Pravin Gordhan faces tough decisions
Not only is Finance Minister Pravin Gordhan facing enormous economic pressure, he is left with the task of restoring the country’s credibility after last year’s axing of finance minister Nhlanhla Nene, making this year’s budget arguably the toughest a South African finance minister has had to face.
Some analysts are already worried that bond yields are trading at levels that price the country’s debt alarmingly close to junk status.
The picture this week became even bleaker when the World Bank dropped its forecast for South Africa’s economic growth to 0.8% for 2016, down from 1.3% in 2015.
The dramatic slowdown spells bad news for the taxman; low growth is expected to hurt the government’s already squeezed tax revenues.
This leaves Gordhan, and the government in general, with almost no room to avoid making some very difficult, and politically unpalatable, decisions about government spending – particularly in a year of local government elections.
The Mail & Guardian reported last week about the tough choices Gordhan spelled out to his colleagues in the ANC, including the possibility of budget cuts that affect social spending, which is a holy cow for the ruling party.
But Gordhan has publicly committed to doing whatever is needed to avoid a credit ratings downgrade.
In an interview last week, Professor Jannie Rossouw, the head of the school of economic and business sciences at the University of the Witwatersrand, said the current level of the exchange rate and the domestic bond rates suggest the market has already priced in a ratings downgrade.
If this could be averted, the exchange rate could improve.
The yield on the benchmark R186 bond was at about 9.4% earlier this week, down from highs of more than 9.8% in January, according to data from the South African Reserve Bank.
Nazmeera Moola, a strategist at Investec Asset Management, said in a note this week, although serious, a downgrade to junk status must be seen in context.
South Africa stands to lose its investment grade rating with one of the three major ratings agencies, Standard & Poor’s. It has rated South Africa at BBB– with a negative outlook and has two years to decide whether to lower this grade or remove the negative outlook and keep the BBB– grade.
In addition, a downgrade to junk only applies to sovereign debt issued in foreign currency, which makes up about 10% of South Africa’s issued debt, she said.
“The vast majority of South Africa’s debt has been issued in local currency. It is also these rand-denominated bonds that have been included in the world government bond index,” she said. As such, a downgrade will not force “widespread selling from rand-denominated South African government debt”, she said.
Nevertheless, things are still “far from well with South Africa’s finances”, she added. The decision to switch finance ministers clearly rattled investors and, even with the trusted Gordhan back at the helm, the rand is still significantly weaker than it was before the reshuffle and bond yields are still 80 basis points higher than before President Jacob Zuma’s announcement.
This is partially to do with the deterioration of the global economy but mainly because of a “loss of trust in the treasury and the South African Reserve Bank”.
Moola said that before the December announcement – despite global developments, emerging market issues and even South Africa’s internal challenges such as Eskom – investors were reassured by the belief that the country has strong structural institutions in the treasury and Reserve Bank.
This trust was undone by the December announcement and “it will take a long time to rebuild it”, she said.
On the revenue side, Gordhan has several options, according to Moola. An increase in the valued-added tax (VAT) rate is the most obvious source of funds but this is going to be difficult to do given the impending elections, she said.
Referring to work done by the Davis tax committee, she said the negative effect on growth by increasing VAT is less than raising the same amount of revenue from corporate or personal income tax.
In a report last year, the committee said an increase of the VAT rate by three percentage points, from 14% to 17%, could raise R45-billion. To raise a similar amount of money from personal or company taxes, the personal income tax rate would need to be raised by 6.1 percentage points and the company income rate tax by 5.2 percentage points. From a macroeconomic perspective, the committee found that “VAT is the least distortionary”.
A common criticism of increased VAT is that it is regressive and disproportionately hurts the poorest consumers. But research has also shown that, with the VAT exemptions on some items, this is not the case, Moola said.
When it comes to expenditure, the government cannot change the wage settlement it reached last year with civil servants, which would lead to a contractual dispute.
Last year the state agreed to an effective 10.1% increase in wages and benefits, and the agreement runs for three years.
Moola said, in theory, the state could retrench workers, but there is no appetite to do this.
This leaves attrition as the only way to curb the growth in the state wage bill, said Moola, although it is not the ideal way by which to “right size” the civil service.
“In order to meet the promises he has made publicly, there need to be hard political decisions made, and not just from Mr Gordhan but from the Cabinet as a whole,” said Moola. “I am very hopeful that they make these decisions. I am just cautious about building them into my base case.”
In a recent media briefing, Nazrien Kader, the managing partner for taxation services in Africa at the advisory firm Deloitte, said: “Possibly no previous minister of finance has had to walk a tightrope like Minister Gordhan will have to.”
She described the challenges the economy faces – including poor growth, the electricity crisis, a growing water crisis, foreign capital outflows and the rising government wage bill – as a “perfect storm”.
Although raising taxes is “usually unwise and unpopular during an election year”, South Africans have been warned of pending tax increases, she said.
It is possible that the marginal tax rate for individuals could be raised to 45% but it is too premature to introduce a wealth tax, as has been proposed in countries such as the United Kingdom.
Kader also said it is possible that a special levy could be applied to companies based on turnover and individuals earning above a certain threshold. She said there is precedent for a levy. “We have previously had the transitional levy, which was purposefully applied to aid the transition to democracy.”
It would be applied as a flat percentage of actual turnover above a certain threshold for companies, or on gross earnings above a certain threshold, and other than from employment, by individuals.
But, with tax increases, the electorate will be “banking on transparency and efficiency”, Kader said. Transparency will be key and Gordhan will be judged on how and where tax collections are spent.
Citizens will be much less tolerant about wasteful expenditure, including public sector wage hikes that exceeded the three-year commitment, Kader said.