Standard Chartered — 02/18/2008
LOOKING AHEAD AT WEDNESDAY'S BUDGET
Razia Khan
To halve unemployment in South Africa by 2014, growth of 6 percent a year was required under the the government's programme - the Accelerated and Shared Growth Initiatives for South Africa (ASGISA). Then predicted growth was dropped from 4.3 percent to 3 percent. The country has two levels of unemploymemt: those who are actively seeking work but are jobless – 26 percemt. And those who for one reason of another have given up seeking work – 38 percent. In a budget review today, Razia Khan (Regional Head of Rssearch, Africa: Standard Chartered Bank) comments: ' We have revised down our full year GDP forecast for 2008 from an initial 4.8% to 3%. Even without taking into account the additional expenditure that may now be required, revenue collection is likely to fall. This will have implications for South Africa’s fiscal policy'. (Razia.Khan@standardcnartered.com).

 Here are a few extracts from Khan's review:

In South Africa,  attention this week will be focused on the annual budget, to be presented on Wednesday
20th February. South Africa’s reputation for fiscal conservatism is now well-established. Only in October last year, the Medium Term Budget Policy Statement (MTBPS) laid out the framework for the achievement of
small budget surpluses over the coming years, despite an accelerated public works program involving
increased spending on infrastructure. Back then, of course, the country was in the throes of a heady
economic upturn. In a short space of time, much has changed. While there is still a chance that revenue
collection for FY 07/08 will perform reasonably relative to initial budget assumptions, the future now looks
much more uncertain with South Africa's recent power crisis impacting negatively on growth prospects. The
South African Treasury has already signalled that growth forecasts are likely to be downgraded, although not
dramatically so. Below, we examine what this is likely to mean for the country's fiscal ratios, and the
implications for Budget policy.

How much, and for how long, does growth deteriorate?
It is perhaps still too early to grasp the full impact of the recent energy crisis on South African growth. After
all, much will depend on the policy mitigants that are put in place - and we will only get a greater sense of this
post-Budget. So it may well be the case - as the Treasury say - that the downgrades to growth forecasts are unlikely to be too dramatic. But at present, we see downside risk dominating and prefer a more cautious
approach. For a long time, largely due to efficiency gains at the South African Revenue Service, South Africa
has consistently surprised with tax revenue overruns. Now, for the first time in many years, we are
concerned that too shallow a downgrading of growth forecasts may result in revenue targets that are
too ambitious.

The reason? It is not the energy crisis alone that needs to be factored in to growth forecasts. The economy faces a triple whammy – the unlikely confluence of earlier interest rate tightening feeding in to the real economy, a global economic slowdown, and – not least – the energy crisis, all taking place at the same time. While we remain upbeat on the medium term outlook (the structural shift now underway in South Africa is too important to be ignored) – we remain concerned about the outlook in the very near term, when cyclical factors exacerbated by the energy crisis are likely to dominate.

Monetary policy – time lags matter
Since June 2006, South Africa has seen 400 bps of interest rate tightening. There is now increasing
evidence that monetary tightening is finally starting to have an impact on the real economy, but a
deteriorating inflation outlook means that it is unlikely that we will see any interest rate easing soon. The full
impact of interest rate policy changes are in any case thought to influence the economy after an 18-24 month
time lag, although as much as 50% of the impact may be seen in the first 9-12 months following an interest
rate change. In other words, we are only just starting to see the full impact of the initial tightening feeding in
to the real economy – with the last rate hike in Dec 07, there is much more still to come.

Next up: a global slowdown – South Africa will not be immune
While South Africa may not be the most open of emerging economies, trade as a percentage of GDP has
increased steadily in recent years. Already-weak manufacturing must now contend with a probable slowdown in South Africa’s key trading partners including the Eurozone, as well as the potential near-term loss of one of its key competitive advantages – an abundant and cheap supply of electricity. While few are predicting that
the energy crisis will mean that South Africa loses its advantage of cheap electricity entirely (it still retains a
very competitive position globally), prices nonetheless are set to rise from current levels. While a weaker
ZAR has in the past provided some stimulus to exports (in 2002, it was part responsible for the achievement
of a small current account surplus), in the context of a global slowdown, and supply-side difficulties at home,
even a weaker currency may not be sufficient to safeguard growth.

Finally, the energy crisis
Then of course, there is the energy crisis itself…it appears to boil down to an underestimate of the growth in demand for electricity, and more fundamentally, poor planning and a low reserve capacity due to the
dwindling of coal stockpiles at power stations. At the time of writing, it is estimated that South Africa will see
at least 6 months of emergency measures, followed by 4 years of power rationing – which will cut the
availability of power to big industrial users in the mining and manufacturing sectors.

Budget 2008: Electricity – the key consideration
Given the centrality of the energy crisis, measures to mitigate the impact on growth as well as support for
Eskom (the electricity parastatal) will be a key focus for the Budget. President Mbeki's State of the Nation
address delivered in early February had already hinted at the State provision of support for Eskom, which
faces at least a ZAR 300bn capex spend over the coming years. The Budget is likely to provide detail on how
this will be done with potentially important fiscal implications. First, there is the size of any support package.

In order to be meaningful, it would likely have to exceed MTBPS projections for the fiscal surplus in FY 2008/09, or 0.7% of GDP. With monetary policy currently constrained, the burden is likely to fall on fiscal policy to provide the necessary mitigants to safeguard growth. Various government ministers have already spoken of the need for a capital injection into the beleaguered state-owned electricity company. Even outside of its planned investment spend, the current crisis has meant that Eskom is running some of its most expensive plants at close to full capacity in order to keep up with demand. Plans to increase existing stockpiles of coal as quickly as possible are likely to have an additional negative impact on the parastatal's operating costs. As a result, Eskom has already been put on watch for a potential downgrade by ratings agencies. This complicates Eskom's access to capital markets, making it more expensive for Eskom to
access the financing it will need over the medium term, at precisely the time that it is likely to need it the most.
Given the potential downside consequences for growth, this is not something the authorities can risk. A more
proactive response is promised.

Something may have to give in the short term, and it is likely that the near term desire for a fiscal surplus may have to give way to a more realistic assessment of the economy’s immediate needs. In our opinion, this would not signal a significant departure from existing policy, and it would not warrant any ratings action for South Africa. Whether it is because of declining revenue, or increased expenditure, or both, it appears unlikely that South Africa will be able to announce another comfortable fiscal surplus in FY 08/09.

The Market Impact
So what is the eventual market impact of the Budget likely to be? Increased spending, and the strong
likelihood of a move from a Budget surplus back to a deficit should, other things being equal, have
implications for the supply of domestic paper, helping to support bond yields. On the exchange rate, we do
not expect any specific policy measures. Nonetheless, it is usually sentiment around the time of the Budget
that emerges as an important influence on the ZAR. While the Budget has been touted in some quarters as a
potential turnaround factor for the ZAR (which has been weakened considerably in recent weeks), we are not
altogether certain that markets will rally in response to this year's Budget.

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