The Supply-side Crisis in the South African Economy
South Africa’s economy is curently afflicted with severe shortages of skilled labour and production capacity constraints, which are reflected in shortages of various raw materials and other products. As a result, the economy now appears to be suffering from an element of dysfunction, with capacity problems becoming endemic. This situation is exacerbating the large deficit on the current account of the balance of payments, which exceeded rand (R)111bn in 2006. In addition, business confidence is reportedly being affected because of the increasing bottlenecks.
Confidence in South Africa’s economy is coming under some pressure. With an uncertain economic outlook owing to capacity constraints and concerns about crime dampening the mood, the RMB/BER business confidence index (March 2007) showed a decline in the early months of 2007. Even so, the economic growth rate remains relatively strong at around 5% a year, and the growth in output has become less volatile in recent years in line with the same global trend. Against the background of a huge current account deficit and rising inflation, a progressively tighter monetary policy was implemented in May 2006, but thus far with scant evidence that the growth in private consumption expenditure is moderating.
The substantial deficit on the current account of the balance of payments, which stood at more than R111bn in 2006 (7.8% of GDP in the final quarter of 2006) constitutes a structural impediment in the economy, and will not disappear in the foreseeable future. However, it is conceivable that the deficit will fall once the huge infrastructural spending programme is past its peak. It partly reflects an inability of the economy to produce the goods and services required in sufficient quantities.
The supply-side constraint is boosting imports and swelling the deficit on the current account of the balance of payments. This partly manifests itself in shortages of key raw materials and products, as well as giving rise to a critical shortage of skilled labour in some sectors. This, in turn, is pushing up wages and salaries, thereby raising costs and prices. In the process, the competitiveness of the economy is reduced, production is constrained and imports are increased.
The bottlenecks now afflicting the South African economy are not unique. However, in the past, they largely occurred during the First and Second World Wars, when certain import products were not available – a situation which boosted segments of local industry at the time. The current supply predicament is a peacetime phenomenon and has materialised in the midst of a boom in imports. The import boom is being further swelled by product scarcity, and economic growth is being impaired to some extent.
Several explanations have been put forward for the supply-side crisis, such as manipulation of product supply by cartels, or the political dynamics of South Africa and its neighbouring countries. However, the most credible explanation is that the shortages are connected to the acceleration of the economic growth rate in recent years after a lean period in the 1980s and 1990s. The faster growth rate is primarily attributable to the unprecedented boom in international commodity prices, which started in September 2001, and which has proved to be far more sustainable than was generally anticipated. This has proved to be tantamount to an enormous unanticipated windfall, which may be sustained for many more years if the predictions of some commodity analysts are correct.
The present upswing in the business cycle commenced in September 1999, and is proving to be the longest upswing by far in the post-war period after 1945. The magnitude of this upswing has most probably been underestimated by many producers, who have accordingly been slow to invest in new productive capacity. The rate of growth of the real capital stock in the country has only gradually expanded, from 0.9% in 1999 to 3.3% in 2005. However, as a ratio of GDP, capital stock has constantly declined, from 247% in 1992 to 193% in 2006. This has aggravated the problems, given the long lead times necessary for building new plants, even though real gross fixed capital formation in manufacturing has accelerated to rise by 12.3% since 2004.
On the positive side, though, this trend will be assisted in coming years by the need to expand capacity to overcome the shortages. For instance, the giant petro-chemical group Sasol is assessing the viability of building a fourth coal-to-liquids plant in South Africa with a potential capacity of 80,000 barrels of oil a day. This project could cost around R50bn, and would be the biggest single investment undertaken in the country for decades.
After recording surpluses on the current account of the balance of payments in 2001 and 2002, deficits have subsequently emerged, totalling R13.7bn in 2003, R44.6bn in 2004, R58.4bn in 2005, and R111.1bn in 2006. But the deficit has now become uncomfortably large. The annualised current account deficit in the final quarter of 2006 was 7.8% of the gross domestic product and amounted to R143bn compared with 6.1% (R110bn) in the first half of the year.
It can be argued that the deficit, which is partly being fuelled by imports made necessary by shortages in the economy, is not especially high when compared with Iceland’s 21% or Romania’s 16%. However the seemingly growing deficit is almost certainly going to remain well above 3% of gross domestic product, the level generally seen as appropriate. Therefore the country is going to continue to be regarded as living beyond its means and vulnerable to a sudden change in foreign investor sentiment.
The current account deficit continues to be financed by capital inflows, which are mainly volatile foreign portfolio investments. The Reserve Bank has indicated that foreign portfolio investment in 2006 amounted to R131bn, compared with only R30bn in 2005. However, foreign direct investment last year recorded a net outflow of R47bn compared with a net inflow of R39bn in 2005.
The size of the current account deficit in 2006 meant that it could not easily be financed by net capital inflows, and the result has been a fall in the external value of the rand during the period from early May to October 2006, from around R6 to the dollar to R7.65 (average for October 2006). Many commentators are arguing that any further fall in the rand will be limited because of further upgrades in the country’s foreign credit rating and also because the current account deficit will narrow, partly because of the weaker rand. However, far from improving, the deficit could, in fact, worsen because of the prospects for huge infrastructural spending as a result by capacity problems. In addition, a further deterioration could occur: partly because of the expected further deterioration in the invisibles account of the balance of payments owing to rising dividend payments to foreign shareholders; partly because of the difficulties being experienced in curbing the growth of household consumption expenditure; and partly owing to the general supply-side crisis afflicting the economy.
The shortages of skilled labour, raw materials and products are pervasive, and mean that a whole range of imports will be necessary, with the shortages persisting. This reflects the long-term nature of the investment required in the industries experiencing bottlenecks. Indeed, the shortages may get worse if the economic growth rate accelerates further, which is possible if the boom in international commodity prices persists, taken in conjunction with the huge domestic demand forces present and the infrastructural spending in prospect.
The maintenance of large current account deficits poses a potential risk to the rand and raises the question whether the capital account inflows will prove to be sufficiently sustainable to keep the rand reasonably stable. Since 1993, the inflows of foreign portfolio funds onto the JSE have proven remarkably stable. They have, in a sense, reduced the need to attract foreign direct investment. However, such investment would convey the advantage of potentially boosting productive capacity in the economy and helping to relieve the supply-side crisis.
In view of the bottlenecks existing in the economy, there is a school of thought that argues that the current broad macroeconomic policies are ill-fitted to maximise the growth potential of the economy. Huge shortages of skilled labour exist side-by-side with high levels of unemployment. The argument put forward is that the structure of the economy needs to be adjusted to render it less dependent on scarce labour skills.
According to this school of thought, South African wages are currently too high compared with real wage levels that would clear the labour market at lower levels of employment. Alongside this conclusion, and of greater importance, this school argues that particularly the weakness of export-oriented manufacturing (and mining to a lesser extent) has deprived South Africa of economic growth opportunities that some other countries have been able to enjoy.
The recommendation put forward is that an export-oriented strategy should be adopted, which would increase the relative profitability of producing tradeables (manufactured and mining products) for world markets. This would then generate greater economic growth by pulling labour into productive activities where the marginal product of labour is higher.
Capital controls on inward flows of funds have been adopted in certain countries in the past, with one of the most recent examples being Thailand in December 2006. Restrictions on short-term foreign borrowings by domestic banks in countries such as Chile and Malaysia in the early 1990s did seem to help moderate the surge in capital inflows.
The bulk of capital inflows into South Africa during the past 15 years or so have consisted of purchases of government bonds and shares listed on the JSE. Any restrictions on such inflows would most probably precipitate huge outflows, deter further inflows for many years, and lead to a slump in domestic security prices.
Whereas income tax as a percentage of the GDP amounted to 11.5% in 1993 and 1994, this ratio has been rising steadily and came to 14.1% in 2006. Other taxes on profits, including capital gains, have risen from 0.4% to 1.2% of GDP over the same period, whereas the overall tax burden has increased from 21.7% to 26.8%. This has represented a structural shift in public finances that is not desirable for a developing economy like South Africa, which has acute shortages of skilled labour.
It can be therefore be argued that more needs to be done through cuts in income tax and company tax rates, which would encourage work effort and boost the supply of labour. Reductions in income tax rates could, for example, encourage skilled workers to work longer hours.
South Africa’s economic growth mix needs to be shifted somewhat from consumption-driven to investment-driven growth, and attracting foreign direct investment would be very desirable. Such a switch in the growth mix is already underway to a certain extent, with gross capital formation (gross fixed capital formation plus changes in inventories) as a proportion of GDE rising from 15.9% in 2001 to 19.6% in 2006. Similarly, the trend in real gross fixed capital formation has been encouraging, with the rate of growth increasing from 3.7% in 2002 to 9.1% in 2003, to 9.6% in 2004 and 2005, and 12.8% in 2006.
Real gross fixed capital formation has also been accelerating in the private sector, with the rate of growth rising from an average of 2.8% per annum in the 1990s to an average of 8.3% per annum since 2000. Even so, this trend needs to be further encouraged in view of the strains on the availability of productive capacity in the private sector. The size of the construction industry alone may need to more than double in the next four years to meet the requirements for new and improved infrastructural facilities, while further large additions to capacity may well be needed in related material supply industries.
A significant cut in the corporate tax rate would be appropriate in this respect, since it would raise the after-tax rate of return on investments, while the associated investments should help to relieve capacity problems in the economy.
It might be argued that such a tax move might boost consumer spending, since companies might be tempted to pass on the benefits of a cut in corporate tax in the form of higher dividends paid to shareholders. However, it can equally be argued that companies that are already cash rich in some cases are in such a position partly because the corporate tax rate is too high to justify new investments.
The current economic bottlenecks should diminish with the passage of time. However, in the interim, various policy mutations should be considered. Some commentators argue in favour of a shift in macroeconomic policies, which would favour sectors of the economy less dependent on scarce labour skills. However, there is also a strong case for reviewing income tax and exchange control policies.