Jac Laubscher, Group Economist: Sanlam Limited

4 July 2008

Focus on economic growth

With inflation figures still surprising on the upside, the focus remains on further interest rate hikes. However, should inflation reach its peak in the third quarter as expected, it would be logical to assume that the peak in interest rates is also approaching. During the previous tightening cycle in 2002 the last increase in the repo rate preceded the peak in inflation by two months.

Monetary policy cannot do anything about historical inflation, and the Reserve Bank will have to accept the fact that inflation will remain outside its target range for some time.

However, the reduction in interest rates will be delayed by the slow decline in inflation, and the extent of the cuts will be limited by the continued high current account deficit. To a certain extent the sharp reduction in interest rates from 2003 to 2005 was an experiment that was not 100% successful, as seen in the explosion of household debt, and rates will not decline to such low levels again quickly.

The focus should now shift to the medium-term outlook for economic growth.

It is painfully clear that the economy is in a cyclical downswing that is intensifying. However, as surely as day follows night, a cyclical recovery will follow in response to an eventual relaxation of monetary policy.

A GDP growth rate of 3% to 3,5% is likely in 2008, and should be a little lower in 2009, depending on the size of further interest rate hikes.

For now the cyclical deterioration in the economy is driven mainly by lower growth in household consumption spending in response to the pressure on real disposable income, specially the discretionary portion thereof. However, capital expenditure by the private sector will follow gradually - the sharp decline in business confidence is already pointing in this direction.

Nevertheless the economy should reach a cyclical turning point by the middle of next year. The real question is whether we will see a return to sustained growth of 4,5% to 5,5% a year, or 3,5% to 4,5%.

The fact that the downswing is clearly not only of a cyclical nature will play a crucial role in this regard. Well-known structural constraints (see ASGISA, for example) are making their presence felt, and the strength and sustainability of the impending cyclical recovery will to a large extent be determined by whether the efforts to eliminate these constraints are successful or not.

The structural constraints cover a wide range of issues, some of which can be regarded as "hard" constraints and others as "soft" constraints. The "hard" constraints include among others the following:

• The inability of the SA economy to generate sufficient savings to maintain a sustained high investment rate. Consequently SA is still dependent on continued foreign capital inflows, which cannot be regarded as a premise.
• Infrastructure deficiencies and bottlenecks. Some of these, for example electricity supply, are currently being addressed, but they also serve as a reminder of other deficiencies in SA's infrastructure, including the electricity distribution network.
• The skills shortages in the economy in the midst of increasing globalisation of the labour market and the obstacles that hamper SA's participation in this market. The inability of the education system to meet the requirements of the labour market is also common knowledge.
• The inability of the public sector to provide basic services and to execute policy effectively.
• A lack of entrepreneurship and a lack of policy to promote entrepreneurship. After years of debating there is still no practical policy in place to promote small and medium-sized enterprises.

The "soft" constraints are of a more subtle nature and can easily go unobserved. These constraints include among others the following:

• The reluctance of the SA population to allow the forces of what Joseph Schumpeter called "creative destruction" to do their work. This is evident in efforts to try to protect industries that are no longer competitive, and the policy to protect jobs instead of workers. The result is a lack of dynamic progress.
• The SA philosophy of life of "I want it all and I want it now" simply does not support a willingness to make sacrifices, and the interests of future generations are given very little attention. These attitudes underlie among others the low propensity to save, and infrastructure neglect.
• A lack of a long-term vision of what we want to achieve and how we want to achieve it, appropriate for the 21st century. It is disappointing that SA is reverting to ideas of decades ago - just think of the obsession with the "development state", not to mention nationalisation.
• A lack of clarity regarding policy priorities and the mixing of priorities, which result in confusion and ineffectiveness. Countries that successfully achieve high economic growth have unequivocally made it their highest priority. The SA government's highest priority is probably the continued transformation of the economy, as defined by the government.
• Questions regarding the institutions on which confidence in the economy rests. These include property rights, the independence of the judiciary, the maintenance of law and order, the combating of corruption, liability of office bearers and respect for democracy.
• A premature attempt to transform SA into a fully-fledged welfare state, given its stage of development.
• Insufficient attention to the incentives that determine human behaviour, and how these are impacted by policy actions. For example, it is an open question whether the policy of black economic empowerment in its current form does not discourage black entrepreneurship.

South Africa therefore does not yet display the characteristics of a winning nation. If the structural constraints are not addressed quickly and effectively, sustainable growth of 3,5% to 4,5% a year lies ahead for SA.

The recent report by the Commission on Growth and Development places significant emphasis on effective leadership, strategy formulation and policy implementation by the state in its pursuit of high economic growth. But the Commission's conclusion is that "government is not the proximate cause of growth. That role falls to the private sector, to investment and entrepreneurship responding to price signals and market forces".

Those who regard the state as the driver of economic growth should take note of this.

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