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Wednesday, January 27, 2010

South African growth prospects

By Cees Bruggemans, Chief Economist FNB
25 January 2010

We have completed an economic downswing and are now embarked on a new economic upswing of rising economic activity and incomes.

But it could well be an upturn that disappoints a bit, at least for some while, not unlike 1999-2003 (average GDP growth of 3.2%) or 1994-1998 (2.7%) or 1986-1989 (2.2%).

Perhaps first a quick survey of the recently completed downturn, followed by some tentative speculation about what may follow in 2010 (and beyond).

According to SARB data, the level of household consumption peaked in 2Q2008, total fixed investment peaked in 1Q2009, total domestic demand peaked in 1Q2009 and imports peaked in 3Q2008, thereafter declining, with none of these spending items yet having bottomed (but expected to do so in 4Q2009 except for fixed investment).

Only government consumption spending has never stopped rising (surprise, surprise). Exports and GDP both peaked in 3Q2008, thereafter declining, with both rising marginally from 3Q2009 with steadfast promise for 4Q2009.

So far, nothing especially disturbing.

When we turn to growth numbers, and we examine the first three quarters of 2009, comparing it with the first three quarters of 2008, we are getting a close approximation of what 2009 overall will probably look like, give or take a decimal point twitching here or there.

There are some surprises in the make-up, mostly pleasant ones.

Household consumption fell by 3.4% in 2009, but government consumption and total fixed investment rose by 4.7% each, causing final demand (some R100bn bigger than total GDP) to fall by a very miniscule 0.3%.

Not much of a recession, compared to the much worse experiences in some other parts in the world? Then again, could some of these numbers still be overstated?

As the SARB’s spending estimates get reconciled with the StatsSA GDP output estimate (and not the other way round), the reconciling items are net foreign trade (which is mostly the real thing, not an estimate), change in inventories (already more a thumb suck) and the residual (the reconciling item proper).

Inventories and the residual item taken together turned out to have declined by 1.6% of GDP in 2009.

When we take final demand and inventory/residual together (-0.3% and -1.6%) we get the 1.9% decline in total domestic demand in 2009. With net trade still improving by 0.1%, overall GDP declined by 1.8%. The final GDP number for 2009 may be slightly better, -1.5% to -1.7%. After future revisions it may prove to be even better.

Interestingly, the inventory/residual/trade components explain 85% of the decline in GDP in 2009. Final demand only does 15%.

It may well be that the level of final demand is still overstated and that consequently the inventory decline has been overstated, with corrections to be made to both in coming years.

But the good news by far is that the largest hit to GDP came from once-off inventory shedding. With its pace slowing down dramatically in 4Q2009, going by the Kagiso Purchasing Managers Index survey, the quarterly bounce is upon us and GDP can presumably only improve further from 4Q2009 onward.

But there is still the composition of the other spending items to be taken into account. Inventories may involve mindless reactionary response, with stabilization following panic cuts and thereafter slow upturns matching final sales performance and responding to any product shortages. But what really rules the roost among the other spending components?

Exports are a function of overseas demand conditions (and our trade competitiveness), household consumption is mostly a matter of habit and government consumption is mostly a matter of political addiction. You will probably agree that this is more mindless stuff.

But fixed investment (especially its private component, along with consumer durable goods replacement) is a function of expectations and uncertainty in which emotion plays a strongly central and independent role. Remember Keynes over a lifetime ago? Nothing has yet changed in our Stone Age make-up.

Imports are a simple function of all these spending items combined, and our relative trade competitiveness.

What can we say about the internal machinations of some of these larger components of spending in the economy during the recent downswing?

The level of total household consumption may have peaked in 2Q2008 and so far has not stopped declining, but it is made up of components with widely varying experiences and these create ultimately funny averages.

Durable consumption (weight of 9% in total household spending) peaked as long ago as 1Q2007, fell over 20% and rose for the first time (minimally) in 3Q2009. The rebound had finally begun!

Semi-durable consumption spending (weight of 11%) peaked in 1Q2009 and had declined by only 3% by 3Q2009 (but with no bottom as yet confirmed). This spending item proved impressively recession-proof so far, but not entirely.

Non-durable consumption spending (weight of 37%) peaked long ago in 2Q2008, since then declining by 5% with as yet no bottom confirmed, matching a weighted employment loss for this period in the economy (full pay-packets being most relevant to this spending item, though important support has been forthcoming from increased transfer payments – government allowances).

Service spending (weight of 43%) peaked late in 4Q2008, fell minimally by 2.5% and was rebounding by 3Q2009, driven by the real modern necessities in our lives.

What’s the good news, and what’s the bad?

Habit supposedly is hardcore here, but there is more.

Durable spending has been lowered so deeply and so long by simply postponing replacement, but these goods wear out and ultimately conditions improve sufficiently for the consumer to be tempted into replacement.

But there is an expectation component here, and many consumers are clearly still bomb-shocked, going by the FNB/BER consumer confidence survey, despite the enticement of low, low interest rates (the same not always being true of all sticker prices, new cars for example, although second-hand was for a while very attractive, good bargains could be had in the furniture and appliances trades and the housing market went rock bottom for a while).

The non-durable component is awaiting the end of job shedding overall (probably imminent) while benefiting from the steadily increasing transfer payment flow. Non-durable spending should therefore bottom soon. Its upturn, though, could be anemic, along with employment, depending to what happens to overall incomes.

The semi-durables do suffer from being non-necessity but they are fun and pick-me-ups, last to economise on and rather quick to give a new lease on the happy life. Semis may bounce shortly, not least because imported prices will remain advantageous (relative value, though having to compete with durable replacement ere long as the credit decision starts to be resurrected – probably an important headwind for semis for the early part of the upswing).

For a while semis may take a back seat to durables, but not in every income category.

That leaves our dire modern necessities (services) likely to lead the recovery parade, at least initially (until finally overtaken by the durable recovery on credit steroids and need to replace aging stuff, but we may have aged a bit ourselves before we get there – this doesn’t yet feel like a cyclical upswing on automatic).

So services in the lead, hesitantly followed by durables finally off the lowered floor (just), with semis and non-durables still to confirm bottoms and thereafter probably hesitant recovery affairs guided by a myriad of uncertain influences.

Optimism sounds differently, right? This sounds more like describing Banafa Banafa’s chances in the upcoming World Cup, statistically not entirely impossible but not quite promising either.

Household consumption really depends on what happens to income, which is really decided elsewhere.

Which brings into focus two bruisers, government and the private business sector, the one gung ho, the other rather subdued, and no prizes for guessing who’s who in this zoo at present.

Government clearly knows where its priorities lie. Its consumption spending growth remains impressive (forward momentum of over 4% annually), while its infrastructure commitment is by now legendary (mostly in a negative sense – Eskom et al – but really very positive – not only World Cup but also the impressive broader infrastructure fixed investment data).

Private business, on the other hand, impressively turned tail during 2009. Long last seen such a pell-mell retreat. Smells of panic. But then electricity and export collapses were no joke, with the world on the brink of financial collapse in late 2008 and even still in early 2009. Even the strongest minds don’t fight those unequal odds for long, except if your name is Canute (and the tide finally did take him).

The total fixed investment story has two layers of two dimensions each (private versus public and sector versus type of assets). All these have individual stories to tell, about the downswing (heroics as well as deplorable collapses cheek-by-jowl), with probable pointers as to what comes next.

First, let us hail the heroes.

By sector, fixed investment in electricity capacity leads the parade (you would never have guessed, would you?), with a 75% gain in 2009. This is followed by transport and communication (really the public component of the former and the private component of the later) gaining 15% in fixed investment spending in 2009. Both these sectors have shown no interruption to their steady cyclical advance during the 2000s decade.

Surprisingly, perhaps, mining was also 9% up in 2009 (but then 2008 was an atrocious base, lest we forget). But mining fixed investment was already faltering again in 2H2009, suggesting the year overall may not be so good, and the speed of recovery in 2010 will depend on many, many things (commodity prices, the Rand, cost escalation, wages, electricity, bureaucracy, taxes).

Closing the Parade of Heroes is general government fixed investment (no surprise) and personal services, steadily increasing fixed investment by 2.5% through weather foul and fair, mostly isolated from the worst cyclical excesses.

If only this public and private partnership (thinking cricket) could have been the entire story, we would have had an indomitable fixed investment story (save for the mining qualification, and not forgetting the deep hardship in private transportation services).

But these qualifications were after all only the minor exceptions. We still need to visit manufacturing. Its fixed investment was down 18% in 2009 as the panic was very real, not only in exports but also in inventory shedding domestically hitting output. Manufacturing fixed investment peaked in 3Q2008, sliding since then by 27% overall and it has yet to bottom.

Financial services saw its fixed investment down by 9% in 2009, mainly due to fewer completed houses added to bank lending portfolios. Its peak was as long ago as 3Q2007 after which the building cycle turned down viciously, with such investment also yet to bottom (but probably being very close now).

This sector split is also reflected in the public versus private split. Fixed investment in the parastatals (Eskom, Transnet mainly) up by 42% in 2009, general government up by 4.3%, with the private sector down by a limited 3.9% (the latter reflecting a welter of different experiences, as discussed, and still weighing a heavy 70% in total investment spending).

So the general 4.7% lift in total fixed investment during 2009 was nearly entirely a public (infrastructure) story, as will again be seen just now in the type of asset analysis. But what are the ramifications for 2010? Can this locomotive keep carrying all?

When analyzing fixed investment by type of asset, a somewhat more demoralizing picture presents itself though there are redeeming features (stabilizers).

The hero is construction works (up 40% in 2009, with no peak in sight, by now with a weight of a third in overall fixed investment, unprecedented for us in recent decades).

Interestingly, transport equipment was also up by 20% in 2009, but this was clearly not the automotive component or any other private component. It was all public.

Non-residential (office, retail, industrial) building fixed investment was also still up, a modest 4.5% in 2009 though receding fast, mostly because large projects take time winding down after the onset of a downswing proper.

But the main drag anchors were the important ones.

Residential building investment peaked as long ago as 1Q2007, since then falling by 20%, with 10% down in 2009 alone, with no bottom in sight yet (though close, for you can only fall so far twelve months into an aggressive interest rate cutting cycle, and mindsets slowly resetting to zero from total panic after the financial crisis scare).

The most shocking performance, again throwing light on mainly the private sector (if only being the dark matter hidden in this number) was fixed investment in machinery and equipment, by now with a weight of only 27% overall (which for us in recent decades is unprecedented low).

This item peaked in 4Q2008 (late), but then fell by 27% in less than a year with no bottom yet, largely explaining (along with the business inventory gutting) why imports collapsed so impressively in 2009.

The good news here must be that the panic of 2008 must have been mostly absorbed by now, that boardrooms must have retreated a safe distance after discounting their worst fears, and that a new base line for future operations has probably been established.

But digging in at a safe distance to cautiously watch uncertain proceedings is not quite the heroics of WW1 trench warfare, out of your foxholes, over the parapet and into a hail of bullets seeking glory. They don’t make them like that anymore, at least not in Western societies.

Still, relative calm seems to be returning to the investment frontline (except for electricity, though here there may also be some movement as light is seen at the end of a very dark tunnel and it may after all not be an onrushing train). The worst cases of shellshock have probably exited, nerves have been calming down, the damage to balance sheets largely contained, there is a new day dawning and the early bird catches the worm (also the first bullet, so be careful).

So a bottom is probably not far away.

Like with residential investment, these huge drag anchors are probably close to stabilizing. Taking off anew into the blue yonder is another matter, but at least that’s where attention can shift next. For the SARB leading indicator is certainly rising smartly now.

Before doing so, a last thought about inventories. The shedding during 2009 was impressive, conserving cash flows, eliminating dead capital, reducing dependence on bank lines that got more expensive.

But that gutting is mostly complete, holes have probably fallen into many shelved products (shortages of stock are encountered everywhere) and with final demand lifting new ordering should improve. The inventory rebound effect on final GDP during 2010 should ultimately be as good as the shedding was in the downswing of 2009.

So with inventories on mindless automatic, public sector investment and government consumption heroically charging ahead, and household consumption mostly a function of income and habit (with export income directly correlated with improving global fortunes, nicely impressive so far), the real domestic swing factor determining ultimate speed of recovery are expectations, durable consumer replacement and business fixed investment commitment.

Okay, we are back to shell-shocked mindsets. How are our patients today? Ready to be manly and at them or rather not yet? Will a few more vitamins do the job (which is what interest rate cuts ultimately really are for the economy)? Or can we get the job done under own power? Do speak up if you could do with another shot for how are we going to know otherwise your state of mind and being?

We realize consumers and boardrooms have been through a torrid time. How torrid has actually never been properly analysed, for that one needs to turn to Freud (and there are very few such aspirants among economists), while psychiatrists generally prove uninterested.

This latest down cycle wasn’t quite your average fare, and we have been through a few bad ones in recent decades. But instead of the action being all domestic (and the political antics certainly didn’t help on any given day these past two years), it was the contemplation of Armageddon globally that had everybody running for their grottos.

Undoing that may take time. Still, equipment will wear out, requiring replacement eventually, but it is remarkable how a recalcitrant manager can push that out in time. Never mind having courage to embark on great new things, committing the balance sheet more aggressively. That will take time.

With the global recovery and renewal story also likely to be a rather drawn-out affair, with still many spills along the way upsetting new apple carts episodically, it will take time for real confidence to return. And this into the gale offered by local ideological policy conflict, further colouring risk unacceptably at times.

Overall, yes, we are set on recovery.

And, yes, the export rebound on the back of global revival and the mindless inventory dynamic will provide lift to GDP in 2010, with good support from ongoing government heroics and households acting mostly out of habit to whatever is being offered to them.

But the real swing factor for the economy, from heavy drag to exuberant change agent, will be consumer durable longings and business fixed investment commitments.

These last two components, with a combined weight of over 20% in GDP, is where our combined cyclical weakness is currently most pronounced still.

They will be back, both of them. But it will take time. Much patience, love, understanding, a shot in the arm once in a while, and much rest.

While we wait for them, our growth will probably be pedestrian and mostly jobless, certainly in most of the private sector. A bleak prospect for a while. But this will also pass, as so much else.

The real debate should be about whether this recuperation process should now be left entirely on autopilot, or whether there should be yet more policy support. Both views have their champions, and their detractors.

But that outperformance will probably have to wait awhile is a general expectation encountered everywhere, also in government, and therefore an extra spur to good governance, an unexpected bonus.

The GDP growth outlook for 2010 therefore still looks modest, probably some 1.5%-2.5% and that off a low base.

Formal employment is 5% off its cyclical peak (while the labour pool has kept growing for two years).

Industrial capacity utilization is well below 80%, more so in the residential building industry which is closer to 50%. There is no safety margin in electricity supply.

The Rand is overvalued on most clear days and the global outlook complex, if sunny.

The new upswing will for quite some while feel like a tiresome uphill struggle. Nothing new in that either, going by the last forty years.

This is probably one more very important reason why business is currently still so very modest in its initial investment response.

A very long learning curve establishes its own expectations base once hubris has been pricked anew. It takes time to overcome this. Sometimes it takes a lifetime. That’s the real business cost of rudely pricking periodic bubbles.

Cees Bruggemans is Chief Economist of First National Bank. Register for his free e-mail articles on

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