South Africa's Economic Outlook 2005: the Household Spending Boom
Without a doubt, 2004 was the South African household’s year in almost every way. Initially, it was the housing market that set tongues wagging with talk of a bubble that could burst at some stage. However, real retail sales in excess of 12 per cent by October 2004 have led to increased concern of a consumer bubble as well.
Our view is that the boom is not an irrational credit-driven spending spree, but that it has been driven by a strong improvement in certain key economic fundamentals. In terms of borrowing levels, the South African consumer has mostly been behaving responsibly.
To explain the recent spending behaviour of South African households, it is important to take a look at the key events leading up to this historic housing and consumption boom. It is far from being an inexplicable coincidence.
By late 2002, the fundamentals were in place for one of the biggest spending sprees seen in South Africa in decades, and that is exactly what has unfolded since.
For many years, households’ contribution to the economy, both via residential property transactions and via normal consumption expenditure, was contained. Prior to 1994, this containment came about as a result of poor economic performance and high political uncertainty. Next it was limited by high real interest rates, which reached a crescendo in 1998. The currency crisis of that year caused prime overdraft rates to go as high as 25.5 per cent.
In the latter half of the 1990s, many institutions were trying to come to grips with increased exposure to global competition following the end of politically-inspired sanctions and boycotts. This often involved labour-shedding, which did not do consumer confidence any good.
With households having raised their overall debt-to-disposable income ratio to 61.4 per cent in 1997, the 1998 interest rate shock was the key cause of greater caution in household borrowing. This diminished the household debt level to 49.2 per cent by the final quarter of 2002. Households’ more conservative approach was also reflected in lower household consumption expenditure expressed as a percentage of GDP. It bottomed at 61.7 per cent in the same quarter, having averaged 63.3 per cent in 1998.
By the end of 2002, households had significantly improved their financial position and the economic conditions required for a housing and consumer boom were just beginning to fall into place.
Certain international developments also played a part in increased consumer confidence domestically. Early in 2002, the world’s largest economy, the United States, finally began to feel the negative effects of running massive fiscal, trade and overall current account deficits. Negative real interest rates only served to exacerbate the situation. Something had to give. It was the once-mighty dollar that was to bear the brunt by commencing a real trade-weighted depreciation in March 2002. This followed close on the heels of a flurry of dollar and dollar-based asset buying – partly in response to terror attacks on the US late in 2001 – to the so-called safe-haven of the United States.
The very same flurry of dollar buying caused the rand to plummet late in 2001, with the real trade-weighted rand bottoming out in February 2002, the same month in which the real trade-weighted dollar peaked. As the dollar moved into what appears to be a long-term trend of depreciation, its real value began to appreciate strongly as from March 2002. This development was important in turning the tide of rising inflation in South Africa, late in 2002. Inflation had previously been fuelled by the rand crash of 2001, along with a global food price inflation shock.
Producer price inflation began to decline after peaking at 15.4 per cent in September 2002, causing CPIX inflation to follow suit shortly after peaking at 11.3 per cent in November of that year. Off that high base, CPIX inflation reached 4 per cent year-on-year by December 2003, and averaged some 4.4 per cent year-on-year for 2004. Even more impressive was the CPIX sub-index for consumer goods (as opposed to services), which recorded an average inflation rate of 3.1 per cent in 2004.
The final quarter of 2002 was thus an important turning point, not only because household debt to disposable income bottomed out, but also because it was the quarter in which inflation turned the corner. This set the economy up for aggressive interest rate cuts of 550 basis points in the second half of 2003 and a further 50 basis points in August 2004. Furthermore, the fact that the rand continued to strengthen and that food price inflation remained benign, has created widespread belief that the near-term future of interest rates will be either sideways or moderately lower.
There is also another respect in which 2002 was important. It signalled a dramatic change in the approach of the South African Reserve Bank (SARB) towards interest rates. The rand crash of late 2001 was the first time that the bank had been put to the test in a crisis situation since the 1998 currency crisis.
Although the 1998 rand crisis was less extreme than the 2001 rand crisis, the SARB had responded to it by raising lending rates by a massive 725 basis points within the space of just over two months. Both the extent and the pace of the interest rate hikes shocked the consumer.
In contrast, the bank kept a cool head in 2001/2002, responding with a less severe 400 basis points in hikes over a period of almost nine months. The Minister of Finance finally let the bank off the hook in October of that year by acknowledging that the 2002 inflation target would not be met. The bank also indicated that it may not necessarily respond to exogenous inflationary shocks that are, by nature, of short duration.
The greater transparency in monetary policy in recent years (Monetary Policy Committee meetings are widely publicised and accompanied by regular Monetary Policy Forums open to the public), along with greater interest rate stability, has served to make households somewhat more comfortable with higher levels of borrowing by increasing expectations that there will probably not easily be a repeat of 1998.
The scene was also set for real household disposable income growth in 2002. This would exceed real GDP growth for seven consecutive quarters, starting in the first quarter of 2003. In spite of a slowdown in real GDP growth from 3.6 per cent in 2002 to 2.8 per cent in 2003, real disposable income growth rose from 3 per cent in 2002 to 4 per cent in 2004. It continued to average quarter-on-quarter annualised growth near to 6 per cent for the first three quarters of 2004.
This development had much to do with the tendency of labour cost increases to lag inflation, with unions trying to play catch-up and companies constrained by labour legislation in their attempts to cut labour cost increases to remain cost competitive. Therefore, the total compensation of employees, expressed as a percentage of GDP, rose to 52 per cent by the end of 2003 after having bottomed out at 48.5 per cent in the final quarter of 2002.
If all of this was not enough, the government began to become more expansionary with regards to its fiscal policy, and the fiscal deficit rose from 1.1 per cent of GDP in the fiscal year ending in March 2003 to 2.3 per cent in the March 2004 fiscal year. This raised the government’s borrowing requirement from 1.4 per cent of GDP to 2.9 per cent of GDP. For the first two quarters of the 2004/05 fiscal year, the deficit averaged around 3.4 per cent of GDP.
Although the government has long intended to raise its capital expenditure, much of the new and more expansionary approach has benefited the area of government consumption expenditure. To be more specific, social services expenditure was the major beneficiary, while social security and welfare transfers have been the fastest growing area of social services expenditure.
Transfers to households from government rose by a massive 33.5 per cent in 2003, contributing an additional SAR12.3bn to household disposable income in that year. This had much to do with a dramatic increase of welfare and social security beneficiaries from 2.9 million in 2000 to 7.4 million by 2003. Moreover, the number of social security beneficiaries is projected to exceed 10 million by the 2006/07 fiscal year. Although this raises the serious question as to whether government retains any control over this area of its finances, it can be seen as a significant stimulus for spending by lower-income households.
The decline in the household debt-to-disposable income ratio between 1998 and 2002, followed by strong disposable income growth and aggressive interest rate cuts in 2003, meant that the total household debt servicing cost as a percentage of GDP, reached a 17-year low in the final quarter of 2003. Not surprisingly, this led to very strong consumption expenditure and demand for housing in 2004.
By October 2004, real retail sales had measured growth of 12.8 per cent year-on-year, and real household consumption expenditure grew at a quarter-on-quarter annualised rate in excess of 6 per cent for each of the first three quarters of 2004, including a 6.7 per cent increase in the third quarter. The average price of houses rose by 32 per cent in 2004, and mortgage advances growth was a key driver of overall household credit growth, which recorded an average year-on-year rate of 14.6 per cent for the first nine months of the year. New motor vehicles also contributed strongly to credit growth, with unit sales rising 22.2 per cent on average in 2004.
Examining certain key household financial ratios, there is little to indicate that households are by historic standards in an overly risky financial position that could lead to a collapse.
In 2004, the cost of household debt servicing, expressed as a percentage of GDP1, began to rise because of a far slower rate of decline in interest rates compared with 2003 and a rising debt-to-disposable income ratio at the end of 2002. (This debt ratio reached 55.4 per cent in the third quarter of 2004, compared with 49.2 per cent at the end of 2002.)
However, the index measuring the movement in the ratio of debt servicing costs as a percentage of disposable income still remains at levels that, prior to the fourth quarter of 2003, were last as low in 1988.
In the third quarter of 2004, household consumption expressed as a percentage of GDP measured 62.7 per cent, significantly up from the 61.7 per cent low in the final quarter of 2002. But it was still lower than the 63 per cent level above which it hovered for the period from 1998 to mid-2002.
In the housing market, too, affordability ratios do not at present pose a major problem. The average house price, expressed as a percentage of average remuneration, has risen, but is still below levels prior to mid-1986 and well below levels achieved at the height of the early-1980s property boom. The cost of debt servicing on a bond for an average-priced house, expressed as a percentage of average remuneration, also seems fairly average by historic standards.
There is also little sign of overextension by households in the official insolvencies statistics. In October 2004, total insolvencies declined by 55.8 per cent year-on-year, after a 57.2 per cent decline in the 12 months to September. Civil judgements for individuals declined by 11.9 per cent in November after a decline of 23.9 per cent in October.
Admittedly, household net savings as a percentage of disposable income are extremely low, measuring only 0.9 per cent in the third quarter of 2004. However, the problem of a low savings rate has been plaguing the economy consistently over the past decade. The issue of income inequality is also ongoing.
Having argued that the key household financial ratios remain relatively sound, they are nevertheless deteriorating gradually. As mentioned previously, debt servicing costs as a percentage of household disposable income have been rising, as has the household consumption-to-GDP ratio. In the housing market, the same upward trend is visible in the average house price-to-remuneration ratio.
A continuation of such trends should suggest that households would begin to rein in the growth in spending. The key difference between the protagonists of a boom and those who see a bubble developing, is the pace at which such a decline in real consumption expenditure growth is expected to occur. A bursting bubble implies some sort of crash. Furthermore, the existence of a bubble seems to imply some type of irrational exuberance, which could end without the onset of a change in the economic environment.
From the above-mentioned ratios, households do not seem to be living beyond their means, on average. It is therefore believed that it would take an economic change of significant proportions to cause a crash in the consumer and housing markets in South Africa. Such an economic shock would need to include an inflationary shock, which in turn would need to cause interest rates to rise sharply and economic growth, along with disposable income growth, to fall sharply.
Given the SARB’s present approach towards interest rates, such an interest rate shock seems difficult to imagine. The exchange rate shock of 2001 proved to be a growth stimulus rather than a growth destroyer because of the less extreme interest rate response compared with 1998. Real household consumption still achieved growth in excess of 3 per cent and solid house price growth continued throughout.
In addition, the rand does not yet appear to be ready for a sharp weakening trend. The past three years of rand strength have enabled the SARB to make a key structural change, building up its international liquidity position to $11.4bn from a net open foreign currency position of $22.5bn in 1998.
In January 2005, credit rating agency Moody’s gave South Africa an upgrade in its sovereign risk rating from Baa2 to Baa1, and capital flows have been strong enough to easily finance a current account deficit that measured 2.5 per cent of GDP during the third quarter of 2004.
Following on the possible foreign direct investment inflows into the financial services sector, capital inflows should once again be strong in 2005, while further support for capital flows should also come from the fact that South Africa’s growth since 2000 has been in excess of 3 per cent a year on average – a considerable improvement from situation that prevailed during the latter half of the 1990s.
However, relative risk is probably the most important factor of all. When the mighty US economy’s perceived risk increases and capital needs to find attractive yields at acceptable risks, a commodity-exporting nation with relatively high interest rates, such as South Africa, is an attraction. Therefore the real trade-weighted rand has traditionally had a strong inverse correlation to the dollar.
The expectation of renewed dollar weakening to above €/$1.40 in the second half of 2005, leads to the view that the rand will go stronger against the dollar before it goes weaker, with an average forecast of $/SAR5.50 for the third quarter. Against the other major currencies, this translates into less strengthening from current levels, but nevertheless means that little, if any, imported inflationary pressure should emanate from the rand’s movement in 2005.
It is believed that the bulk of the US dollar’s weakening will be over by late 2005, with the euro peaking just above €/$1.40. Although the US is still expected to be living with its wide twin deficits at year-end, some signs of improvement are expected in both the trade and current account deficits late this year.
This improvement will be driven by dollar weakness as well as the impact of rising US interest rates in curbing US import demand. The Fed Funds rate is expected to exceed 3 per cent by the end of this year.
However, the expectation of the dollar moving weaker before it gets stronger is the primary driver of the view that the rand’s strength is not yet over. Against the dollar, the local currency is expected to bottom at $/SAR5.50 during the third quarter before commencing a weakening trend moving into 2006. On a trade-weighted basis, the weakening trend is expected to commence slightly earlier, during the third quarter.
The rand’s strengthening against the other major currencies is believed to be almost complete. Although dollar weakness can be seen as supportive of the South African currency, a widening domestic current account deficit is expected to restrict further strengthening in the rand. Therefore, although it is not expected to bring much further disinflationary pressure to the domestic economy from imported sources, the rand is also not expected to prove problematic from an inflation point of view.
Furthermore, although there are admittedly abundant upside risks, oil markets are expected to weaken following the Northern Hemisphere winter, with oil prices also being helped lower by a cooling US economy. This is expected to allow for a further moderate interest rate cut of 50 basis points in South African interest rates during 2005 on the back of an average forecast CPIX inflation rate of around 3 per cent, compared with 4.4 per cent in 2004.
The stimulus from interest rate cuts in 2005 is thus not expected to be extreme, especially compared with the stimulus the consumer received in 2004. That stimulus emanated from 550 basis points-worth of rate cuts in 2003 and a further 50 basis points in 2004.
Furthermore, real disposable income growth is expected to move gradually back into line with real economic growth as institutions succeed in bringing their nominal labour cost increases back into line with low inflation.
The gradual diminishing of two key sources of stimulus for household demand, coupled with the fact that rising household debt expressed as a percentage of disposable income is gradually making the household debt burden less affordable, points towards a gradual decline in residential property price increases and the rate of increase in real consumption expenditure demand.
Indeed, this gradual cooling off can already be seen in the housing market, with year-on-year rates of increase in house prices having declined from a peak of 35.5 per cent in September to 32.7 per cent in December, and month-on-month rates of increase now significantly lower than a year ago.
New motor vehicle sales growth averaged 30.3 per cent year-on-year in the final quarter of 2004. This rate of increase is forecast to decline to around 11 per cent by the final quarter of 2005.
Total real household consumption expenditure growth is estimated at 6 per cent for 2004, and is forecast mildly lower at 5.6 per cent for 2005 and 4.5 per cent in 2006, with durable and semi-durable goods consumption growth declining in most of the major product categories.
In other words, the emphasis is on gradual declines, with 2005 remaining a good year for the housing and consumer markets, albeit with a mild loss of growth momentum.
As the South African household is the largest source of demand for final South African output, it is expected to be the main driver of overall economic growth in 2005, despite an expected slight slowdown. Although the 5.6 per cent real household consumption growth rate will be slightly lower than the 5.8 per cent real fixed capital formation growth forecast, fixed capital formation remains a far smaller demand component.
Overall, real gross domestic expenditure growth is forecast at 5.1 per cent, and it can thus be said that domestic demand remains the key to economic growth in 2005, while exporters continue to battle to come to grips with the dramatically changed rand environment. Real exports are forecast to grow at 3.3 per cent for the year, which is below the forecast overall economic growth rate of 4.1 per cent.
Although the 4.1 per cent 2005 economic growth rate exceeds the anticipated 3.7 per cent for 2004, the best growth is expected to take place in the initial stages of this year. Growth will begin to lose momentum from quarter to quarter as the consumer gradually loses steam.
As always, risks to the global and domestic economy abound. Should certain of these risks come to fruition, it is possible that the household and consumer bubble could burst.
Two key risks are the possibility of an oil price shock and/or a dollar collapse.
An oil price shock could rapidly bring about a global economic recession. Such a shock, should it occur, is expected to effect the dollar negatively because it is believed that sharp upward pressure on oil prices would be caused by geopolitical issues in the Middle East, where the US is heavily involved.
In such a case, South Africa would be partly protected by a gold or precious metals price boom, depending on the US monetary policy response. However, with the demonetisation of gold, such a boom is not expected to reach early 1980s proportions.
Severe further dollar weakness would see the rand strengthening significantly to partly, but not entirely, offset the inflationary effects of oil price increases. Under its inflation targeting regime, the SARB would probably not relax its monetary stance in view of the inflationary effect of higher fuel prices.
The combination of a stronger rand and weaker global demand for South African exports could also place severe pressure on domestic economic growth, households’ disposable incomes, and thus housing and consumption expenditure.
Although the negative effects of an oil price shock may be immediate, an independent dollar collapse may set the South African consumer up for a nasty shock at a later stage. A sharp dollar depreciation could be expected to lead to the rand renewing its strengthening trend, moving significantly stronger than in our baseline forecast.
The impact for South Africa would be disinflationary (compared with an oil price shock, where higher oil prices would offset a stronger rand), and could see the CPIX inflation rate moving lower than the 3 per cent target. Although other economies with low interest rates may have little ammunition to stimulate domestic demand and sustain economic growth in a deflationary environment, the SARB still has a lot of room left to reduce its repo rate, which is currently at 7.5 per cent.
However, although interest rate cuts could keep up the economic stimulus, the country would run the risk of creating a consumer bubble that would set it up for a later crash. Household debt-to-disposable income could skyrocket, and the mismatch between domestic expenditure and national income (the current account balance) could be blown out of proportion. This would set the rand up for a sharp depreciation at a later stage, when capital flows turned against the country, and possibly interest rates would have to rise sharply.
The South African consumer remains the key driver of overall economic growth. Therefore, as consumer demand growth gradually comes off the highs of 2004, economic growth is also expected to slow. However, far from being in a bubble situation, the South African household appears to have been spending responsibly, driven by a cost of debt servicing that was last as low in the late-1980s, along with strong real disposable income growth. Therefore, barring a major economic shock, a soft landing for the consumer and housing markets seems the most likely scenario.
1 Recent data on debt servicing costs of households are not available, but as a proxy, household debt was amortised over a fixed term to obtain an “average repayment” value.