Recent Economic Developments and Outlook

Recent economic developments reflect a combination of macroeconomic improvements alongside deterioration in some other areas. The normalization in rainfall patterns has supported a rebound in agricultural output, while mining production is up on the back of moderate improvements in commodity prices. Household debt stocks – which peaked at nearly 90 percent of disposable incomes in 2008 – are now back to 2006 levels, slightly above 70 percent. The current account deficit has also narrowed on the back of an increasingly positive trade balance, moving to below 4 percent of GDP in 2016, while inflation has moderated. However, subdued manufacturing production and weakness in the retail and financial sectors continued to weigh on growth, resulting in the contraction of GDP in the fourth quarter of 2016 as well as in the first quarter of 2017.

Consistent with the broad trends in staff’s assessment, the authorities expect a rebound in economic performance over the medium-term. Official forecasts tabled in February 2017 are for growth of 1.3 percent in 2017 and 2 percent in 2018. A revised forecast that takes first and second quarter growth outcomes into account will be published in the Medium-Term Budget Policy Statement in October 2017. Meanwhile, the authorities expect inflation to remain within the target range of 3-6 percent. Import growth is expected to remain low due to the subdued levels of domestic demand, thus containing the current account deficit to around 3.5 percent of GDP.

The authorities assess risks to the outlook to be titled towards the downside due to rising global policy uncertainty, persistently low consumer and business confidence and the constraining effects of long-run structural challenges of unemployment and inequality. This underlines the importance of the authorities’ goal of achieving better income distribution through transformation for inclusivity.

Fiscal Policy and Public Debt Management

The authorities’ fiscal stance is driven by three overarching considerations: the macro-economic outlook; budget execution; and risks emanating from the financial position of state-owned entities (SOEs). Despite weaker growth in recent years, the authorities have maintained an excellent record of containing the fiscal deficit. Accordingly, the main budget balance was reduced to −3.9 percent in 2016/17.

The 2017 Budget re-emphasizes the authorities’ determination to protect public finances and create an enabling environment for economic growth. Based on the authorities’ growth forecasts, the consolidated deficit is projected to narrow to 2.6 percent in 2019/20, aided by additional fiscal consolidation measures that will further reduce the spending ceiling by R26 billion and raise additional revenues of R13 billion. Nevertheless, the authorities have taken note of staff’s growth projections. Within the budget framework, they have made it clear that should growth outcomes disappoint, they would adjust their medium-term spending plans accordingly while protecting social spending for the most vulnerable.

Within the lower spending ceiling, the authorities have reprioritized spending by cutting the government wage bill and other current spending, and re-allocated the funds to education, health services, social protection, and municipal functions in rural areas. The newly-reformed government procurement system is already a major tool for efficiency and transparency.

Recent ratings downgrades and the hike in US interest rates pose risks for government debt, while low growth remains the main reason for the rise in gross debt. In this regard, the authorities will continue to manage public debt through active debt-management practices and in terms of the strategic portfolio risk benchmarks published annually in the Budget. The limit for foreign-currency denominated debt is set at 15 percent of the total debt portfolio, and domestic markets continue to be the main source of government borrowing. In the meantime, short-term risks have been substantially mitigated by lower inflation and sustained appetite for emerging market securities, largely offsetting the impact of ratings downgrades.

The public-sector borrowing requirement is also affected by the financial position of SOEs. In response to elevated risks, no additional guarantees are currently planned for SOEs, and reductions in overall transfers to state owned entities are reflected in the 2017 Budget. Meanwhile, the authorities have taken several steps to improve governance, including through approval by the Cabinet of a collaboration framework between SOEs and the private sector, guidelines for the remuneration and appointment of board members and corporate executives, as well as a new shareholder policy. The Cabinet is also expected to consider new efficiency rules for SOEs during the 2017/18 fiscal year.

Monetary Policy

The Monetary Policy Committee (MPC) of the South African Reserve Bank (SARB) kept the policy rate unchanged at its most recent meeting in May 2017. Headline inflation has declined to within the target range of 3-6 percent, and the SARB expects it to reach levels of around 5.4 percent in the final quarter of 2017, due to a sustained slowdown in food, fuel and electricity price increases. Core inflation also decelerated due partly to the resilience of the currency during much of 2016, supported by an improved current account and positive global sentiment towards emerging markets.

Given the overall macro-economic developments, including the widening negative output gap, the SARB has indicated that it is likely that the end of the tightening cycle that began in 2014 has been reached. However, the improvement in the outlook is still modest and inflation expectations remain elevated. In this regard, the longer-term forecast trajectory is uncomfortably close to the upper end of the target range, leaving little headroom to absorb unforeseen shocks. Therefore, risks to the inflation outlook are assessed as more or less balanced.

Import cover was above 5 months in December 2016 and has slowly improved in the first quarter of 2017. In the meantime, as reflected in the staff report, the current account deficit continues to narrow due to an improving trade balance, while non-financial corporations remain well-hedged against foreign currency risks, and the fully flexible exchange rate continues to be a key aspect of the economy’s fundamentals. The authorities will continue to utilize occasional foreign exchange inflows to replenish reserves.

Financial Sector Policy

The domestic financial sector remains robust and resilient, aided by effective supervision of the sector through established rules and standards, historically deep and liquid domestic markets, a flexible exchange rate, and low foreign currency exposure. The banking sector continues to achieve high capital adequacy levels of around 15.9 percent, with non-performing loans remaining stable at 2.9 percent in 2016. The liquidity coverage ratio has continued to rise above the minimum requirement of 70 percent, reaching 107.8 percent in December 2016. Meanwhile, credit growth has fallen, with growth in gross loans retreating to around 3 percent in 2016 compared to 11.3 percent at the end of 2015. While lower credit extension has negative implications for household consumption, this reflects an expected outcome of the more stringent lending rules that are bringing correction to the market and helping with needed deleveraging among households.

Since the last Article IV consultation the Financial Sector Regulation (FSR) Bill was passed by the lower house of Parliament and is likely to be enacted soon. The Bill assigns primary responsibility for protecting and enhancing financial stability, which used to be shared with the Financial Services Board, to the SARB. In addition, the Financial Intelligence Center Act (FICA) has been signed into law, thus fully aligning the country with international standards on AML/CFT. With stress tests already institutionalized, thematic on-site inspections and reviews by the SARB’s Bank Supervision Department now include AML/CFT checks.

The authorities agree with staff that financial inclusion and increased competition in the banking sector should be a major priority. There are currently 32 banking institutions in the country, excluding mutual and cooperative banks. In 2016, three institutions were granted new banking establishment authorizations, and the SARB is focused on promoting a multi-tiered system, which can provide more tailored financial services, including to small and medium-sized enterprises (SMEs). In the meantime, while appreciating staff’s useful analysis, the authorities maintain a prudent and balanced approach to financial inclusion, by also focusing on preventing high household indebtedness and the associated risks.

Structural Reforms

Policy actions continue to be guided by the National Development Plan (NDP), which emphasizes inclusive growth through broad-based transformation and breaking down structural impediments to new economic activities, increased competition in industries dominated by a few participants, accelerated market inclusion for previously disadvantaged groups, and a return to a path of rising per capita incomes. To achieve this, the authorities will prioritize education and skills development, strengthen competition laws, increase private sector participation in industries dominated by public sector enterprises, provide support to labor-intensive sectors such as agriculture and tourism, and overcome spatial fragmentation in urban areas.

The authorities are committed to tackling infrastructure bottlenecks that hinder growth. Economic infrastructure accounts for around 77 percent of all government infrastructure spending over the medium-term. In this regard, one of the most important reforms is the establishment of a new facility that is designed to streamline many of these projects through a uniform life-cycle costing and budgeting process, thus achieving greater efficiency within the existing budget. In addition to these, the authorities have committed to signing off on the outstanding power purchase agreements with independent power producers (IPP) in renewable energy and gas. The IPP program has contributed not only to minimize electricity supply shortages over the past year but to also diversify the energy mix and increase private sector participation in the electricity sector.

The government procurement system will also become an important vehicle for transformation. In 2017, revised preferential procurement policy regulations, designed to channel most of the government’s R500 billion annual procurement towards local producers and previously disadvantaged groups, took effect. The budget also supports private sector job creation, including through allocations to promote tourism, small and medium enterprises and cooperatives, agriculture, as well as scientific and industrial research.

The most recent initiative to address inequality is the agreement between business, labor, and the government on a national minimum wage. When implemented, this could contribute towards reducing wage inequality and increase domestic demand. Negative employment effects will be mitigated by the existence of sector-determined minimum wages already in place in several sectors. In addition, provision has been made for exemptions of small enterprises that cannot afford the wage increases, while any inflation-inducing indexation moves will be prevented. The authorities continue to recognize that addressing education shortcomings and wage rigidities should be prioritized.

Conclusion

The authorities remain committed to macro-economic policies that promote growth, confidence, and financial stability. They view the macro policy stance, including inflation targeting, a flexible exchange rate, and deficit reduction as broadly appropriate for promoting growth and reducing volatility. Additional policies to deliver a more inclusive growth outcome are indispensable to achieving long-run growth and the authorities agree with staff that these can be implemented in a manner that promotes socio-political stability. The authorities look forward to the Fund’s continued contribution to their reform efforts.