The importance of addressing supply-side weaknesses

Looking back at the economy over the last few years reminds us how tough it has been for households and businesses. Since those pre-Covid days, the economy has hardly grown at all. Compared to first quarter 2019 GDP, the economy gained a mere 5% over the five and a half years to June this year  (growth of less than 1% a year).  Households are spending only 6% more than they did then and capital formation is down by about 14% in real terms. How could such a deterioration be allowed to take place?

Figure 1: Vital SA economic statistics (2019 = 100)
 

Source: SA Reserve Bank and Investec Wealth and Investment, 24/10/2024

The supply side of the economy has performed poorly – led by the well-documented, confidence-sapping failures of the state-owned enterprises and government generally, including those of the provinces and municipalities. But demand management by the Reserve Bank can also be held responsible for at least some of the weaknesses. Much of the period since 2021 has been accompanied by higher interest rates both absolutely and relative to inflation. That is despite the grave weakness in demand for goods, services and labour.

The Reserve Bank’s Monetary Policy Committee provides a full explanation regularly for these interest rate settings. It has been fighting the inflation that arose after 2021 as the rand weakened. The idea of a dual mandate of the US Fed kind – low inflation and employment growth – has been anathema to our determined inflation fighters.

Shocks to the price level caused by exchange rate weakness – unrelated to immediate monetary policy settings and inflation trends – are not ignored when interest rates are set. Yet such shocks (not of the Reserve Bank’s doing) lead inevitably to more inflation followed by higher interest rates and in turn still weaker demand, already under pressure from higher prices. Higher prices have their complex causes, but they also have rationing effects on the willingness to spend more, given the minimal growth in incomes.

The problem for the Reserve Bank has been that the rand weakened decidedly after 2021, against not only the US dollar but also other emerging market and commodity currencies. This was South African-specific in nature, linked to the failures of government and the failure of the economy to grow. The rand – against the US dollar, the Australian dollar and most emerging market currencies – had recovered well from the Covid-linked risk aversion that had put pressure on the rand and the market in SA Bonds. It may be recalled that the rand had recovered to R14 against the US dollar in early 2021. But then the sense of South Africa’s failures to realise economic growth took over the currency and bond markets. And the weaker rand inevitably forced prices higher at a faster rate.

Figure 2: The rand against the US dollar, emerging market currencies and the Australian dollar (2019 = 100)
 

Source: Stats SA, Bloomberg and Investec Wealth and Investment, 24/10/2024

Figure 3: Interest rates and the rand against the US dollar
 

Source: Stats SA, Bloomberg and Investec Wealth and Investment, 24/10/2024

Figure 4: The rand and short-term interest rates
 

Source: Stats SA, Bloomberg and Investec Wealth and Investment, 24/10/2024

The connection between the foreign and domestic exchange value of the rand, and the outlook for the SA economy has never been clearer. The government of national unity has raised the prospects for growth, and the rand, bond and equity markets have responded accordingly. Inflation is therefore on the way down. Over the past three months, it has averaged a year-on-year rate of 2.4%. Interest rates at the short end of the market have come down and will come down further, provided the rand holds up – perhaps not so much vs the US dollar, which may be getting a Trump boost, but against the other currencies similarly affected by a firmer US dollar.

We should not expect the Reserve Bank to change its pro-cyclical approach. We should however insist and hope that the supply-side weaknesses of the economy are well addressed. Raising the GDP growth rates to a modest 3% will not only promote economic and political stability, but it will also bring with it lower interest rates and less inflation.