By Arthur Kamp, 13 August 2013
The current business cycle upswing could not be more different from the former upswing, which commenced in September 1999 and peaked in November 2007. An outstanding feature of the last one was higher productivity growth, which encouraged a sharp increase in fixed investment spending. By the end of 2008, private gross fixed capital formation had increased to its highest level ever, at 15% of GDP. Foreign capital inflows, mainly in the form of equity, complemented domestic savings to help fund investment.
In contrast, productivity growth has been weak during the current economic upswing, which began in September 2009. Labour productivity, for example, advanced by just 1.2% during 2012. Consumption, including spending by government, has been the major contributor to domestic spending and growth and the recovery in investment spending, which collapsed during the recession, has been tepid.
While the current upswing has been in place for nearly four years, the ratio of total gross fixed capital formation to GDP (a measure of investment taking place in the economy) remains below the level recorded at the peak of the previous upswing. Not surprisingly, real GDP growth has disappointed – advancing well below its potential growth rate, which we think is little more than 3%.
Ordinarily, a sharp increase in commodity export prices (relative to import prices) raises income growth and domestic savings. However, the increase in SA’s commodity export prices has been accompanied by higher consumption spending and a decline in the domestic savings ratio. The fall in the savings ratio is reflected in a wider current account deficit, in large part financed by foreign investors purchasing local government bonds.
Government consumption, which in part reflects its wage bill, is at its highest level in history (22.4% in 2012), while households have deleveraged. At 60.9% of GDP in the first quarter of 2013, the ratio of household consumption spending remains below 61.7% – the level recorded in 2008. But the share of government consumption in GDP had climbed from 18.6% of GDP in 2008 to 22.1% by the first quarter of 2013.
Government’s dissaving is reflected in the significant shortfall on the current account. This twin deficit problem – a combination of a high fiscal deficit and a current account deficit – has left the country vulnerable to any unexpected upward adjustment in global risk-free interest rates.
A country running a current account deficit builds up net foreign liabilities including debt. SA’s current account balance has been in deficit since the second quarter of 2003. During this period, the country’s gross foreign debt ratio has climbed from less than 20% of GDP in 2004 to 35.7% of GDP (120.1% of export earnings) at the end of 2012.
While the overall level of foreign debt, per se, is not high and some 60% of SA’s total foreign debt is rand-denominated, it is higher than it has been historically. The increase in the ratio of foreign debt in recent years in large part reflects public sector borrowing. In particular, rand-denominated bond debt, which includes government debt, has climbed from 2.2 % of GDP in the first quarter of 2008 to 11.6% at the end of last year. This accounts for just about the entire increase in foreign debt over the period. And, since SA continues to run a large current account deficit, in large part funded by debt capital, the persistent upward trend in this ratio is set to continue.
Moreover, in time investors are far more likely to fund productivity-driven investment spending that holds the promise of generating good growth (and returns on investment) in a low inflation environment. Currently, this is not the case in SA and we need to ask why the rest of the world should save by investing in our financial markets so that we can continue consuming.
We cannot predict the level of foreign savings inflows into SA. But, we do observe that, historically, current account deficits of the current magnitude have not been sustained.
US Federal Reserve Chairman Ben Bernanke’s warning in May that the Federal Open Market Committee would need to consider scaling back its purchases of financial assets ‘within the next few meetings’ focused attention on emerging market countries that run large current account deficits and rely on debt capital inflows to fund domestic investment – a group that includes SA. As US Treasury yields increased, subsequent to the Chairman’s announcement, the rand and the domestic bond market sold off aggressively.
At least we can argue the currency, at the time of writing, is undervalued following its sharp plunge in May and June. We think it is reasonable to argue purchasing power parity should hold in the long run. Admittedly, sharp currency falls are a risk to the inflation outlook. But, assuming domestic inflation remains relatively well contained in line with current consensus forecasts, the rand should firm – especially since the US Federal Reserve has been at pains of late to emphasise that the current low range of the Federal funds rate of 0% to 0.25% would be appropriate for as long as unemployment remains above 6.5%; inflation projections between one and two years ahead do not exceed 2.5% and long-term inflation expectations remain well anchored. Given current forecasts, this implies the US policy rate could remain unchanged until 2015. Even so, the US Fed is unlikely to hold off indefinitely. So it is imperative that progress is made in reducing SA’s government budget deficit. The deficit has been running at about 4% to 5% of GDP for four straight years. But a lack of income growth continues to constrain government’s revenue growth, increasing the likelihood that the deficit will remain above the projected numbers.In the absence of fiscal consolidation, the private sector will need to save more (implying a marked slowdown in private sector spending, including investment and employment creation) should foreign capital inflows wane.
The recent announcements around US monetary policy and the subsequent volatility in currency and debt markets suggest SA’s current business cycle upswing is at risk. The country’s weak fundamentals have been highlighted and less government consumption and higher productivity growth are needed to reduce this vulnerability.