Growth in the South African economy is “as good as it gets”, says investment company Citadel’s chief economist Dave Mohr.
“Whilst we believe that 4% growth for 2005 is achievable, we are concerned that our new-found prosperity does not appear to be so solidly based as is commonly believed. What seems to be happening is that the good news is over-emphasised, whilst potential risks are ignored.
“The common perception is that the current sweet spot will last for ever, but we know that is not going to happen,” Mohr said.
The South African economy is currently delivering its best performance in many decades with the expansion entering its 68th month, but Mohr believes that the growth is unbalanced, with South Africa dependent on volatile foreign capital inflows for its continued prosperity.
“Economic growth is above 4%, whilst inflation is at 3%. Consumer borrowing rates hover around 20-year lows and the long-term investors are happy to lend to government at about 8% — also the lowest in more than two decades,” Mohr said.
Mohr pointed out that, very importantly, almost all South Africans appear to be benefiting from the current economic trends.
Although interest rates are at two-decade lows, depositors and lenders are still receiving significant real returns of about 4% on their investments.
Homeowners are enjoying a boom in property prices. In the past five years, residential property prices have registered their biggest real price gains in more than four decades.
After a rocky period in 2002, local equity investors have also shared in almost a doubling in the JSE Securities Exchange since mid-2003, provided they were not boots and all in resource shares.
In the labour market, conditions are also favourable. The latest labour survey indicated 251 000 new jobs were created between March and September 2004. In addition, wages and salaries rose 4% above inflation.
Consumers received a further boost to their international purchasing power from a soaring rand.
In the past three years, the estimated dollar purchasing power of the average employed South African rose by 150%.
Consumers have not been shy to use their surging consumption power. For example, car sales rose by 50% between early 2003 and March 2005. Real household spending ended 2004 accelerating at a rate of 7% — the highest in 16 years.
Government finances also benefit from the buoyant economy and markets. Borrowing costs are down and revenue is up, allowing the government to spread the benefits of economic prosperity.
In the past two years, the number of people receiving social grants rose from 7,9-million to about 10-million, and this is projected to grow to 12-million in 2007.
Foreign investors also appear to be endorsing the increased prosperity of the local economy.
Foreign capital inflows surged to R64-billion in 2004, allowing South Africans to consume much more than they are producing and enabling the South African Reserve Bank to rebuild the country’s official foreign exchange reserves by $7-billion over the past 12 months.
“However, despite the booming economy and markets, several developments call for caution. South Africa’s economic growth continues to lag the average emerging market and global growth rates. According to the International Monetary Fund, global growth reached a three-decade peak of 5% last year [the highest since 5,1% in 1976],” Mohr cautioned.
In addition, the acceleration in domestic growth appears to be based on a domestic spending boom. Consumers, companies and the government are all joining in the spending spree.
At the end of 2004, domestic real consumption and fixed investment grew at annual rates of 8,5% and 9%.
Although some of the spending boom reflects “catch up” from years of suppressed spending, several warning lights are starting to flash.
Firstly, local consumers are rapidly expanding debt levels. Several indicators of household borrowing are growing beyond real rates of 20%. Lower interest rates and the booming residential property market are acting as catalysts for higher borrowing.
However, given the current rates of debt escalation, any sharp rise in interest rates or setback to the property market could result in substantial distressed debt.
“Whilst the acceleration in fixed capital formation is to be welcomed, the surge in property related investment [real residential investment growth in 2004 was the highest since the mid-1960s] suggests that potential surplus capacity could be developing. Previous property booms typically ended with substantial surplus capacity and tears as owners have over-capitalised,” Mohr said.
Following years of spending restraint, government outlays have picked up significantly. With armament purchases, increased social grants and accelerated infrastructural spending all kicking in at present, the share of government spending is currently approaching the bloated levels of the early 1990s, despite a rapidly growing economy.
Government spending appears to be on a 9% real spending clip, a rate clearly not sustainable over the long term. In his November 2004 Medium-Term Budget Policy Statement, the minister of finance, for example, stated that the current acceleration in the number of people receiving social grants is not sustainable over the longer term, and the government strategy is to move people from being dependent on the government to becoming contributors to the government as they become tax payers by being employed.
The combination of a strong rand, lower interest rates, buoyant financial and property markets and strong increases in real wages has led to a rapid rise in imports.
In the past two years, import volumes are up more than 30%. At the same time, domestic exports have not fully benefited from the booming world economy.
Commodity prices have surged about 50% in dollar terms, and related export volumes have picked up. However, manufacturing exports have suffered and overall export growth severely lagged import growth.
Consequently, the balance on the current account of the balance of payments deteriorated to its biggest deficit in more than 20 years, despite booming commodity prices.
At its current rate of deterioration, the deficit on the current account as a share of the economy could soon reach the levels currently being experienced by the United States.
Any deterioration in the present elevated levels of commodity prices, as has happened so often in the past, will merely accelerate these trends.
Although the Reserve Bank’s level of foreign exchange reserves has risen substantially, it’s still believed to be well short of levels that could act as a buffer to any adverse current account developments.
Expressed in months of import cover, the foreign exchange reserves are still only hovering at about three months.
Measured against the reserve levels of other emerging markets, South Africa continues to be close to the bottom of the ladder.
This low level of reserves is a direct consequence of the different exchange policies followed by South Africa and most of the emerging markets.
Whereas most of the successful emerging markets, particularly in Asia, appear to be targeting a competitive real exchange rate, the domestic real exchange rate is allowed to fluctuate widely. In the past three years, the real trade-weighted rand rose by 60%.
Currently, the widening current account deficit is easily financed by capital inflows, hence the continued strength of the rand.
However, a close examination of the composition of these inflows reveals potential sources of concern.
Firstly, the bulk of the identifiable inflows appear to be portfolio flows. These flows are typically fickle and any change in sentiment towards emerging markets could, as in the past, trigger a reversal of such flows. The past few years’ emerging markets have been the darlings of the financial markets.
Negative real short-term interest rates in the US led to an international search of alternative higher yielding markets.
Emerging markets were major beneficiaries and emerging market financial ratings rose to historically high levels.
Emerging market assets appear to be priced for perfection. In recent weeks, however, with US interest rates rising, markets are starting to question the current high rating of emerging markets.
Secondly, direct foreign fixed investment, the most stable component of capital inflows, remain at disappointingly low levels and totally inadequate to fund the growing current account deficit.
Economic cycles historically have often been dictated by balance-of-payments developments. Current balance-of-payments trends are precariously balanced and could easily lead to unstable financial trends.
Such instability will lead to significant financial volatility, with the rand weakening and interest rates rising. Current favourable economic trends will be negatively influenced and financial and property markets will not escape unscathed. — I-Net Bridge