South Africa's net foreign portfolio liability commitments could reach an estimated R600 billion by

South Africa's economic success of the past four years, as depicted by among others above potential economic growth, was made possible by the massive inflow of foreign portfolio capital. These inflows assisted in financing the growing imbalances (as portrayed by the large current account deficit of 6.5% of GDP).

However, research by the Stockbroking and Asset Management firm Dynamic Wealth indicates that these inflows created a vicious circle increasing the imbalances contributing to the economy becoming a victim of its own success.  

It is evident from the research that, though the portfolio capital inflows sustained the success of the South African economy and record performance of the JSE for almost four years, it also may become the main reason for a possible collapse in both. Mr. Adam Jacobs, Economic Consultant to Dynamic Wealth, therefore called to the authorities to take steps to prevent this possibility.

Jacobs' research estimates that the countrys liability commitments stemming from the portfolio inflows increased from R307 billion in 2003 to about R900 billion this year. This was, among others, due to the sharp increase in the prices of shares on the JSE.

The worrying aspect however is that the net assets foreign reserves created by the portfolio inflows (shares and bonds owned by foreigners) was only R432 billion over the same period. However, Jacobs says that although the foreign reserves should have increased by this amount, the actual increase was only R219 billion as a result of some leakages.

This means that the country sold its silverware for R219 billion to foreigners that is now worth about R600 billion. Foreigners also reap the benefit of interest and dividends being paid in addition to the capital appreciation resulting from the strong bull run on the JSE.

The beginning of the story can be traced back to 2002, when Statistics South Africa wrongly calculated rental inflation. When the mistake was finally rectified on 30 May 2003, it transpired that the CPIX was almost two percentage points lower than originally calculated. The Monetary Policy Committee of the Reserve Bank reacted by reducing the repo rate with 5.5 percentage points within the next six months.

Consumers consequently increased their debt load from 50% of disposable income in 2003 to 71.8% in 2006. Together with large income tax relief, it contributed to real gross domestic expenditure (GDE) increasing by 30.7% between 2002 and 2006.

This contributed to economic growth breaking out of the 2% to 3% band to 4% to 5%. The higher growth also pushed up company profits and thus foreign buying of shares became rampant. However, the instant success can be compared with using steroids to improve performance. Jacobs says that this not only injected enormous liquidity into the South African financial system, but also kept the rand strong and inflation lower than it would have been under normal circumstances, forcing further interest rate cuts.

Eventually, the lower interest rates and overspending resulted in negative savings by households of 0.6% of disposable income in 2006. Also due to the large outflow of dividends and other factor payments to foreigners, real gross national income (GNI) only increased by 22.6% between 2002 and 2006 (way less than the increase in GDE), accounting for the ever increasing CAD. Net income payments to foreigners increased from R29.4 billion end 2002 to a seasonally adjusted annual figure of R48 billion for the first six months of 2007.
 
Prof. Chris Harmse, Chief Economist of Dynamic Wealth, says the authorities unfortunately did not react to the warning signals and the process now reached a stage of feeding on itself, thereby creating a vicious circle. Increasing current account deficits require larger capital inflows, which in turn lead to higher factor payments to foreigners and this then increases the current account deficit further.

Harmse says the authorities still have time to neutralise the growing liability commitments created by the portfolio inflows. If not, the economy will eventually be the victim of higher inflation and interest rates, causing lower economic growth, increasing unemployment and poverty instantly undoing the successes created the past decade or so.

In this respect, Jacobs says coordinated fiscal, monetary, labour and trade policies are needed to correct the situation. In addition, the scrapping, or at least further relaxation of exchange controls (also to correct the artificial level of the rand exchange rate), are needed to eventually neutralise the factor payment outflows (by dividend inflows). Active open market transactions to withdraw excess liquidity will also relieve the pressure.