Annual Economic Report - www.reservebank.co.za/aer
Introduction
The global economic setting continued to be favourable during the past year. World economic growth was strong in 2006 and is expected to broadly retain its momentum in 2007. At the same time, individual country growth rates have gradually become more uniform with fewer outliers as economic policy frameworks have become more focused on sustainability and soundness. The fact that aggregate growth was more consistent also contributed to individual countries’ economic stability, as did the continued strength of commodity prices.
A broadly similar observation may be made with regard to inflation: In recent years global average inflation has reached fairly low levels, while the dispersion of individual country inflation rates has also narrowed considerably, with the exception of a small number of outliers.
Although consumer price inflation remained moderate in most parts of the world over the past year, the prices of commodities remained high and capacity pressures intensified. A sustained increase in oil prices not only impacted directly on inflation, but also encouraged the diversion of agricultural products to the production of bio-fuels, thereby contributing to an acceleration in food price inflation. Under these circumstances, quite a number of central banks tightened their monetary policies further in order to contain inflation.
A number of risks remained in the background. Global current-account imbalances continued, but during the past year the United States (US) dollar depreciated significantly against most major currencies, probably contributing to the containment of the deficit on the US current account. Risk premia imbedded in the prices of financial assets rose from very low levels, with a number of events triggering an enhanced awareness of risk among market participants and resulting in a rather abrupt repricing of risk. Probably the most important events of this kind were the turbulence in emerging markets in May 2006 which strengthened international investors’ preference for investment in the more mature markets; the fall in share prices in China in February 2007 and the resulting correction in numerous markets; and the strains developing around the risky “sub-prime” segment of the mortgage market in the US, which led to a loss of confidence in counterparties and culminated in a reduction of liquidity in the credit markets and a sharp decline in global share prices in August 2007. Although the effect of the first two events soon petered out, it remains to be seen how the most recent disruption will impact on wealth, confidence, expenditure and economic activity in general. In a number of economies central banks viewed the turbulence to be severe enough to warrant injections of liquidity into the financial markets.
Africa again recorded a robust rate of economic expansion in 2006, registering a real growth rate of roughly 5½ per cent for the third successive year. Against a background of favourable commodity prices, sustained global growth, debt relief, improved economic policies and a stronger emphasis on infrastructural development, it is projected that the economic upswing will maintain its solid momentum in 2007.
Replicating the global growth trajectory, real economic growth in South Africa came to approximately 5 per cent in each year from 2004 to 2006 and broadly retained this momentum in the first half of 2007. This solid performance seems likely to sustain the current economic upswing which started in September 1999. Having persisted for approximately 8 years, the upswing is twice the length of the previous longest expansionary phase of the business cycle. It has also contributed to a favourable reassessment of the country’s potential growth rate.
Viewed from the production side, the most consistent growth in the economy over the past year and a half was recorded in the services sector. Telecommunication services continued to expand briskly, bolstered by improvements in technology and price reductions in some areas. Lively conditions in the financial and real-estate markets continued, accompanied by strong demand for credit and banking services, while the trade sector benefited from strong domestic expenditure.
By contrast, the primary sector recorded a disappointing real growth performance during the period under review. Agricultural output was impeded by erratic climatic conditions. Mining production was lacklustre, notwithstanding favourable prices for the sector’s products as strong international prices were amplified by the weaker exchange value of the rand from May 2006. The weak response of production volumes in mining to favourable prices not only reflected the inevitable depletion of ore bodies in some areas, but also logistical and environmental constraints as well as interruptions on account of maintenance and industrial action.
Production in the secondary sector expanded apace in the past 18 months as the construction industry, in particular, recorded double-digit rates of real growth, responding to the infrastructure drive and buoyant demand for residential and non-residential buildings. This also translated into strong demand for manufactured products used by the construction industry. However, the robust performance extended to most manufacturing subsectors, benefiting from brisk local sales and exports which were reinforced by the more competitive exchange value of the rand during the past year. Capacity utilisation in manufacturing remained high.
Growth in real domestic expenditure outpaced that in real domestic production over the past year and a half, as has been the case since 2002. All the components of domestic final demand continued to expand strongly over the past 18 months. Real final consumption expenditure by households rose briskly, supported by rising levels of employment and disposable income. A slight moderation set in during the first half of 2007, partly on account of the increases in interest rates from June 2006. Nevertheless, this did not prevent the ratio of household debt to disposable income from scaling new heights. However, despite some individual households overextending themselves, the aggregate household balance sheet remained sound as rising prices of houses and shares bolstered the value of the household sector’s assets.
Real final consumption expenditure by general government continued to rise as government expanded its staff complement and stepped up service delivery. Among the final expenditure components, the strongest growth over the past year and a half was recorded by gross fixed capital formation. From 2006 this expenditure component accelerated to a double-digit rate of real growth, and in the first half of 2007 this had raised the ratio of fixed capital formation to gross domestic product to more than 20 per cent – the first time since 1989. While the strongest increases were attributable to public corporations, and especially to the electricity utility’s investment programme, general government and the private sector also stepped up their capital expenditure considerably.
Buoyant domestic expenditure resulted in high imports. Despite a further improvement in the terms of trade, driven by buoyant prices of export commodities, the deficit on the current account of the balance of payments widened to 6,5 per cent of gross domestic product in 2006 – the highest since 1975 – and registered a broadly similar ratio in the first half of 2007. Merchandise imports rose across all categories – consumer, capital and intermediate goods – while payments for services also increased. Income payments to non-residents in the form of dividends and interest rose strongly, consistent with solid company profits and non-residents’ growing investment into South Africa.
The deficit on the current account of the balance of payments continued to be more than fully financed by net financial inflows from abroad. Most important among these were portfolio inflows. In 2006 non-residents stepped up their holdings of both South African shares and bonds, while in the first half of 2007 their focus was on shares, consistent with the sustained growth in company profits and share prices.
With the overall balance of payments remaining in surplus during the past year and a half, the South African Reserve Bank (the Bank) increased its gold and foreign exchange reserves to a level of almost US$30 billion at the end of August 2007. The Bank’s international liquidity position, an indicator of exposure to currency risk, which had amounted to a negative US$23 billion at its worst point during the Southeast Asian crisis of the late 1990s, improved to a positive value of US$23 billion by early 2007 and came to US$27,4 billion by the end of August 2007. The exchange value of the rand depreciated significantly from the second week in May 2006 as international investors’ enthusiasm for emerging-market exposure dwindled, but from around August 2006 started to move within a relatively stable trading range at nominal levels against a basket of currencies that were around 15 to 20 per cent lower than before the decline in May.
Consistent with the growing economy, employment continued to trend higher during the period under review. Average wage settlements accelerated somewhat, from around 6,2 per cent in 2005 and 6,5 per cent in 2006 to 6,8 per cent in the first half of 2007. Government employees received an increase of 7,5 per cent in mid-2007 following protracted negotiations and industrial action. The most recent settlements were concluded against the background of significantly higher realised inflation, increasing shortages of skilled and semi-skilled workers, and strong growth in company profits.
Twelve-month CPIX inflation remained within the target band of 3 to 6 per cent from September 2003 to March 2007 – a period of more than 3½ years, which was helpful in moderating inflation expectations. However, the exchange rate depreciation from May 2006 as well as rising energy and food prices bolstered inflation. In an environment of high capacity utilisation, strong expenditure growth and buoyant credit extension, the risks of these temporary forces becoming entrenched in an ongoing inflation spiral were significant, and prompted the Monetary Policy Committee (MPC) of the Bank to tighten policy. This was done in a gradual fashion, with increases of 50 basis points at each of the June, August, October and December 2006 meetings of the MPC. After a respite at the first two MPC meetings of 2007, the repurchase rate was again raised by 50 basis points on each occasion at the June and August 2007 meetings. Other money-market interest rates moved higher alongside the repurchase rate.
In the domestic bond market, yields moved lower from September 2006 as the earlier downward trend of the exchange rate made room for a sideways movement, crude oil prices receded and it became clear that government would need to borrow little if anything in the bond market in the near term. However, rising oil prices, accelerating inflation and increases in short-term interest rates resulted in a significant increase in bond rates from late February 2007. Share prices, on balance, performed very well during the past year and a half, setting successive record highs. The jitters in international financial markets during August 2007, which were mainly related to some investors’ exposure to high-risk mortgage loans in the US, nevertheless spilled over into a significant decline in South African share prices.
The National Credit Act came into full effect on 1 June 2007, providing for enhanced transparency, fairness and responsibility in the extension of credit. While in some instances it is likely to result in more rigorous processes in the screening of credit applications, possibly leading to longer processing times and higher rejection rates, it is too early to quantify the impact of the new regulatory environment on credit extension. However, the most rapid increases in bank credit extension over the past year were in loans and advances to companies – a category which falls outside the scope of the new Act. Strong fixed capital formation and inventory investment, mergers, acquisitions, empowerment deals and participation in the financial markets in general bolstered the demand for credit by the corporate sector. While the tempo of increase in bank loans and advances to the household sector slowed during the past year, this still remained at high levels, with mortgage advances in particular maintaining strong momentum. This was consistent with the buoyancy of the real-estate market, where house prices maintained double-digit rates of increase over twelve-month periods. Banks continued to securitise some of their assets; if these were added back, it would have resulted in moderately higher rates of increase in loans and advances than in the conventional aggregates measured on the banks’ balance sheets.
Strongly rising income and expenditure, lively financial market activity as well as increases in asset prices and wealth supported growth in the broad money supply, M3. Higher rates of interest on M3 deposits and precautionary motives in the light of asset price volatility may also have raised the demand for money. As before, the increase in M3 was mainly concentrated in the deposit holdings of companies rather than households.
The national government recorded a fiscal surplus in 2006/07 as its strong revenue growth continued, and projected another surplus for 2007/08. For the public sector as a whole, a small deficit was projected as capital expenditure was set to increase significantly. Fiscal prudence and low levels of both government and external debt contributed to the decision during June and July 2007 of two ratings agencies to revise South Africa’s foreign-currency ratings outlook from stable to positive.
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