Where to for the South African economy?

What every bungee jumper knows

By Cees Bruggemans, Chief Economist FNB
1 June 2009

As monthly output releases paint a grim picture of an economy in freefall and operating way below resource capacity, financial data releases (falling inflation, constrained credit extension, narrowing trade deficit, firming Rand) keep reinforcing the case for more policy support.

Eventually freefall bottoms out and recovery commences.

Yet imagine global policy not being supportive, with our industrial and mining exports subjected to unlimited decline. Or an economy in which government spending tails off with failing tax collections, steadily increasing unemployment, progressively more anxious households seeing income curtailed and asset values declining, forcing spending cutbacks and reduced borrowing, with businesses seeing their markets disappearing, losses mounting and defensively cutting their inventories, investment, labour force, costs.

Without end until the very end.

That is genuine freefall, like a bungee jumper in full flow, except there are no ropes tied around the ankles to check the descent before final disaster strikes.

As every bungee jumper knows, the sport isn’t a suicide pact. Ankles are supposed to be expertly secured with a flexible lifeline that stretches and then snaps back before real damage is done.

Just so the modern economy, securely attached to safety harness and flexible rope, ready at any time for unexpected freefall, with safety measures activated to create bouncing return to safety.

As shock takes the economy into its grip, inviting spending cutbacks by consumers, businesses and foreign importers and giving rise to waves of output curtailment, policy support swings into action.

Modern governments don’t panic as tax revenues start to fail, maintaining their spending while covering their expanding funding shortfall through borrowing, indeed stepping up their spending assists to economic agents in need (unemployment support).

The most flexible shock absorbers are currency and interest rates, their aggressive adjustment supporting exporters, indebted households and producers generally.

Such actions globally underwrite international demand and export potential, once inventory cutbacks have been fully absorbed.

Thus spending and output freefall eventually slows, ends and recovery snapback commences.

Demand starts to rise again, supported by higher government spending and interest-sensitive purchases as business and household expectations lose their anxious edge.

Household income stabilizes, corporate earnings start benefiting from productivity gains, companies cease cutting back and increase spending levels, eventually also raising employment.

With the budget deficit approaching 5% of GDP, and with interest rates cut by 4.5% in six months, prime now at 11%, the downward draft in output is being checked.

Most importantly, policy actions globally are even more aggressively supportive, while defensive output cutbacks in response to banking and credit shocks late last year were probably overdone, even if realistic at the time.

All of this creates recovery potential, even beyond the natural output recovery following inventory disruption.

In our mining, manufacturing, electricity and transport sectors (especially their export-related activity), the output declines probably mostly ended four months ago as global activity started its stabilisation.

In household consumption-related sectors such as motor trade, residential building, retail, wholesale and hotel trades, there is probably still a gradual descent in output underway as income and borrowing curtailment and increased saving keep cutting into spending levels.

But policy support is still steadily expanding its reach and ere long should check also these declines. But there are one negative and one positive operating.

Returning global risk appetite and improving emerging market and commodity prospects are improving our terms of trade (export prices improving relative to import prices, increasing our national income) while redirecting growing volumes of foreign capital our way.

SARB is probably not fully sterilising excess inflows, with government preoccupied with its growing budget deficit, borrowing requirement and national debt, its willingness to supply sterilization bonds limited.

The Rand can firm, breaking through 8:$, with potentially more to come, checking exporter income gains, but also reinforcing downward pressure on our inflation.

Positively, this along with tightened bank credit criteria may yet create further downward interest rate potential, prime possibly moving towards 10%.

GDP output (and national income) may hit bottom in 2Q2009 or 3Q2009, and be in recovery mode from 4Q2009, recording 1%-2% decline in 2009 followed by 2%-3% growth in 2010.

Formal employment may fall back towards 9 million during 2009-2010 before starting to expand again.

The budget deficit as share of GDP may peak next year, thereafter starting to narrow again.

As inflation falls through 2010, prime may hug 10% for two years before renewed commodity price surges and inflation pickup sets in motion a new tightening cycle.

The Rand will be a plaything of global forces, potentially facing a longish period of firmness as global growth and risk appetite return, our appetite for forex accumulation is limited, and our risk profile not particularly threatening once everything (trade deficit, banks, external indebtedness, capital flows, growth, asset returns, liquid markets) are taking into account.

Our bungee jump is approaching its low point. Without assists gravity would keep pulling us towards destruction. Instead, prepare to bounce shortly.

Cees Bruggemans is Chief Economist of First National Bank.

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