South Africa
2007 Article IV Consultation -Staff Report; Staff Statement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for South Africa
Author: International Monetary Fund
Publication Date:
06 Aug 2007
eISBN:
9781451841053
Language:
English
Keywords:
ISCR; CR; staff appraisal; market confidence; IMF staff representative; confidence; public; fiscal policy; interest rate; U.S. dollar; broad money; financial system; Africa
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This 2007 Article IV Consultation highlights that real GDP in South Africa grew by 5 percent in 2006 and continued to grow vigorously in early 2007. Growth was driven by strong domestic demand, with private consumption and investment spending supported by continuing robust consumer and business sentiment and low interest rates until late 2006. Asset prices continued to rise rapidly in 2006 and early 2007. Executive Directors have considered that the economic outlook for South Africa remains broadly positive.

Abstract

This 2007 Article IV Consultation highlights that real GDP in South Africa grew by 5 percent in 2006 and continued to grow vigorously in early 2007. Growth was driven by strong domestic demand, with private consumption and investment spending supported by continuing robust consumer and business sentiment and low interest rates until late 2006. Asset prices continued to rise rapidly in 2006 and early 2007. Executive Directors have considered that the economic outlook for South Africa remains broadly positive.

I. Recent Economic and Policy Developments

1. South Africa has made significant economic progress in the past decade. After sluggish growth in the early years of the political transformation, the country started to reap the benefits of sustained good macroeconomic management and structural reforms, recently supported by favorable external conditions. The economy is undergoing its longest expansion on record, and in recent years has experienced elevated growth in an environment of rapid credit expansion, booming asset prices, strengthening public finances, and rising international reserves financed by large capital inflows. At the same time, however, the external current account has widened markedly, and inflation pressures have recently intensified.

2. The economy grew by 5 percent in 2006 for a third year in a row, and by 4.7 percent in the first quarter of 2007, driven by strong domestic demand. Household consumption was fueled by growing disposable income, relatively low interest rates until late 2006, and wealth effects from rising asset prices. Private fixed investment remained buoyant, supported by strong business confidence. Public sector investment and government consumption also expanded robustly.

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Contribution to Real GDP Growth

(Percent)

Citation: IMF Staff Country Reports 2007, 274; 10.5089/9781451841053.002.A001

Source: South African Reserve Bank

3. The expansion in economic activity lifted employment, which rose by 4.1 percent in the year to September 2006. The unemployment rate, however, declined only modestly, to 25½ percent, as labor force participation rose significantly. Remuneration per employee in the formal nonagricultural sector rose by 9.1 percent (y-o-y) in the last quarter of 2006.

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CPIX and Core Inflation, January 2001 - April 2007

(Annual percent change)

Citation: IMF Staff Country Reports 2007, 274; 10.5089/9781451841053.002.A001

Source: SARB.

4. Inflation pressures intensified lately, leading to a breach of the Reserve Bank’s target band of 3–6 percent in April 2007, for the first time in 3½ years. CPIX inflation increased during 2006, prompting the MPC to raise the policy interest rate (the repo rate) between June and December by a cumulative 200 basis points, to 9 percent.1 Following a pause in the tightening cycle, an unexpectedly large jump in inflation to 6.3 percent in April led to an upward revision in the MPC’s inflation outlook and an ensuing 50 bps increase in the repo rate in June.

5. The SARB maintains a flexible exchange-rate system, while building up international reserves. The SARB has a publicly-announced policy of intervening in the foreign exchange market only to purchase foreign exchange to gradually bolster its reserve position. By May 2007, gross reserves reached US$27.9 billion, equivalent to about 200 percent of short-term external debt, or 3.4 months of imports of goods and services.

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International Reserves, January 2001 - April 2007

(Billions of US dollars)

Citation: IMF Staff Country Reports 2007, 274; 10.5089/9781451841053.002.A001

Source: SARB.

6. After depreciating markedly in mid-2006, the rand has fluctuated without a defined trend. Like other emerging market currencies, the rand came under pressure following global financial market turbulence in May-June 2006, and depreciated by 10.6 percent in real effective terms between end-2005 and July 2006. Since then, the weakening effect of the rising current account deficit on the rand has been broadly offset by renewed strength in commodity prices and widening interest differentials with the U.S. and the Euro area.

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Commodity Prices and the Real Effective Exchange Rate, January 2001 - May 2007 (January 2001=100)1

Citation: IMF Staff Country Reports 2007, 274; 10.5089/9781451841053.002.A001

Sources: IMF staff estimates and Datastream.1 Real effective exchange rate data through March 2007.
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Savings and Investment

(Percent of GDP)

Citation: IMF Staff Country Reports 2007, 274; 10.5089/9781451841053.002.A001

Source: SARB.

7. The external current account deficit widened significantly, to 6.5 percent of GDP in 2006 and 7.0 percent of GDP in the first quarter of 2007, reflecting the continued strength of domestic demand. In 2006, growth in import volumes substantially exceeded growth in export volumes, while the terms of trade improved marginally. From a savings investment perspective, investment rose by 2¼ percentage points of GDP and national savings declined slightly (with an increase in public savings partially offsetting a fall in private savings). The current account deficit was financed by portfolio inflows, mainly equity. External debt rose, but remains at modest levels of 22½ percent of GDP, with 37 percent of this debt being denominated in rand.

8. Reflecting strong tax revenues, the national government’s fiscal balance yielded a surplus of 0.6 percent of GDP in FY2006/07 after recording a deficit of 0.3 percent of GDP a year earlier. As in recent years, booming demand and greater efficiency in tax collection contributed to large revenue gains beyond budgeted levels. On the expenditure side, a rise in social spending was broadly offset by a decline in interest payments and other spending. By end-2006, government debt had declined to about 31 percent of GDP.

National Government Main Budget 1

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Source: South African authorities and IMF staff estimations.

For fiscal year beginning April 1.

Consolidated central and provincial government. Education, health, transfers, and other.

Using tax-specific elasticities to tax-specific base gaps (see IMF Country Report 06/328).

9. Credit growth has remained buoyant despite recent interest rate hikes, thereby raising household indebtedness. Credit to the private sector grew by 25.1 percent in the year to April 2007, supported by rising incomes, wealth effects, employment, and confidence. On the supply side, intensified bank efforts to reach lower-income strata of the population contributed to the expansion. Lately, an increasing share of the new loans have reflected corporate sector borrowing. Household debt rose to 76 percent of disposable income by March 2007, up from 68 percent a year earlier. Households’ debt service relative to disposable income has also risen, partly reflecting the recent increase in interest rates.

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Household Debt and Debt Service

(Percent of disposable income)

Citation: IMF Staff Country Reports 2007, 274; 10.5089/9781451841053.002.A001

Source: SARB.

10. Asset prices continued to rise strongly in 2006 and 2007. The Johannesburg Stock Exchange all-share index surged by 40½ percent in the 12 months through May 2007, driven by strong commodity prices, favorable growth prospects, and positive assessments from rating agencies. Residential property prices also continued to rise, by 15½ percent in the 12 months to May 2007.

II. Policy Discussions

11. The authorities’ main objectives are to accelerate growth and reduce unemployment and poverty within a stable macroeconomic environment. The government’s Accelerated and Shared Growth Initiative for South Africa (ASGISA) seeks to relax key binding constraints on growth, and aims to achieve average growth rates of at least 4½ percent in 2005-09 and 6 percent in 2010-14, and halve the unemployment and poverty rates by 2014 from 2004 levels. Against this background, discussions with the authorities focused on the economic outlook and risks; policies to maintain macroeconomic and financial stability; structural reforms to raise growth and reduce unemployment; and regional implications of South Africa’s developments and policies.

Summary of Previous Consultation Discussions

Macroeconomic policies. There has been broad agreement on policies, as the Fund has generally supported the authorities’ views on fiscal policy, inflation targeting, exchange rate policies, international reserves management, and exchange control liberalization.

Structural policies. The Fund has supported South Africa’s fiscal and financial sector reforms, trade liberalization, and initiatives to reduce unemployment. It also encouraged identifying and revising aspects of labor legislation that constrain job creation, but progress in this area has been difficult. The Fund considered that privatization, within a proper regulatory framework, could help enhance the efficiency of state-owned enterprises, but the authorities favored instead the restructuring of the large enterprises, together with the sale of their noncore assets. The Fund has also recommended further liberalization and simplification of the trade regime; while there has been some progress, the authorities indicated that decisions on the tariff structure would depend on the outcome of the Doha round and the conclusions of their industrial policy review.

A. Outlook and Risks

12. The authorities and staff agreed that near-term economic prospects are broadly favorable. A broad range of indicators point to continued robust output growth, and the external environment is expected to remain benign. Staff’s baseline scenario envisages output growth of 4¾ percent in 2007 and 4½ percent in 2008, the latter being somewhat below government projections. Inflation is expected to remain above the upper limit of the target band in the near term. Continued strength of domestic demand would keep the current account deficit relatively high, above 6 percent of GDP in 2007 and 2008.

13. The main downside risks to the near-term outlook are a possible deterioration of the global environment and the potentially excessive pace of domestic demand. Weaker appetite for emerging market assets, or a substantial rise in global interest rates, could reduce capital inflows to South Africa, prompting a sharp depreciation of the rand and thus additional interest rate increases to keep inflation in the band. Household balance sheets would deteriorate, as mortgages at variable interest rates have grown strongly, potentially contributing to dampening growth. Also, a negative supply shock in world oil markets could slow growth globally, and in South Africa, especially if accompanied by a sharp fall in commodity prices. The widening current account deficit and high reliance on portfolio inflows have raised vulnerability to external shocks, particularly a “sudden stop” in capital inflows (Box 2). However, the country’s strong fundamentals, including low external debt, a solid and improving reserves position, a sound financial sector, and adherence to a flexible exchange rate, should help limit the adverse impact of these shocks on the economy. The authorities agreed that the widening current account deficit implied some risks, but considered that South Africa would likely continue to attract significant capital inflows in the years ahead, especially given the abundant global liquidity. On the domestic front, staff considered that the continued rapid growth in domestic demand, in combination with capacity constraints—as evidenced for instance by the record high manufacturing capacity utilization, and emerging scarcity of energy, cement, and steel—could lead to further widening of the current account deficit and intensifying price pressures.

14. Staff envisages potential real GDP growth gradually rising over the medium term to about 5 percent. In this scenario, rapidly growing investment would relieve the most pressing capacity constraints—especially in electricity and transport networks—allowing faster sustainable growth than hitherto (text table). Other productivity-boosting reforms, including under ASGISA, would also contribute to the pick-up in potential growth. At 4¾ percent, average projected growth in 2007-12 would be slightly lower than potential growth, as the present positive output gap closes over that period. The external current account deficit would gradually narrow to around 4½ percent of GDP by 2012, although risks of a higher deficit remain if growth continues to be driven by domestic demand. The National Treasury projects sustained output growth rates above 5 percent in coming years under the assumption of higher potential growth than estimated by staff, resulting from more optimistic projected increases in fixed capital formation and employment, as well as the continuation of the very strong TFP growth experienced in recent years.

GDP growth and contributions (period average)

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Assessing the Risks from South Africa’s Current Account Deficit1

Following a sharp swing from a small surplus in 2002 to a deficit of 6.5 percent of GDP in 2006, South Africa’s current account balance is now something of an outlier among non-European emerging market economies (EMEs). Moreover, while many European EMEs (such as Turkey and Hungary) also have large current account deficits, a relatively larger share of their deficits are covered by direct investment inflows, which are considered a stable form of financing. South Africa, by contrast, is unusually reliant on portfolio equity inflows to finance its deficit (figure).

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Emerging Markets: FDI-adjusted Current Account Balances

Citation: IMF Staff Country Reports 2007, 274; 10.5089/9781451841053.002.A001

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South Africa: Investment, Savings, and Current Account

Citation: IMF Staff Country Reports 2007, 274; 10.5089/9781451841053.002.A001

An examination of the factors contributing to, and financing, the deficit yields several insights:

  • The deficit reflects a private sector savings-investment imbalance (i.e., not fiscal origin).

  • Rising investment appears to be an increasingly important driver of the imbalance (figure).

  • The stock of external liabilities is low by EME standards; sizeable deficits for several years would be needed to push external liabilities to worrisome levels (figure).

  • Recent developments indicate that the near-term outlook for portfolio inflows to South Africa is broadly favorable. In the year to early June, nonresident purchases of equities and bonds have amounted to about 2¼ percent of annual GDP. A J.P. Morgan survey also suggests that investors are underweight in South African equities relative to a neutral global portfolio allocation.

While these factors provide some reassurance that the current account position may not be an immediate threat, deficit levels of 6-6½ percent, financed by portfolio inflows, will continue to leave South Africa exposed to a “sudden stop” in capitals flows. Strong fundamentals are already in place that should help to limit the consequences of a sudden stop. Other policy measures, such as further accumulation of reserves, continued improvements in the structure of external debt, and reforms to enhance the flexibility and openness of the economy, might also help to reduce the likelihood and the costs of a sudden stop.2

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Emerging Markets: Net Foreign Assets

Citation: IMF Staff Country Reports 2007, 274; 10.5089/9781451841053.002.A001

11 See Chapter I of the Selected Issues Paper.2 Sectoral balance sheets are discussed in Chapter IV of the Selected Issues Paper.

15. South Africa’s debt position appears sustainable under a variety of shocks. In stress tests conducted by staff, government debt remains below 30 percent of GDP and external debt stays below 25 percent of GDP (Appendix I). Even with a current account deficit wider than projected by 1 percentage point of GDP in each year in the 2007-12 period, external debt would stay below 30 percent of GDP in all scenarios.

B. Preserving Macroeconomic and Financial Stability

Monetary Policy

16. During the discussions, both the SARB and staff saw upside risks to the inflation outlook. Staff noted that SARB projections at the time of the April MPC meeting showed a significant probability that inflation would breach the upper limit of the band for several quarters, and thus considered that some tightening may be needed to anchor inflation expectations well inside the band and prevent second-round effects from recent rises in fuel and food prices. SARB officials agreed fully on the importance of anchoring inflation expectations and addressing second-round effects, but had not seen compelling evidence in these areas. They noted, for example, that while forward-looking projections of inflation had shown inflation rising to the top of the band temporarily, measured price expectations appeared to be well-grounded. The MPC had therefore elected to“wait and see” how the 200 bps tightening in the second half of 2006 worked its way through the economy.

A01ufig12

Inflation, January 2001 - April 2007

(Annual percent change)

Citation: IMF Staff Country Reports 2007, 274; 10.5089/9781451841053.002.A001

Source: SARB.
A01ufig13

Breakeven Inflation Rates 1

Citation: IMF Staff Country Reports 2007, 274; 10.5089/9781451841053.002.A001

Source: Datastream.1 Represents the spread between CPI-indexed bonds and regular bonds. The difference between CPI and CPIX inflation has lately been in the 1/2 to 3/4 percentage point range.

17. On June 7, the MPC raised the repo rate by 50 basis points to 9½ percent. Information available after the mission revealed an unexpectedly sharp jump in inflation in April. The MPC indicated that updated forecasts showed a deteriorated inflation outlook, with the baseline projection showing CPIX inflation marginally above the ceiling of the target band for most of the next several quarters. It also underscored that risks were strongly on the upside and that it would not hesitate to tighten policy further if necessary.

Exchange Rate Policy, Reserve Accumulation, and Exchange Controls

18. There was agreement that the flexible exchange rate system should be maintained. The current system is an integral part of the inflation targeting regime and helps provide a cushion against external shocks.

19. Staff found no strong evidence of any significant exchange rate misalignment. This assessment was based on the results of the most recent CGER (Consultative Group on Exchange Rate Issues) exercise and on additional work by staff (Box 3). While indicators based on the analysis of the current account pointed to a moderate overvaluation, those based on the relationship between the exchange rate and economic fundamentals pointed to an undervaluation. The authorities agreed that it was difficult to estimate an equilibrium value for the rand.

Estimates of the Equilibrium Exchange Rate

The IMF’s CGER exercise uses three approaches to assess the exchange rates of advanced and emerging market economies (see Methodology for CGER Exchange Rate Assessments, available at http://www.imf.org). As of February 2007, the two indirect methods based on evaluations of the current account, the external sustainability approach and the macro balance approach, suggested overvaluation of the rand in the 10-15 percent range. The direct, equilibrium REER approach, indicates an undervaluation of the rand of over 30 percent; the CGER exercise disregards this estimate because of data shortcomings.

The results from these types of analysis are sensitive to changes in specification. In the sustainability approach, if one wanted to stabilize South Africa’s NFA at the average level for emerging market economies (instead of South Africa’s much stronger level), the estimated overvaluation of the rand would be cut in half. Re-estimating the macro balances equation with only emerging market economies rather than a mix of advanced and emerging countries reduces the estimated overvaluation by about 1/3 as well. Re-estimating the equilibrium REER approach using only South African data (rather than panel data) and a somewhat different set of fundamentals would yield an undervaluation of less than half the size of the CGER estimate.

20. Staff supported the SARB’s current policy of gradual accumulation of reserves. While there is no specific target for the level of reserves, the policy aims at bringing reserves holdings broadly in line with those of other emerging markets. In relation to other countries, South Africa’s holdings are broadly comfortable in terms of short-term external debt, but relatively low in terms of other indicators (table). Also, South Africa’s holdings are markedly above the 100 percent of short-term external debt benchmark, but still below the sum of short-term external debt plus the current account deficit, another commonly used benchmark.2 On that basis, staff agreed that some further accumulation would be beneficial.

South Africa: Indicators of Reserve Adequacy at end-2006

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Source: Country authorities and IMF staff estimates.

Median values for a group of 48 emerging market countries.

Short-term debt at remaining maturity.

Countries with independently floating exchange rate regime as defined by the IMF Annual Report on Exchange Arrangements and Exchange Restrictions (2005).

21. The authorities continue to relax exchange controls gradually. Remaining controls apply to capital outflows by residents, and mainly comprise limits on overseas investment by institutional investors, the prohibition of portfolio investment abroad by corporates, and limits on offshore investment by individuals. Staff supported the relaxation of controls, as it allows for a better allocation of resources, and, by deepening the foreign exchange market, could help reduce exchange rate volatility over the medium term. Staff favored simplifying the administration of controls—for instance, replacing prior authorization with reporting requirements for investments within the allowed limits—to reduce compliance costs.

Fiscal Policy

22. South Africa’s fiscal position is strong. Over the last few years, large revenue gains from robust economic growth and improved revenue administration more than offset the impact of high expenditure growth on the fiscal balance. Despite capacity constraints at subnational levels, expenditure has generally been well targeted at social and infrastructure needs.

23. The authorities envisage a broadly balanced budget in coming years. In official projections, continued strong revenues would keep the national government’s budget surplus at 0.6 percent of GDP in fiscal year 2007/8. Only modest deficits are projected for subsequent years, despite planned further rapid increases in noninterest expenditure over the medium term (7¾ percent a year in real terms) to relieve infrastructure bottlenecks and social needs, and to prepare for the 2010 FIFA World Cup. Government debt would fall considerably over the medium term. Staff projections suggest moderately stronger fiscal outcomes than official projections in coming years, mainly on account of higher revenue.

24. Staff and the authorities exchanged views on the contribution of fiscal policy to demand management. On the basis of staff estimates, the fiscal stance would remain neutral in 2007/8 and turn expansionary afterwards (table).3 Staff supported the thrust of the government’s fiscal plans but suggested that maintaining a neutral stance in coming years may be more appropriate given the concerns arising from the current account deficit. Even if revenues were higher than officially forecasted—as staff projected—a neutral stance would require a moderately lower (but still ample) average growth in expenditure than currently planned.4 The authorities agreed that fiscal policy needed to be sensitive to the risks arising from external imbalances, and pointed to recent improvements in the fiscal stance in this regard. They added that the stance of fiscal policy would also remain mindful of the need for increased public spending to meet important social and investment priorities.

Cyclically adjusted fiscal balances, 2004/5 - 2009/10

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Sources: National Treasury and IMF staff estimates.

According to staff’s fiscal and GDP projections.

Using tax-specific elasticities to tax-specific base gaps (see IMF Country Report 06/328).

25. The authorities have launched an initiative to reform social security. It envisages a mandatory multi-pillar scheme covering old-age pensions, unemployment insurance, and death and disability benefits. Planned for 2010, the scheme would be funded by a payroll tax, while the budget would separately provide for a wage subsidy for low-wage earners to partly offset the associated increase in labor cost. The authorities explained that key features of the new system were still under study and remained to be discussed with stakeholders. Staff supported the goal of strengthening old-age income security, and concurred with the authorities on the need to proceed with caution due to the complexities of this undertaking and its potential effects on labor costs and work incentives. Staff also considered it important that the reform should ensure the full funding of liabilities, and, more broadly, limit possible adverse effects on the public finances, a view shared by the authorities.

26. Treasury officials and staff discussed the pros and cons of increasing reliance on consumption taxation relative to corporate and personal income taxation in the medium term. Staff considered that such a shift could reduce the variability of tax revenue and strengthen incentives to invest and work, but that it would require improving targeted social assistance to offset the impact of higher consumption taxes on the poor. The officials noted that the bases of VAT and excise taxes are already relatively broad with few exemptions. To generate significant further revenue from these taxes would, therefore, require an increase in their respective tax rates. They further noted that at present it might be difficult to introduce effective mechanisms to compensate many of the poor households adversely affected by such rebalancing. Staff suggested further study of these issues.

Financial Sector

27. South Africa’s financial system is generally sound and well regulated. The banking sector is adequately capitalized and profitable, with an average capital adequacy ratio of 12.7 percent and a nonperforming loan ratio of 1.1 percent as of early 2007 (Table 7). Among the large banks—accounting for 84 percent of the sector in terms of assets—exposure to foreign exchange and interest rate risks is limited, and incipient securitization has contributed to improving balance sheet management. Banks expect to comply with the January 1, 2008 deadline for implementation of Basel II principles; the new regime is expected to have a neutral effect on their capital adequacy ratios. Pension funds, collective investment schemes and insurance companies have also performed well on the back of rising domestic asset prices, and compliance with prudential requirements remains strong.

28. While welcoming the developmental benefits of recent rapid credit expansion, the authorities and staff agreed that it also created risks.5 Driven by buoyant credit and interest rate hikes in 2006, the ratio of debt service to income for households has risen, although it remains below historical highs for South Africa. While the bulk of credit growth takes the form of secured lending, the authorities have expressed concerns about the vulnerability of new borrowers, and there have been signs of some moderate deterioration in asset quality. In this regard, the recent entry into effect of the National Credit Act, although likely to lengthen slightly the foreclosure process for nonperforming loans, is expected to increase banks’ ability to assess the creditworthiness of individual households and limit risks from household credit.6

29. In the context of rapid credit growth, further enhancements to the regulatory and monitoring framework could be considered. Staff recommended: (i) collecting and regularly analyzing data on the distribution of household debt by income category, as aggregate numbers may mask pockets of weakness; (ii) conducting periodic stress tests on individual bank data—in addition to system-wide tests—encompassing credit, interest rate, liquidity and foreign exchange risks; (iii) monitoring more closely the effects of asset price developments on mortgage credit, including on the rate of re-mortgaging by households to finance consumption; and (iv) reinforcing prudential standards, such as on loan-to-value and debt service-to-income ratios.7 The authorities broadly agreed with the recommendations, while indicating that implementation would need to take into account potential compliance costs, particularly given the ongoing intense preparations for Basel II.

30. Staff discussed progress with financial development and regulatory issues. Access to financial services is expanding, as the share of South Africa’s population who do not benefit from formal financial services has declined to an estimated 49 percent in 2006 from 55 percent in 2004. Commitments under the Financial Sector Charter (FSC) have allowed the rapid expansion of low cost (“Mzansi”) accounts, and introduction of money transfer facilities and insurance products, thus increasing access to basic financial services. The authorities also plan the introduction of a regulatory framework for cooperative and dedicated banks with the aim of further enhancing access to financial services.8

31. The authorities confirmed their interest in an FSAP update for South Africa in early 2008. Such an exercise could provide considerable benefits in view of the significant developments in the financial sector since the initial FSAP in 2001.

C. Achieving Higher Growth

ASGISA

32. ASGISA has identified six major constraints on growth: (i) the relative volatility of the exchange rate; (ii) inadequate infrastructure and logistics; (iii) skills shortages; (iv) barriers to entry and competition in key economic sectors; (v) the regulatory environment, particularly the burden on small and medium enterprises (SMEs); and (vi) capacity limitations within the government. These constraints are being addressed, but most of them are outside the Fund’s core area of expertise.

33. The authorities indicated that exchange rate volatility is being addressed through sustained adherence to sound macroeconomic policies, assisted by a steady build-up of foreign reserves. They, therefore, saw no need to depart from their current exchange rate policy. Given concerns about exchange rate volatility, staff noted the practice in some inflation targeting countries of announcing an explicit policy for intervening in the foreign exchange market under extraordinary circumstances. 9 Those countries specify conditions under which the central bank might consider foreign exchange intervention to calm nervous markets or signal large misalignments. If effective, such intervention could limit overshooting and thus reduce currency volatility. Staff indicated, however, that the track record of such policy was short and the ability to identify large misalignments was limited, and thus determining whether a similar policy would be advisable for South Africa required further analysis. The authorities were skeptical about the benefits of such policy in South Africa, given doubts about the effectiveness of intervention in the rand market, uncertainty about the appropriate level or range of the exchange rate to defend, and the significant costs and viability of large-scale sterilized intervention. On this basis, the SARB policy excludes commitments to support any particular level of the rand.

34. Regarding infrastructure and logistic deficiencies, staff supported medium-term investment plans and efforts to enhance the efficiency of state-owned enterprises (SOEs). Work has progressed on several projects. In 2006, public enterprises raised their investment by 19 percent in real terms, in addition to the 9¾ percent real growth in government investment. In the medium term, energy and transportation SOEs plan further sizable investment expansion to relieve bottlenecks in electricity, port, and railway networks. Staff recommended that investment projects continue to be supported by ex-ante cost-benefit analysis and take into account implementation capacity, particularly since a large part of the program is to be undertaken by subnational governments and SOEs. The authorities noted that major investment projects do undergo rigorous review, especially if a state guarantee is requested. Moreover, they would like to increase the use of public-private partnerships (PPPs) to help relieve implementation constraints in municipalities, but that this approach faced regulatory hurdles which would be addressed in the year ahead.

35. Staff argued that the new industrial policy framework could introduce economic distortions. The framework includes potentially conflicting objectives, and, while cross-cutting interventions (such as enhancing competition policy and supporting research and development) seem justifiable on economic grounds, the basis for sectoral interventions is less well-founded. To avoid large distortions, it would be important that interventions be based on identified market failures or regulatory needs, subject to independent evaluations, and limited in duration.

Competitiveness

36. An assessment of South Africa’s international competitiveness paints a mixed picture. The country’s share of exports in world markets is at about the same level as in the late 1990s, with a rebound occurring since 2002 reflecting the upward trend in world commodity prices. In volume terms, however, South Africa’s market share has been falling throughout the period. Survey-based indicators of competitiveness usually rank South Africa above or about the same level as the larger Latin American countries, but below Chile and the more dynamic Asian emerging markets (table). South Africa ranks well on business efficiency, followed by government efficiency. Its poorest ranking pertains to infrastructure, broadly defined to include physical infrastructure and human capital.

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Export Market Shares (Index, 2000=100)

Citation: IMF Staff Country Reports 2007, 274; 10.5089/9781451841053.002.A001

Source: IMF.

World Competitiveness Ranking1

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From the World Economic Forum (WEF) and the International Management Development (IMD). The years mentioned refer to the timing of the surveys.

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IMD Elements of Competitiveness, 2007

Citation: IMF Staff Country Reports 2007, 274; 10.5089/9781451841053.002.A001

37. The authorities are addressing competitiveness concerns through measures to raise productivity and reduce costs. Under ASGISA, they are strengthening infrastructure and logistics, with an emphasis on energy and transportation. Moreover, they are introducing in pilot form the practice of conducting regulatory impact assessments of new legislation, building capacity in local governments, and improving the skills of the labor force through training of workers and facilitating the immigration of those with scarce skills.

Labor Market

38. While employment growth has recently picked up, unemployment remains very high. South Africa’s high unemployment is the result of several factors—some of them a legacy of the apartheid—including: (i) rapid growth of female and unskilled labor supply, together with a structural shift in labor demand towards skilled labor; (ii) long distances between places of residence and places of work, which raise the cost of job search and (perhaps together with the system of social grants) raise reservation wages; and (iii) labor market regulations and practices that discourage job creation. The individual effect of these factors is difficult to ascertain and merits further analysis.

39. Staff supported current targeted initiatives to reduce unemployment. These include skills development programs and public work programs. Staff suggested an evaluation of the effectiveness of these initiatives to ensure that resources are allocated efficiently. The authorities are also considering how best to reduce the complexity and delays in labor arbitration procedures. Staff recommended that adjustments in officially determined minimum wages and in public sector wages (the latter owing to its possible impact on private wage settlements) take into account their potential effect on employment.

Trade Policy

40. The process of trade liberalization has largely stalled in recent years. South Africa made significant progress in reducing tariffs and simplifying the trade regime in the mid-1990s, but relatively limited reform has occurred since then.10 Staff suggested further lowering the overall level of protection and simplifying the tariff structure, for instance by reducing the number of tariff bands and tariff peaks. The authorities saw some merit in further liberalization, but argued that moves in this area needed to be informed by developments in ongoing multilateral and regional trade negotiations and the emerging industrial policy strategy, which seems to call for maintaining tariff protection on certain sectors, while reducing tariffs on selected inputs.

41. The authorities stressed their preference for multilateral liberalization, but saw preferential trading arrangements as a useful second-best option. Partly as a result of delays in negotiations under the Doha Round, South Africa and its partners in the Southern African Customs Union (SACU) have been negotiating preferential trading agreements.11 Staff reiterated that these agreements should be broad-based, with simple and nonrestrictive rules of origin, to limit trade diversion and complement multilateral liberalization.

42. South Africa is negotiating a review of its Trade Development and Cooperation Agreement (TDCA) with the European Union (EU). As South Africa’s SACU partners (together with other African countries) are negotiating an Economic Partnership Agreement (EPA) with the EU, it has been agreed that the TDCA and EPA negotiations will be integrated into a single set of discussions. It is hoped that these negotiations will be completed by end-year, but significant issues remain to be resolved. The authorities noted that harmonization of the region’s trading relationship with the EU, its most important external trading partner, would contribute to regional integration.

D. Regional Spillovers

43. South Africa’s strong economic performance in recent years has benefited the wider region (Box 4).12 The success of the SARB’s inflation targeting regime continues to ensure that inflation remains relatively low and stable throughout the Common Monetary Area (CMA).13 The depreciation of the rand over the past year has mitigated concerns about competitiveness in Lesotho and Swaziland. The strength of domestic demand in South Africa has brought large revenue windfalls to BLNS via the SACU revenue-sharing arrangements.

44. South Africa has indicated that it wishes to revisit the existing SACU revenue-sharing arrangements. The authorities expressed concerns about the equity of the current arrangements. In view of possible moves to establish a broader customs union within the Southern Africa Development Community (SADC), they also noted the desirability of developing revenue-sharing arrangements that would facilitate the expansion of SACU.14 Staff agreed with the authorities that changes to the revenue-sharing arrangements could have a substantial fiscal impact on the smaller SACU members. Any changes agreed among the SACU partners would therefore need to take full account of such effects.

South Africa and Southern Africa

South Africa is the dominant economy in Southern Africa, accounting for over two-thirds of the combined GDP of the 14 SADC members. Economic linkages between South Africa and its neighbors are already close in many instances, and are expected to intensify over timew.

Common Monetary Area (CMA). The currencies of Lesotho, Namibia, and Swaziland are pegged at par to the rand through the CMA, and capital flows freely within the CMA.1 As a corollary, interest rates in the smaller CMA countries are closely linked to those in South Africa, and inflation rates across the area differ by relatively modest amounts (figure).

A01ufig19

Consumer Price Inflation in southern Africa (Percent).1

Citation: IMF Staff Country Reports 2007, 274; 10.5089/9781451841053.002.A001

Source: IMF Staff Estimates.1 Other SADC refers to median for other SADC member states. LNS refers to average for Lesotho, Namibia, and Swaziland.

Southern African Customs Union (SACU). One of the world’s oldest customs unions, includes the members of the CMA plus Botswana. Customs and excise duties collected in SACU are distributed to member countries according to an agreed formula. SACU payments, which constitute a major part of fiscal revenues in the BLNS countries, have increased significantly in recent years, reflecting both the strength of domestic demand in South Africa and the impact of a new sharing formula that became effective in 2005 (table).

SACU Revenue Payments

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Source: National authorities budget documentation, IMF staff estimates

Southern African Development Community (SADC). South Africa is central to economic integration within the SADC region, accounting for about 60 percent of all intra-SADC trade and 70 percent of its GDP. Outward investment by South African companies is expanding and South African banks operate in all 14 SADC member states.2 South Africa and BLNS have already eliminated tariffs on imports from the rest of SADC as part of efforts to establish a SADC free trade area by 2008. In 2004, SADC Heads of State also agreed on plans to deepen regional integration through the establishment of a customs union, common market and, ultimately, monetary union. Implementation of this agenda will be challenging with a number of issues, including multiple and overlapping memberships of regional groupings, still to be resolved.

Labor market linkages. South Africa continues to attract large numbers of workers from neighboring countries, a pattern in place for decades. While data on labor inflows are generally poor, there are indications that labor inflows have picked up in recent years, reflecting both the demand-pull effects of South Africa’s strong growth and skill shortages and also the supply-push effects of economic turmoil in some countries, notably Zimbabwe.

1 Botswana is not part of the CMA but pegs its currency to a basket comprising the rand and the SDR.2 The integration of South African banks in the region and its supervisory implications are discussed in IMF Country Report 06/328.

45. South Africa’s economic linkages with the rest of the region have grown significantly, but there is scope for further expansion of ties beyond SACU. The authorities see the expansion of trade and investment flows within SADC as an important contribution to the region’s growth prospects, while noting that a significant push will be needed to achieve SADC’s stated objective of a fully-functioning free trade area by end-2008. Many further obstacles would need to be overcome to establish a SADC customs union.

E. Equity Issues

46. Staff expressed support for the government’s initiatives to reduce social and wealth disparities. Progress in these areas is critical for strengthening social cohesion and thus the government’s ability to advance economic reforms.

  • Black Economic Empowerment (BEE). This initiative operates primarily through sector-specific voluntary “charters” that set targets for several empowerment indicators, including black ownership, black participation in management, and skills development. The government has recently enacted codes of good practice, which clarify implementation rules and thus should significantly reduce uncertainty about this initiative for firms and investors.

  • Land reform. This initiative, launched in 1994, aims at transferring 30 percent of commercial agricultural land to previously disadvantaged groups by 2014, but so far only about 4 percent has been transferred. Regarding land restitution (return of land lost due to racially discriminatory laws), the government will continue with its approach involving negotiations with current owners, with resort to expropriation at fair value and according to well-defined legal principles if negotiations reach a deadlock. Regarding land redistribution (transfer of privately held land—not subject to restitution claims—supported by state resources), the government is broadening its efforts. It has launched a state-led approach, under which government agencies will proactively identify both land for redistribution and the potential beneficiaries who would acquire this land with state financial support. This initiative complements the previous beneficiary-driven approach, under which beneficiaries identify land they want and then ask the state for financial support. Staff understands that the acquisition of land for redistribution will continue to take place at prices freely negotiated with current owners.

F. Other Issues

47. The HIV/AIDS epidemic has adversely affected social indicators, such as child mortality and life expectancy.15 The government’s HIV/AIDS program has become more extensive in recent years. By late 2006, an estimated 225,000 people had started ARV treatment under the public sector program (some 25-30 percent of the estimated number of people in need of treatment), aided by active donor support. The government launched a new national HIV/AIDS strategy in April 2007, aimed at halving the rate of new HIV infections and expanding access to proper treatment to 80 percent of HIV positive cases by 2011. The economic impact of HIV/AIDS is highly uncertain; a recent (2006) study by the Bureau of Economic Research estimates a reduction of ½ percentage point in long-term GDP growth.

III. Staff Appraisal

48. South Africa has made considerable economic progress in the past decade. Sound macroeconomic management and structural reforms, supported in recent years by favorable external conditions, have led to higher growth, lower and more stable inflation, sound public finances, a healthy financial system, and stronger international reserves. South Africa’s steady expansion has benefited the rest of the region.

49. Recent economic performance has been strong, although the external current account deficit has widened and inflation pressures have lately intensified. Output and employment have continued to grow at a rapid pace by historical standards, and vibrant economic activity has contributed to a fiscal surplus, the first in several decades. But surging demand has produced a marked increase in the current account deficit, financed by portfolio inflows, and inflation pressures have risen, reflecting supply shocks and the buoyant demand.

50. The near-term outlook remains broadly positive, with downside risks arising from possible external shocks and the continuing strong pace of domestic demand. On the external side, the large current account deficit has raised the vulnerability to external shocks, including a decline in capital flows to emerging markets. The country’s strong fundamentals should help limit the impact of those shocks on the economy. The main domestic risk is that demand, which is already pushing capacity constraints, would lead to further widening of the current account deficit and additional price pressures.

51. In view of the inflation outlook, the increase in the repo rate in June was appropriate. While inflation pressures partly resulted from supply shocks to food and energy prices, it is important that monetary policy act to contain their second-round effects on other prices and keep inflation expectations anchored. As noted in the June MPC statement, the risks to inflation are strongly on the upside, so further increases in the repo rate may be needed to bring inflation back within the target band over the medium term.

52. The flexible exchange-rate system, with foreign exchange purchased by the Reserve Bank only to strengthen its international reserves, remains appropriate. The floating exchange rate is an integral part of the inflation-targeting framework and helps the economy adjust to shocks. While the uncertainty surrounding estimates of an equilibrium exchange rate seems large, there is little conclusive evidence of any significant exchange-rate misalignment. Competitiveness concerns should continue to be addressed by measures to raise productivity and reduce costs. Gross international reserves have increased significantly over the last years, but are still lagging behind those in other emerging markets according to some benchmarks. Some further accumulation could thus be useful as a buffer against external shocks.

53. Continued progress in the relaxation of capital controls would be beneficial. It would improve financial management by institutional investors, corporates, and individuals. Simplifying the administration of existing controls would reduce compliance costs, for instance by replacing prior authorization with reporting requirements.

54. Fiscal policy is contributing to reducing macroeconomic risks, while addressing development needs. With surpluses in the past and current fiscal years, fiscal policy is appropriate in view of the large current account deficits. Going forward, keeping the fiscal policy stance neutral would seem appropriate, until the current account deficit starts declining. Vigorous expenditure expansion is targeted at relieving important infrastructure bottlenecks and meeting pressing social needs. Success in the government’s efforts to enhance implementation capacity at the subnational level would help achieve full and efficient execution of these programs.

55. The upcoming social security reform will be a major undertaking. The goal of strengthening old-age income security is welcome. The authorities are fully aware that the complexities of this effort and its potential effect on labor costs and work incentives call for caution in design and implementation, to avoid discouraging formal employment. It will be important to limit possible adverse effects on the public finances, including by ensuring full funding of created liabilities.

56. The financial system remains sound and well-regulated; the monitoring framework could benefit from further enhancements given the rapid credit growth. Major banks are actively preparing for the introduction of Basel II principles in 2008, and the authorities are carefully monitoring financial stability risks. Monitoring could be strengthened by regularly analyzing the distribution of household debt by income category and conducting stress tests on individual bank data. In the current buoyant environment, it would be important to consider reinforcing prudential standards on loan-to-value and debt service-to-income ratios. The forthcoming FSAP update should be useful in taking stock of developments in the past years and assessing the banking system’s vulnerability to shocks.

57. The authorities’ development strategy, ASGISA, provides a valuable coordinating framework for the government efforts to raise growth and reduce unemployment and poverty. The emphasis on relieving infrastructure bottlenecks, enhancing workers’ skills, and improving microeconomic conditions should go a long way toward achieving those objectives. At the same time, it is important to avoid introducing market distortions by limiting state interventions to cases of market failures or regulatory gaps. While exchange rate volatility has been identified as a constraint on growth, the authorities’ restatement of their position against trying to manage the exchange rate is welcome.

58. Additional labor market and trade reforms could contribute to raising growth. The initiatives in place to reduce unemployment—by enhancing workers’ skills and implementing public work programs—remain well grounded. At the same time, it would be useful to identify and revise those labor market regulations and practices that discourage job creation. South Africa implemented significant trade reforms in the 1990s, but additional efforts to simplify the tariff structure and lower most favored nation tariff rates are warranted.

59. South Africa’s strong economic performance in recent years has benefited the wider region. The strength of domestic demand in South Africa has brought substantial revenue windfalls to Botswana, Lesotho, Namibia, and Swaziland, via the SACU revenue-sharing arrangements. Any changes to these revenue-sharing arrangements, agreed among the SACU partners, would need to take full account of the fiscal impact on the smaller members. The expansion of trade and investment flows within the wider SADC would contribute importantly to the region’s growth prospects.

60. Addressing social disparities and the legacy of apartheid is important for the ability of the government to sustain economic reforms. The authorities have enacted codes of good practice for their Black Economic Empowerment initiative that clarify implementation rules, reducing uncertainty for firms and investors. They are also reinforcing the land reform program to speed up implementation, while keeping it based on well-defined legal principles.

61. It is expected that the next Article IV consultation will be held on the standard 12-month cycle.

Figure 1.
Figure 1.

South Africa: Real Sector Developments

Citation: IMF Staff Country Reports 2007, 274; 10.5089/9781451841053.002.A001

Source: SARB and IMF.
Figure 2.
Figure 2.

South Africa: Money, Prices and Interest Rates

Citation: IMF Staff Country Reports 2007, 274; 10.5089/9781451841053.002.A001

Source: SARB, BER, Datastream, and IMF.
Figure 3.
Figure 3.

South Africa: External Sector Developments

Citation: IMF Staff Country Reports 2007, 274; 10.5089/9781451841053.002.A001

Source: SARB and IMF.1 Gross reserves minus foreign loans received and minus forward position. The SARB’s open position in the forward market was closed in February 2004.
Figure 4.
Figure 4.

South Africa: Fiscal Developments

Citation: IMF Staff Country Reports 2007, 274; 10.5089/9781451841053.002.A001

Source: National Treasury and IMF.
Figure 5.
Figure 5.

South Africa: Exchange Rates, Asset Prices and Spreads

Citation: IMF Staff Country Reports 2007, 274; 10.5089/9781451841053.002.A001

Source: SARB, Datastream, Absa, and IMF.
Table 1.

South Africa: Selected Economic and Financial Indicators, 2003-08

Nominal GDP (2006): US$ 255 billion

Population (2006): 47.5 million

GDP per capita (2006): US$ 5,368

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Sources: South African Reserve Bank (SARB); IMF, International Financial Statistics; and Fund staff projections.

CPIX is the consumer price index (CPI) excluding the interest on mortgage loans. It is the targeted definition of inflation.

In U.S. dollars; annual percent change.

For 2007, March relative to December 2006. From December 2005 to December 2006 the rand depreciated 16 percent in nominal effective terms and 10.7 percent in real effective terms.

Contribution (in percentage points) to the growth of broad money.

For 2007, as of June 22. Between June and December 2006 the SARB increased the repo rate from 7 to 9 percent.

Calendar-year figures, based on staff’s fiscal and GDP projections for 2007 and 2008.

Table 2.

South Africa: National Government Main Budget, 2003/04-2009/10 1

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Sources: South African authorities; and Fund staff estimates and projections.

For fiscal year beginning April 1. National government comprises the central government and subnational spending financed by transfers from the national revenue fund.

Staff projections based on the 2007 Budget Review.

Southern African Customs Union (SACU) payments are based on a revenue-sharing formula.

Provision of bonds to the South African Reserve Bank in settlement of the Gold and Foreign Exchange Contingency Account.

Table 3.

South Africa: Nonfinancial Public Sector Operations, 2003/04-2009/10 1

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Sources: South African authorities; and Fund staff estimates and projections.

For fiscal year beginning April 1.

Staff projections based on the 2007 Budget Review.

Consolidated national and provincial governments.

Includes net extraordinary payments.

“Other” includes provincial and local governments, social security funds, other extrabudgetary institutions, and privatization receipts.

Health, education, welfare and community development.

Table 4.

South Africa: Balance of Payments, 2005-12

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Sources: South African Reserve Bank (SARB) and Fund staff estimates and projections.

End of period.

Gross reserves minus foreign loans and minus forward position. The SARB’s open position in the forward market was closed in February 2004.

Table 5.

South Africa: Monetary Survey, 2002-06

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Source: South African Reserve Bank (SARB).

Part of the increase in private sector credit in 2003 is due to a change in accounting rules for derivatives.