The SA economy has endured several severe economic shocks in the past few years: a labour shock, a commodities shock, an electricity shock, and on top of everything, the worst drought in 55 years.
At last, however, there is a sense among economists that the business cycle is bottoming out and that SA will enjoy relatively better growth and lower inflation next year, maybe even an interest rate cut in the second half — if the promised rains come.
A summer with good rains is essential for increasing food supply and tempering food inflation, which has been the driving force behind the CPI target breach for much of this year.
Historically, SA’s business cycle has bottomed when inflation has peaked. Last month, the Reserve Bank revised down SA’s expected inflation trajectory considerably.
It now expects inflation to peak in the fourth quarter of this year at 6.7% (compared with 7.1% previously) and to return sustainably within the target range earlier than before, in the second quarter of 2017.
The significant statistical base effects created by drought-induced high food prices this year will result in lower food inflation and eventually lower headline CPI in 2017. This will raise consumers’ disposable income and spending, boosting GDP growth. Favourable weather patterns could push food price inflation down even faster than the Bank expects.
Recent rand strength has also played a role in the Bank’s improved inflation outlook. The unit strengthened by almost 6% against the US dollar in the third quarter and was the biggest gainer in September among more than 140 world currencies tracked by Bloomberg.
The stronger rand reflects improved foreign sentiment towards SA. Though sustainable growth is still missing, commodity prices appear to be firming, inflation expectations have come off and SA’s current account deficit has narrowed significantly, partly due to increased exports, which suggests the economy is at last rebalancing.
If the rand and the rain play ball, further rate hikes are probably off the table. The Monetary Policy Committee (MPC) worded it more cautiously last month when it noted that "should current forecasts transpire, we may be close to the end of the tightening cycle".
What would really get a fledgling recovery going would be an interest rate cut. Though some economists are starting to foresee a cut in the second half of next year, Citibank economist Gina Schoeman believes that "the bar to cut is high" and that the repo rate is likely to remain on hold at 7% throughout 2017.
For cuts to commence, she says, the Bank’s medium-term CPI outlook would need to be heading well within the 3%-6% target band, inflation expectations (which have proved "extremely sticky") would need to be dropping significantly, and there would need to be a marked reduction in inflation risk. The last-mentioned encompasses such large unknowns as the outcome of the US elections, the US Federal Reserve’s rates policy, local politics and the threat of a domestic sovereign credit rating downgrade.
All these risks are likely to prevent the Bank from becoming comfortable with the expected disinflationary trend in CPI in 2017, Schoeman believes.
The dynamic that causes inflation to peak when GDP growth troughs is due to the consumer-heavy composition of GDP in SA. Since household consumption makes up 60% of GDP, and because households spend all of their disposable income, as soon as inflation slows down consumers spend the difference. Household consumption therefore picks up and drives the GDP upturn.
"Sadly, there is very little about that dynamic that is conducive to big job creation, so the consumer benefits only for as long as inflation is cyclically low," explains Schoeman. "When that trend turns, GDP growth slows again."
To drive a sustainable (as opposed to merely cyclical) recovery, SA needs to undertake structural reform. This could include reducing logistics costs (like making broadband cheaper), improving SA’s skills set, and reducing labour’s propensity to strike.
Without a sustained faster pace of growth, the outlook for real GDP growth per capita will remain dire.
On Citi’s estimates, SA’s real per capita GDP increase will average only zero from now until 2020. This would be the weakest "recovery" in real per capita GDP growth across all previous upturns of the economy.
The bottom line is that SA needs a more investment- or production-heavy economy.
Encouragingly, Deutsche Bank economist Danelee Masia detects signs that this rebalancing may indeed be occurring. If she’s right, it will be more than just the cyclical bounce caused by SA’s recovery from the drought that would propel the GDP growth rate to around 1%-1.5% next year from around zero in 2016.
Current data shows that wage growth has subsided and, through a reduction in the number of jobs, productivity has improved for the first time in several years, notes Masia. As a result, the employee compensation to GDP ratio (the wage share) seems to have peaked and, conversely, the corporate profit ratio (the capital share) has bottomed (see graph).
For a business cycle recovery to commence, probably in the first half of 2017, this process will have to deepen, she adds. Employee compensation may have to ease further, towards a 5% increase from 8% now.
The resultant improvement in labour productivity would provide a critical support for net exports, which would remain the driver of growth in the cycle. Masia estimates that a recovery in productivity similar to what occurred during SA’s 1999 and 2009 economic upswings would be consistent with an annual economic growth rate of 1.8% to 2.2% over the next two years.
In the process, profit margins would recover, leading to a resumed increase in private sector investment, fuelling higher overall GDP growth after a lag.
Inflation would also be expected to abate, given falling unit labour costs and productivity improvements. Masia is consequently expecting an interest rate cut in the second half of 2017. This would allow profit growth to gain further traction.
For this nascent upswing in the business cycle to be given half a chance, SA must avoid a confidence-sapping sovereign rating downgrade to junk in December. The odds are roughly 50-50, and hinge partly on whether finance minister Pravin Gordhan remains in his post and delivers a strong minibudget later this month.
The finalisation of mining legislation, clarity on the mining charter, the introduction of secret strike balloting, and improvements to the governance and balance sheets of state-owned enterprises are all reforms that are eagerly awaited by business and the rating agencies.
Delivering on these would provide just the boost to confidence the economy needs at this key turning point in the cycle.