News in Charts: Despite a strong Q2, South Africa’s economic outlook remains bleak

Despite a strong Q2, South Africa’s economic outlook remains bleak

• South African GDP expanded at an annualised rate of 3.3% in Q2, aided by a rebound in mining. But the country’s economic outlook remains bleak.
• China’s decision to ‘double down’ on its investment-led growth model has provided South Africa some breathing space, but headwinds, including persistently high unemployment, remain.
• Political developments are an additional woe, and have been the focus of recent investor concern.
• Looking ahead, the economy’s structural weaknesses, exemplified by poor labour market dynamics, are likely to impair its growth performance.

Data revealed that South Africa’s (SA’s) GDP grew at an annualised rate of 3.3% in the second quarter. Aided by a rebound in the volatile mining and quarrying sector, after a sharp contraction in the previous quarter, the figures do little to alter our view that SA’s economic outlook remains relatively bleak. Political developments pose an additional woe, with mounting uncertainty in recent weeks weighing on investor sentiment. The rand had been among the worst performing emerging market currencies, declining by 6% against the US dollar in August, before rebounding in response to the better-than-expected GDP data.

Political risk has increased

Investors’ concerns about SA’s economic prospects increased following the announcement that the country’s technocrat Minister of Finance (MoF), Pravin Gordhan, faced allegations of impropriety from his time at the helm of the country’s tax agency. Mr Gordhan was a reluctant appointment following ‘Nenegate’, when the MoF was changed three times in four days. The market-friendly MoF, Nhlanhla Nene, was controversially dismissed, only to be replaced by little-known backbencher David van Rooyen. The resulting market turbulence forced President Jacob Zuma to quickly change course and appoint Mr Gordhan, who has since announced bold measures to tackle rising debt levels at state-owned enterprises. Market participants have taken the recent allegations as a sign that President Zuma is attempting a politically motivated takeover of the finance ministry.

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Even before recent events, the country’s credit rating was at risk of being downgraded to below investment grade by the major ratings agencies. Such an outcome appears increasingly likely. Moody’s, for example, has previously highlighted the country’s institutional framework as a particular source of strength, but that view will now be harder to justify.

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A credit downgrade would risk wide economic repercussions. Foreign investors are important participants in the government’s bond market, and hold 20% of outstanding debt. In the event of a downgrade, the risk premium attached to South African government bonds would likely increase, driving up borrowing costs. Domestic banks would likely face higher funding costs as well, and given their large presence in the economy, with assets amounting to 115% of GDP, this risks further negative effects on economic activity.

Politics aside, the outlook was already bleak

SA’s recent political saga, and the risk of a possible credit downgrade, add to its list of economic headwinds. These include a heavy reliance on commodities, as well as persistently high unemployment rates. No matter Mr Gordhan’s fate, the country’s economic outlook appears sluggish at best.

South African GDP growth is likely to ease in 2016, to just above 0%, marking the fourth consecutive annual deceleration. The country sends a higher proportion of its exports there than either Europe or the US. And the second quarter’s strong mining and quarrying data suggest that China’s efforts to ‘double down’ on its investment-led growth model are providing a fillip to growth. Nonetheless, given a sluggish global backdrop, commodities prices are unlikely to return to their previous highs anytime soon, and the South African economy will have to adjust accordingly.

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Structural weaknesses are long-standing

The importance of commodities notwithstanding, SA’s economic performance cannot be explained by external factors alone. The country’s inefficient government bureaucracy and shoddy infrastructure, including poor electricity generation, have long drawn ire from businesses. And its labour market is a particular source of concern.

High joblessness is a chronic problem. The unemployment rate was 26.6% in the quarter to June, and has not been below 20% in the past two decades. Against conventional economic wisdom, that has not prevented real labour costs from rising. The country’s high levels of income inequality likely play a role. No matter its cause, the result is that jobs growth has been modest at best. And many of the country’s citizens are effectively locked out of the labour force.

SA’s poor labour market dynamics are exemplified by the relationship between economic growth and unemployment. As the chart below shows, its unemployment rate tends to increase by more than in other emerging market economies during economic downturns, but also decreases by less than elsewhere during upturns. Reducing joblessness is a constant uphill struggle.

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Since 2001, employment has increased by an average of 188,000 per year during upturns, which is relatively weak given an average 588,000 increase in the working age population. In other words, even during periods of positive growth, the economy does not create enough jobs to materially reduce the unemployment rate. During downturns, employment declines by an average of 165,000. Without cyclical increases in inactivity, SA’s unemployment rate would rise well beyond its current level.

This asymmetric employment response to growth points to high unit labour costs. Indeed, these increased by 25% from 2010 to 2014, which was much higher than in Korea (7%) or Israel (8%). As our chart shows, real wage growth has consistently outpaced that of labour productivity. Those in employment benefit, but at the expense of those who are out of work. Absent urgent reform or a period of historically strong economic growth, of which there appears little sign, SA’s unemployment rate is likely to remain worryingly high.

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In summary, economic outlook remains bleak

SA’s economic prospects have been thrust into the limelight by mounting political uncertainty, but the country already faced a number of headwinds. Its structural weaknesses, exemplified by poor labour market dynamics, are long-standing. It is these that render its economic outlook so bleak. While China’s determination to boost economic growth by ‘doubling down’ on credit-fuelled investment will provide SA with some breathing space, it does little to address the nation’s home-grown problems. SA’s economy must adapt. To date, there is little sign of that.