South Africa: In a tight spot Global Economic Outlook, Q1 2017

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South Africa’s economy continues to be stifled by weak growth and the need for fiscal consolidation. The threat of a sovereign credit rating downgrade still hangs in the air, though tempered by the government’s avowed commitment to fiscal consolidation.

Introduction

South Africa’s economy continues to be stifled by weak growth on one side and the need for fiscal consolidation on the other. Weak growth links back to tepid external demand, subdued private investment, low business confidence, labor market challenges such as high unemployment and skills shortages, and political uncertainty. While spending on infrastructure and skill development is necessary for long-term economic growth, South Africa needs to exercise fiscal prudence to retain its investment-grade sovereign credit rating. South Africa’s monetary policy might also tighten in 2017 in response to US monetary tightening. A rating downgrade of South Africa’s sovereign debt, though not that likely in the coming quarters due to a commitment to fiscal consolidation, will imply higher borrowing costs that will put upward pressure on domestic interest rates. Weak growth and tight economic policy make for a difficult economic scenario.

A slowdown in 2016

The International Monetary Fund (IMF), in its October 2016 outlook, projected a global growth rate of 3.1 percent, slightly slower than 3.2 percent in 2015 and 3.4 percent in 2014.1 IMF estimates show that the economy of sub-Saharan Africa, one of the fastest-growing economic regions of the world since 2000, is likely to grow just 1.4 percent in 2016, down sharply from 3.4 percent in the previous year.2 A major reason behind the region’s decelerating growth is the slowdown in its two largest economies: Nigeria and South Africa. Both Nigeria and South Africa have come under pressure from slowing global demand and weak commodity prices. According to the IMF, South Africa’s economy is projected to record growth of just 0.1 percent in 2016.3 In 2016 until the end of Q3, the South African economy grew 0.3 percent: The primary sector (agriculture and mining) shrank 4.8 percent; the secondary sector (manufacturing, construction, and utilities) expanded 0.3 percent; the tertiary sector (wholesale, retail, transport, finance, and government services) expanded 1.2 percent; and taxes (less subsidies) contracted 0.8 percent.4 South Africa’s Ministry of Finance projects that economic growth for 2016 will be 0.5 percent.5

A major reason behind the region’s decelerating growth is the slowdown in its two largest economies: Nigeria and South Africa.

Latest data indicate that on a quarter-over-quarter seasonally adjusted annualized basis, economic growth (measured by production) slowed to 0.2 percent in Q3 from 3.5 percent in the previous quarter (figure 1).6 Mining was a major contributor to overall growth due to an increase in iron ore production in response to the rising iron ore prices. A recovery in mineral prices could boost future mining activity in the country. General government, finance, real estate, and business services also contributed to overall GDP growth in Q3. However, agriculture, manufacturing, utilities (electricity, gas, and water), and trade subtracted from overall growth. Agriculture contracted for the seventh straight quarter, as a direct consequence of drought conditions across the country. Manufacturing contracted after a strong showing in the previous quarters, due to slowing domestic demand and weak trade. A contraction in manufacturing and weak domestic demand is reflected in declining utilities production. Measured by expenditure on GDP, growth in Q3 was 0.5 percent, down from 3.7 percent in the previous quarter. Gross fixed capital formation subtracted 0.2 percent from overall growth in Q3, while exports subtracted 9.0 percent.7

Growth slowed to 0.2 percent in Q3 2016

Fiscal policy is likely to remain tight in 2017

The most prominent threat to the South African economy in 2016 was a sovereign credit rating downgrade to below investment grade, primarily due to fiscal imbalance (figure 2). Though this threat did not materialize in 2016, it has not gone away. All three major ratings agencies have pegged South Africa’s sovereign credit rating at the lowest investment grade (or just above) with a negative outlook, due to structural imbalances, political instability, and weak business confidence. South Africa is likely to come under the scrutiny of the ratings agencies once again in mid-2017.

Rising government debt in South Africa has attracted the scrutiny of ratings agencies

All three major ratings agencies have pegged South Africa’s sovereign credit rating at the lowest investment grade (or just above) with a negative outlook, due to structural imbalances, political instability, and weak business confidence.

The ruling administration has made a commitment to fiscal consolidation. The medium-term budget policy statement (MTBPS), delivered in October 2016, indicates that South Africa’s Ministry of Finance expects the budget deficit for the fiscal year 2016–17 to be 3.4 percent of GDP, slightly lower than 4.2 percent in the previous year.8 The budget for the next fiscal year (2017–18), due to be presented in February 2017, will likely reinforce a commitment to fiscal discipline in order to negate the threat of a ratings downgrade. However, political instability and weak economic growth continue to pose risks.

On the external front, what might work to South Africa’s advantage (and to the advantage of sub-Saharan Africa) is an uptick in global commodity prices, strengthening economic growth in the United States and Europe and allaying fears of a China hard landing. Internally, boosting domestic investment remains critical to overall growth: Gross fixed capital formation declined 5.2 percent in Q3 on a year-over-year basis, the third straight quarter of decline (figure 3). Investment in machinery also declined in Q3 for the fourth straight quarter.9 Business confidence remains low and is likely to weigh on investment decisions. According to the South African Chamber of Commerce and Industry, the average of the business confidence index in 2016 was 93.5, far lower than 100 in 2015 (the base year for the index).10 Furthermore, monetary policy might also tighten in the near term.

South Africa needs to boost falling domestic investment

Interest rates could edge up in 2017

The South African Reserve Bank (SARB) might come under pressure to raise the policy interest rate in 2017 in response to the domestic price rise and US Federal Reserve’s tightening monetary policy. The policy repo rate has been held steady at 7.0 percent since a hike in April 2016. Even though the real effective exchange rate of the South African rand has been on an upward trend since the beginning of 2016, higher interest rates and improved economic performance in the United States are likely to keep the US dollar strong and exert downward pressure on the rand’s recovery. Other factors likely to contribute to a weaker rand are a widening current account deficit in South Africa and a high inflation differential between the two countries (United States and South Africa). A weaker rand will likely add to inflationary pressure. Another factor likely to contribute to inflation is the higher price of crude oil. Inflation data in each month of 2016 (November 2016 being the latest available data point) was above the SARB’s target inflation range of 3–6 percent (figure 4).11 Drought fueled inflation, resulting in a sharp rise in food prices. If drought conditions abate, resulting in lower overall prices, and if the rand does not weaken considerably, then the SARB might hold the policy repo rate steady in the short term.

However, if interest rates are hiked, they are likely to weigh heavily on already-weak business investment and indebted consumers. Household debt in South Africa is roughly 75 percent of disposable income.12 Despite a decline from the highs of 2008, the level of household debt coupled with tighter monetary policy will likely keep consumer expenditure under pressure. If South Africa stumbles in its fiscal consolidation plan or falls far short of its GDP growth potential (as it has in 2016), then a ratings downgrade in mid-2017 could result in a steep increase in interest rates and borrowing costs.

Inflation exceeded the SARB’s target range (3–6 percent) in 2016

South Africa’s woes: More of the same

Apart from trying to maneuver between weak growth and tight fiscal (and monetary) policy, South Africa’s economy will have to continue to address certain persistent problems in 2017. Unemployment is likely to remain high: The official unemployment rate rose to 27.1 percent in Q3 2016, the highest level since early 2004 (figure 5).13 High unemployment means that South Africa’s tax-paying population will remain relatively low, making balancing the fiscal budget difficult. Another problem is a shortage of skilled labor. This problem is rooted in a weak education system. According to the Organization for Economic Cooperation and Development’s 2015 ranking of education systems, South Africa ranks 75 out of a list of 76.14 Furthermore, inequality in South Africa continues to remain stark, as indicated by the country’s Gini coefficient score of 0.66–0.69, one of the highest readings in the world.15 Infrastructure shortcomings also continue to plague the country. The South African minister of finance, in his October MTBPS, committed to adding revenue through tax measures; allocating additional government expenditure to post-school education, health services, and social protection; and continuing investment in infrastructure. He also forecasts weak but improved growth of 1.3 percent in 2017.16 Though this is encouraging, South Africa will have to do a lot more if it is to meet its National Development Plan goals by 2030.

Unemployment has risen to a multiyear high