Abstract
2018 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for South Africa
Our South African authorities appreciate the candid engagements during the 2018 Article IV Consultation, and look forward to further regular interactions with and helpful advice from the Fund on policies that can raise potential output and improve the economy’s resilience. The recent change in political leadership presents an important opportunity, and the new administration has embraced a new urgency about reducing high unemployment, poverty, and inequality. In this regard, they are focused on addressing the long-running impediments to growth, increasing the levels of investment in the economy, accelerating reforms, protecting the most vulnerable, and improving governance.
In recent years, however, macroeconomic policy has been complicated by a combination of slow growth; significant structural challenges; a deterioration in the financial position of state-owned entities; policy uncertainty; as well as several exogenous shocks, such as the fall in commodity prices and a historic drought. Nevertheless, the economy has maintained strong fundamentals, underpinned by a diverse industrial base, deep and liquid domestic capital markets, a flexible exchange rate and effective inflation targeting, strong institutions, and the newly-enhanced financial stability framework. Based on these fundamentals and the opportunities presented by a supportive global environment, the authorities agree with staff on the potential impact of a well-executed reform agenda, and are determined to make progress in this regard.
Recent developments and the economic outlook
A strong turnaround in the primary sector and robust global growth have provided much-needed support to growth in 2017. Following two consecutive contractions, agriculture grew by 17.7 percent in 2017, as a prolonged drought came to an end. At the same time, favorable global economic conditions helped the mining sector to achieve a growth rate of 4.6 percent, compared to a contraction of 4.2 percent in 2016. Accordingly, a larger merchandise trade surplus compared to 2016 partially offset the deficit in services, income and transfers, narrowing the current account deficit from 2.8 percent of GDP in 2016 to 2.5 percent in 2017. With positive supply side shocks during 2017 and slow private credit extension, inflation slowed from 6.4 percent in 2016 to 5.3 percent in 2017, reaching 4.6 percent in June 2018.
During the first quarter of 2018, high-frequency data and global forecasts portended a strong recovery in household consumption and a rebound in private investment following the change in political leadership. In this context, the authorities have projected a growth rate of 1.5 percent for 2018 and 1.8 percent in 2019. Nonetheless, they recognize the opportunity to accelerate growth to be in line with the reform scenario presented by staff. This is critical to address the challenges of high unemployment, poverty and inequality facing the country. For these reasons, the authorities are accelerating efforts to restore confidence and boost investment, particularly in manufacturing and services, and will target more policies that improve the inclusivity of growth.
Since the tabling of the 2018 Budget, the balance of risks to the outlook have tilted further downwards, with international trade tensions likely to affect South Africa’s largest trading partners, should they escalate. In addition, a stronger dollar and higher US bond yields, as well as changing sentiment towards emerging markets, have led to lower capital flows, while global oil prices are trending up.
Fiscal policy and debt management
The primary objective of the 2018 Budget is to reduce the budget deficit and stabilize debt as a share of GDP over the medium term. The authorities’ fiscal consolidation plans envisage a primary deficit approaching zero in 2021, with the consolidated budget deficit declining from 4.3 percent in 2018 to 3.5 percent in 2021. After taking into account the reprioritization of spending, the overall expenditure ceiling has been revised downward by R5.8 billion or 0.1 percent of GDP. In addition, 0.7 percent of GDP in new revenue measures in 2018/19 have been implemented. The measures include an increase in the VAT rate, limiting personal income tax bracket adjustments for inflation, and an increase in the fuel levy and excise duties. Under the baseline growth scenario, these actions should ensure that non-interest government spending remains within the ceiling, currently translating to 26.6 percent of GDP. This will help stabilize the debt ratio at around 56.2 percent of GDP in 2022/23.
The authorities appreciate staff’s analysis and recommendations on government spending and debt dynamics in the Selected Issues paper, and welcome further bilateral engagements on the recommendations. Some of the major policy changes recommended by staff – such as the wage setting process, the ownership structure of state-owned enterprises (SOEs), tertiary education subsidies, as well as the appropriate structure and size of government – will require intensive reviews and decisions at a high-level. That said, within the existing framework, the authorities are taking strong actions to reign-in government spending, including reducing staff numbers by compelling government departments to remain within their allocated budgets, regardless of higher unit labor costs emanating from the latest wage agreement. They have also announced plans for an updated employee-initiated severance package (EISP) and early retirement arrangements to reduce headcounts, especially within non-critical functions.
The financial and management challenges facing SOEs are being addressed. For instance, as reflected in Box 4 of the staff report, corporate boards and management teams of large SOEs such as ESKOM and South African Airways have been dismissed, as part of efforts to address previous governance failures. New management teams have been tasked with developing financial recovery plans for their respective enterprises. In addition, the authorities agree with staff’s recommendation that stronger conditions are required before granting debt guarantees from the sovereign, and they have been working actively on finalizing these measures. In the meantime, they are cognizant of the high risk to the fiscal strategy posed by SOEs, including the national airline, which may require financial assistance. In this regard, while addressing the short-term financial challenges, they are exploring different long-term solutions, including greater private sector participation.
The authorities remain committed to maintaining strong policy buffers against external risks, as well as a risk-based approach to financing. The flexible exchange rate is a key buffer, while portfolio benchmarks are in place to limit foreign-currency debt to 15 percent of the total portfolio. At the same time, the authorities will continue utilizing domestic markets as the primary source of government borrowing. In addition, the bond-switch program, by which shorter-dated bonds are exchanged for bonds with longer maturities, will continue.
Further, the authorities welcome staff’s advice on the policy options for further reducing inequality, as outlined in the Selected Issues paper, and will take these into consideration. In the meantime, fiscal policy will continue to provide for poverty reduction and progressivity. This will be achieved, among others, through high-coverage protection for the most vulnerable, including social grants that will increase above inflation over the medium-term, and the zero rating of VAT for basic foodstuffs and goods.
Monetary policy
The Monetary Policy Committee (MPC) of the South African Reserve Bank (SARB) provided some additional accommodation in July 2017 and March 2018, lowering the repurchase rate to its current level of 6.5 percent per annum. At this level, the MPC assesses the stance of monetary policy to be accommodative and appropriate given the current state of the economy.
During its most recent meeting on July 19, 2018, the MPC signaled that the bottom of the inflation cycle had been reached. Although inflation will remain within the inflation target range of 3–6 percent over the medium term, risks to the inflation outlook are tilted to the upside. The main drivers of risk include oil prices, rand weakness due to shifting emerging market sentiment, higher domestic electricity prices, and changes in global monetary settings.
The MPC’s approach to inflation targeting is to look through the first-round effects and focus on the second-round effects. With risks and uncertainties at higher levels, the MPC has signaled that it will continue to be vigilant and will not hesitate to act should there be second round effects that take inflation significantly away from the mid-point of the target range.
The exchange rate continues to play an effective role as a buffer from external shocks and the authorities remain committed to a flexible exchange rate. The authorities also remain committed to take advantage of opportunities to accumulate reserves, including from FDI flows. At the end of December 2017, the level of international reserves remained close to end-2016 levels, at around 5 months of projected imports.
Financial sector policy
The Financial Sector Regulation Act was signed into law in August 2017, and the implementation of the Twin Peaks regulatory framework commenced on April 1st, 2018 through the launch of the Prudential Authority and the Financial Sector Conduct Authority. This development follows the enactment of the Financial Intelligence Center Act (FICA), through which the country is fully aligned with current international standards on AML/CFT. Periodic stress tests and on-site inspections – which include AML/CFT checks – have been institutionalized, and will in due course include insurance companies. Meanwhile, work is ongoing on a new resolution framework that will include the establishment of an explicit deposit insurance scheme for banks.
The banking system remains sound, with high capital adequacy and liquidity ratios. It is also noteworthy that, despite poor economic growth, South African banks have maintained a reasonable return-on-equity of between 16 percent and 17.4 percent, with after tax profits still increasing by 7.6 percent in 2017. While the authorities agree with staff’s conclusion in the Selected Issues paper that the vulnerabilities of smaller banks would, in isolation, not be of systemic importance, they remain vigilant about addressing the vulnerabilities of small banks. Indeed, the recent failures of the African Bank and VBS Bank were handled effectively, with no significant impact on the overall system, and with broadly successful protection of depositors. The new framework will further strengthen this already capable system.
The authorities are making steady progress in improving financial inclusion. In this regard, the granting of two new banking licenses in 2017 should help increase competition in the sector and expand the provision of financial services. The authorities have also noted an improvement in the amount of lending to small and medium-sized enterprises (SMEs), and will work towards further improving access to credit for SMEs.
Structural and governance reforms
The new administration has committed itself to clear objectives and has moved swiftly to address policy uncertainty, improve the pace of policy implementation, and strengthen governance. In this context, the independent power producers (IPP) program is being accelerated, while delays in finalizing the mining charter, and the legislation dealing with mineral and petroleum exploration, are being addressed.
The authorities are also finalizing a Single Transport Economic Regulator Bill, which will help improve efficiency in the transport sector. They are also reviewing programs that may be contributing to inefficiency, including tax incentives to certain industries, and are amending public procurement legislation in order to align previously disparate procurement regulations across different components of the state. They have also been clear about their goal to attract more private sector participation in network industries and explore a mass restructuring of the electricity/energy market. The authorities have also embraced the opportunity to contribute to regional integration. In this regard, they recently signed the African Continental Free Trade Area (CFTA) with the African Union and are proceeding with the process of getting it ratified through Parliament.
The authorities acknowledge that there is need to address issues related to corruption and governance, and are taking more wide-ranging and forceful steps than reflected in the staff report. For instance, the judicial system continues to be very effective in applying legal sanctions. In addition to the large-scale management changes, a judicial commission was appointed to investigate administrative, legal, and ethical violations in the South African Revenue Service (SARS), a critical institution of the government. Meanwhile, across numerous state institutions, various high-level officials have been suspended, dismissed, or placed under disciplinary action. In some cases, criminal indictments have been issued and judicial processes are taking their course. Furthermore, the authorities are assessing the legal and enforcement gaps that contributed to the phenomenon known as “state capture”.
Conclusion
South Africa is a diverse and vibrant democracy, where consultation and collaboration is highly valued. Although this does at times affect the speed of policy implementation, raising the level of potential growth is the most important objective for the authorities in the medium-term. They will continue to work towards attracting investment and rebuilding confidence, while stabilizing public finances and placing public debt on a sustainable path. They consider that inflation targeting and a free-floating exchange rate are vital tools in the policy arsenal, and will continue to protect these buffers.