Treasury's credibility to ensure fiscal sustainability at stake

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While government's proposed fiscal package to raise additional revenues of R25bn and cut expenditure by R27bn over the next two years sent a positive signal to the market, more may need to be done to meet medium-term targets and avoid pressure on issuance further down the line.

Softer global growth expectations, weak commodity prices and domestic energy supply constraints are likely to trigger marginal downward revisions to Treasury's real GDP growth forecasts from their MTBPS projections of 2.5% in 2015 and 2.8% in 2016. As a result, revenue collections, particularly further down the line, could come under increased pressure.

Meanwhile, this year's headline budget deficit is unlikely to deviate much from the MTBPS forecast given that lower-than-expected revenues are likely to be met with lower expenditure levels. Furthermore, thanks to a favourable boost to nominal GDP on the back of the latest national accounts revisions, the budget deficit ratio (relative to GDP) could even come in slightly better than October 2014's projections.

Tax policy changes

With this year's budget expected to toe the line, major tax policy changes are unlikely for this fiscal year. That being said, tax policy adjustments, including a potential VAT hike, are still likely over the medium term, especially in light of lagged expected poor performance in corporate taxes as a result of energy supply pressures. On a fiscal year-to-date basis, fuel levy collections are above target and personal income taxes are outperforming thanks to above-inflation wage settlements.

VAT and excise duties are also in line. Corporate taxes and custom duties, however, are coming in below budget targets with offshore earnings only partly offsetting the benign domestic environment. Nevertheless, policy and administrative reforms, reduced compensation for fiscal drag, potential hikes to the fuel levy (in light of lower oil prices) and small cuts to government's outlay on goods and services spend are likely to get the budget back in line this year.

We do not expect any significant changes to corporate taxes other than closing tax loopholes. SA's corporate tax rate ranks reasonably high on an international comparison and increasing this rate could dissuade investment into the country. While we believe the chances of a VAT increase in the upcoming budget have lessened, this is likely to be used as an additional revenue source further down the line. Particularly seeing as increasing the VAT rate by just 1% could garner an estimated additional R14bn worth in revenues.

This would, however, have to be accompanied by measures to alleviate the impact on poorer households. Additional hikes to the top income tax bracket (which may only provide an additional R4-R5bn) or increases to dividend taxes or estate duties may even be used to pave the way for higher VAT increases given the political challenges to raising so-called regressive taxes.

State-owned enterprises (SOEs)

The weak state of several of SA's SOEs' balance sheets could very well require further support from the sovereign over the medium term. The International Monetary fund (IMF) recently ran a risk scenario involving negative shocks to SA's medium-term growth rate and absorbing the stock of SOEs' debt. Under these extreme conditions, SA's public debt-to-GDP ratio could rocket above 70% by the end of the medium-term expenditure horizon.

For now, government has committed a deficit-neutral R23bn support package to Eskom which will be raised through the selling of state assets. Yet, we expect higher electricity tariffs to be approved early next year given energy regulator Nersa's decision to allow for a full pass-through of Eskom's increased usage of the open-cycle gas turbines.

Government also recently announced a 90-day turnaround strategy for South African Airways which includes cancelling non-profitable routes. In our view, it has become increasingly necessary for government support to failing SOEs to be accompanied by greater oversight, sound business plans and drawing on private sector resources.

Rating agencies

Although this year's fiscal target is likely to be met, placating rating agencies at the next Fitch and Standard & Poor's review in June 2015, we remain concerned about medium-term fiscal targets given pressure on trend growth in SA following energy constraints and labour market tensions. Fragile SOE balance sheets, including uncertainty over Sanral's funding model, and longer-term expenditure plans like the National Health Insurance add further pressure to SA's debt-to-GDP trajectory.

What's more, the 15% projected change in SA's debt-to-GDP profile between 2009 and 2019 is expected to be the highest amongst its emerging market peers, placing even more emphasis on the need for additional measures should the economic outlook worsen.

SA's longer-term debt sustainability hangs in the balance with slow progress on structural reform to which the rating agencies are playing close attention as a directional indication of SA's trend growth.

Land reform

The latest proposals on land reform in the State of the Nation Address (SONA), involving pilot projects for farmland redistribution and an attempt to ban new foreign land ownership, shows an increasing tendency toward higher state involvement.

Traction on Project Phakisa, furthering initiatives in the mining and oil/gas sectors, amongst others, bodes well, but funding for large-scale infrastructure projects in line with the National Development Plan (NDP) remains questionable. While government announced that they are reviewing immigration policies, making it easier to attract foreign skills, this is not new and progress on a range of other NDP proposals remains slow.

SA continues to struggle against peers in the Global Competitiveness Indicator rankings when it comes to infrastructure and goods and labour market efficiency. Without significant political resolve to drive reform, SA could remain a laggard against emerging market peers and faces further ratings risk.

Public sector wage bill

The ratings agencies have voiced concerns over SA's bloated public sector wage bill which has crowded out government capital spending in past years, further capping trend growth in the economy. This time around, however, official jobs figures show that the rate of growth in public sector hiring has slowed significantly. Furthermore, the lower oil price feeding into lower headline inflation estimates this year provides Treasury with more breathing room for inflation-linked wage settlements. Although, this will still be some way off the 15% the unions are demanding.

While the contingency reserve (an amount set aside to fund unforeseen spending pressures) has been drawn down, there is still a buffer of R5bn for the coming fiscal year, and R15bn the following year, which could be used to fund cost overruns.

Following on from the SONA, the discussion around minimum wages may be on the agenda. The implementation of minimum wages looks increasingly likely as we near the 2016 municipal elections. But this could, in our opinion, have further negative repercussions on employment growth and inflation going forward.