Second quarter GDP, announced on 3 September, was disappointingly smaller than the quarter before. The news sent the rand immediately weaker and the cost of servicing SA debt higher. The rand declined not only against the US dollar but also weakened against other emerging market currencies. This indicated SA-specific rather than global forces at work. And the spread between RSA yields and their US equivalents widened taking SA dollar denominated debt further into high yield, junk territory. SA dollar debt with five years to maturity offers investors about 2.5 percentage points more than US debt of the same duration. Investment grade debt would offer only about 1.5 percentage points more than US Treasury Bonds.
Some of the weakness in the USD/ZAR exchange rate and weakness in the rand against its emerging market peers has been reversed in recent days, as has the upward pressure on RSA and emerging market risk spreads.
What then can be done to reverse the vicious circle in which SA finds itself, the slow growth that drives capital away, weakens the rand that adds to inflation? And leads seemingly inevitably to still slower growth in spending and output? Faster growth by the same market logic would do the opposite: attract capital, strengthen the rand and the Treasury and lower inflation.
South Africa clearly has a supply side problem. We are not producing enough (adding enough extra value) to generate additional incomes. The reasons for this failure may seem complex but I would argue that it is the result of policies that focus primarily on who benefits from the output produced, rather than on how to raise the levels of output, incomes and employment. In other words, redistribution undertaken or feared at the expense of output and incomes. South Africa needs to impress the world and its own citizens that we will care about raising output. The revised mining charter, to be made public soon, gives the timely opportunity to demonstrate a new pragmatic economic approach, one intended to attract rather than repel capital on internationally competitive terms.
But South Africa not only has the problem of too little supply. It also suffers much from too little demand. Too little demand was exacerbated in the Q2 GDP estimates by a large decline in the demand to hold inventories. Without the reduction in inventories of R14bn in constant prices, growth in GDP in Q2 would have been 2.9% higher. Reducing stock piles and goods and services in production to satisfy demands rather than increasing the output of them may however point to more rather than less output to come.
But even leaving aside declining investment in inventories or volatile quarterly changes in agricultural output – that could easily reverse themselves – the growth in final demand by households, firms and government is running well below even our limited potential supplies of good and services. And has been doing so for many years now. That is to say interest rates have been too high to match demand and potential supply even growing slowly. Interest rates have a predictable effect on the willingness of households to spend (out of after-mortgage payment income) and the willingness of firms to spend to satisfy those demands. Their influence on prices is much less predictable.
The link between interest rates, the exchange rate and inflation is highly unpredictable, given the forces that drive the exchange rate. That take their cue mostly from global rather than South African events. Indeed as the market has revealed the relationship between growth, inflation and interest rates is not what standard theory might predict. Slower growth leads to a weaker rand, more inflation and still higher interest rates that depress demand and growth further. The impact of less demand on prices is vitiated by the likely impact of the weaker exchange rate on prices.
Thus raising interest rates in response to rand weakness exaggerates the business cycle rather than smooths it. The Reserve Bank should have reduced interest rates much faster and sooner than it has, to help match weak levels of demand with potential supply. The best it can now do for the economy is to surprise the market by not raising rates. And then over the course of the next few years, if demand remains as weak as it has been, to reduce them without then being thought soft on inflation. This would help take SA closer to a virtuous circle of faster growth and less inflation and give the economy some head room to undertake the supply side reforms that are essential if its growth potential is to be raised permanently. 13 September 2018