SA current account deficit: How is it financed?

At 7.3% of gross domestic product (GDP) South Africa’s current account deficit (CAD) in 2007 tilted towards the side of unsustainability.

This was clearly illustrated in the last quarter of 2007 when capital inflows emanating from foreigner purchases of South African assets were not enough to finance the CAD. As a result South Africa Inc. had to utilize some of its foreign reserves to finance the CAD. This situation continued in January and preliminary indications are that it lasted throughout the first quarter of 2008.

If this situation is left unattended for a prolonged period, it will pressure the economy toward destabilization. To avoid this, the authorities need to implement policies which will bring about the desired effects of lowering the CAD as a percentage of GDP and improving the environment for foreigner’s to invest in South Africa, says prof. Chris Harmse, chief economist of Dynamic Wealth.

Harmse says the possibility of South Africa’s CAD/capital inflows not being sustainable was researched by Dynamic Wealth after picking up some peculiarities in South Africa’s foreign finances. For example, the South African Reserve Bank continued to announce increases in its foreign reserves even though money was flowing out of the country at a massive scale.

Dynamic Wealth therefore tried to answer questions such as “Where is the money coming from allowing the Reserve Bank to build foreign reserves even though the country was recording trade deficits on a monthly basis and foreigners turned sellers of shares and bonds since October last year?” and “How dependent is South Africa on foreign inflows?”

As a result tests were performed to determine the sustainability/non-sustainability of the CAD/capital inflows. Firstly, a test was performed to determine whether South Africa’s foreign reserves are used to finance the CAD. On the surface it does not look like it as capital flows to the value of R517 billion since 2004 exceeded the CAD by far. It allowed the Reserve Bank to build foreign reserves of R139 billion till end 2007.

However, research conducted showed that some 21% of the gross total capital inflows in 2007 consisted of foreign asset reduction – i.e. South African banks having to utilize its foreign reserves to finance the CAD. Banks’ gross total foreign reserves (foreign loans and advances) declined from R235 billion/$33 billion in August 2007 to R181.1 billion/$24.4 billion in January. This utilization of Banks’ reserves to finance the CAD allowed the Reserve Bank to increase its foreign reserves.

This meant that even though the Reserve Bank’s foreign reserves continued to grow, the combined gross reserves of the Reserve Bank and Banks dropped from $62.7 billion to $58 billion between August 2007 and January this year.

This type of situation is very dangerous if allowed to continue indefinitely. Utilizing Bank reserves is not out of the order though – it has happened many times before and will happen again in future. However, if major events such as an international credit crisis and electricity problems occur simultaneously to prevent capital flows, the situation becomes non-sustainable.

Another test, namely whether foreign savings/inflows are being utilized to finance consumption expenditure, proved to be false meaning that foreign inflows to South Africa are utilized to finance investment (and not consumption).

Thirdly, research showed that South Africa is becoming more and more dependent on foreign inflows to run its economy. In this respect, the country is not saving enough and must therefore rely on foreign savings to finance local investment. In addition, a larger proportion of South Africa’s own savings are now flowing out of the country to finance foreign investment thereby increasing the foreign savings needed to finance local investment. This situation (local savings flowing abroad) will increase as South Africa’s economy normalizes (relaxing foreign exchange controls further).

When this occurs, it is imperative for foreign savings to increase. And it must be the correct foreign savings, namely foreign direct investment. Currently the majority of South Africa’s foreign inflows consist of portfolio flows which are rapidly reversible.

According to economic literature a larger dependence on foreign savings should not be a problem as long as the savings are in the form of foreign direct investment – which is not the case for South Africa.

A fourth condition, namely whether a skilled labour force is available also pointed to non-sustainability.

Against this background Harmse says the authorities can’t continue to ignore the gaps in South African economic policy when compared to the rest of the world. South Africa is part of a globalised system where countries are competing for foreign capital inflows to finance their growth. Some countries are implementing incentive schemes luring the capital diverting it away from other possible recipients. As such South Africa receives lees than half a percentage point of the foreign investable capital.

Harmse says even though the South African authorities don’t support the type of incentive schemes applied by other countries the fact of the matter is that those schemes are part of the system and it dents South Africa’s ability to attract foreign capital. South Africa therefore must be exceptional in all other ways to outperform these countries in order to lure foreign capital. Otherwise the CAD will continue to be a drag on our economic growth rate limiting our growth potential to between 4% and 4.5%.