South Africa 2016Budget Preview:It’s now or never

Mr Gordhan will deliver the Budget Review on Wednesday 24 February.

    The economy has entered treacherous waters as growth is at its weakest in six years, whilst facing a credit downgrade. Matters are complicated by increased uncertainty in global markets. In an unprecedented move, business and government have reached an agreement in recent weeks to take tough action if sub-investment grade status is to be averted. This includes, among others, tax hikes and expenditure cuts. Such measures will be essential for fiscal consolidation to remain on track (from -3.8% in 2015/16 to 3% in 2018/19).

    We estimate a cumulative three-year budget shortfall of 2.5% of GDP.

    The reality is, as our estimates reflect, proposals have to be balanced for the Finance Ministry to plug a cumulative R115bn budget shortfall over the medium term. Even then the borrowing requirement will increase by R52bn. These shortfalls are rooted in the weaker economic outlook, increasing inflation pressures and higher borrowing costs. We think that revenue and expenditure measures will come to R55bn (1.2% of GDP) and R47bn (1% of GDP) respectively over the medium-term, and will most likely be back-loaded.

    The expenditure ceilings will need to be lowered. The wage bill requires particular attention, albeit faced with limited options. In October, the Treasury assessed resource constraints to be “less binding from 2018/19 onwards”. This year not only marks the second-consecutive year which real government expenditure was forecast to grow at 2.5% yoy, but it also contained a contingency reserve (i.e. unallocated spending) of R15bn.

    As with expenditure, we believe revenue proposals will also likely be phased-in over time. The growth environment in 2018/19 may be more suitable for structural tax proposals, when an estimated R35bn additional revenue is needed. Carbon taxes and VAT increases will probably be adjusted in the final year. In the interim, we believe no more than R10bn - R15bn can be squeezed from new taxes, such as capital gains taxes and possibly additional tax adjustments to the upper income tax rate. In the event that the Treasury decides to implement changes to VAT this year, this may have serious inflationary consequences, which would pose a risk to our call of 100bps cut next year.

    The challenge is to balance the macro-economic risks with the medium-term challenge of fiscal consolidation.

    Ratings’ agencies are also wary of reduced fiscal flexibility and the rate of change in government debt in recent years. These are two (of five) separate credit metrics that inform the ratings view. South Africa’s fiscal flexibility has already deteriorated. It means that the target of reaching -3% in the medium term cannot be pushed out another year. In addition, the rate of change in the debt to GDP will have to improve, not increase as the Treasury forecast in October last year. But this may be a significant challenge in the face of higher interest costs and a weaker exchange rate. Judging from recent exchange rate pressures alone, we estimate an increase in the debt ratio of 5.2% for 2016/17 - assuming Treasury still comes to market with an offshore loan.

    Debt consolidation will be tricky, but there are temporary short-term solutions.

    We estimate an increase in funding of R14bn, R26bn and R14bn in 2016/17, 2017/18 and 2018/19, respectively. The bulk could come from less expensive short-term loans and liquidation of cash balances. Treasury could also continue to make use of the surplus funds held at the Corporation for Public Deposits totalling R73bn over the next three years. But this could be undesirable over the long-term, as it will raise the consolidated fiscal deficit