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Summary of the Economy
Dr. Cees Bruggemans
23 May 2007
For the past 12-18 months, my main theme has been high GDP growth plus rotation in growth composition.
The growth has turned out higher than expected and seems to be still accelerating. Overall there has been limited rotation, though in some specific sectors more than expected.
Published data now suggests 5% GDP growth momentum these past three years. Instead of agricultural disappointment last year supposedly pulling the overall performance down, this effect didn?t keep us from 5% overall growth.
Instead, revisions continued on the upside. Excluding the underperforming 25% of GDP (including the public sector), the remaining 75% of GDP outperformed, averaging over 6%.
Yet this probably still remains a modest output underestimate, going by VAT and income tax collections (after allowing for better collection success) and market research. The high growth era of recent years has created substantial opportunities for entrepreneurial self-starters, many of whom may have opted to stay below radar screens for as long as possible.
The property income item in the national accounts continues to act as a lively residual, outperforming on the upside. We are anything but overestimating income growth in the economy.
As to composition rotation, there has been slowing in the durable consumer goods sector, with new passenger car growth falling off substantially, indeed turning mildly negative this year. Similarly, the upper end of the property market (over R1m) has seen prices stabilizing these past two years, with residential new building plans declining so far from this year.
Both these important markets may have been intimidated by interest rate risk this past year. Yet the commencement of their slowing preceded the interest rate tightening by a fair margin. Instead, some indigestion and saturation may have occurred, car replacement having been bunched enough to exaggerate the buying cycle. On the property side, higher incomes tend to carry much higher debt loads relative to income. Affordability, risk-awareness and price-resistance may have created temporary saturation in demand, calming things down these past two years, in addition to interest rate prospects doing so. The changing wealth outlook here may also have assisted in slowing car buying down.
Yet despite these important slowings these past 18 months, overall household consumption growth still speeded up in 2006, with 1H2007 so far hardly a retail disappointment. Income growth has been strong, business and self-starter components enjoying mostly surging income gains in an ongoing high growth environment.
Although reported credit growth peaked late last year, and is now gradually easing, the easing is more pronounced in the household sector and less noticeable in the corporate sector. There isn't an overwhelming falloff underway, even as bad debt provisions are rising (from deep cyclical lows).
We should really add back bank debt securitizations, still small last year but bigger this year, to get a better sense of overall credit momentum.
The main impression is therefore less of a household falloff in spending growth than suggested by leading parts of the durable goods sector and important property segments. Consumption growth is remaining robust around 5%-7%, primarily driven by good income growth, coupled to very high consumer confidence as per the FNB/BER consumer confidence index.
At the same time, we seem to have entered an era of full resource utilization in many parts of the economy, creating growing shortages and import spillovers. Luckily, the balance of payments remains easily financed under present global conditions. Any product shortfalls continue to be easily met through competitively priced imports, keeping a lid on domestic pricing intentions.
Meanwhile the high output growth, its endurance and the capacity shortages it is creating, seems to be unleashing a still intensifying fixed investment boom. This is true in the public sector, with politicians and policymakers pushing haste with infrastructure expansion, and also in the private sector, where rising import levels are creating ever bigger opportunities for local production.
Real fixed investment has been growing at 12%-13% this past year, and still seems to be accelerating. Although the fixed-investment-to-GDP has risen from 14% to 20% of GDP so far in this expansion, there is every prospect of rising considerably higher into the 20%-30% range these next 5-10 years, thereby setting unprecedented records.
This scramble partly reflects unwise bunching of investment effort, both in the public and private sectors, misreading the growth cycle and its global underpinnings, and now suddenly wanting to overcompensate for lost time. This is especially unnecessarily weighing on the scarce skilled labour resource creating enormous challenges to still undertake the mushrooming effort without triggering unwanted price accelerations. On this score the silver lining is the ability to source abroad, at least in some respects (contractors).
Besides these strong domestic demand drivers, it isn't as if exports will be poor relations forever. Especially mining and manufacturing will probably be in a position, either for improving regulatory reasons or due to new capacity additions, to make bigger trade contributions, also eventually again improving import substitution.
This demand picture suggests ongoing domestic spending growth of 6%-7% in an economy whose potential output growth is conservatively estimated at 4.5% by the SARB. There is, though, an upward bias to this potential as the fixed investment effort continues to intensify and identified constraints are addressed, however slowly.
Underlying inflation pressure has so far been contained near 4%, in line with unit labour cost growth of 4%-5% and inflation expectations for 2007-2008 of just over 5%. CPIX inflation at 5.5% should shortly touch 6% under the influence of external supply shocks (oil, food), before falling back again towards 5.5%, still on average within the SARB's target range.
The 2% interest rate tightening in 2006 effectively aimed to neutralize the 15% Rand deterioration of that period, with only a minimal part of the policy action so far aimed at containing inflation expectations.
Although real demand growth is still gunning strongly at 7%, relative to a conservatively estimated output growth potential of 4.5%, capacity utilization in manufacturing is 87%, certain labour skills are in short supply, and some unionized wage demands are shrill indeed, underlying inflation pressure is yet to show much evidence of accelerating.
The safety valve of importing has been important in containing such price pressures, made possible by easy global liquidity conditions and large capital inflows, well in excess of the current account deficit, supporting the Rand. Thus, the SARB has been able to lift foreign reserves to $27bn, the hot-running economy has been accommodated and the Rand has been kept reasonably firm, preventing undue inflation pressure from gaining a foothold.
With domestic spending and output momentum probably achieving maximum speed at present, and importing likely to keep growing faster than exporting (investment growth also exceeding saving increments), the current account deficit may still widen towards 7% of GDP. Even after allowing for Rand payments to Custom Union participants (over 1% of GDP), this still leaves a current account deficit of at least 6% of GDP to be funded externally on a continuous basis.
If the necessary external funding would cease to be forthcoming, for whatever reason, the Rand would weaken and interest rates would likely rise on a 10%-for-1% basis. In the process more rotation in growth composition would likely be forthcoming, with household consumers making less of a contribution but producers gaining greater income gains, quite possibly maintaining the overall growth performance.
There continues to be regular emphasis on external risks of capital flow reversal, and therefore this scenario playing out.
Less often heard is the very opposite risk, namely of too much foreign capital continuing to flood in. This remains for now our current reality, and could potentially still continue to be the case for a considerable time.
The world economy is growing fast at 5%. There is more desynchronisation, with the US slowing down, Europe speeding up and emerging markets uniformly outperforming. This favours our export prospects, while it is starting to unwind some of the global risks, especially the large trade imbalances and Dollar exposure.
Remaining risks are episodic market misreadings of Fed intentions, and new asset price bubbles replacing old preoccupations. Just as the US and Spanish housing markets are finally standing down, the Shanghai stock market and Japanese carry-trade potential seem to be reaching for new unconstrained highs.
Even so, any episodic tribulations from these sources may be more of an adjusting nature rather than having the potential of disrupting the dominant global growth and financing themes.
The same applies to event risk such as war, oil disruption, pandemics, long-term climate change and such-like risks, including increased global risk-taking and credit leverage, whose potential remains acknowledged, but so far without significant activation.
Assuming leadership and policy continuation locally, and high growth and an absence of significant disruption globally, the road seems reasonable clear for continuing outperformance during 2007-2008.
In other words, real household and government spending growth of 5%-7%, real fixed investment growth of 12%-15%, real output (GDP) growth of 5.0%-5.5%, current account deficit of 6%-7% of GDP, underlying labour cost and core inflation of 4%-5%, CPIX inflation of 5.5%.
Short-term interest rates should remain unchanged for the duration, prime sticking to 12.5%, though any rate bias will remain nearly exclusively on the upside.
With company earnings growth continuing in the 20%-30% range, equity market outperformance remains a realistic expectation.
Original article published at www.fnb.co.za.
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