South Africa's economic time bomb

Ok. So it has been a while since I last posted anything. I needed a break. But I am back and I have been fuming over recent South African events. One cannot help but be affected by the political turmoil at home. A lot of people complain about South Africa's economic woes, but few offer simple viable solutions. This post summarises some policy proposals.

South Africa's policy prescriptions - what should they be? South Africa followed a standard textbook example in responding to the financial crisis in 2008/09. Its demand side policies consisted of: (1) Decreasing the primary balance and run consecutive deficits; (2) Decreasing monetary policy interest rates to historic lows and keeping them there (except for one weird 25 basis points hike that seemed to match what our emerging partners were doing); (3) Allowing the exchange rate to depreciate substantially in the hope of generating foreign demand for locally produced goods.

Apart from following the standard textbook model South Africa also had to cope with new banking regulations put forth by Basel. The government continues to delay much needed electricity supply (bad management is to blame, although it looks a bit ridiculous that the Treasury keeps missing the implementation date of the new power stations). It had to deal with sovereign debt downgrades (explains one part of the weak exchange rate story) up to the point where we are one notch away from being non-investment grade (S&P) and two notches away according to Moody's (admittedly I think the rating agencies have made a mistake on this one - South Africa was not close to any default - but bad ratings increases the likelihood of default - this to me implies that the rating agencies are trying to create a self-fulfilling prophecy). It seems like the Treasury has caved a bit under pressure by increasing tax rates at a time when the economy is hardly growing - in my view a mistake by the Treasury. Inflation at its upper limit of the target range also increased the pressure to raise wages (at a time when government is trying to reduce the deficit). Let's leave aside all the political turmoil for a moment and analyse what, if any, additional measures the government can take to speed up the economy.

Suspend ridiculous wage demands temporarily. One thing is certain; the wage hikes do not match productivity growth - the economy is forecast to grow 2% in real terms while wage demands exceed inflation by anything above 3% (inflation seems to fluctuate around 6%). Perhaps it is government's strategy to reduce income inequality by increasing wages rather than growing the economy, decreasing unemployment, keep inflation stable etc. The consequences of higher wages when economic activity is suppressed = higher unemployment. The demand for labour in standard textbook economics depends on maximizing productivity subject to inputs (wages and labour, capital and rent). Higher wages reduce company profits and reduce expansions. Now take a low growth environment and add business pressure by increasing wage demands...unemployment bam! We are already witnessing lower growth in government employment amidst an increase in the working age population.

South Africa has a low savings rate and consumers are current consumers (i.e. the spend most of what they earn rather than save). When wages are indexed to inflation and consumers do not save we have a situation where inflation increases - which will lead to higher wage demands, which will lead to higher inflation etc. (you get dizzy swirl). We need to note two additional features of the South African economy - despite the very weak exchange rate (historically) the current account deficit has not subsided. Those sneaky economists who wish to invoke the J-curve as an explanation has ran out of time - we have had a persistent depreciation for a long time. Exports have increased - but imports have increased too. Thus add the high wage growth to the weak rand and you would expect higher inflation. Note that inflation is rather high given that potential and actual GDP growth is already low.

      Lower the inflation target. If wage spirals become a serious concern then the SARB should lower the inflation target. There are many reasons for doing this (admittedly many reasons to keep it this high too). A high inflation target is often associated with more volatile inflation (in contrast to keeping inflation stable -wink wink SARB). Yes I know that inflation has been lower and more stable since SA adopted inflation targeting. I am saying that it can be lower and even more stable by simply lowering the target (see http://www.voxeu.org/article/how-are-inflation-targets-set). Anchored inflation expectations at a lower rate also mean that interest rates should be lower. The costs of higher inflation seem to outstrip the benefits substantially (these include the costs of adjusting prices, investment uncertainty, higher debt service costs, discourages savings, higher taxes due to bracket creep etc.). In addition, an inflation rate of 6% implies that R1 will be worth less than 50 cents in twelve years from now (i.e. value of assets are halved every twelve years if there is no interest compensation).

      Make banking more competitive. Banking costs in South Africa constitute a crime in my books. The fact that almost all the banks charge similar interest rates on loans and provide ridiculously low savings rates is a modern day travesty. Millions of household face unreasonably high interest payments on their loans because (1) credit access rules are not stringent enough and (2) because interest rates are super high. The banks don't seem to care that much since households meet their liability obligations even if it leads to debt traps. Now take whatever savings you have and deposit it into a bank account...oh crap after a few years you will have less in real terms since you started depositing funds because inflation is higher than deposit rates...is it then strange that South Africa has such a low household saving rate?

Education - need I say more? Sustainable and high long term growth depends on good education. No, not access to education (South Africa has done a decent job), but quality of education. The economics department of the University of Stellenbosch has done a lot of good research on this topic. Unfortunately there seems to be a widening gap between the academic view and the government. Our children do not compete well against our African neighbours in standardised tests. We don't have enough teachers and we don't have good teachers. South Africa already struggles to absorb labour. A lot of South Africans are simply unemployable (we don't have jobs that match the supply of unskilled labour). We will have to contend with generations of unskilled labour the more we procrastinate on fixing the education system. This too is a crime against children who deserve to have a decent education. I am sorry to say, but the ANC is still messing up and is hardly taken to task.

Implement a rules based fiscal policy. South Africa's budget system is one of the world's most transparent systems. However, as with any forecast it had to adjust its fiscal figures on many occasions. If the government says that debt will be x% next year and debt comes out as x%+5% then it might lead to credibility issues. Uncertainty, whether caused by government or not, does not sit well with institutional investors and rating agencies. To address these uncertain terms government has to offer handsome returns for holding bonds. Debt service costs have become one of the biggest expenditure items which avert resources away from investment spending. To make government more credible it could be more specific about its expenditures and implement a rule that is not too stringent when forecast errors occur (something that is inevitable). Each province and municipality should be held accountable for its expenditures and revenue collection. We see that municipalities do an excellent job at remunerating its workers, but do not spend on service delivery or investment (once again making the argument that wage growth should be tied to productivity as opposed to inflation). This is an increasing trend which begs the question of whether government should become more centralised. What is the use of having a decentralised government if it cannot meet its objectives? The taxpayer foots the salary bill of high paying officials that simply renege on their obligations and responsibilities. Pooh pooh!

Increase the VAT rate dammit. What tax is least distortionary? What tax exempts certain goods from being taxed? What tax has a low rate? What tax base as a percent of GDP is seriously high? What tax could possible nudge people to save more if its rate increased? What tax could cover a lot of silly expenses such as e-tolls without having to burden specific users when the whole country benefits in economic terms from improved traffic flow? What tax could decrease the fiscal pressure to consolidate? Hmmm...oh can it be Value Added Taxes? You bet! But why does the government increase capital gains when it hardly makes a dent in the deficit? And what is up with small increase in income taxes - it sounds like it is more of a signaling thing and not meant to change behaviour. VAT has a single rate that all people face. Certain goods, such as food for sustenance, are VAT exempt or zero rated (there is a difference between the two), which means that the poor are not that adversely affected. Internationally, South Africa has relatively low VAT rate, although it is one of the government's main sources of revenue. This is only because the VAT tax base, consumption, is very high. Increasing VAT is not a panacea for South Africa's current economic woes, but it will lessen the pain somewhat - like morphine for a severely injured patient. I really do not understand why the government hesitates to increase VAT, but quite easily increases taxes that hurt the economy while collecting very little revenue...really!

Obviously policy decisions are more nuanced. The fact remains that other countries are able to implement small changes with huge economic benefits. The Treasury and the SARB have excellent policy makers and academia reminds the government that implementing certain policies is beneficial to all. The ANC for some logic-defying reason resists these proposed changes. Instead it seems that the ANC is intent of focusing on weird redistributive policies such as BBBEE and land ownership. They are weird because the benefits have not been quantified and the majority of the country is still poor. Imagine if the ANC instead focused on simple growth strategies. Redistribution will improve and wealth will increase. I think the ANC do this to their detriment and they will bleed votes because of a lack of policy foresight and additionally slow economic growth for decades to come. Sad really.