MID TERM BUDGET STATEMENT PREPARES FOR 6% GROWTH

UNCLAS SECTION 01 OF 03 PRETORIA 004508

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E.O. 12958: N/A
TAGS: ECON EINV EFIN ETRD BEXP KTDB PGOV SF
SUBJECT: MID TERM BUDGET STATEMENT PREPARES FOR 6% GROWTH

(U) This cable is Sensitive but Unclassified. Not for
Internet Distribution


1. (U) Summary. Finance Minister Trevor Manuel delivered
his Mid Term Budget Policy statement (MTBPS) with the South
African economy facing relatively high growth, low
inflation, improving global markets, and low budget
deficits. Manuel's emphasis was on doubling South Africa's
current long-term average growth from 3% to 6%. Two major
themes emerged from the MTBPS: (1) the government would
accelerate growth by ramping up public sector investment in
the nation's infrastructure; and (2) the government would
reinforce public sector spending on existing social programs
in health, education and housing. Manuel did not announce
any major new tax or expenditure programs, but did recognize
that better management of welfare programs at both national
and provincial levels was essential. Manuel did announce
additional measures to relax foreign exchange controls. End
Summary.

Manuel Cites Favorable Economy
--------------


2. (U) Finance Minister Trevor Manuel cited low inflation,
increasing growth, and a much lower fiscal budget deficit as
South Africa's "sweet spots" during his Mid Term Budget
Policy statement (MTBPS) address. He said that South Africa
must now focus on fixing obstacles to increasing its 3% long-
term growth to 6%. By focusing primarily on improving
infrastructure, education, and housing, the MTBPS reaffirmed
the importance of developing the economy's supply potential
to shift the growth trajectory upwards. South Africa's
"sweet spots" should continue as the MTBPS forecasted steady
growth above 4%, low inflation and smaller than expected
budget deficits for 2006 through 2008. Forecasted growth in
2005 was raised to 4.4%, the highest since 1988. Peaking in
2006 at 5.2%, targeted consumer price inflation (consumer
prices excluding mortgage costs) should recede to 4.8% and
4.5% in 2007 and 2008, respectively. Thus, inflation should
remain well within the 3-6% target inflation range during
the 2005-2008 period.

Budget Deficit Lower than Expected
--------------


3. (U) Compared to the forecasted 3.1% budget deficit to GDP
ratio made last February, the budget deficit should be
significantly smaller, reaching 1% in 2004 and an average
2.1% over the next three years. An extra R30 billion ($4.6
billion using 6.5 rands per dollar) extra in tax revenue
should be collected this year as compared to forecasted
amounts. The Government spent only 46% of its appropriation
during the first six months of 2005/06, or R4.6 billion
($700 million). In the second six months, the public sector
should step up its spending on transportation and
electricity infrastructure, as well as low income housing.
This is part of a push to raise public sector fixed
investment over the next three years to 6.7% of GDP up from
its current level of 5.6%.


4. (U) Government will also funnel additional resources to
the provinces and local government. In 2006/07, provincial
and local governments should receive 57% and 6% of the
national government's non-interest government expenditures,
respectively. Provinces should receive an additional R30
billion over the next three years. Funding for housing and
transport projects should get R20 billion or 36% of the
additional planned government expenditures. For education
and health, Government will focus on improving the quality
of services, rather than on expanding their coverage.

No Foreign Funding and Growth Impediments
--------------


5. (U) According to the MTBPS, South Africa's current
account deficit should remain above its 2005 estimate of
3.5% for the next three years, reaching 4.1% by 2008. The
National Treasury believes that the deficit should be easily
financed by short-term foreign investment flows, which are
to some extent tied to the value of the rand. The National
Treasury still believes that the country would be better
served if it could attract higher levels of foreign direct
investment, but this has not yet materialized. Net foreign

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direct investment contributed only 9% to the financial
account surplus in the first half of 2005. [Note: a few
large British investments announced in 2005 should change
this view.]


6. Demand for South African goods should improve over the
next three years. In 2006, the world economy should grow by
4.3%. Although growth in the Euro-zone countries, including
some of South Africa's major trading partners, will grow
much slower than the world average, they should grow faster
in 2006. In 2005, the Euro-zone countries grew at 1.2%
compared to 3.5% for the United States. In 2006, the Euro-
zone growth should recover in 2006, reaching 2.2%.


7. (U) To ease the outward flow of foreign currency, Manuel
announced the next phase in the gradual relaxation of
exchange rate controls. Mutual funds and investment
companies will be allowed to hold up to 25% of their total
retail assets in foreign currency investments, up from 20%
and 15% of assets, respectively. South African banks will
be allowed to lend foreign currency denominated instruments
to South African companies and 3% of their total assets or
40% of their offshore capital without South African Reserve
Bank approval. Manuel announced no changes to exchange
controls governing individual South Africans.

No Tax Breaks
--------------


8. (U) Other than reforms in the tax treatment of medical
insurance plans and the introduction a 15% withholding tax
on foreign entertainers, Manuel made no mention of any other
tax changes or a reduction in tax rates. He did mention,
however, several changes on the revenue side for 2006, the
most important being the abolition of the Regional Services
Council (RSC) levies. The RSC levies consist of a payroll
and a revenue tax, which together constitute 80% of the
revenue collected by large urban metropolitan areas. Manuel
made no mention of raising any additional taxes to make up
for the loss of the RSC levies, although likely candidates
would have been taking a share of the fuel tax, creating a
new local business tax, and/or transferring more revenue
from the National Treasury to cities. Manuel added he would
announce adjustments to individual tax brackets and other
changes in February, but gave little detail about how these
would affect personal or corporate taxes.


9. (U) So far, the South African Revenue Service (SARS) has
collected R21 billion ($3 billion) more than anticipated in
last year's budget. Analysts believe that this revenue
overrun is likely to reach R30 billion ($4.6 billion) by
year's end. Local economists have offered several
explanations for the large discrepancy between the growth in
tax collections and the growth in GDP, such as improved tax
collection by SARS, a shift in consumer spending towards
higher valued goods, or the possibility that GDP growth has
been underestimated and will have to be revised upward in
early December. What is evident is that strong consumer
spending has driven VAT and customs revenue higher, and that
both corporate and personal income tax revenue has been
higher than expected.

Supply Side Emphasis
--------------


10. (U) The MTBPS emphasized infrastructure spending,
improving public services, the provision of better housing,
and improving job skills as ways to accelerate growth. Over
the Mid Term Expenditure Framework (MTEF) period from 2006
through 2008, government fixed investment spending will grow
from R18.9 billion ($3 billion) to R39.5 billion ($6
billion),with the greatest increases seen in low income
housing, rail transportation, road construction and the
provision of water services. The government also wants to
spend more on public health facilities and education.
Welfare spending as a percent of total expenditures will
fall from 19.1% in 2005 to 18.4% in 2008. Spending on
education will remain at close to its 2005 share of 21.4%
throughout the MTEF period.

Comment
--------------


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11. (SBU) The MTPBS and subsequent comments by government
officials stress the importance of infrastructure and
education in achieving higher growth. The question is,
"Will the South African economy deliver the appropriate
supply response?" Cement prices have risen considerably
faster than inflation, and rationing has already been
reported in the Eastern Cape. Shortages of engineers and
skilled labor are repeatedly cited as a constraint on
growth. Total investment should reach nearly 18% of GDP in
2008, still far short of the estimated 25% needed to achieve
6% real growth. Large investments in infrastructure by both
government and state-owned enterprises such as Eskom in
electricity, Transnet in transportation, and a new national
water utility should boost the economy and at the same time
improve basic infrastructure, but they test the supply
response of an economy already moving at full throttle. The
result may only highlight the constraints on growth posed by
the lack of skilled labor and labor market inflexibilities,
high transport and communications costs and the extreme lack
of capacity in government to deliver needed municipal
programs and services to the very large poor population
distributed throughout the country.

HARTLEY