Thematic view: Economic growth, R&D and knowledge creation

Market and economic highlights:

• The extent of economic stimulus in China remains the dominant theme, given its implications for South African GDP growth this year. Our exposure to developed markets such as the US, UK, Germany and other parts of Europe, and their weak relative levels of demand for our exports (around 34% of exports) is set to be a headwind for GDP growth. There have been a few promising first moves such as the People’s Bank of China cutting rates, but some high-frequency data such as manufacturing and, more recently services activity (early September), is not yet supportive of a particularly stronger outlook for the Chinese economy this year. 
• Specific to South Africa, the most notable occurrence in the macroeconomic space was the speedy unwind of the performance seen in the rand/dollar exchange rate from July to August, with the currency depreciating around 5%. 
• The South Africa July inflation print came out at 4.7% versus a consensus estimate of 4.9%. While inflation has been heading towards the middle of the Reserve Bank’s target band of 4% to 6%, some upside risks could push the inflation rate above 5% in the coming months. These include the rand/dollar exchange rate and the continued increases in the price of Brent crude. 
• At the time of writing, the currency had further depreciated in the early days of September. The currency is 2.5% weaker against the dollar so far in September. The performance of the currency is an important input for the Reserve Bank’s quarterly projection model (QPM). While inflation is relatively comfortably within the band, inflation expectations can materially shift the Reserve Bank’s thinking around the direction of interest rates over the next few months. It is our view that the Reserve Bank can start cutting in the first half of next year, but the current macro environment is less supportive than a few weeks ago. 
• Many economists are warning of a worsening growth outlook and the likelihood of material revisions to fiscal estimates by National Treasury at the Medium-Term Budget Policy Statement (MTBPS) on 1 November. Energy and logistics constraints are an additional headwind for economic activity (in addition to the slower growth globally mentioned above). At the time of publishing, the National Treasury has sent a directive to government departments and institutions to cut spending in some non-priority areas. 

Thematic view: Economic growth, R&D and knowledge creation

This month we explore the causal linkages between innovation and GDP growth. A study by Pradhan, Arvin, Nair & Bennett (2023), which looked at the endogenous dynamics between innovation, financial markets, venture capital and economic growth in Europe is a guiding research paper on some of the trends we will explore in this analysis. We also look at South Korea specifically, in the light of the changing economic dynamics in the post-World War 2 period.

At the onset, it’s important to clarify that this discussion is exploratory – we acknowledge the complexity of what investment in education may translate into in terms of the relative performance or uplift to a given economy. Each economy has its complex structures and relative exposures to types of economic activity, and therefore this exercise cannot be undertaken as a one-size-fits-all approach.

The basis of the analysis is premised upon chart 1 below, which looks at education spend (as a percentage of GDP) and the number of researchers per one million people. Number of researchers is essentially a proxy for the degree of knowledge creation within an economy. The degree of knowledge creation is important, insofar as it is a drive for innovation and economic progress. The World Bank defines the researchers in Research & Development (R&D) as follows:

“The number of researchers engaged in Research &Development (R&D), expressed as per million. Researchers are professionals who conduct research and improve or develop concepts, theories, models techniques instrumentation, software or operational methods. R&D covers basic research, applied research, and experimental development.”

Chart 1 below shows that South Africa is among the outliers when it comes to the level of education spending as a percentage of GDP and the number of researchers produced per one million people. South Africa spends a significant portion of tax revenues on education but this does not appear to directly correlate with the number of researchers produced. The number of researchers per one million people appears to correlate with the rankings of the World Knowledge Index in Table 1 below. 

Chart 1: Education trends across select G20 nations

Date sampled: 24 Aug 2023
Source: Investec Wealth & Investment, OECD, World Bank

Table 1: World Knowledge Index rankings for select G20 nations

Source: Knowledge4ALL, IWI, 24th Aug 23

Knowledge creation appears to be biased to the West, South Korea and Japan. Chart 2 below similarly shows that South Korea has had consistent and continued growth in spending on R&D as a percentage of GDP, while countries such as South Africa has had no growth at all in expenditure in R&D as a percentage of GDP. The importance of spending on education and R&D is illustrated by a fundamental shift in the economy of South Korea following World War 2. 

Chart 2: Growth in gross expenditure on R&D as a percentage of GDP 

Date sampled: 30 Aug 2023
Source: I&WI, UNESCO Institute for Statistics

One fundamental underpin of the South Korean economy has been its history of focusing on applied technology. This has shaped the emergence of multinational corporations in heavy industry, known as chaebols (Dayton, L. 2020). Dayton gives Samsung as one case of a large chaebol which ultimately became a significant contributor to economic activity and growth in South Korea.

The power of patents

Chart 3 below shows the relationship between the number of patents approved by the World Intellectual Property Organisation (WIPO) and GDP growth in South Korea. The assumption is that innovation leads to economic growth, what is called the supply-leading hypothesis. The premise is that innovation increases marginal productivity and output. We should highlight that the r-squared (a measure of correlation) is low. This is to be expected due to the complexity of GDP growth contributors. The key point from the chart is that positive patent growth and GDP growth are mostly aligned, with 83% of observations of positive patent growth coinciding with positive GDP growth.

Chart 3: Relationship between patents and GDP growth (South Korea)

Date sampled: 12 Sep 2023
Source: Investec Wealth & Investment, World Bank, WIPO

Chart 4 shows that in the US, the linkage between patent growth and GDP growth one year later is also weak. 

Chart 4: Relationship between patents and GDP growth (US)

Date sampled: 12 Sep 2023
Source: Investec Wealth & Investment, World Bank, WIPO

Charts 5, 6 and 7 below show the relationship between patent grants and GDP growth, but in this instance, we have investigated what growth in patents over a preceding 10-year period means for GDP growth for the following five-year period. The results are robust for the sample of Australia, South Korea and the US. We have included Australia because it is a large commodity exporter, unlike South Korea.

Chart 5: South Korea number of patents (10 years before) and average GDP growth (five years later)

Date sampled: 6 Sep 2023
Source: Investec Wealth & Investment, World Bank, WIPO

Chart 6: US number of patents (10 years before) and average GDP growth (five years later)

Date sampled: 6 Sep 2023
Source: Investec Wealth & Investment, World Bank, WIPO

Chart 7: Australia number of patents (10 years before) and GDP growth (five years later)

Date sampled: 6 Sep 2023
Source: Investec Wealth & Investment, World Bank, WIPO

Is there a knowledge creation opportunity for South Africa?

Considering the nature of the discussion above, we can ask the question: Are there opportunities for South Africa to exploit knowledge creation to enhance its domestic industry? As a net importer of technology, a concern is our reliance on exogenous factors (such as offshore innovation) which in turn influences the performance of our domestic industry and creates efficiencies and competitiveness. Our need to import technology contributes to our current account deficit. While we are cognisant of the fact that the data is aggregate data and not granular and that therefore we should steer away from broad-based conclusions, it should be noted that those countries that carry the economic risk of funding expenditure in R&D don’t always get the benefit of it.

One potential example … the just energy transition.  The Sustainable Development Goals are specific in the actions required by governments globally to reduce greenhouse gas emissions, which includes a pivot towards renewables including solar photovoltaic (PV) power. South Africa mines a large number of the key commodities to manufacture solar PV. However, the manufacturing process of solar PV happens offshore to a large extent and South Africa is an importer of solar equipment. The demand for solar panels has increased globally and there may have been an opportunity for South Africa to become a net exporter of solar PV (leaving aside capacity constraints such as labour, power and logistics in this analysis).

This becomes more apparent as we consider the current commodity down-cycle, which is hurting the South African fiscus. Had South Africa put itself in the position to beneficiate the commodities currently being exported for the production of solar panels, we would have benefitted from not only the continued export of these commodities but we would have received the premium attached to the value-added products. This would have been positive for job creation in South Africa. On a positive note, the country is currently investing in training individuals (as part of the skills and development programmes) in solar installation due to the increase in local demand and opportunity amid the current power crisis.

Chart 8 below does not suggest that innovation has a material impact on the performance of the South African economy one year later. There were several years with negative growth in patents but still positive GDP growth – this implies that South African GDP growth is primarily driven by “other” factors, including global demand for commodities. The underpin of the SA economy one year later is not innovation, but innovation is nonetheless important for trend GDP, which implies that for the longer-term outlook of the SA economy, innovation and education is important. We also suggest that results from South Korea, the US and Australia (in addition to the GDP trend effect of innovation on SA) supports the idea that greater innovation leads to better economic performance.

Chart 8: Relationship between patents and GDP growth (SA)

Date sampled: 12 Sep 2023
Source: Investec Wealth & Investment, World Bank, WIPO

But, as shown in chart 9, there is a strong correlation between average five-year GDP growth after 10 years of patent growth (a proxy for innovation). This implies that the level of innovative capital in the economy does influence the level of economic activity. The chart implies that South African GDP growth would be around 0.5% over the five years from 2021 to 2025 given that average patent growth for the period 2010 to 2020 was around -0.017% (essentially flat over the period implying no growth in innovation).

Chart 9: Number of patents in SA (10 years before) and GDP growth (five years later)

Date sampled: 11 Sep 2023
Source: Investec Wealth & Investment, World Bank, WIPO

Conclusion – lifting the trend line

Investment in R&D and its relative impact on researchers should have a positive impact on economic performance. This theory holds in our examples of the impact of the 10-year average of growth in patents, a proxy for innovation, on the average GDP growth for the five years thereafter. South Africa’s patent growth over the 10 years through to 2020 has been zero, which suggests that we will have below-trend GDP growth of just under 1% over the five years 2020 to 2025 compared with our peers, where the relative patent growth over the same period translates to between 2% and 3% trend GDP.

The last consideration is the impact of trend GDP growth on asset class performance. Knowledge creation, innovation and its impact on GDP is an important consideration given the implications of long-term growth prospects on bonds and, to a large extent, listed equities. Weak GDP growth is having a material impact on our relative economic and fiscal outlook, with many commentators highlighting the threat of a debt spiral given rising sovereign debt levels amid a slow growth environment. A boost in innovation would help to reduce the country’s gearing towards the commodity cycle (agriculture and mining). A good example of R&D would be to position our economy ahead of time for the Just Energy Transition (such as solar PVs). Presently SA’s economic growth potential and expectations are closely tied to the commodity cycle, which worsens the impact on the economy during a down cycle.

In closing, a good example of South Africa’s challenges lies in the excellent step by the government to implement a tax incentive to encourage private-sector companies to invest in scientific or technological R&D. This incentive was implemented under Section 11D of the Income Tax Act, 1962 (the ITA) and has evolved since its introduction in 2006. Unfortunately, the website was last updated in 2018, a negative indication of work being done in this space. 

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