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31 August 2021 – The economy is only slowly emerging out of the crisis
After the initial outbreak of the Covid-19 crisis, stringent containment measures helped in saving thousands of lives but also seriously undermined economic activity. In 2020, the South African real GDP shrank by -7%, leading to the worst economic contraction in the country’s recent history. Importantly, South Africa’s growth outlook was already weak before the Covid-19 outbreak, with only +0.2% growth in 2019 (+1.1% on average between 2014-2019), as a result of structural weaknesses as well as poor competitiveness and productivity. Public sector inefficiencies; underinvestment and poor infrastructure, particularly in the energy sector; low-skilled human capital and persistent regulatory constraints have reduced the country’s growth potential to around +2% over the past decade. Going forward, greater demand for commodity exports from China (its main trade partner) and recovering internal demand should bring a modest boost to economic activity, even as South Africa continues to be severely affected by new waves of infections. We expect GDP growth to rebound by +2.9% in in 2021 and +2.4% in 2022.
The South African Central Bank (SARB) reduced its policy interest rate to 3.5%, a historically low level when the crisis hit. Yet inflation reached 5% in summer 2021 on the back of recovering demand, rising commodity prices and past currency depreciations. We expect the SARB to start to raise interest rates by end 2021.
Reconciling growth with fiscal consolidation is a major challenge
In South Africa, major State Owned Enterprises (SOEs), in particular the national power company Eskom, have become heavily reliant on government support over the past few years. In addition to increasing transfers to unviable SOEs (equivalent to 10% of GDP in 2019), a growing public sector wage bill (12.2% of GDP), the interest payment burden on public debt (4.1% of GDP) and poor revenue collection have fueled sizeable fiscal imbalances. Amid the Covid-19 crisis, the budget deficit hit a record high in 2020 (-12% of GDP) due to the R500bn (10% of GDP) stimulus package and SOEs’ continued financial losses. In the absence of ambitious structural reforms, we expect the budget deficit to remain at around -10% of GDP in 2021 and -8% of GDP in 2022.
Mounting public debt constitutes one of the key risks for the South African economy and investor sentiment. In the context of the Covid-19 crisis, South African government debt soared by 15 points of GDP to reach 77% of GDP in 2020 from 62% the year before. In view of structural impediments to growth and the lack of a clear reform agenda, we expect public debt to exceed 90% of GDP in the medium term. Moreover, a possible materialization of public guarantees that are estimated at 26% of GDP (SOE debt and state-guaranteed loans during the Covid-19 crisis) constitute a substantial risk for public debt sustainability. Although only 10% of South African debt is denominated in foreign currency, 40% of it is held by non-residents, exposing the sovereign to the risk of rapid sell-offs.
In South Africa, having a fully free-floating exchange rate regime acts as a shock absorber in times of crisis by compressing imports. After being in deficit since 2022, the “unusual” trade surplus of 2% of GDP in 2020 was the result of a dramatic import contraction. In 2021 and 2022, we expect the trade balance to return to a deficit (around -2%) with the impact of recovering imports.
As the SARB does not intervene aggressively to defend the exchange rate of the ZAR, foreign reserves have remained stable in 2021 at around 5-6 months of import coverage. After a sharp depreciation (around -20% between Jan-August 2020), driven by large capital outflows (up to 3% of GDP), the exchange rate of the has rand recovered progressively to its pre-Covid levels.
Increasing social risk is a threat to economic activity
The World Bank 2020 Doing Business survey ranks South Africa 84 out of 190 economies (it was 74th five years ago). South Africa still retains a good ranking in the protection of minority investors (rank 13th) and paying taxes (54th). However, recurrent power blackouts, difficulties to start a business (139th) and strong barriers to trade (145rd) are key bottlenecks. Barriers to domestic transactions and to register a property (106th) are among other key impediments to business activity. Overall, rigid product and labour markets reduce the country’s competitiveness.
Strong impediments to cross-border trade and deeper trade integration with the Southern African area continue to hinder the country’s export potential. However, South Africa is set to become a key beneficiary of the African Free Trade Agreement (AfCFTA), thanks to its established manufacturing bases and existing economic ties within Africa.
South Africa is one of the most unequal countries in the world in terms of income distribution (Gini coefficient =0.7). GDP per capita has been on a declining trend since 2014 as the growing weaknesses of the public sector have been curtailing economic activity. The Covid-19 outbreak deteriorated the economic situation further, with the unemployment rate rising above 32% and income per capita dropping dramatically. We identify South Africa as one of the hot spots regarding social risk, with possible detrimental consequences for economic activity. In July 2021, for instance, a week-long violent riot, which began after the arrest of former president Jacob Zuma, caused significant material damage and property destruction (0.8% of GDP).
Strengths
- Rich natural resource base (gold, platinum, chrome, manganese, vanadium, coal and diamonds).
- Key strategic economic and political player in the region
- Judicial and business environments aligned with advanced standards
- Exchange rate flexibility helps to cushion external shocks and the central bank has an established track record of proactive and credible policy stance
- Deep financial markets and a sound banking sector (overall ample liquidity, good asset quality, satisfactory capitalisation)
Weaknesses
- Dramatic deterioration of public debt ratios because of the activation of state guarantees to SOEs
- Large budget deficit because of growing wage bill, public debt interest payments and transfers to loss-making SOEs
- Structural issues weigh on potential growth (low productivity, public sector inefficiencies, skilled human capital shortages, weak competitiveness) while product and labor markets remain highly rigid
- High dependence on volatile portfolio investment flows to finance the current account deficit
- Underinvestment and aging infrastructure (energy and transport) limit the development of a diversified industrial base
- High poverty, income inequality and unemployment (above 30%) are sources of social tensions Source: Euler Hermes