The South African Reserve Bank concludes its September monetary policy meeting on Thursday. The majority of economists expect rates to be kept on hold, given the current levels of inflation. And with positive economic growth seen in the second quarter, it may be hard to argue otherwise. But given the uncontrollable force of inflation, driven more by currency movements than anything else, Investec’s Brian Kantor asks if the committee will help or hinder the recovery. Given expectations that the economy will continue to struggle despite this green shoot. And because the country’s recovery is more reliant on consumer spending than anything else, Kantor says the Reserve Bank, through its previously unhelpful interest rate movements and money supply actions, has significantly influenced this growth. Yet more interesting insight from one of SA’s finest. – Stuart Lowman
By Brian Kantor*
GDP grew in the second quarter, despite very weak spending. Without a recovery in spending the SA economy will continue to struggle. Will the Reserve Bank help or hinder a recovery?
The SA economy, measured by GDP (the real output of goods and services) grew in the second quarter (Q2), at a satisfactory (annual equivalent) rate of 3.3%. In the first quarter (Q1) output had declined at a -1.3% annual rate. Hence the economy avoided a recession – defined conventionally as two successive quarters of negative growth. However an examination of the expenditure side of the economy reveals a much less satisfactory state of economic affairs. Total spending, Gross Domestic Expenditure (GDE) in real terms declined in Q2 by as much as GDP increased, at a -3.3% rate. The difference between GDP and GDE is by definition net exports: the difference between exports that add to domestic output and imports that substitute for domestic output. On a seasonally adjusted basis, export volumes grew very strongly in Q2, while import volumes declined enough to add a net 6.7% to the GDP growth rate.
Final demand makes up a large component of GDE. It aggregates the compensation spending by households and government and the expenditure by government agencies and the private sector on additional capital goods. This aggregate declined (by 0.1%) in Q2 – an improvement on the 2.8% decline estimated in Q1. The further component of GDE is inventories accumulated or run down. In Q2 inventories are estimated to have declined by a real R22.7bn, contributing a large negative (-3.2% p.a) to the GDP growth rate in Q2.
When the spending of households is aggregated with that of privately owned businesses on capital equipment, that is when government spending and investment in inventories are excluded from final demand, we find a similar reluctance of private households and firms to spend more. Private demand for goods and services has been growing at consistently slower rates in recent years appears and now appears to be in retreat, having declined marginally in real terms in Q2 2016, not quite keeping up with inflation, defined as the year on year increase in the GDP deflator. The supply of money and bank credit has been growing as slowly as private spending. This is clearly not co-incidental. The growth in spending and credit to fund spending tend to run together.
The performance of the economy in recent years indicates clearly that the increases in interest rates imposed on the economy since January 2014, while they have worked to reduce spending and so the growth in GDE and GDP, have not helped in any significant or predictable way to reduce inflation or inflation expected. Inflation in SA – that leads rather follows inflation expected – has been dominated by shocks in the form of a weaker exchange rate that has driven up the prices of imported goods and a further shock in the form of a severe drought that has reduced domestic supplies of food staples and increased dependence on imports. Higher regulated prices and taxes on expenditure have added to the supply side shocks that can drive prices higher – despite weak demand that only to a limited extent has helped to hold back prices generally . The exchange rate itself has taken its cue, not from interest rates set in Pretoria, but in Washington DC. It is not only the rand but all emerging market currencies that have depreciated as capital flowed to developed, rather than less developed markets, in recent years. Moreover wage rates and prices are determined simultaneously and interdependently in SA. Higher money wages do not cause inflation- they are inflation. Higher real wages have come at the expense of employment opportunities as well as profit margins over the past few years as employees share of GDP has increased at the expense of profits and owners. Prices are never set to simply add a constant profit margin to costs- including wage costs. They are set according to what the market can bear – and what the market can bear depends very much on the state of the economy- that has remained unaccommodating to the private firms setting prices.
The reality that the Reserve Bank finds it so hard to recognize that their scope to control inflation is very limited if the domestic authorities do not have any consistent influence over the exchange rate. This has been the case for South Africa as it is for most emerging market central banks with flexible exchange rates that have responded to highly unpredictable capital flows. The figures below demonstrate that the common global rather than SA forces that have been responsible for almost all of the weak rand and the higher prices that have come with it. The EM Currency basket represents nine equally weighted emerging market currencies (The Russian ruble, Indian rupee, Hungarian forint, Mexican, Chilean and Philippine pesos, Turkish lira, Brazilian real and Malaysian ringgit). Though it must be added, the rand has been a distinct under performer since 2012 – losing about 20% more than the EM basket Vs the US dollar. The current value of the rand is now (20 September) a little ahead of where it would be predicted to be – given the exchange value of the EM basket as its predictor – and so also taking into account the weaker bias against the rand.
The Reserve Bank, through its unhelpful interest rate and money supply actions, has significantly influenced the growth in spending. Higher interest rates may have reduced measured GDP growth by as much as 2% p.a. without much reducing inflation. Inflation has been driven higher mostly by the weaker rand and the higher food prices The feedback loop from higher interest rates to less spending and so on to inflation has been overwhelmed by these supply side shocks. Higher interest rates depress demand but they have no predictable influence on the exchange rate, hence on import and export prices, or on administered prices and higher expenditure taxes all of which can push prices higher – and real demand lower. And so inflation targets only becomes(barely) achievable with still slower growth in spending and output – a heavy sacrifice for the economy to have to make for very little benefit in the form of low inflation.
It would be far better for the economy if the Reserve Bank made it very clear that the exchange rate and the drought are not within its ambit of control. And hence the temporarily higher prices that follow such shocks are best ignored and allowed to pass through. The Reserve Bank would then have to ensure that domestic spending does not put pressure on prices. Its interest rate and money supply settings can then be designed only to prevent excess demand for goods and services driving up prices while the impact of the supply side shocks on prices must best be ignored. Such a policy would not imply that the Reserve Bank will have turned soft on inflation. Low inflation will remain a very important objective of its policy. But only that part of the inflationary process that it can realistically hope to influence- and that is state of domestic demand.. It policies should aim at not too much demand to drive prices higher and not too little demand that holds back potential growth – as it has been doing.
The hope for a cyclical recovery of the SA economy and the lower interest rates that will be necessary to the purpose, rests on a degree of rand stability that will accompany a revival of capital flows into EM markets and currencies. A normal harvest will also help to hold down inflation in 2017. It will take lower interest rates to encourage the demand for and supply of bank credit. It will take lower inflation and inflation expected to encourage the Reserve Bank to lower short term rates. It would seem self-evident, given the want of demand for goods and services and for the labour to help produce them, that the direction of SA interest rates should be downward rather than upward.
The highly competitive weak rand – now some 30% below its purchasing power equivalent value (see below) will continue to encourage exports (labour relations permitting) and discourage imports and may help sustain GDP, as it did in Q2 2016. However, given the importance of household spending for the economy, accounting as it does for over 60% of all spending and given also the further dependence of capital expenditure by private companies on the demands households make on their established capacity, any consistent recovery in the SA and the weak economy – will require the stimulus of lower interest rates. We can hope that a stable or better, a stronger rand and less inflation, makes this possible. We can also hope for a more realistic and helpful narrative from the Reserve Bank that recognises that interest rates influence growth much more than inflation and that maintaining growth rates is a highly appropriate objective for monetary policy – especially when controlling inflation is not within its control.
- Brian Kantor is chief economist and strategist at Investec Wealth & Investment.
- The views expressed in this column are those of the author and may not necessarily represent those of Investec Wealth & Investment
