
B and D).


12. (U) Recently, rigid labor policies have become a
public policy concern. Companies seem to avoid hiring
because of the costs and legal obligations that it
imposes. As a result, the most successful firms in South
Africa continue to be those that are capital intensive,
such as metals processing, chemicals, and pulp and paper.
Labor-intensive industries such as clothing and textiles,
footwear, food processing, wood and wood products are for
the most part weak competitors against cheap imports. A
debate has been initiated on how to make it easier to
hire unskilled workers. There is concern that government
training programs are not effective in meeting the demand
for skilled labor.


13. (U) In June 2005, the ANC released a controversial
document, penned by Deputy Minister of Finance Jabu
Moleketi, entitled "Development and Underdevelopment -
Learning from Experience to Overcome the Two Economy
Divide" that suggested a more flexible labor regime.
Proposals included waiving minimum wage and other
collective bargaining arrangements for younger workers,
establishing a separate regime for certain sectors such
as tourism, textiles and clothing, agriculture, small and
medium enterprises, as well as household and child care,
and establishing a separate regime for industrial
development zones. The document evoked considerable
criticism from the union and communist wings of the ANC
at its National General Council Meeting in July 2005.
The political jury is still out. (Ref C)


14. (U) On July 24 2005, after a three-day cabinet
retreat, President Mbeki publicly embraced the 6% growth
target and announced the formation of a high-level
economic task force headed by Deputy President Phumzile
Mlambo-Ngcuka to find ways to achieve it. Task force
members include Finance Minister Trevor Manuel, Trade and
Industry Minister Mandisi Mpalhwa, and the premiers from
Guateng and Eastern Cape Provinces. They are charged
with proposing ways to speed up growth and job creation
in time for the Medium Term Expenditure Framework due in
Parliament in October.

Comment: The Prospect for Growth
--------------


15. (SBU) A growth rate of 3.7% created a net 168,000
jobs for the economy in 2004, but economists agree that
job growth will have to be considerably higher to make a
real dent in unemployment. Most economists agree that an
average annual growth rate in the neighborhood of 6% or
more would be needed to reduce unemployment and poverty
in half by 2014. Hirsch and other policy makers assume
that a 25% fixed investment to GDP ratio would be
required to achieve 6% growth, but do not see it
happening until 2014. The Department of Treasury expects
growth to be 4.3% in 2005 and to average 4.2% per year
over the next three years.


16. (SBU) While the level of fixed investment needed to
stimulate higher growth and significantly reduce
unemployment can be debated, the shear volume of public
sector investment that the government is prepared to push
onto the economy is bound to stimulate growth above the
country's ten year average of 3.0%, reduce unemployment
levels, and hopefully the number of people living in
poverty. The real question is "How much bang for the
buck will the government get?"


17. (SBU) Prospects for short-term success would improve
if municipalities were better able to manage their public-
private partnerships, if state owned enterprises were
better managed, and if there were better skills
development programs for the unemployed. Prospects for
long-term success and the trajectory for growth would
improve if the government could afford more fixed
investment in the early years. This leads us to conclude
that foreign development assistance that added to the
size of the stimulus in the early years, or to the
ability of government to manage the stimulus, would go a
long way in helping South Africa achieve higher,
sustainable growth, reduce unemployment, and alleviate
poverty sooner rather than later. Given that South
Africa is perhaps the only real engine of growth for sub-
Saharan Africa, we would like to see that happen sooner.