Economic Prospects, 4th Quarter 2006

The current buoyancy in the economy should not conceal the fact that a more challenging growth environment is unfolding. Indications are that the global economy is heading for a slowdown next year. Domestically, there are leading indications that the interest rate increases are starting to impact. The favourable pricing environment of recent years is also rapidly changing and financial volatility has reared its ugly head. These developments point to a more challenging economic environment over the short term.

The lively domestic market of recent years is likely to cool down and growth will depend more on the expected export recovery. The BER remains optimistic that the SA economy will overcome these challenges in relatively good shape, with growth expected to move down only a notch or two- from the heady 5% level closer to 4% over the short term. Sustained fixed investment and associated employment growth and an expected recovery in exports should compensate for the projected slowdown in the interest rate and price sensitive components of real domestic expenditure. The BER projects real GDP growth of 4.3% and 4.1% during 2006 and 2007 respectively, even though the unit became slightly more pessimistic on inflation and interest rates.

Inflation, interest rates and the exchange rate The BER warns that strong domestic spending, rapid monetary growth, a weaker currency and balance of payments pressures, accelerating food prices and the threat of higher unit labour costs do not bode well for the inflation outlook. The high producer inflation rate (9% in September) suggests strong pipeline inflation pressures. While inflation expectations have remained relatively well-behaved and within the 3-6% target range (5.3% in respect of CPIX inflation in 2007), we are likely to witness some passthrough from the currency depreciation and PPI inflation to CPI inflation. CPIX inflation is projected to peak at 6.2% (2007Q1) and to average 5.9% during 2007, before moderating to 5.7% during 2008.

Interest rates are projected to increase by another 100- 150 basis points over the next 6 to 8 months (on top of the June, August and October 50 basis point hikes). The anticipated high level of inflation (around the upper range of the 3-6% inflation target during the course of 2007) will make it difficult for the SARB to relax monetary policy before the end of next year.

While the outlook for the financial variables is uncertain, we are unlikely to witness a repeat of the currency depreciations during 1998 and 2001; we should also allow for two-way movements in the rand exchange rate, i.e. bouts of weakness may be followed by recoveries. Having said that, the rand may prove vulnerable as global interest rates rise, commodities decline and the domestic balance of payments current account deficit remains on a high level.

Economic growth
All indications are that the SA economy continued to perform strongly during the third quarter of the year, probably matching the second quarter growth rate of close to 5%. The growth momentum in real domestic expenditure is strong, interest rate hikes have a delayed impact and the weakening rand exchange rate stimulates economic activity, particularly in manufacturing. However, on more than one front the growth environment is likely to become more challenging.

With interest rates a cumulative 250 basis points up, CPIX inflation around the upper range of the inflation target and PPI inflation peaking in double digit territory in 2007, this outlines a different financial environment compared to the one in force over the 2003 to 2006H1 period. Financial markets may also prove more volatile due to a precarious balance of payments position and a vulnerable rand exchange rate. These conditions are generally not conducive to robust economic growth. Fortunately, there are important supports, both globally and locally.

In terms of the BERs economic forecast, the impact may be more significant in respect of the composition than the level of growth. Higher inflation and interest rates are likely to cool down the 6-7% domestic spending momentum in the economy, closer to a 4% level. The BER scaled down its forecast for real household consumption expenditure to 3.6% next year (projected to decelerate from an estimated growth rate of 6.6% in 2006). This and the weaker rand exchange rate should cool down import growth and- combined with a currency -induced recovery in exports- allow net exports to make a more positive
contribution to overall GDP growth.

Sustained fixed investment spending- driven by production capacity pressures- and associated employment growth are expected to compensate for the negative impact of higher interest rates on the interest rate sensitive components of household spending and private fixed investment. The favourable fixed investment trend is also likely to be supported by a recovery in export growth. Manufacturers export expectations have improved, albeit evident that most of the renewed growth impetus may only be visible next year and during 2008. Much in the short-term economic outlook will depend on this expected export
recovery.

There is widespread consensus that the world economy is heading for slower growth in 2007; however, considerable variance of opinion exists amongst analysts on how sharp the slowdown in the USA economy will be. A harder landing in the US economy is likely to lead to weaker world economic growth. Fortunately, important global supports remain, e.g. the robust economic growth performances in China and other developing economies, sustained growth in Japan and a promising economic recovery in the Euro area. These factors are likely to contain the expected slowdown in the world economy and support the anticipated domestic export recovery.

Pieter Laubscher, Chief Economist