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Strict fiscal consolidation crucial to avoid Moody’s downgrade

19 February 2018 Johann Els, Old Mutual Investment Group
Johann Els, Head of Economic Research at Old Mutual Investment Group.

Johann Els, Head of Economic Research at Old Mutual Investment Group.

The shocking abandonment of fiscal consolidation as a key policy anchor in the October 2017 Medium Term Budget Policy Statement (MTBPS) led to the downgrade to sub investment grade by S&P and the credit watch by Moody’s.

Since then, however, the accelerated speed at which events have moved – mostly in a positive direction – has been encouraging, despite being unexpected. Considering that newly sworn in President Ramaphosa has strong business experience and was heavily involved in the creation of the acclaimed National Development Plan (NDP), it is more likely now that the ANC will return to their more pragmatic policies.

It is against this backdrop that Old Mutual Investment Group’s Head of Economic Research, Johann Els, believes the upcoming budget will need to be a lot tougher than what South Africa has seen in the recent past. “While we do expect a somewhat better economic environment during 2018, which should marginally improve the fiscal numbers, a clear return to fiscal consolidation is needed. This should include both revenue and expenditure measures to speed up narrowing of the budget deficit in a more sustainable manner in order to stabilise the debt ratio.”

Els warns, however, that this will not be easy and will likely be painful to most taxpayers. “Minister Gigaba has mentioned in parliament, following the MTBPS fiasco, that an extra R30bn in taxes would need to be raised in this Budget. While a tighter fiscal stance is clearly needed, it would also need to be balanced with the need to not hurt economic growth too much – a key requirement by Moody’s.

“Thus, significant tax hikes are needed and would likely be concentrated at the top end of the income spectrum,” explains Els.

He outlines a number of options by which this could be done. “Fiscal drag, i.e. not making allowance for inflation pushing taxpayers into higher tax brackets, could raise R10bn, and an additional top marginal tax rate could result in a further R4-R5bn. R16bn could be raised by reducing tax expenditures via levying VAT on petrol (or alternatively a hefty fuel levy hike), while eliminating medical tax credits could raise R18bn (or R4-5bn if only for higher income groups). Since a wealth tax will probably not yet be introduced, capital gains tax and dividends tax rates could be raised again, along with normal excise and sin tax hikes, as well as the sugar tax.”

The big positive, however, would be a possible hike to the VAT rate, says Els. “While government has always said they will keep a VAT hike for when National Health Insurance is introduced, circumstances dictate that it might be necessary to consider this now. I do think that the probability of a VAT hike is higher now than over the past few years.

“A 1% hike in the VAT rate from 14% to 15% will raise around R20bn. Thus, a 2% hike could raise additional revenue of R40bn. Even if some of this is ‘given back’ as additional increases in social grants or additional zero rated goods, significant amounts could be raised which could make a serious impact on the budget. The probability of a tiered VAT rate structure has also become somewhat more probable. This, for example, could come in the form of a higher rate for luxury goods (20%?) and a still higher rate (30%?) for ultra-luxury goods.”

Within such an environment – coupled with likely sustained improvement in business and consumer confidence – Els predicts better economic growth for 2018. “There might even be some upside to our already above consensus 1.8% GDP growth forecast for 2018. This is a decent uplift from the 0.3% GDP growth in 2016 and the estimated 0.9% growth in 2017.

“Should politics continue to improve and the Budget marks a return to fiscal consolidation, then Moody’s might be willing to postpone a credit rating downgrade and the Rand could hold onto its gains. Under such circumstances inflation is likely to remain low – and likely lower than the Reserve Bank’s (SARB) forecast. Our own inflation forecast of 4.4% average for 2018 – already below consensus – could mean inflation rates below 4% over the next few months. This, combined with tighter fiscal policy, could lead to circumstances where the SARB could consider restarting its cutting cycle. We expect three rate cuts this year of 25 basis points each.”

Els concludes that while there are still many uncertainties, it seems reasonably clear that the improved political backdrop provides potential for a more positive outlook for 2018 than before. “The local currency and investment markets have already moved quite sharply to reflect much of this.”

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