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Financial environment changes for the SA economy

11 August 2006 Pieter Laubscher, Chief Economist

The South African financial environment has been shaken by a depreciating currency, interest rate hikes and a strong dose of "emerging market jitters", with South Africa being one of the more notable "victims" faced with a current account deficit measuring 6.4% of GDP during the first quarter of 2006. The question now is how these mainly financial developments are likely to evolve over the short term and what the impact will be on the domestic economy.

The BER expects resilience in the first place on the back of healthy structural business cycle characteristics and a competitive boost to manufacturing activity. The financial reactions should be of a contained nature. Secondly, rotation is expected: the consumer sector is likely to cool down without undue harm to the fixed investment drive in the financially healthy business sector, while public sector infrastructure fixed investment spending also continues to accelerate.

Real GDP growth is projected to come in at a lower rate than previously forecast; however, a sustained 4% growth rate over the short term remains a realistic prospect. Nonetheless, the BER revised the outlook for the financial variables appreciably: the rand's projected adjustment is happening sooner, CPIX inflation could breach 6% early next year and interest rates could increase further (on top of the June and August 50 basis points hikes).

Emerging market jitters this time around

Global financial market conditions unravelled rapidly in the wake of the May 2006 US Fed Funds interest rate hike to a 5% level. With all three major central banks currently embarked on tighter monetary policy, international investors have generally retreated from riskier investments in emerging markets. Intense geo-political developments are adding insult to injury and inflating the risk premia discounted in international oil prices.

The BER forwards three reasons why the domestic impact could be relatively muted. Firstly, global real economic growth is projected to remain close to a trend pace, 2006/7. The US slowdown (and Japan's to a lesser extent) is likely to be countered by a promising recovery in the Euro area and sustained robust growth in China, India and other developing economies of the world. Secondly, the emerging market group of countries is less vulnerable due to generally improved macro-economic fundamentals. No major emerging market crises are foreseen, albeit those countries with larger foreign financing requirements are more at risk. Thirdly, while global inflation risks have grown, particularly in the wake of oil prices breaching $75/b, the projected increase in global inflation and policy interest rates continue to be of a contained nature.

CPIX inflation to breach the upper 6% target level

While the actual CPIX inflation rate for June 2006 (4.8%) reveals little demand-side pressures, the inflation risks identified previously have all developed into more viable threats to the inflation outlook: food prices are accelerating above 6%, the rand exchange rate is under pressure (projected to end 2007 at R7.60/$) and the combination with high oil prices is playing havoc with domestic petrol prices. CPIX is projected to breach the 6% target (07Q1). However, it is likely to be a one-off spike in inflation CPIX inflation is projected to decline to a 5% level by the end of next year; PPI inflation is projected to average 6.5% in 2007, mainly due to oil price and exchange rate depreciation pass-through effects.

The deteriorating inflation outlook is cause for the SARB to take pre-emptive action (guarding against secondary inflation processes developing); however, the current tightening of monetary policy should rather be seen as an attempt to align monetary policy with the changed global financial environment and SA's balance of payments vulnerability in this context. This will require more interest rate hikes to dampen domestic spending and imports, something which a temporary breach of the inflation target can hardly justify. The BER anticipates a further 50 basis points increase in the repo and prime rates before the end of the year; long-term interest rates are already discounting this prospect. There is a risk of additional monetary policy tightening should the currency come under bigger pressure.

A 4% real GDP growth rate remains a realistic prospect over the short term

Real GDP growth accelerated during the first quarter of 2006 to a 4.2% pace from a revised 3.2% pace in 2005Q4 and the available evidence suggests that the strong economic performance continued, if not accelerated further, during the second quarter of the year. While both business and consumer confidence declined somewhat, real economic indicators (e.g. retail sales volumes, manufacturing production volumes, Investec PMI, car sales, BER business survey results) continue to point to robust economic activity.
However, on the consumer spending side, some evidence of a slowdown in growth rates is present. The BER expects that the combination of higher interest rates and inflation (affecting the durable and semi-durable goods sectors) and higher food and petrol prices (affecting the non-durable goods sector) is likely to cause an appreciable slowdown in real consumer spending over the short term. Real household spending is projected to slow from growth of 6.9% (2005) and 5.9% this year to 3.8% next year.

However, the BER emphasises important counter-balancing factors. Firstly, the injection from public sector infrastructure fixed investment spending; secondly, sustained private fixed investment growth (outside the interest rate sensitive residential sector) as production capacity constraints continue to exert pressure; and, thirdly, the competitive boost to manufacturing conditions as import replacement and revived exports become stronger growth drivers. Furthermore, domestic spending is not expected to contract, only to decelerate from a 6-7% pace closer to 4%.

This implies that the domestic market will remain relatively lively. Exports are also expected to perform well in the wake of the currency depreciation and a generally favourable world economic growth environment. Real GDP growth is projected to come in at 4.3% this year and 4.1% next year; this represents a marginal downscaling of the BER's previous forecast (2006Q2) of 4.5% and 4.2% respectively.

Pieter Laubscher, Chief Economist
Bureau for Economic Research

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