ECONOMIC HEALTH CHECK
Distress in Europe Slows South Africa's Economic Recovery
By Calvin McDonald and Jorge Iván Canales-Kriljenko
IMF African Department
September 6, 2012
- Distress in Europe has delayed South Africa's economic recovery
- Strong macro policies, supervision have supported stability amid low financial risks
- Labor, product market reforms could cut unemployment, boost competitiveness
South Africa’s economic and financial policy frameworks have reliably delivered domestic and external stability, but the country needs to build on its many policy successes.
In its regular annual assessment of the South African economy, covering the year to July 2012, the IMF said South Africa faces the immediate challenge of conducting policy under a highly uncertain global environment and of making firm progress on reforms that promote the long-run inclusive growth needed for maintaining social cohesion.
In its review that concluded August 1, the IMF urged further action to expand employment opportunities, secure better education and health outcomes, and build more efficient infrastructure, while maintaining macroeconomic and financial stability in a risky global environment.
Since the IMF’s previous annual economic assessment, renewed distress in Europe—South Africa’s main trading-partner region—has delayed South Africa’s recovery. Economic output will take longer than envisaged earlier to reach potential: reflecting the global slowdown, growth is likely to fall below 3 percent in 2012, and gradually recover ground to close the negative output gap, now two years later than envisaged.
External sources of risk include slower demand for South African exports and a further decline in commodity prices. Renewed concerns about the euro area and signs of a slowdown in China have recently tilted risks to the downside.
Increased risks, from a low base
Although vulnerabilities remain low, risks have increased. External debt remains moderate and about half of it is rand denominated. International reserves are currently adequate, but the expected increase in foreign liabilities warrants increasing reserve coverage over the medium term.
Banks’ capital and liquidity cushions have stabilized at comfortable levels, and credit growth and bank profitability have started to pick up from a low base. The main risks remain banks’ dependence on domestic short-term wholesale funding and their heavy exposure to home mortgages. Broad regulatory reforms to further enhance financial sector resiliency are under way.
Fiscal and monetary policies stance have appropriately reacted to the slowdown. They have provided further stimulus in the face of weak external demand and a negative output gap. But after four years of monetary and fiscal stimulus, the policy space to deal with adverse shocks has significantly diminished.
In a severe adverse scenario that could lead to a substantial deceleration in economic activity, authorities agreed with IMF staff that monetary policy should provide most of the stimulus given the more limited fiscal space.
Rebalancing fiscal spending
Although the fiscal stance is broadly appropriate, rebalancing the composition of public spending remains a priority. As recognized in the 2012 Budget Review, the composition of spending needs to shift away from the wage bill and toward capital spending to help promote long-term growth.
The IMF assessment welcomes the authorities’ renewed drive for building public infrastructure. Because of bottlenecks in electricity generation, transport, and port infrastructure, South Africa has not benefited as much as other resource intensive emerging market economies from its large terms of trade gains of the last decade. This in turn has discouraged investment in South Africa’s natural resource industry, and some key exports have seen substantial volume declines despite high commodity prices.
The IMF staff team has argued for rebuilding fiscal buffers in the medium term. The credibility of this commitment would improve with the forthcoming publication of a report on South Africa’s long-term fiscal dynamics. This report would highlight the medium-term tradeoffs involved in fiscal spending associated with government priorities, including the envisaged National Health Insurance scheme and social security and retirement reforms.
The health insurance reform rightly aims to improve access to public health services, while improving its quality and coverage. Visiting IMF staff endorsed the authorities’ gradual and cautious implementation, and stressed that attention should be given to design issues, which determine incentives and ultimately the cost of the programs. Although financing options are still under debate, the chosen financing package should keep the fiscal consolidation plan intact and preserve fiscal sustainability.
IMF staff and national authorities agree that labor and product market reforms are key to reduce high structural unemployment, improve external competitiveness, and foster inclusive growth. If not addressed, the stubbornly high unemployment rate, especially of the young, is likely to become politically and socially unsustainable.
A durable pickup in job creation that reduces mass unemployment seems unattainable without major labor and product market reforms.The structure of product and labor markets has contributed to preserving inequality and high unemployment. They have ended up protecting insiders at the expense of the unemployed. IMF staff welcomed the national debate on the steps needed to achieve more inclusive growth in the context of the National Development Plan.
High margins in product markets and wages in labor markets have resulted in uncompetitive domestic costs of production, eroding external competitiveness, and excluding part of the population from formal economic activity. This has constrained South Africa’s ability to diversify its exports into areas that go beyond its comparative advantage of exploiting its mineral endowment.
The relatively high wages and profits for insiders have resulted in higher consumer price levels and unemployment for outsiders. In addition, labor market arrangements have set entry-level wages above the productivity of inexperienced workers with little marketable skills, including through relatively high minimum wages. The struggle for dividing rents between highly concentrated, oligopolistic firms and strong and politically influential labor unions has resulted in large economic losses associated with frequent labor strikes.
IMF staff and the authorities agreed that a four-pronged approach is needed to improve external competitiveness and reduce structural unemployment.
• Labor and product markets reforms to increase their flexibility, contestability, and access, which would contribute to reduce domestic costs of production and better aligning wages with productivity levels at the firm level
• Improved service delivery in health and education to improve human capital, marketable skills, and entrepreneurship of the currently unemployed
• Short-term active labor interventions to create first-time employment opportunities for the young; and
• Better infrastructure in network industries that remove bottlenecks and support higher growth rates.