At the start of this year, I forecast that inflation would peak in the middle of the year and might even breach the upper target band of the Reserve Bank.
This breach should be temporary as economic growth picks up in Europe and South African exports increase. However, there are certain scenarios that may significantly affect the rand’s strength and inflation during this year.
Currently, the major risk factors to South Africa’s growth and inflation prospects are capital outflows, European growth, the stand-off over Ukraine, and local labour and political instability.
In the past year much has been written about the US Federal Reserve’s tapering of monetary policy and how this has led to significant capital outflows from emerging economies. Those emerging economies with high current account deficits and higher risk profiles were hardest hit by the reversal of capital flows.
These flows resulted in currency devaluations across the board for many emerging economies. South Africa was particularly hard hit with a rand devaluation of 28 percent from January last year to January this year.
Compounding this situation is the strength of growth expected in the US and the UK. Emerging economies attract foreign flows if growth in these markets exceeds that of developed economies.
This has been the case in the past, but this year the tables have turned for many emerging economies, such as South Africa, Brazil and Russia, which will experience lower growth rates than those in the US and UK.
Nor is South Africa attracting enough foreign direct investment (FDI). The FDI inflows since 2010 have been dismal. The lack of FDI investment has been identified as a major risk factor to the high current account deficit. The bottom line: South Africa is simply not attracting enough investment to finance this deficit. Frost & Sullivan estimates that in order to maintain the current account deficit under these conditions, the country would need to attract at least $10 billion (R106bn) in FDI a year.
We have averaged only $3bn a year in the past three years. This is a significant shortfall which cannot be financed by bond and equity purchases alone.
In order for the rand to recover, levels of exports need to improve. Most of South Africa’s exports to Europe are high value-added products with significant backward and forward linkages in the local economy. The decline in exports to Europe has had a major impact on economic growth and has contributed to the growing current account deficit.
Growth is expected in Europe this year and this will have a positive impact on South Africa’s exports to this region, however the tensions between Russia and Europe may lead to a situation where growth may stagnate once again.
Local conditions have the ability to seriously affect economic growth and inflation prospects this year. Since the beginning of the year we have seen rising tensions in the labour sector with a major strike in the platinum industry. So far, the industry is already reporting an approximate revenue loss of R11.2bn.
In terms of inflationary pressure there are two major considerations. The first is the direct capital outflow, or loss of potential inflow of FDI, and the second is the indirect effects of a credit downgrade.
Credit ratings agencies, such as Fitch or Standard & Poor’s, will assess a wide variety of economic, social and political elements in South Africa’s economy to base a rating upon. Credit ratings play an important role as they help determine a country’s cost of borrowing.
Since the affirmation of ratings late last year from many agencies, things have steadily deteriorated in many aspects for South Africa. Strikes have flared up in the platinum sector again, the rand received a serious devaluation in January driven by capital outflows, and the nation has received a particularly damaging report on the involvement of the president in Nkandla.
If the country slips further on the corruption perceptions index, it may be very likely that it will receive a downgrade this year. This would compound the negative impact of international economic and political conditions and there may be a further devaluation of the rand.