South Africa: In search of an economic foothold Global Economic Outlook, Q3 2016

South Africa’s economic challenges have intensified. The economy contracted in the first quarter of 2016; and weak growth, political unrest, and deteriorating fundamentals have resulted in the currency slipping and inflation climbing. Policymakers will likely face difficulty in navigating internal and external challenges.

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South Africa’s economic challenges have intensified. The economy contracted in the first quarter of 2016, as mining production and exports came under pressure from subdued commodity prices, weak external demand, a strong US dollar, and sluggish global trade. Furthermore, weak growth, political unrest, and deteriorating fundamentals have resulted in the South African rand slipping and inflation climbing. In June, South Africa narrowly escaped a rating downgrade to below investment status.1 Even though the economy has some time to mend before it comes under the scrutiny of ratings agencies again, the route to growth is unclear, especially as monetary and fiscal policy is tightened. Furthermore, the United Kingdom’s decision to exit the European Union is likely to add to global uncertainty, which in turn will add to South Africa’s burden. Policymakers are likely to face several difficulties in navigating internal and external challenges. The short-term outlook is therefore likely to be rather dim.

A grim picture for growth, mining, and exports

Economic growth slipped into negative territory in Q1 2016. Real GDP, measured from a production standpoint, contracted at a seasonally adjusted annualized rate of 1.2 percent in Q1, down from growth of 0.4 percent in the previous quarter.2

Mining was the major drag on overall growth. The sector shrank 18.1 percent, resulting in a 1.5-percentage-point subtraction from growth in real GDP (figure 1). In Q1, the mining sector was hit by lower production of iron ore and platinum group metals. The drop in production is linked to a downward trend in global commodity prices, stemming from weak global demand, growing uncertainty, and an appreciation of the US dollar. Production has also been hit by rising costs of inputs and labor. The Q1 decline in mining production also caused a contraction in both the electricity and transport sectors due to weak demand.

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Analyzed from an expenditure-on-GDP standpoint, the South African economy shrank at a seasonally adjusted annualized rate of 0.7 percent in Q1. This is the first time that South Africa has included an expenditure-on-GDP statistic in its quarterly release. The expenditure lens, which puts overall demand in focus, paints an equally grim picture. Household spending, net investment, and trade registered declines, while government consumption grew, albeit at a slower pace than the previous quarter. Trade was hit the hardest, with both exports and imports declining at an annualized rate of 7.1 percent. The decline in exports shaved off 2.2 percentage points from overall growth in expenditure on GDP in Q1. A decline in exports, particularly exports from South Africa’s mining sector, links back to the overarching trends of weak external demand, global uncertainty, a strong dollar, and sluggish global trade, catalyzed by a slowdown in China. The decline in GDP from both a production as well as an expenditure perspective indicates that South Africa faces both internal supply-side challenges as well as weak internal and external demand.

Different factors likely to keep exports under pressure

South Africa’s exports, which constitute nearly a third (30 percent) of all expenditure on GDP, are likely to remain under duress given the current global economic backdrop. In particular, economic developments in South Africa’s major export destinations are likely to work against exporters. China, which is South Africa’s single-largest export destination (accounting for roughly 10 percent of all exports in 2015), is slowing as it attempts to transition away from fixed investment as the primary driver of economic growth. As a result, Chinese demand for commodities has declined. This is pertinent for South Africa because 84 percent of all South Africa’s exports to China are either mineral products or base metals. In fact, South Africa is, on the whole, a commodity-exporting nation: Mineral products, precious stones and metals, and base metals constituted more than half (54 percent) of the country’s total exports in 2015.3

A decline in exports, particularly exports from South Africa’s mining sector, links back to the overarching trends of weak external demand, global uncertainty, a strong dollar, and sluggish global trade, catalyzed by a slowdown in China.

Figure 2 shows that China’s imports of minerals and metals from South Africa have declined in dollar terms, while figure 3 shows a decline in the price of industrial inputs and metals. Commodities are priced in US dollars, so a strong dollar means that commodities cost fewer dollars than before. This results in commodity exporters such as South Africa earning fewer dollars for their exports. Another factor influencing South Africa’s exports to China is the devaluation of the renminbi. China’s currency is at a five-year low against the dollar, with further devaluation a possibility. A weak yuan makes Chinese imports of commodities, priced in dollars, comparatively more expensive, increasing downward pressure on demand.

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Apart from China, South Africa’s large single-country export destinations include the United States (9 percent of exports) and Japan (6 percent of exports). However, despite the strong dollar and appreciating Japanese yen, the value of imports (in dollars and yen respectively) from South Africa to both of these destinations has declined (figure 4). Additionally, the Eurozone, an important export market for South Africa (the European Union as a whole accounted for 24 percent of South Africa’s exports in 2015), has also displayed tepid demand.4 As a result, the Eurozone’s imports from South Africa have remained flat, as seen in figure 5. Moreover, Brexit is likely to have repercussions on South Africa’s trade with both the United Kingdom and the European Union, particularly due to the uncertainty surrounding the renegotiation of trade deals in the short term.

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Besides a drop in the value of South Africa’s exports, export volumes have also flattened over the last four quarters, as shown in figure 6. The recent dip in volume stems from weak global trade (figures 7 and 8). Not only has the value of global trade dipped, the volume of trade has also been suppressed.

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The interplay of all these factors is likely to keep exports under pressure. This is likely to contribute to South Africa’s current account deficit.

External and internal challenges likely to make policy formulation difficult

South Africa’s current account deficit has been in negative territory since Q2 2003. The trade deficit contributes a fifth (an average of 22 percent over the last three quarters) to the total current account deficit. However, net foreign investment income payments account for 60 percent of the country’s current account deficit.5 Furthermore, since Q4 2014, net foreign nondirect investment income payments have become more prominent (figure 9). As a result, net foreign investment income payments are no longer dominated by net payments to direct investors. The risk associated with the rising share of payments to nondirect investors is that short-term foreign portfolio investments, or hot money, could flow out of the South African economy quickly if better risk returns are available elsewhere or if South Africa’s economy deteriorates further.

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Brexit poses a threat in the short term because British banks’ claims on South African entities stand at 178 percent of South Africa’s foreign currency reserves.6 In the medium term, the US Federal Reserve’s (Fed’s) normalization of monetary policy also poses a threat. For the time being, the Fed’s gradual, cautious approach is likely to be advantageous to South Africa as well as to other emerging markets.

The conundrum that the central bank faces is that the price rise and subsequent tightening of monetary policy come at a time when the economy is at risk of entering a technical recession. However, arresting inflation and supporting the rand also remain key concerns for the central bank.

A further complication is that South Africa also runs a budget deficit. In fact, the budget has been in deficit every year since 2008.7Alongside weak economic growth and political unrest, a budget deficit and a trade deficit have resulted in downward pressure on the rand, which is further complicated by Brexit. As a result, despite recovering some ground between mid-January and the beginning of May, the rand has depreciated roughly 33 percent against the dollar since the beginning of 2015 (as of June 24, 2016). A weak rand, coupled with the fact that the country is in the grip of severe drought, has resulted in consumer prices rising above the central bank’s upper limit of 6 percent. The consumer price index rose 6.5 percent in May from a year ago. Food prices, in particular, are a cause for concern, rising 12.3 percent in May.8 In response, the South African Reserve Bank (SARB) has been tightening monetary policy: The policy interest rate has edged up from 5.0 percent at the start of 2014 to 7.0 percent as of May 2016. The conundrum that the central bank faces is that the price rise and subsequent tightening of monetary policy come at a time when the economy is at risk of entering a technical recession. However, arresting inflation and supporting the rand also remain key concerns for the central bank. Furthermore, real interest rates need to be kept attractive, especially because South Africa’s current account deficit is funded (and in part fueled) by foreign investment.

Fiscal policy is also likely to remain tight. The budget for the fiscal year 2016–17, released in February, outlined measures to curb spending and increase taxation in order to rein in the budget deficit. This is crucial if South Africa is to avoid a rating downgrade to below investment status. Equally important is achieving economic growth. However, in an environment marked by weak internal and external demand, declining confidence among consumers and businesses alike, and tight monetary and fiscal policy, growth will be hard to come by. In such a situation, South Africa’s persistent weaknesses are underscored. Unemployment, for instance, climbed to an astounding 26.7 percent in Q1, up from 24.5 percent in the previous quarter. Low labor force participation (58.7 percent in Q1 2016, of which 73 percent are employed) means that just above 40 percent of South Africa’s total population is employed.9

Continued economic weakness could also put South Africa under the lens of ratings agencies later in the year. A downgrade to below investment status would make an already uphill journey a lot steeper.

Productivity also has been a problem: Real output per employee has declined year over year for the last five quarters. As productivity declines, labor costs continue to rise. Unit labor cost in the nonagricultural sector climbed an average of 5 percent year over year over four quarters in 2015.10 An economic environment of rising prices and low growth could mean that business owners will not be able to meet the demands of trade unions, therefore leaving room for labor strikes that disrupt production and hamper economic growth.

A positive sliver in South Africa’s otherwise gloomy economic situation is the relative absence of rolling power cuts in 2016 compared with 2015, mainly due to the renewal of aging coal-powered plants. In similar fashion, South Africa will probably have to make the best use of all the resources at hand. In such a scenario, policy formulation is likely to remain extremely challenging.

GDP growth likely to remain weak in the short term

South Africa’s economy runs the risk of entering a technical recession, its first since 2009. The myriad internal challenges and external headwinds facing the economy are likely to keep growth subdued. The International Monetary Fund and the SARB both forecast a growth rate of just 0.6 percent in 2016.11 However, global developments stemming from Brexit are likely to lower forecasts. Continued economic weakness could also put South Africa under the lens of ratings agencies later in the year. A downgrade to below investment status would make an already uphill journey a lot steeper. South Africa desperately needs to find an economic foothold if it is to escape such a plight.