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13 Mar 2014

South Africa’s year of reckoning

David Faulkner

by David Faulkner

Economist, South Africa, HSBC

South Africa’s year of reckoning

Rising interest rates in South Africa will restrain already fragile private investment

South Africa’s increase in interest rates this year and rising inflation mean that an economy already buffeted by global and local headwinds will also see growth choked off as domestic demand collapses. This will help reduce the country’s current-account deficit, but means we are cutting our 2014 growth forecast from 2.6 per cent to 1.8 per cent.

The deterioration in the inflation outlook and the risk of a weaker rand increasing inflation further were the apparent motivations for raising interest rates.

However, we also see it as the outcome of financial-market pressures, with the country’s central bank needing to demonstrate resolve in the face of large capital outflows, currency weakness and rising rates in other fragile emerging markets that have large external deficits.

The marked slowdown in domestic demand will result in another year of sluggish growth for the South African economy

Weaker growth prospects as domestic demand collapses, some currency appreciation as the current-account balance improves, plus favourable moves in fuel prices during the second half of 2014 should allow monetary policy to be refocused on growth.

But we see headline CPI inflation averaging 6.2 per cent this year before re-entering the 3 per cent to 6 per cent target range early in 2015 and slowing to 5.5 per cent.

We expect growth to remain sluggish. Household consumption prospects are suppressed by low confidence, high debt and the absence of private-sector job creation. Higher inflation and borrowing costs will compound these headwinds to consumer spending by slowing real disposable income growth and deterring purchase decisions.

Rising interest rates will also restrain already fragile private investment.  Low levels of business confidence, policy uncertainty, and a binding energy constraint that remains in place into 2015 underpin the bleak prospects for fixed capital formation.

The marked slowdown in domestic demand will result in another year of sluggish growth for the South African economy. We have thus cut our expectations of GDP growth from 2.6 per cent to 1.8 per cent for this year and from 3.1 per cent to 2.7 per cent for 2015 as household consumption slows sharply and investment stalls.

South Africa’s large current-account deficit places it squarely in the ‘Fragile Five’ alongside Brazil, India, Indonesia and Turkey. The deficit has widened sharply over the past two years, even as the rand weakened, with the trade balance worsening in tandem with deteriorating terms of trade, robust import growth and strikes in key export industries.

The recent shifts in capital flows and the associated impact on currencies have highlighted the unease that exists towards economies running large current-account deficits at a time when tapering by the US Federal Reserve signals the erosion of high levels of global liquidity and the eventual start of monetary normalisation. It is now unclear how or whether South Africa’s large external deficit can be financed.   

Ongoing pressure on fragile emerging markets accompanied by currency weakness and rising interest rates should accelerate a correction in the balance of payments deficit during 2014 and 2015 by choking domestic demand.

Past corrections have been economically disruptive, with domestic demand contracting rapidly, but it should help narrow the current-account deficit from 5.8 per cent of GDP in 2013 to 4.5 per cent this year and 4 per cent in 2015.

This research was first published on 18 February 2014.
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