South Africa: Staff Report for the 2016 Article IV Consultation

South Africa has made considerable economic and social strides since 1994, but faces significant challenges. Deep-rooted structural problems-infrastructure bottlenecks, skill mismatches, and harmful insider-outsider dynamics-have kept unemployment and inequality unacceptably high. Also, a confluence of external and domestic shocks, combined with heightened governance concerns and policy uncertainty, have weighed on confidence and growth. Though private balance sheets are still strong, vulnerabilities are elevated.

Abstract

South Africa has made considerable economic and social strides since 1994, but faces significant challenges. Deep-rooted structural problems-infrastructure bottlenecks, skill mismatches, and harmful insider-outsider dynamics-have kept unemployment and inequality unacceptably high. Also, a confluence of external and domestic shocks, combined with heightened governance concerns and policy uncertainty, have weighed on confidence and growth. Though private balance sheets are still strong, vulnerabilities are elevated.

Context: Confluence of Shocks on Top of Existing Structural Challenges and Vulnerabilities

1. South Africa has made considerable economic and social progress over the last two decades, but faces substantial challenges. Annual per capita growth averaging 1.5 percent since 1994 and broadened access to social assistance and services have resulted in much improved living standards. Strong institutions and policy frameworks have contributed to macroeconomic stability. Globally-competitive corporates and a deep and sophisticated financial system have resulted in a globally-integrated economy. Yet, many South Africans have not sufficiently benefited from these improvements. Infrastructure bottlenecks, skill mismatches, and product and labor markets with harmful insider-outsider dynamics have left over a quarter of the labor force unemployed and income distribution among the most unequal in the world (Figure 1).

Figure 1.
Figure 1.

Improved Living Standards in the Democratic Era, but High Unemployment and Inequality Persist

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Sources: South Africa Audience Research Foundation, South Africa National Treasury, Social Security South Africa, WEO, World Development Indicators, and staff estimates.
A01ufig1

South Africa has made significant progress since 1994

(using latest available data for 2015)

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Note: Lower numbers represent better outcomes; a shift closer to the center indicates improvement.1/ On a scale of 100, measures distance (in percent) away from the perfect score.Sources: The Global Competitiveness Report, WEF; and WDI, World Bank.

2. The global transitions—China’s slowdown and rebalancing, weak commodity prices, and the U.S. monetary policy normalization—are taking a heavy toll on South Africa. China’s key role in the world economy and South Africa’s high reliance on mining exports result in significant spillovers from China’s transitions and the commodity price fall, despite the country being an oil importer (Box 1). China’s growth now matters more for South Africa than the E.U.’s and the U.S.’s growth. Commodities are the main channel, closely followed by global financing conditions likely capturing confidence effects. The commodity channel is also likely operating via Sub-Saharan Africa (SSA)—now absorbing 30 percent of South Africa’s exports and a major destination of South African corporates’ large expansion abroad—and is reducing corporate profitability and incomes across the economy. In addition, South Africa’s financing conditions are closely tied to those in the United States, though the two economies are moving in opposite directions. Outward spillovers to South Africa’s immediate neighbors will be significant. Spillovers to the rest of SSA are rising but remain muted (Box 2).

South Africa suffering from global transitions

article image

Cumulative impulse response of domestic long-term rates after one year to 1 percent increase in federal funds rate.

Sources: UNCTAD and staff estimates.

Spillovers from Global Transitions

This box explores spillovers from the ongoing global transitions—China’s rebalancing, lower commodity prices, and tighter global financial conditions—on South Africa. The results suggest China’s growth matters more for South Africa than U.S.’ and Europe’s growth, with commodity prices and financing conditions the main transmission channels. The impact of commodity prices is amplified by inter-sectoral linkages. Tighter global financial conditions have a significant impact on South Africa, mainly though bond yields and equity prices.

Spillovers from China and lower commodity prices 1

Rising trade linkages and reliance on commodities have increased spillovers from China. China absorbs 10 percent of South African exports, the most of any country. More importantly, it plays a key role in determining global demand for South Africa’s commodity exports, which account for 34 percent of total goods exports (51 percent including manufactured commodities), and commodities imports including oil, which account for 16 percent of total goods imports.

A01ufig2

China’s role in South Africa’s main commodities 1/

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

1/ The size of the bubbles represents the fall in real prices since end 20102/ South Africa is an oil importerSources: Bloomberg, UN Comtrade and MIT Observatory of Economic Complexity

Staff analysis suggests China’s growth now matters more for South Africa than that of the U.S. and the E.U. Using quarterly data from 2000, a VAR suggests that a one percentage point decline in China’s real GDP growth would lower South Africa’s growth by 0.3 percentage point (q/q sa annualized) after one quarter. This is smaller than the impact of a shock to the U.S. and the E.U. growth, and broadly consistent with estimates found in previous studies, including the World Bank’s June 2015 Global Economic Perspectives. However, the impact of a shock to China’s growth rises to 1 percentage point in the post-crisis sample, significantly exceeding the impact of shocks originating in the U.S. and the E.U. Though data limitations preclude a full analysis, the impact of a decline in China’s secondary sector could be even greater.

Spillovers from the US, EU, and China to South Africa

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Impact of a 1 percentage point negative growth shock on South Africa’s growth after 1 quarter.

A01ufig3

Impact of growth shock in China: Spillover channels

(percentage points of real GDP growth)

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Source: Staff estimates.

Commodity prices and global financial conditions are the main transmission channels. A decomposition following Swiston and Bayoumi (2008) suggests the decline in South Africa’s export commodity prices following a shock to China’s growth has a large and persistent impact.2 Financial spillovers (proxied by U.S. financial conditions), which likely capture global confidence effects, are also important. Spillovers through trade are small and positive, suggesting the impact of exchange rate depreciation on competitiveness outweighs the fall in global demand. Declining import commodity prices (mainly oil) provide a partial offset.

The impact of lower commodity prices is amplified by sectoral interlinkages. An analysis of input-output tables in South Africa suggests linkages between the commodity sector and the rest of the economy are significant. A sectoral structural VAR identified using multipliers from the input-output table suggests a 10 percentage point decline in export commodity prices would reduce real GDP growth by nearly 0.2 percentage points (q/q sa annualized) after two quarters, with most of the impact coming from downstream (e.g., construction) and upstream (e.g., transport) sectors including manufactured commodities. A Swiston and Bayoumi decomposition suggests that the main transmission channels are changes in corporate profitability and employment in the non-mining sector.

A01ufig4

Intersectoral linkages with the commodity sector

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Sources: EORA MRIO Database and staff estimates.
A01ufig5

Impact of shock to export commodity prices: Spillover channels

(10 percentage point drop; impact after 2 quarters)

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Source: Staff estimates.

A shock to China’s growth worsens South Africa’s external and fiscal balances, but the impact on inflation is ambiguous. Mineral export growth declined to -7 percent in 2015 from an average of 19 percent in 2011–13 on lower demand and prices. The lower oil import bill is a partial offset, and the terms of trade are expected to remain negative over the next few years.3 Fiscal revenues are affected mainly through growth, with corporate income tax growth down from an average of 10 percent between FY11/12-FY13/14 to an estimated 2.2 percent in FY15/16. Lower oil prices are fully passed through to retail prices, with petrol prices in early-2015 27 percent below their 2014 peak. However, this effect has been partly offset by depreciation. Anecdotal evidence points to a significant deflationary impact from overcapacity in China, which South Africa has partly offset through increasing tariffs by 10 percent on some steel imports (within the WTO bound rates). The overall impact on inflation in South Africa is therefore ambiguous.

Spillovers from tighter global financial conditions

High external financing needs and a large share of bond and equities held by foreign investors make South Africa vulnerable to spillovers from tighter global financial conditions. Almost half of South Africa’s portfolio liabilities are held by U.S. investors. Estimates in Caceres et al. (2016) suggest a 100bps increase in the U.S. policy rate would increase South African long-term rates by 73bps after one year, above the EM average, but short-term rates are not significantly affected.4 South Africa-specific estimates underlying the 2014 Spillover Report suggest a 0.2 percent decline in growth after one year following a 100bps rise in U.S. bond yields, with most of the spillovers coming from a 79bps increase in long-term bond yields and declining equity prices. Simulations using a broader set of countries in the 2015 Spillover Report and in Buitron and Vesperoni (2016) suggest that an unexpected tightening of monetary conditions that pushes up U.S. bond yields by 100 bps would spill over to bond yields in EMs and non-systemic advanced countries, result in capital outflows, and lower industrial production growth by 3½ percent per annum after one year.5 Most EMs would also experience significant exchange rate depreciation, though South Africa is relatively shielded from negative balance sheet effects given low corporate leverage and limited FX mismatches.

1/ Nose, Manabu, Magnus Saxegaard, and Jose Torres (2016), “The Impact of China’s Rebalancing and Lower Commodity Prices on South Africa”, IMF Selected Issues Paper.2/ Swiston, Andrew and Tamin Bayoumi (2008), “Spillovers Across NAFTA”, IMF Working Paper 08/3.3/ This contrasts with the 2014 Spillover Report which found a positive impact on South Africa’s trade balance from lower metal, energy, and food prices.4/ Caceres, Carlos, Yan Carrière-Swallow, Ishak Demir, and Bertrand Gruss (2016), “U.S. Monetary Policy Normalization and Global Interest Rates”, Forthcoming IMF Working Paper.5/ Buitron, Carolina and Esteban Vesperoni (2015), “Big Players Out of Synch: Spillover Implications of U.S. and Euro Area Shocks”, IMF Working Paper 15/215.

Outward Spillovers to Sub-Saharan Africa

Outward spillovers from South Africa’s growth to SSA are likely to have increased following South African corporates’ expansion in the region and are significant for its immediate neighbors. Increased regional integration could also expose South Africa to reverse spillovers from the region.

Past research suggests that, apart from its immediate neighbors, South Africa has limited spillovers to the rest of Africa, but these are likely to have increased. Several studies have shown that South Africa’s growth has limited spillovers on SSA, once global growth is controlled for.1 However, SSA’s share in South Africa’s imports has more than doubled over the last decade. South African companies in retail, banking, and telecommunications have established large networks in several sub-Saharan African countries. South Africa now represents an important export destination and source of FDI, especially for neighboring countries.

A01ufig6

Exports to South Africa from neighboring countries, 2014

(percent of total exports)

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Sources: Country authorities, and staff estimates.
A01ufig7

South Africa regional imports have increased

(percent)

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Sources: IMF Direction of Trade Statistics
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South Africa’s outward FDI position

(percent of recipient country’s GDP, average)

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Sources: IMF Coordinated Direct Investment Survey and WEO.

Other countries of the Southern African Customs Union (SACU) will be the most affected by South Africa’s slowdown. Besides the growth impact, SACU countries rely heavily on South Africa in their shared customs receipts, as South Africa accounts for about 85 percent of total SACU imports. With imports having declined in 2015 and low growth expected going forward, combined with the lags built in the SACU revenue formula, this vital source of revenue will decline markedly.

A01ufig9

SACU revenue

(percent of GDP)

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Sources: BLNS Authorities, and staff estimates.

South African firms have many subsidiaries in SSA, which could dampen their profitability going forward. About 75 percent of African subsidiaries are in services, trade, and financial sectors. The 10 firms with the highest number of subsidiaries are some of the top listed companies. While African subsidiaries have contributed to South African corporates’ high profitability in the past decade, the deteriorating performance of SSA could adversely affect profitability.

A01ufig10

South African subsidiaries in Sub-Saharan Africa

(number of subsidiaries)

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Sources: Orbis and IMF staff estimates
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Industry breakdown of South African subsidiaries in SSA

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Sources: Orbis, and staff estimates
A01ufig12

South African subsidiaries performance

(in percent, median)

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Sources: Orbis, and staff estimates.
1/ Basdevant, O., A. Jonelis, B. Mircheva, and S. Slavov (2014), “The Mystery of Missing Spillovers in Southern Africa: Some Facts and Possible Explanations,” IMF African Departmental Paper 14/03; Canales-Kriljenko, J., F. Gwenhamo, and S. Thomas (2013), “Inward and Outward Spillovers in the SACU Area”, IMF Working Paper 13/31; International Monetary Fund, 2012, “Nigeria and South Africa: Spillovers to the Rest of Sub-Saharan Africa,” Chapter II, Regional Economic Outlook, Washington, (October).

3. Leadership changes at the National Treasury last December and subsequent political developments have heightened governance concerns and increased policy uncertainty. Changes in ministerial appointments at the Treasury in December 2015 shook investor confidence, with the subsequent recovery of financial markets not fully retracing the initial sharp losses. These and subsequent political developments have kept perceived political risks and policy uncertainty high, though the strength of South Africa’s institutions has been affirmed. The President has announced that local elections will take place on August 3. General elections are due in 2019.

A01ufig13

Rising economic policy uncertainty

(Index: 0-100)

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Sources: BER, Factiva, and staff estimates.

4. Growth and employment, which were already low, are faltering and continue to underperform peer countries.1 Real GDP growth declined to 1.3 percent in 2015 versus 1.6 percent in 2014 (2½ percent adjusted for major strikes) (Figure 2).2 Growth in 2015 was a post-crisis low and in the bottom quintile of emerging markets (EMs). Falling commodity prices played an important role (with the impact amplified by intersectoral linkages), as did electricity constraints and a severe drought, estimated to have directly detracted 0.5 and 0.2 percentage points from growth, respectively. Private consumption, which benefitted from fewer days lost to strikes, lower inflation, and a generous public wage increase, continued to underpin growth. Net exports contracted as imports recovered more than exports after the 2014 strikes.3 Weak business confidence and policy uncertainty weighed on private investment. The economy weakened further in 2016Q1, with real GDP contracting by 1.2 percent (q/q, saar). Though mining played a big role, the weakening was across sectors and private consumption and investment fell. The unemployment rate also rose to 26.7 percent in 2016Q1, and the sluggish employment growth since the global financial crisis has now turned into job losses in almost all sectors of the economy, with especially large retrenchments in mining and construction (Figure 3). Potential growth has declined in recent years and is expected to recover only moderately over the medium term.

Figure 2.
Figure 2.

Growth is Weakening Further

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Sources: Andrew Levy Employment Publications, Haver Analytics, National Energy Regulator, SARB, South African Weather Service, and staff estimates.
Figure 3.
Figure 3.

Labor Market: Deteriorating Outlook Exacerbates High Structural Unemployment

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Sources: Haver Analytics, ILO, SARB, StatsSA, and staff estimates.
A01ufig14

Growth underperforming 1/

(real GDP growth, percent)

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Sources: WEO and staff estimates.1/ The light blue area represents the three center quintiles for other EMs.

5. Vulnerabilities remain elevated and have increased in the real and fiscal sectors.

  • The current account has started adjusting, albeit mainly due to lower oil prices. Volume adjustment remains slow due to structural bottlenecks and policy uncertainty that result in low responsiveness of exports to currency depreciation despite some uptick in tourism, electronics, and automotives recently (Figures 4 and 5).4 A shift to a positive net international investment position (IIP) in 2015, partly due to depreciation, is a source of strength, as is a favorable debt currency and maturity composition, and the fact that about 1 percent of GDP of the current account deficit consists of Southern Africa Customs Union transfers, paid in rand. Nevertheless, in the event of a shock, some foreign assets may be difficult to liquidate quickly, as 40 percent of total foreign assets are FDI. Hence, South Africa’s still large current account deficit (4.3 percent of GDP), financed by non-FDI inflows, and gross financing needs (19 percent of GDP), and sizable gross external liabilities (139 percent of GDP, among the highest in EMs) remain a significant vulnerability.

  • Though the rate of increase has slowed, as fiscal stimulus injected in response to the global financial crisis has been withdrawn, government debt continues to rise and is now above the EM median. This, coupled with low growth, sizable contingent liabilities from financially-weak state-owned enterprises (SOEs) reliant on government guarantees, and spending pressures, triggered an increase of vulnerabilities in the real and fiscal sectors. These trends are reflected in pressure on the sovereign credit ratings, and South Africa’s credit spreads now trade broadly in line with non-investment grade countries.

Figure 4.
Figure 4.

Lower Oil Prices Contributed to External Adjustment

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Sources: Haver Analytics, SARB, WEF, and staff estimates.
Figure 5.
Figure 5.

Elevated Vulnerabilities

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Sources: Capital IQ, Haver Analytics, National Treasury of South Africa, WEO, and staff estimates.
A01ufig15

South Africa has one of the largest current account deficits among EMs, financed by non-FDI flows

(in percent of GDP)

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Sources: Haver, and SARB.

South Africa’s Long-term Sovereign Ratings

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Sources: S&P, Moody’s, and Fitch.Note: Moody’s does not differentiate between LC and FX credit risk. S&P allows a maximum difference of two notches.
A01ufig16

Government debt higher than peers’ median

(percent of GDP)

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Source: WEO
A01ufig17

South Africa’s CDS trade as high-yield 1/

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

1/ Credit Rating represents average of ratings from S&P, Fitch and Moodys for each country. Data as on May 31, 2016.Source: Bloomberg

6. Monetary and fiscal policies are on a tightening course. After averaging 4.6 percent in 2015, headline inflation has started rising mostly due to base effects of fuel prices and food prices reflecting the drought (Figure 6).5 In April 2016, headline and core inflation were at 6.2 percent and 5.5 percent y/y, respectively, versus the 3–6 percent target band. The South African Reserve Bank (SARB) raised the policy rate by 50bps in 2015 and 75bps in 2016 to 7 percent, citing rising inflation and elevated risks. Markets expect additional 80bps in hikes by end-2017. Fiscal consolidation, which started with the 2013 Budget, has resulted mostly in a contractionary stance, but the fiscal deficit has remained sticky as growth has underperformed (Figure 7).

Figure 6.
Figure 6.

Monetary Policy is on a Tightening Course Though Demand Pressures Muted

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Sources: Bloomberg, L.P., Haver Analytics, Reuters, SARB, WEO, and staff estimates.
Figure 7.
Figure 7.

Despite Fiscal Consolidation, Fiscal Risks Rising

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Sources: National Treasury of South Africa, SARB, WEO, and staff estimates.

7. Most private institutions’ balance sheets remain strong, but financial indicators signal some deterioration ahead. Financial and corporate soundness indicators remain healthy, as South African firms have traditionally been run conservatively and benefit from market concentration (Figures 8 and 9). But a weaker labor market, higher interest rates and inflation, and a softening housing market are pressuring highly-indebted households. The corporate sector—historically highly profitable and with low leverage—is seeing lower profitability, with pockets of stress (e.g., mining, construction, steel, and agriculture). Equity prices of financial institutions and some corporates have declined markedly in the past year. Overall equity market performance has been in line with EMs due to a high share of foreign earnings and dual-listed firms.

Figure 8.
Figure 8.

Financial Sector Resilient, But Challenges Ahead

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Sources: Bloomberg, L.P., Capital IQ, FirstRand Bank, IMF Financial Soundness Indicators database, Moody’s CreditEdge, SARB Quarterly Bulletin, South Africa National Credit Regulator, and staff estimates.1/ 2016 data is through February.
Figure 9.
Figure 9.

The Strong Corporate Sector Is Facing Some Headwinds

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Sources: Bloomberg, L.P., Capital IQ, Corporate Vulnerability Utility, Haver Analytics, Orbis, SARB, WEO, and staff estimates.
A01ufig18

South African firms are more profitable than most EMs

(Return on equity, 2014, capital-weighted mean in percent)

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

* Estimated using Capital IQ for 2015.Sources: Capital IQ and Corporate Vulnerability Utility.
A01ufig19

The expected default frequency of non-financial corporates has increased

(percent of population)

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Source: SARB Financial Stability Reviews

8. Financial markets have weakened and financial conditions have tightened.

  • In the first part of 2015, yields moved in line with other EMs and the nominal effective exchange rate was stable benefitting from lower oil prices and low dollar debt (Figure 10). But as China shocks hit, financial markets sold off markedly and more so after leadership changes at the Treasury. Portfolio outflows ensued, yields rose, and the rand depreciated 14 percent versus the dollar between October 2015 and February 2016 with rising volatility. Financial markets recovered some ground up to mid-June, as credit rating agencies maintained their ratings and global risk sentiment turned more positive toward EMs.

  • So far, growth in credit to corporates has remained buoyant, underpinned by activities in renewable energy and commercial property, investments abroad, and substitution for reduced bond financing. Credit growth to households is subdued. The financial cycle seems to have peaked at a relatively low level, and the SARB has determined that there is no need to activate countercyclical capital buffers for banks as the credit gap remains negative. Banks’ funding costs are rising (partly due to regulatory changes), lending standards have become stricter, and overall financial conditions have tightened.

Figure 10.
Figure 10.

Financial Markets Underperforming

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Sources: Bloomberg, L.P., EPFR, Haver Analytics, S&P, and staff estimates.
A01ufig20

Financial cycle has peaked at a relatively low level

(percent, y/y)

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Sources: Haver, SARB, and staff estimates.
A01ufig21

Financial conditions remain tight

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Sources: Bloomberg, L.P. and staff estimates.

9. Keenly aware of the challenges, the authorities have devised plans to boost growth and achieve economic transformation, but implementation has fallen short. The authorities have articulated the NDP’s 2030 vision in the Medium-Term Strategic Framework, successive Industrial Policy Action Plans, and more recently the Nine-Point Plan (Annex I). However, implementation has lagged and progress on past Fund advice in the structural area has been mixed. On the other hand, infrastructure bottlenecks, especially in electricity, have started easing, and macroeconomic policies have been broadly in line with previous Fund recommendations.

10. The 2016 Article IV consultation focuses on the recent shocks, risks, and the policy response. In particular, the consultation centers on: (i) the spillovers from global transitions and the macro-financial linkages that could amplify or buffer the impact of shocks; (ii) considerations that may help calibrate the macroeconomic policy mix to minimize the growth impact; and (iii) measures that can reduce policy uncertainty, and build confidence and trust.

Sobering Outlook and Elevated Downside Risks

11. The near-term outlook is based on a projection of further deterioration before a muted recovery from 2017. The commodity price shock has yet to fully filter through to production and employment, the global recovery is fragile, macroeconomic policies and financial conditions are tightening, and high policy uncertainty persists. Against this backdrop, real GDP growth is projected to fall to 0.1 percent (-1.6 percent in per capita terms) in 2016. Private investment is expected to contract, consumption growth to weaken, while net exports are projected to contribute to growth. Electricity bottlenecks are less of a constraint on growth given the additional generation capacity and subdued demand in the electricity-intensive mining and manufacturing sectors. Only a feeble recovery is envisaged from 2017 (1.1 percent), approaching 2–2½ percent in the outer years, as shocks dissipate and new power plants are completed. South Africa’s unemployment rate seems to respond more (less) strongly to changes in output during downturns (upturns) compared to EMs, suggesting unemployment may rise over the medium term. The current account deficit is forecast to narrow slightly to 4.1 percent of GDP in 2016, but rise to 4.8 percent of GDP in 2017 on weaker terms of trade before improving in the rest of the projection horizon. Inflation is projected at 6.7 percent in 2016, before easing to 5.6 percent by end-2017.

A01ufig22

South Africa’s unemployment rate rises more in downturns and falls less in upturns

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Note: The figure represents ratios of mean changes of the unemployment rate to mean changes in real GDP per capita growth over all downturns (dot) and upturns (bar) for each country. Sources: ILO, WEO, and staff estimates.

12. Downside risks dominate. External risks, notably further shocks from China, a sharp increase in global financial volatility, and lower global growth weigh heavily on the outlook (Annex II). Domestic risks are equally prominent, especially from politics and policies perceived to harm confidence and from the realization of SOEs’ contingent liabilities. All these risks would depress growth and asset markets and are amplified by South Africa’s vulnerabilities. They would be particularly damaging if accompanied by downgrades of the sovereign credit rating to speculative grade. On the upside, the recent dialogue between government, businesses, and labor could catalyze reform implementation and boost activity.

13. The linkages between capital flows, the sovereign, and the financial sector could amplify the impact of shocks.

  • Banks are intermediating a larger share of capital inflows and their ratings are linked to the sovereign (Box 3). Also, the country’s financial cycle has become increasingly correlated with the U.S. financial cycle and appears linked to capital flows. In case of a capital outflow shock, import compression could follow and depress growth. As foreign investors and domestic non-bank financial institutions adjust their portfolios, large losses in bond and equity markets are likely, as is a reduction in wholesale funding for banks. Banks’ funding profile would likely worsen, which combined with new regulatory requirements, could contribute to a significant rise in term funding premia. Banks’ buffers are deemed sufficient to withstand a significant increase in non-performing loans (NPLs) on the households’ unsecured credit and corporate books. A combined shock—higher funding costs, deteriorating asset quality, and reduced liquidity—could lower financial sector profitability, lead to a liquidity squeeze, induce banks to curtail lending, and further reduce growth, with sizeable implications for tax revenues: finance, real estate, and business services account for about half of personal income tax and one third of corporate income tax.6

  • Sovereign downgrades could trigger capital outflows. The market appears to have mostly priced in a downgrade of the sovereign FX debt rating to speculative grade. The impact on the sovereign would be mitigated by the low level of government FX debt. However, the effect on SOEs and banks could be more significant, and countries with large SOEs and limited fiscal space face a stronger sovereign-corporate nexus. Furthermore, downgrades of South Africa’s local currency sovereign debt rating to speculative grade could have significant consequences, given that foreigners hold a third of local currency government bonds and about a fifth of that is estimated to be rating-sensitive, though still two and three notches away and not in staff’s baseline. In addition, equity flows have shown a high correlation with bond flows in times of stress, and foreign equity holdings at about 45 percent of GDP are high, though potential outflows would be mitigated by the fall in equity prices and depreciation. While large domestic financial institutions could provide a backstop in terms of availability of government financing, this could amplify vulnerabilities and linkages between capital flows, the sovereign, and the financial sector. Moreover, a speculative rating would also weaken the profile of the foreign investor base, making it more reliant on short-term oriented investors.

Macro-Financial Linkages: Capital Flows, the Sovereign, and the Financial Sector1

Extensive macro-financial linkages could amplify shocks given South Africa’s high reliance on external finance, high foreign ownership of local securities, and banks’ increasing role in intermediating capital flows. Sovereign rating downgrades to speculative grade could trigger capital outflows and generate negative feedback loops.

Banks are intermediating a larger share of capital inflows. In recent years, South Africa’s external financing has shifted from portfolio and FDI to other investment, mainly short-term bank flows, and unrecorded transactions. These inflows have played a stabilizing role as net FDI turned negative and portfolio flows moderated. Banks’ liabilities, though accounting for only a quarter of total external debt, make up half of those due within one year. FX funding on average is about 10 percent of banks’ liabilities, but it is higher for some banks. And while banks’ FX position is small, it has risen and there could be some maturity mismatches as part of the FX assets is corporate loans to fund acquisitions abroad. Banks’ credit rating outlook is tied to the sovereign and so are their funding costs. The outlook for strong inflows via banks is uncertain, also because particularly European banks (accounting for 76 percent of total external bank borrowing) are retrenching.

A01ufig23

Other investment flows comprise primarily bank flows and are negatively correlated with portfolio flows

(percent of GDP)

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Source: Haver

Shocks that cause sudden declines in capital inflows or a foreign investors’ pullout from local assets could lead to sharp economic adjustments. The immediate impact would be a currency depreciation and declines in bond and equity prices. The floating exchange rate and limited original sin would mitigate the impact, and the large stock of external assets (157 percent of GDP) could provide a buffer. But 40 percent of FX assets are FDI which may be difficult to liquidate quickly, and financial institutions have 12 months to repatriate if regulatory limits are breached. In case of large outflows, growth could weaken sharply, as exports respond slowly to depreciation, while domestic demand would decline amid import compression and a forced adjustment of the current account deficit as financing becomes scarcer and costlier. Limited policy space would likely prevent counter-cyclical responses, as the authorities may have to hike rates to counter inflation if the depreciation is large and take measures to contain the fiscal deficit.

A01ufig24

Limited original sin in external debt

(in percent of GDP)

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Source: SARB

The financial sector is also vulnerable to large capital outflows, placing additional downward pressure on growth and public finances. South Africa has a large and highly-interconnected financial system, with assets three times GDP. While non-banks financial institutions (NBFIs, with assets of 210 percent of GDP) could backstop foreign sales and absorb new issuance, they would have to rebalance their portfolios away from other assets, e.g., equities and banks’ certificates of deposits, which with corporate deposits and other funding from NBFIs and corporates account for close to 60 percent of banks’ funding. This would lead to further equity price declines, tighter liquidity, and higher banks’ funding costs. Though capital controls keep rand liquidity in the closed system, the deteriorating banks’ funding profile would force banks to deleverage, at a time when firms face lower external and bond financing. NPLs would rise. Financial sector profitability would fall, significantly affecting fiscal revenue.

A01ufig25

Banks rely heavily on domestic wholesale funding

(in percent of total liabilities)

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Source: SARB

Impact of a FX sovereign debt downgrade to speculative grade. As other countries’ experiences suggest, credit spreads could widen further if the downgrade materializes, driven by forced bond sales by investors with mandates restricted to investment grade securities. JP Morgan estimates such sales at round US$2 billion. The direct impact on government would likely be limited given very small FX issuance. SOEs are more reliant on FX borrowing. The subsequent deterioration in SOEs’ balance sheets could feed back to the sovereign via credit guarantees or other financial support. For banks, credit rating downgrades could raise rollover and hedging costs, as syndicated loans for EM banks (and firms) are typically of 3-year tenor, at floating rates, with fees and credit spreads tied to their rating. Also, downgrades to speculative grade could trigger covenants, entailing reviews, cost escalations, or loans becoming callable.

A01ufig26

CDS spread typically widen upon downgrade

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Sources: Bloomberg and staff estimates.

Impact of a potential downgrade of the LC debt to speculative grade. Non-residents hold 34 percent of South Africa’s LC government bonds, 12.5 percent of GDP. Due to either index restrictions or investment mandates, staff estimate that a downgrade to speculative grade could trigger forced sales of about 2½ percent of GDP. Other bond investors might also sell anticipating price declines, and equity flows have displayed high correlation with bond flows in times of stress. With non-resident portfolio equity holdings at 45 percent of GDP, potential equity outflows could be large, though they would be mitigated by depreciation and price declines.

A01ufig27

Bond indices that require investment grade

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

1/ Citigroup World Government Bond Index.2/ Vanguard Government Bond Index.3/ Barclays Global Aggregate. Sources: Bloomberg and staff estimates.
A01ufig28

Rating sensitivity of LC government debt investors

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Sources: Bloomberg, National Treasury, and staff estimates.

Sovereign downgrades to speculative grade could reduce participation of long-term nonresident investors. Typically, real money investors, such as sovereign wealth funds, pension funds and insurance companies, are more rating-sensitive. Also, a GFSR (2014) study showed that institutional investors (currently the majority in South Africa) tend to take longer to return after a downgrade to speculative grade compared to retail investors. Hence, more short-term oriented investors (e.g., hedge funds and mutual funds) that tend to trade more could hold an increasing share of South Africa’s bonds, possibly resulting in more volatile portfolio flows.

1/ Miao, Hui, Pablo Morra, and Yi Wu (2016), “Macro-Financial linkages: Capital Flows, Sovereign Ratings, and the Financial: Capital Flows Sovereign Ratings, and the Financial Sector Nexus,” IMF Selected Issues Paper.

Authorities’ views

14. The authorities broadly agree with the near-term outlook, but are more sanguine about South Africa’s medium-term prospects than staff. They concur on the expected slowdown in private consumption and investment in the near term due to lower confidence and weaker commodity prices. They maintain a more positive medium-term outlook on investment and exports, expected to benefit from a gradual recovery in confidence and external demand, which will allow companies to capitalize on improved competitiveness from the exchange rate depreciation. The authorities believe that government and private sector initiatives aimed at expanding infrastructure, transforming cities, supporting SME development, and regional integration will boost growth and employment, although these are not included in the authorities’ baseline forecast for 2016. They are confident about medium-term prospects in the rest of the African continent and the opportunities that those present for South African firms. They have identified agro-business and tourism, in addition to the value chains linked to mining and the auto industry, as sectors that can generate job-rich growth, and view their Broad-Based Black Economic Empowerment (B-BBEE) and Black Industrialists policy as likely to lead to significant progress on social transformation.

15. The authorities concur with the key risks and vulnerabilities, but emphasize that there are also upside risks. The concerted effort to raise cooperation between social partners to unblock growth can help leverage South Africa’s strengths. Conservative export forecasts present further upside to growth. On the downside, the authorities note that prevailing global uncertainties complicate policy making and give more prominence to risks stemming from trading partners’ lower growth, the impact of U.S. monetary policy normalization on financial markets and capital flows, and China’s new growth model. While recognizing the significant impact of possible credit rating downgrades, the authorities view the risk of a local currency downgrade to speculative grade as remote at this stage. Finally, they emphasize the economy’s resilience to capital outflows, the flexible exchange rate, low levels of FX debt, and deep financial and capital markets.

Policies

Boosting growth and job creation, thus reducing extremely high unemployment and inequality, and promoting social transformation remain South Africa’s key challenges. In addition, the shocks that hit the economy in 2015 require immediate attention to maintain hard-won macroeconomic stability and restore confidence. Progress in the structural area is urgent given that global growth and commodity prices are expected to remain low for long, many of the problems are structural, and macroeconomic policies have to address vulnerabilities. Macroeconomic policies have to be designed and calibrated carefully: too little tightening and confidence could wane and debt could continue rising, but too much tightening could further weaken growth and become self-defeating. Recent country experience suggests that EMs that took more consistent and decisive action and complemented macroeconomic adjustment with structural reforms achieved the largest improvement in fundamentals and were more resilient to subsequent shocks.

A. Fiscal Policy

16. The 2016 Budget envisages additional consolidation aimed at stabilizing debt.

  • High revenue buoyancy—partly the result of policy measures—and the withdrawal of a proposed reduction in social security contributions should yield a 3.9 percent of GDP deficit in FY15/16. With measures to cut compensation budgets and raise revenue, the authorities anticipate the deficit to fall to 2.4 percent of GDP by FY18/19 and debt to peak at 51 percent of GDP in FY17/18 and decline thereafter.

  • The Budget emphasized slowing public sector hiring, greater spending efficiency, and less waste, mainly by blocking hiring for non-essential personnel in the central payroll system and more robust procurement processes. But the 2015 public wage settlement and rising interest rates mean interest and compensation absorb a rising expenditure share (46 percent).

17. In the baseline scenario, which includes staff’s macroeconomic assumptions and the proposed Budget measures, achieving the authorities’ targets will be challenging.

  • The Budget projects higher growth and GDP inflation than staff. As a result, staff project the fiscal deficit to decline more slowly than in the Budget to 3.2 percent of GDP by FY2018/19. Debt would reach 53½ percent of GDP by FY2018/19 and continue rising, albeit slowly.

  • As acknowledged in the Budget, the fiscal outlook is subject to significant risks: weaker growth and commodity prices, greater support for SOEs, and higher borrowing costs.7 If contingent liabilities and permanently lower growth materialize, debt could reach 70–75 percent of GDP by 2021 (see accompanying Debt Sustainability Analysis). The mooted new nuclear power plants could pose considerable fiscal risks depending on scale and modalities. On the upside, buoyancy could continue exceeding expectations and the authorities’ efforts to combat Base Erosion and Profit Shifting could widen the tax base.

18. Policies to maintain debt sustainability are critical for investor confidence, but need to be carefully chosen and calibrated to avoid pressuring an already-weak economy.

  • The 2016 Budget is appropriately ambitious, though if staff’s macroeconomic assumptions materialize debt may not stabilize at 51 percent of GDP in FY17/18 as envisaged by the authorities.8 The sharp adjustment required in a short period of time to keep debt at that level could reduce growth as much as -1½ percent. Instead, given that the weak economic outlook is the main reason behind the buildup of fiscal vulnerabilities and that growth is critical for confidence, implementation of pro-growth structural reforms (as outlined below) would be the best sustainable way to ensure an improved fiscal outlook over the medium term. Only if such reforms are not an option, should fiscal policy be tightened further and this should be done over a multi-year period to minimize the growth decline (which could render the consolidation self-defeating) and with a composition that protects the poor.

  • Specifically, building on strengthened procurement processes and performance budgeting could reduce waste, freeing up resources to aid the consolidation without compromising service delivery and hence with minimal impact on growth and the poor. Asset sales could also reduce borrowing and arrest the debt rise, while contributing to growth, especially if combined with decisive SOE reforms (see below) and appropriate regulatory frameworks.

  • Absent structural reforms and measures suggested above, additional spending or revenue measures to stabilize debt at the authorities’ debt peak projection (51 percent of GDP) should be calibrated based on conservative estimates of the multiplier to ensure credibility, but phased over a longer period than the three-year budget horizon to smooth the adjustment. Over the longer term, reducing debt to 40 percent of GDP as recommended in the 2014 Article IV Consultation Staff Report would be advisable to leave space for shocks.

  • Laying the groundwork for targeted expenditure cuts, including to the bloated government wage bill, while protecting social grants and investment, would avoid the need for across-the-board cuts that would be most damaging to growth and hurt especially the poor. If the need for fiscal consolidation is sizable or large spending projects (e.g., National Health Insurance) materialize, further revenue measures, notably raising consumption taxes toward the EM average, could be needed. Strong commitment to a fiscal anchor, besides the expenditure ceilings, lengthening the budget horizon, and communication about future fiscal policy could be instrumental in maintaining credibility, in addition to protecting South Africa’s strong fiscal institutions.

A01ufig29

Relatively low consumption taxes

(percent of GDP)

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Sources: OECD, and WEO.
A01ufig30

Wage bill one of the highest among EM peers

(percent of GDP)

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Source: WEO

19. Improving spending efficiency and composition is critical to maintain confidence, ensure public support for, and minimize the growth impact of the consolidation.

  • As noted by the Auditor General, progress in strengthening procurement processes has contributed to a reduction in “irregular, fruitless, and wasteful and unauthorized expenditure” in the national and provincial governments by 28 percent in FY14/15 relative to FY13/14.9 However, “irregular, fruitless, and wasteful and unauthorized expenditure” in municipalities increased by 30 percent during the same period and, despite a much smaller budget, is now similar in magnitude to that seen in national and provincial governments.10 An eTender portal, central supplier database, and mandatory use of centrally-negotiated contracts should help increase the efficiency and effectiveness of government spending and, as the Chief Procurement Officer reported, reduce “the risk of fraud, corruption, and losses”.11 However, increased performance monitoring and consequences for poor performance (as recommended by the Auditor General) remain important to ensure that government receives value for money. At the same time, it is critical that the use of public procurement as a tool to advance social transformation does not undermine transparency surrounding procurement decisions.

  • A generous public sector compensation favors insiders: civil servants represent 40 percent in the top 3 deciles of the income distribution.12 Slowing growth in public wages, which at 184 percent of GDP per capita are high among EMs, will require stricter monitoring of wage and personnel decisions across all spheres of government, and a reassessment of the institutional structure for public wage negotiations.13 A more rigorous process for selecting and costing investment projects is also important.14

A01ufig31

Public employees represent 40 percent in top 3 earnings deciles

(percent, 2014)

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Sources: Labor Market Dynamics, StatSA, and staff estimates.
A01ufig32

High public wage bill largely due to high public wages

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Sources: Country authorities, and staff estimates.

20. Concrete steps to reform SOEs are needed to lower fiscal risks, and improve confidence and growth.

  • The government’s commitment that support to SOEs be budget neutral, and conditional on sound business plans and improved governance and operational efficiency, is welcome. However, as the recent report by the Presidential Review Committee on State-Owned Entities notes, SOEs’ challenges require far-reaching reforms (Box 4).

  • A strong governance framework, including transparency surrounding board appointments and remuneration of board members and management, and stronger accountability are essential to improve efficiency and ensure incentives are aligned with those of the country.

  • Greater private participation—e.g. allowing private competition in some sectors, partial stock market listings, or management contracts to run certain parts of SOEs’ operations—and effective regulators could help improve efficiency and service delivery, and free up resources for SOEs’ investments. Clear mandates for every SOE that quantify the cost and address potential conflicts between commercial and developmental activities would facilitate benchmarking performance and contribute to greater accountability.

State-Owned Enterprises in South Africa

SOEs’ performance has deteriorated. Several SOEs suffer from inefficient operations, poor governance, and weak balance sheets. Far-reaching reforms are needed to ensure SOEs deliver essential economic and social services, hence supporting growth and the fiscal accounts.

South Africa’s key SOEs play an important role in the economy. Most SOEs are small, but a few, notably Eskom (electricity), Transnet (ports, pipelines, and freight rail), South Africa Post Office (SAPO), South Africa Airways (SAA), SANRAL, and PetroSA, are large and/or several have a monopoly position in their sector. Moreover, because of their strategic position in network industries and their role in carrying out the government’s infrastructure build program (over the next three years SOE account for 39 percent of total public infrastructure spending, equivalent to around 7 percent of GDP), SOEs are an important part of the enabling environment for the private sector. According to the Presidential Review Commission on State-Owned Entities (PRC), SOEs contribute in excess of 8 percent to overall GDP.

A01ufig33

High public ownership in network sectors and weak SOE governance

(Index from 0 = least restrictive, to 6 = most restrictive)

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Source: OECD Product Market Regulation

The financial performance of SOEs has deteriorated. Measures of profitability and leverage have worsened, though some SOEs (e.g., Transnet) perform well. Also, leverage measures have improved since the government’s recapitalization of Eskom in 2015/16. As noted in the 2014 Financial System Stability Assessment (FSSA), reasonable shocks to borrowing costs and earnings could undermine SOEs’ ability to service debt and require government intervention. Also, PetroSA, South African Airways (SAA), and the South African Post Office (SAPO) are loss making and (in the case of Eskom, SAA, SANRAL and SAPO) reliant on government guarantees which have increased to R553bn (14 percent of GDP) in FY2015/16 from R177bn (8 percent of GDP) in FY2007/08.1 Auditors’ concern with SAA’s going-concern status means it has yet to finalize its FY14/15 financial statements.

South Africa: State-Owned Enterprise Performance (capital weighted mean) 1/

article image

Major state-owned enterprises listed in Schedule 2 of the PFMA, excluding development finance institutions

Sources: National Treasury of South Africa and staff estimates.

The authorities are keenly aware that SOEs face a number of challenges that require far-reaching reforms. In addition to their poor financial position, the 2016 Budget Review maintains that many entities suffer from “internal weaknesses such as inefficient operations, poor governance, and weak balance sheets”. The PRC found that “governance, ownership policy, and oversight systems”, and “the quality of the board and executives’ recruitment…and remuneration frameworks and practices” in SOEs were inadequate.

1/ This amount excludes R200bn in guarantees issued to independent power producers under power-purchase agreements with Eskom.

Authorities’ views

21. The authorities affirmed their commitment to and confidence in meeting the budget targets. The authorities’ core commitments are to expenditure limits, achieving a primary surplus over the medium term, and ensuring a stable national debt-to-GDP ratio. Even if growth were to develop as in staff’s projections, they maintain that deficit targets are likely to be met in 2016/17—by which time the bulk of the consolidation will have been achieved. They point to a history of excellent budget execution (i.e., spending remaining within the expenditure ceiling), the budget’s conservative tax buoyancy assumptions (relative to recent years), and savings from procurement reforms ensuring that the Budget’s targets are met. The bulk of the spending reductions have been targeted at compensation budgets—an area of expenditure that has been a key driver of deficits over the past decade.

22. Underscoring their commitment to the debt sustainability principle, the authorities are committed to take additional measures, should debt stabilization be seriously at risk. They stress the dilemma that fiscal policy would face, if growth disappointed substantially: if necessary, they will consider additional reprioritization of spending and additional revenue options as appropriate to maintain confidence or stretch out the adjustment to minimize the growth impact. The authorities will balance these imperatives on the basis of data and analysis of fiscal and economic developments as they materialize over the medium term, but remain committed to the stabilization of debt.

23. The authorities are taking measures to improve SOEs’ efficiency and governance. They monitor fiscal risks associated with SOEs on an on-going basis and associated contingent liabilities are reported in the Budget. The 2016 Budget outlined four broad areas of reform that will be overseen by the Deputy President, which include exploring ways to stabilize SOEs’ financial performance, quantify the cost of developmental activities, improve transparency and governance by benchmarking boards’ and executives’ performance and compensation, and where appropriate, seeking greater private sector participation.

B. Monetary Policy

24. Inflation is projected to remain elevated, above the target band, but contained. Headline inflation is rising mostly due to base effects of fuel prices, higher food prices reflecting the drought, and currency depreciation. Though headline inflation will likely peak at about 7 percent in 2016Q4 and exceed the target band for the first half of 2017, core inflation is projected at 6 percent in 2016 and to ease to 5.6 percent in 2017. Staff expect inflation to remain contained for several reasons. The output gap is projected to widen (to 2¼ percent in 2017). Imported inflation is expected to remain negative in dollars. The FX pass-through seems unlikely to jump given a widening output gap and still-solid retailers’ profits (Box 5). Unit labor costs are rising more moderately and job losses should keep them in check. Inflation expectations remain well-anchored, though slightly above 6 percent. The impact of the SARB’s hikes is still filtering through, which takes up to six quarters, and regulatory changes being phased-in will likely tighten financial conditions further.

25. The SARB faces difficult trade-offs and uncertainty. While cutting interest rates would be unlikely to boost growth as policy uncertainty and reduced investor confidence will likely constrain private spending, additional monetary tightening would further depress growth.15 And while inflation is above the band, it is mainly because of supply shocks, which are expected to subside in 2017. Core inflation is within the band. Moreover, there is considerable uncertainty surrounding inflation projections, especially due to the volatile exchange rate. Considering that additional monetary tightening would hurt an already-weak economy and the 2016 Budget envisages sizable consolidation, monetary policy could remain on hold for now. Consideration could also be given to whether greater specificity on the inflation target might help enhance communication and guide inflation expectations within the band.

Authorities’ views

26. The SARB is concerned about inflation risks and remains focused on its inflation mandate. The SARB indicates that increases in food and fuel prices, the large exchange rate depreciation, real wage growth higher than productivity, and the threat of second round effects pose elevated inflation risks. Recent Monetary Policy Statements reflect concerns that inflation expectations are cemented at the upper end of the target band, which does not leave room for shocks. Also, the fact that inflation is projected to stay outside the band for a protracted period risks unhinging inflation expectations. The SARB views the impact of its actions on economic activity as limited, and reaffirms that its utmost contribution to growth is via ensuring price stability, which the existing flexible inflation targeting regime can deliver. The SARB reiterates that they view the real policy rate to be supportive of the economy, and that any further adjustments to the monetary policy stance would be informed by incoming data and the potential impact thereof on the inflation trajectory going forward, in the context of a flexible inflation targeting framework.

Exchange Rate Pass-Through to Consumer Price Inflation

Our estimates indicate that the FX pass-through to inflation declined markedly in the early 2000s, but has declined only slightly in recent years when the global deflationary environment helped contain inflation. The pass-through is lower when the output gap is negative.

The FX pass-through has been moderate despite substantial depreciation since 2010. Core inflation’s increase from 3.0 percent in 2011Q1 to 5.5 percent in April 2016 is moderate compared to the 48 percent depreciation of the nominal effective exchange rate (NEER). The global deflationary environment contributed to the apparently low pass-through. The substantial decline in oil prices in 2015 reduced headline inflation and helped contain core inflation. The rising share of imports from China (to about 20 percent of non-oil imports), where PPI has been declining for four years, contributed to the decline in total foreign PPI in 2014/15. As a result, despite the sizable depreciation of the rand, non-oil import price growth declined markedly in 2015.

A01ufig34

Core Inflation and NEER

(percent; Index: 2010 = 100)

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

1/ NEER is reversed so that a larger value represents a weaker exchange rate.Source: Haver.
A01ufig35

Import Prices (in Rand)

(y/y percentage change)

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

1/ Q1-2016 is an average of y/y percentage change for January and February, 2016.Source: Haver.

Estimates of the FX pass-through to headline inflation in South Africa range from around 20 percent1 to the low 10s.2 The SARB has maintained its estimate of 20 percent, but some recent cross-country studies find smaller pass-through estimates. Gruss and Carriere-Swallow (2016) also finds a large decline in FX pass-through in recent years.

Our estimates suggest that the FX pass-through declined markedly in the early 2000s, while it declined only slightly in recent years. We focused on non-oil import prices and core inflation as there exists an automatic mechanism for complete pass-through of fuel prices. Following Chew et al. (2011)3 and Kabundi and Mbelu (2016), we estimate the FX pass-through using an error correction model, focusing on non-oil import prices and core inflation using quarterly data for 1980–2015.4 Average long-run first-stage pass-through from the NEER to non-oil import prices (controlling for foreign producer prices) is about 80 percent, with full pass-through occurring in six quarters. Average second-stage pass-through from import prices to core inflation (controlling for unit labor costs) is about 30 percent. Rolling 10-year window estimates show large declines in overall FX pass-through around the time of the introduction of the inflation targeting regime (2000), but only small declines in recent years, to 22 percent. The pass-through is found to be smaller when the output gap is negative. This study finds little evidence that the FX pass-through is related to the size of the depreciation or exchange rate volatility.

article image
Note: *** p<0.01. Variables are found to be co-integrated.
A01ufig36

Overall pass-through

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Source: Staff estimates
1/ A. Kabundi and A. Mbelu (2016), “Has the exchange rate pass-through changed in South Africa?” forthcoming SARB working paper; Albagli, E., A. Naudon, and R. Vergara (2015), “Inflation Dynamics in LATAM: A Comparison with Global Trends and Implications for Monetary Policy,” Central Bank of Chile working paper No. 58; G. Gopinath (2015), “The International Price System,” NBER WP 21646.2/ Kolerus, C. and J. Menkulasi (2016), “Inflation Dynamics in EMs: The Role of Exchange Rate Pass-through and Oil Prices;” Gruss, B. and S. Carriere-Swallow (2016), “Exchange Rate Pass-Through: First- Versus Second-Round Effects,” forthcoming IMF Working Papers.3/ Chew, J., S. Ouliaris, and S. Tan, 2011, “Exchange Rate Pass-Through over the Business Cycle in Singapore,” IMF WP 11/141.4/ The analysis uses import-based NEER and foreign PPI (excluding oil exporting countries) with time-varying weights.

C. Structural Reforms

27. The authorities have made some progress on structural reforms, especially in infrastructure, but some other measures have been counterproductive.

  • The bringing online of Medupi’s first unit and some independent power producers (IPPs), maintenance improvements, and lower demand have reduced load-shedding. Private providers have expanded broadband, contributing to improving South Africa’s ranking in the World Economic Forum’s Global Competitiveness Index. But some freight transport projects are postponed, port tariffs remain among the highest in the world for manufactured goods, and the drought has exposed structural challenges in water supply.

  • The use of Socio-Economic Impact Assessments is a positive step, though not all policy initiatives are covered. The Employment Tax Incentive Act has led to 270,000 youths being employed during its first year. The proposed national minimum wage could help reduce inequality, though depending on its level and modality, risks causing job losses, especially among the less-skilled, young, and SME workers. The Competition Commission’s pro-active market inquiries in different product markets hold the promise of facilitating market entry for smaller businesses. Government, in collaboration with the private sector, is exploring ways to boost SMEs. Nonetheless, large businesses and labor unions maintain a stronghold on insider-outsider dynamics that contribute to above-market-clearing wage settlements that are binding on the entire sector and hinder SMEs’ entry and development, and employment. Besides, complex business regulations are particularly damaging for SMEs.

  • However, lack of clarity about pending legislation that would determine modalities for property expropriation and pricing of strategic minerals, as well as implementation of B-BBEEE codes in the mining sector are examples of policy uncertainty. In addition, stricter limits on temporary contracts have reduced employment especially for the low skilled. Stricter visa requirements hurt tourism and their reversal, though partial, is welcome. Finally, BER surveys report that more than 80 percent of responding firms in the manufacturing sector point to the general political climate as a constraint on their business.

28. A comprehensive package of structural reforms remains the preferred policy to increase growth, create jobs, and lower income inequality. In addition to closing infrastructure gaps, greater product market competition, more inclusive labor market policies and industrial relations, and improved education and training remain critical to promote growth and employment in the private sector. 16 Job creation, especially in SMEs, which are more labor intensive and hire a relatively high share of low-skilled workers, is the best way to ensure a sustainable reduction in inequality (lowest 20 percent only hold 2.5 percent of national income). These reforms will lower business costs, increase efficiency, boost employment and savings, and reduce the external gap, making the economy more resilient. Advancing these reforms will require building trust among stakeholders, ideally via a social bargain. Labor and businesses could agree on wage restraint in return for saving jobs and hiring commitments. Government could improve the functioning of SOEs, and the quality of government services, especially in education, and represent the interest of outsiders (the unemployed and SMEs).

29. An alternative option might be implementation of a focused set of tangible measures that can have some positive effects even in the short term and generate reform momentum.

  • Focus. The severe effects of high unemployment on poverty, inequality, and social cohesion and analysis pointing to the critical importance of prior work experience suggest a need for a clear focus on jobs.17 With fiscal space exhausted, the priority must be to boost private sector employment, including temporary and informal jobs.

  • Principles. A centralized evaluation of all policy proposals should be done systematically to ensure that reforms, at a minimum, “do no harm” to growth and private employment. Reforms that reduce policy uncertainty and boost confidence and trust should be favored.18

  • Actions. Improving governance and SOEs are key interventions to build confidence and trust. Clarifying the regulatory environment in mining would help lower policy uncertainty (Box 6). Reforms in the authorities’ G20 growth strategy—including reducing business costs (e.g., port tariffs and spectrum allocation for broadband) and trade liberalization to promote regional integration—would further promote SMEs, and policies to reduce crime and transport costs could help the unemployed find jobs.19

  • Timing. Research shows that reforms that increase wage flexibility are particularly important in bad times as they offer firms channels other than retrenchments to cut labor costs.20 Therefore, the introduction of the proposed national minimum wage should be accompanied by reforms that increase wage flexibility, including exempting SMEs from collective bargaining outcomes, and the introduction of contracts where workers gradually accumulate benefits and job security. While the benefits from such reforms typically take time to materialize, they could lift growth in the short run if they boost confidence and signal policy consistency. Furthermore, these labor market reforms should be supported by product market reforms, such as lowering fees in telecommunications and transport, which could have large positive spillover effects to other sectors.

  • Momentum. The authorities need to sustain reform momentum even as some impediments to growth are lifted and others become binding. Other countries’ experience highlights the importance of publicizing successful reforms.21

The Role of Policy Uncertainty and Structural Bottlenecks. What’s Holding Back Exports?

This box explores the role of policy uncertainty, using a new measure based on “news chatter”. Our results suggest that policy uncertainty has a negative impact on South African exports and the responsiveness of exports to the exchange rate depreciation.

Policy Uncertainty

It is well known that investment and exports are subject to partially irreversible fixed costs that result in a real option value of delaying investments and hiring which increases with rising uncertainty. Baker et al. (2015), for example, find that increased policy uncertainty leads to diminished investment, employment, and output across 12 major economies.1 To assess the importance of this channel for exports we follow Baker et al. (ibid) and construct a “news chatter” measure of economic policy uncertainty which tracks news articles that include words related to policy, economics, and uncertainty in South Africa.2 The resulting index suggests uncertainty was high around 2012 when industrial relations in the mining sector reached a nadir, and has picked up in recent months after leadership changes at the Treasury.

Drivers of South Africa’s Export Performance

We investigate the role of policy uncertainty in explaining South Africa’s poor export performance by estimating a dynamic panel across 10 sectors. Our results suggest economic policy uncertainty has a statistically significant impact on the level of exports and the sensitivity of exports to movements in the REER. In particular, a one standard deviation increase in uncertainty would result in a drop in export volumes of 5 percent and a decline in the elasticity of exports to movements in the REER. Consistent with Anand et al. (2016), electricity shortages also adversely affect export volumes, while labor market disputes appear to be captured by the uncertainty measure itself.3 The above results are also used to construct a measure of competitiveness that captures policy uncertainty and electricity constraints, as well as the REER. While the REER points to an improvement in competitiveness since 2010, the new competitiveness measure suggests competitiveness deteriorated in 2011–12 and in 2014. Both regression results and granger causality tests show that the new measure outperforms the standard REER in explaining export performance.

A01ufig37

Alternative measures of competitiveness

(index, 0-1)

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Source: Hlatshwayo, Sandile and Magnus Saxegaard (2016).
1/ Baker, Scott R., Nicholas Bloom, and Steven J. Davis (2015), “Measuring Economic Policy Uncertainty”, NBER Working Paper No. 21633.2/ Hlatshwayo, Sandile and Magnus Saxegaard (2016), “The Consequence of Policy Uncertainty: Disconnects and Dilutions in the South African Real Effective Exchange Rate-Export Relationship”, IMF Working Paper WP/16/113.3/ Anand, Rahul, Roberto Perrelli, and Boyang Zhang (2016), “South Africa’s Exports Performance: Any Role for Structural Factors?” IMF Working Paper WP/16/24.

Authorities’ views

30. The authorities re-affirm the primacy of the National Development Plan and are committed to speeding up its implementation. The NDP (2012-2030) is being implemented through successive 5-year Medium Term Strategic Frameworks, which inform the expenditure framework on which the Budget is based. Based on short-term circumstances and risks, the authorities revisit policy priorities each year and monitor and evaluate departments’ performance. The Nine-Point Plan is one such mechanism and puts forward immediate actions/priorities for government to boost growth and employment. Recognizing challenges to policy implementation at the sectoral level, the authorities are implementing the Malaysian style fast results framework, called Project “Phakisa,” to unblock implementation challenges through work with social partners on sector-specific interventions.22 To date, this style of intervention has been utilized to explore opportunities in the oceans economy, reforming education and primary health care, and transforming the mining industry.

31. The authorities highlight that cooperation with social partners and policy certainty are imperative for higher inclusive growth and are optimistic that results are forthcoming.

  • The dialogue with social partners focuses on three key areas: (i) restoring confidence and reaffirming the country’s investment grade rating; (ii) catalyzing employment growth in key sectors; and (iii) SOE reforms, including exploring opportunities for private sector participation. The interactions have already resulted in the creation of an SME venture fund, which includes not only finance, but also mentoring by seasoned business leaders for start-ups.

  • To improve industrial relations, the government is finalizing a framework with social partners to reduce economic disruption caused by large, protracted strikes. Further, the national minimum wage will be an important tool in addressing income inequality: the modalities are being discussed, but the government will ensure that due consideration is given to minimizing possible adverse employment effects.

  • The authorities point to bright spots of increased FDI in the automotive industry after the renewal of the support program till 2020 and of the Africa Growth and Opportunity Act till 2025, and higher numbers of tourist arrivals after the partial reversal of visa requirements: they hail these as examples of policy certainty.

32. The government is committed to infrastructure investments and is exploring ways to boost the economy with a range of interventions.

  • The authorities highlight that energy supply is currently stable. They have stepped up efforts to partner with the private sector and the renewable energy independent power producer (IPP) program has begun to diversify South Africa’ energy mix. Building on the success of these IPPs, the authorities have solicited bids for a coal-fired IPP. A similar process has been instituted for gas-fired IPPs. The BRICS New Development Bank recently approved a loan for electricity transmission lines.

  • InvestSA is a one-stop shop that should facilitate FDI by coordinating and accelerating government departments’ approvals. A Red Tape Impact Assessment bill dedicated to reducing red tape is with parliament and the authorities are assessing the ease of doing business across various municipalities to improve the business environment, especially for SMEs. Nine of the largest municipalities are undertaking a peer learning process based on a World Bank survey to roll out good practices. Government and businesses are working closely via the Presidential Business Working Group to address regulatory and licensing issues, and the Inter-Ministerial Committee on Investment will oversee progress and alleviate indentified obstacles.

  • To enhance competition, the Competition Act amendment (into effect from May 1) classifies cartel behaviour as a criminal rather than a statutory offence.

  • The authorities are confident that South Africa will soon ratify the World Trade Organisation Trade Facilitation Agreement, and that tangible progress is being made for the Tripartite Free Trade Zone between the East Africa Community (EAC), the Common Market for Eastern and Southern Africa (COMESA), and the Southern Africa Development Community (SADC) with the framework agreement completed and the Tripartite Free Trade Area launched in June 2015. The African Union Heads of State and Government also have commenced negotiations for the Continental Free Trade Agreement.

  • The authorities also maintain that the recently-approved Protection of Investment Act will ensure that South Africa continues to provide protection to foreign investors in a manner consistent with Constitution and in accordance with international best practice and international customary law.

D. Other Policies to Manage Vulnerabilities and Strengthen Resilience

33. Despite the large currency depreciation, South Africa’s external position is moderately weaker than desirable. The REER has depreciated by 32 percent since December 2010. But the current account deficit is still 1½–2½ percent of GDP wider than the estimated norm, though the gap is narrowing (Annex III). A low saving rate—reflecting inter alia low employment—is the root cause. The envisaged fiscal consolidation will help raise savings, but structural policies that can raise employment and eventually household savings remain essential for a sustained improvement, as well as to increase competitiveness (including via reducing business costs) and the responsiveness of the trade balance to exchange rate depreciation.

34. Higher reserves and measures to promote a stronger external financing mix would bolster resilience to shocks. Reserve coverage remains 4–15 percent (US$2-7bn) lower (more when including a buffer for commodity price shocks) than implied by the Fund’s reserve adequacy metric and below most EMs’. The BRICS’ Contingency Reserve Arrangement and the swap with the People’s Bank of China can help bridge this gap. The SARB should seize opportunities, including those created by large FDI inflows, to increase reserves. The authorities also should agree on institutional responsibilities for funding FX purchases, and investigate the nature of unrecorded transactions. Many of the reforms outlined above to improve the business environment and reduce policy uncertainty, as well as facilitating highly-skilled immigration, would help attract FDI and boost South Africa’s role as gateway to Africa.

A01ufig38

Reserves still low compared to EM peers

(percent of IMF metric)

Citation: IMF Staff Country Reports 2016, 217; 10.5089/9781475568608.002.A001

Source: Staff estimates.

35. Financial reforms are advancing.

  • The Financial Sector Regulation Bill is expected to be promulgated in 2016. In line with the 2014 FSSA, it implements the Twin Peaks system, consolidates financial sector supervision at the SARB (including enhancing group-wide supervision), and creates the new Financial Sector Conduct Authority to improve consumer protection. A draft bill to introduce a resolution framework in line with the Financial Stability Board’s Key Attributes of Effective Resolution is expected in 2016Q4 and will facilitate intervening failing institutions, discourage wholesale funding by clarifying the hierarchy of claims, and introduce a deposit guarantee scheme. Parliament is expected to consider the new Insurance Bill that would strengthen prudential regulation in 2016.

  • The Liquidity Coverage Ratio (LCR) requirement has risen to 70 percent from January 2016, and will rise progressively to 100 per cent (of which up to 40 percent from the SARB’s Committed Liquidity Facility) in 2019 vs. the current 84 per cent. Requirements for Domestic Systematically Important Banks will be fully implemented in 2016 and risk-based capital will be fully implemented in 2019.

  • Banks have started to reduce short-term wholesale funding and rely more on term funding and retail deposits in anticipation of the implementation of the Net Stable Funding Ratio (NSFR) from 2018. The SARB’s application of national discretion has made the NSFR less challenging.23

36. Banks’ asset quality and profitability are likely to deteriorate, requiring heightened monitoring. NPLs are likely to rise moderately with the weaker economy and employment outlook and tighter financing conditions. While higher interest rates initially boost banks’ profitability, as most loans are at floating rates and re-price faster than banks’ liabilities, this eventually reverses as credit costs rise. Banks’ profitability is also pressured by higher funding costs as they source longer-term funding and increase capital. SARB’s recent stress tests indicate that even in severe adverse scenarios with a protracted recession or high financial market volatility with significant depreciation, banks’ average common equity tier 1 capital adequacy ratio remains above of the regulatory requirement.24 However, banks’ net open FX position (negative) has recently increased and there could be maturity mismatches in banks’ FX portfolios. Also, rollover risks and higher hedging costs could rise at times of lower capital inflows. Given that risks are amplified by extensive macro-financial linkages, consideration could be given to combining the shocks analyzed in the stress tests with liquidity shocks associated with capital outflows, and planning measures that could address potential disorderly market conditions. Also, supervisors could consider examining banks’ capital plans and the expected path with intensified scrutiny. If weaknesses are identified, additional reserves, higher provisions, or restrictions on dividends distribution might be needed. A strengthened crisis preparedness plan that involves both the SARB and the National Treasury would be helpful.

37. Recent country experience suggests that EMs that took consistent and decisive action became more resilient. Policy responses to external shocks since the taper tantrum varied, reflecting different fundamentals, policy space, and political constraints (Box 7). Like South Africa, most EMs allowed exchange rates to act as shock-absorber, hiked policy rates, and announced fiscal tightening. However, countries that achieved the most significant improvements in fundamentals and boosted growth also took structural reform measures, including steps to facilitate FDI, labor and product market reforms, actions to increase private sector participation in state-controlled sectors, and fuel subsidy reforms. As a result, these countries were more resilient during subsequent shocks.

Authorities’ views

38. The authorities concur that the current account deficit is somewhat high. They project the current account deficit to remain between 4 and 5 percent of GDP over the medium term. But they note positive developments in FDI and export prospects in the automotive sector, improving services balance, and the prospects of improvement in the long-standing income balance deficit as South African firms’ outward FDI matures. The authorities are less concerned about increased banks’ funding abroad as it is mainly matched by FX loans for offshore expansion to domestic firms on the strength of their South African balance sheets. They agree that the net creditor position is a source of strength, but indicate that it could change easily given high exchange rate volatility. Finally, the authorities note the difficulties in assessing the level of the REER given the many structural factors affecting South Africa’s competitiveness.

39. The authorities remain committed to a flexible exchange rate regime. The floating exchange rate regime continues to be the key adjustment mechanism to external shocks, including capital account shocks. Exposure to exchange rate risk in banks’, corporations’, and households’ balance sheets is limited, and SOEs are required to hedge fully their exchange and interest rate risks. Less than 10 percent of government debt is in FX. They concur with staff that large scale FDI inflows could present opportunities for reserve accumulation.

40. The authorities broadly share staff’s assessment of the vulnerabilities, and remain confident about financial sector health. Since the 2014 FSAP, they have implemented several of the recommendations to enhance the regulatory architecture and are making good progress toward an upgraded resolution framework. They have completed their first top down stress test since the 2014 Financial Sector Assessment Program that attests to the soundness of the banking sector in severe stress scenarios, given large capital buffers and high profitability. The authorities appreciate staff’s analysis of macro-financial linkages, though they see protracted low growth and the attendant asset quality deterioration as the most prominent risk rather than liquidity shocks. They also underscore mitigating factors, especially the depth and liquidity of the financial sector and a strong domestic investor base.

Emerging Markets’ Policy Responses to External Shocks in Recent Years

This box takes stock of policy responses and economic outcomes in selected EMs (Brazil, India, Indonesia, Mexico, Poland, Turkey, and South Africa) since May 2013. EMs that took decisive and consistent policy actions, including structural reforms, became more resilient to subsequent shocks.

EMs’ policy responses varied, reflecting different fundamentals, policy space, and political constraints.

  • Exchange rates were allowed to absorb the brunt of the pressures, with FX intervention used primarily to ensure orderly market conditions.

  • Most countries hiked policy rates (by 75-625 basis points bps). Once inflationary pressure subsided, some countries were able to reverse the tightening partially (Indonesia) or fully (India). Mexico eased initially, and tightened later on. Poland lowered rates since 2013.

  • Most countries announced fiscal tightening measures, with varying degrees of success. India and Mexico introduced expenditure rationalization policies. Mexico approved a tax reform in 2013. South Africa announced further fiscal consolidation. In early 2015, Brazil announced a fiscal adjustment plan, but revised down its fiscal targets later on in view of weak revenue performance and political difficulties getting measures approved by Congress. Turkey maintained a neutral fiscal policy stance. Poland strengthened its fiscal position.

  • Some countries took structural reform measures. India allowed higher FDI in multiple sectors, including infrastructure, and insurance. India and Indonesia undertook fuel subsidy reforms. Mexico allowed greater private sector participation in the energy sector, and undertook labor and product market reforms. Indonesia launched a series of economic packages, including trade liberalization measures, easier tourist visa regulations, actions to increase predictability and transparency in the labor market, actions to ease the process of business, and measures to facilitate private investment in infrastructure. Poland took actions to increase labor market flexibility, and ease administrative requirements for business start-ups and construction permits.

  • Other measures included temporary import restrictions and mobilizing diaspora savings (India), easing of inflow CFMs (Brazil and Indonesia), and contingent credit lines.

Summary of policy actions in selected EMs (2013-16)

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Source: IMF Staff Reports.

Recent country experience suggests that EMs that took decisive and consistent structural reform actions became more resilient. Reforms varied by country, including steps to facilitate FDI, labor and product market reforms, actions to increase private sector participation in state-controlled sectors, and fuel subsidy reforms. In general, countries that undertook decisive reform efforts boosted confidence, were able to maintain robust growth and improve macro fundamentals, and were relatively less affected during subsequent shocks.

Key macroeconomic developments in selected EMs (2013-15)

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Source: WEO.

Staff Appraisal

41. South Africa has achieved remarkable progress in two decades of democracy, but faces unacceptably high unemployment and inequality. Strong institutions and policy frameworks have contributed to macroeconomic stability and rising living standards in the democratic era. Yet, infrastructure bottlenecks, skill mismatches, and harmful insider-outsider dynamics have prevented many South Africans from benefiting from these improvements. On top of these deep-rooted impediments, the economy has been adversely affected by external shocks and domestic confidence shocks that have heightened governance concerns and policy uncertainty.

42. The outlook is sobering and downside risks prevail. Growth is projected to weaken further in 2016—the third year in which per capita incomes would fall. The muted recovery expected from 2017 is likely insufficient to address unemployment and inequality. The main risks stem from further shocks from China, tighter global financial conditions, lower growth, political risks, and SOEs’ contingent liabilities. Vulnerabilities and linkages between capital flows, the sovereign, and the financial sector could amplify the impact of shocks, especially if combined with sovereign credit rating downgrades to speculative grade. The recent dialogue between government, businesses, and labor is welcome and could yield concrete results.

43. Structural reforms are urgent and imperative. With fiscal and monetary policy having to address vulnerabilities and given the many structural obstacles, structural reforms are the only sustainable way to boost growth, create more jobs, and reduce inequality. The authorities have made welcome progress in infrastructure, but action is urgently needed in other areas. Ensuring that the proposed national minimum wage is designed so as not to undermine job creation and the goal of reducing income inequality is important. While some structural reforms take time to yield positive growth effects, immediate benefits from a carefully-designed reform package can stem from confidence effects and signalling of policy consistency. A comprehensive package of reforms, ideally via a social bargain that includes greater product market competition, more inclusive labor market policies and industrial relations, and improved education/training remains the preferred option. An initial, focused set of tangible measures could help boost confidence and trust, lower policy uncertainty, and hence generate sustained reform momentum.

44. The 2016 Budget is appropriately ambitious, though additional measures might be needed to stabilize debt over the medium term. The buildup of fiscal vulnerabilities reflects lower-than-anticipated growth, not a lack of fiscal discipline. Growth-enhancing structural reforms, measures to boost spending efficiency, including by limiting the public wage bill, and greater private participation in SOEs are therefore the best sustainable ways to stop debt from rising. Asset sales could also be considered. But if growth underperforms and the measures above do not materialize, a package of fiscal measures that maintains medium-term debt sustainability while minimizing the negative growth impact and protecting the poor may be needed. Concrete progress on reforming SOEs is essential to improve governance and public services, and would boost private sector growth.

45. The SARB could consider holding interest rates unless core inflation or inflation expectations rise substantially. With the impact of past policy rate hikes still filtering through and financial conditions still expected to tighten, a widening output gap and sizable fiscal consolidation are expected to help contain inflation. This suggests that monetary policy might be able to remain on hold, unless inflation expectations or core inflation increase markedly, or external financing becomes problematic. The SARB could consider ways to enhance its inflation targeting regime to facilitate guiding inflation expectations within the band.

46. Advances in financial sector reforms are welcome and heightened monitoring of financial sector risks and contingency planning is warranted. Financial sector reforms are progressing and are in line with FSSA recommendations. The SARB’s recent stress tests find that South Africa’s financial system is well capitalized and can sustain large shocks. Nevertheless, stepping up the monitoring of financial sector risks and contingency planning is warranted given the rising pressures that the weak economy, tightening financial conditions, and regulatory changes are imposing on the financial system.

47. Higher reserves and attracting a stronger external financing mix would boost resilience. South Africa’s strength includes a floating exchange rate, favorable currency and maturity debt structure, and a net external creditor position. The current account deficit remains higher than the estimated norm despite the large depreciation, though some adjustment is occurring. International reserves are below desirable levels, and the SARB should seize opportunities to increase reserves.

48. It is proposed that South Africa remain on the standard 12-month Article IV cycle.

Table 1.

South Africa: Selected Economic and Social Indicators, 2012–17

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Sources: South African Reserve Bank and National Treasury, Haver, Bloomberg, World Bank, IMF INS database, and Fund staff estimates and projections.

General government unless otherwise indicated.

National government.

May for 2016.

April for 2016.

Table 2.

South Africa: Consolidated Government Operations, 2012/13–2018/191

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Sources: South African National Treasury and Fund staff estimates and projections.

Data is on a fiscal year basis (April 1-March 31); The authorities projections are based on the 2016 Budget.

National government.