From around May 2006 global investors became significantly more wary of the relatively low risk premia attached to investment in emerging markets, demanding higher returns in those markets or preferring to channel funds to the more mature markets where interest rates had risen to more attractive levels. This triggered a decline in share and bond prices and a depreciation of currencies in a number of developing countries, with those countries running sizeable current-account deficits generally more severely affected than the others.
South Africa counted among the countries whose financial-asset prices and exchange rates declined on account of the reassessment of risk and reward in emerging-market economies, reinforced by a retraction in international commodity prices from their previous highs. From mid-May to mid-June 2006 the South African all-share price index, the prices of long-term bonds and the exchange value of the rand all declined significantly. However, over the subsequent three months share market sentiment improved again. Share prices eventually rose to new record highs by early September, buoyed by the robust economy, appealing prospects for some commodities and vigorous growth in company profits.
Despite the volatility in the financial markets from May 2006, the growth rate of the South African economy was not only sustained but accelerated significantly in the second quarter of the year. The annualised rate of growth in real gross domestic product rose to virtually 5 per cent in the second quarter, bolstered by substantially stronger growth in the secondary sector. In manufacturing, for instance, the real value added expanded at a stronger pace than before as real domestic final demand continued to surge, alongside a more competitive external value of the rand in the latter half of the second quarter. Capacity utilisation in the manufacturing sector accordingly rose to comparatively high levels. Growth in the construction sector continued apace in both the first and the second quarters of 2006. Only the agricultural sector registered a contraction in real value added during the second quarter, partly due to the significantly smaller maize crop which was also harvested comparatively late.
Domestic expenditure continued on its robust expansion path, with all the components of domestic final demand registering strong increases in the second quarter of 2006. The household sector’s real disposable income was buoyed by rising employment and wage levels, higher transfers from government to households, and some tax relief to individuals. As household disposable income continued to increase in an environment of relatively subdued interest rates, real final consumption expenditure by households rose briskly, led by purchases of durable and semi-durable consumer goods. This was accompanied by rising debt levels. Household debt relative to disposable income reached a new record high in each successive quarter from mid-2005, with debt mainly incurred in order to acquire fixed property and consumer durables. The cost of servicing the debt relative to household income started to edge higher as the amount of debt outstanding increased, with the interest rate on such debt also starting to rise somewhat in the second quarter of 2006.
Real final consumption expenditure by general government rose strongly in the second quarter of 2006, mainly reflecting the acquisition of high-value military equipment as part of the defence procurement programme. Simultaneously, real gross fixed capital formation increased briskly, lifting the ratio of gross fixed capital formation to gross domestic product to 18.1⁄2 per cent. Four years earlier this ratio stood at less than 15 per cent, but investment responded well as the expansion in economic activity continued to become the longest upswing in the business cycle history of the country. In the second quarter of 2006 solid increases in capital expenditure were recorded by all three institutional sectors, i.e. private business enterprises, public corporations and general government. Real inventory levels also rose strongly in manufacturing as well as in the wholesale, retail and motor trade sector, consistent with the general buoyancy of demand in the economy.
With domestic demand recording robust increases, imports rose strongly in the second quarter of 2006. Exports also increased significantly during this period, with both the volume and price of exported goods bolstered by the strength of the world economy. The trade deficit nevertheless widened in the second quarter. However, net service and income payments to non-residents declined, mainly on account of higher dividend and interest receipts by South African investors on their offshore investments as well as increased expenditure by foreign tourists. This was sufficient to result in a slight reduction in the deficit on the current account of the balance of payments, to 6,1 per cent of gross domestic product in the second quarter.
The deficit on the current account continued to be financed by capital inflows, which came in a variety of forms. Inward portfolio investment, which was exceptionally strong in the first quarter of 2006, moderated somewhat in the second quarter but remained high. The second-quarter inflow again mainly consisted of share purchases by non-residents. Foreign direct investment activity continued, with a non-resident investor acquiring shares in a domestic tyre manufacturing company and South African news distribution and petro-chemical companies stepping up their holdings of foreign direct investment assets. Non-residents also increased their deposits with South African banks during the second quarter of 2006.
The overall balance of payments recorded a smaller surplus in the second quarter of 2006 than in the first as the South African Reserve Bank (the Bank) moderated its net purchases of foreign currency in the market. In July and August the Bank, sensitive to market conditions, continued to exercise caution in acquiring foreign exchange from the market. The gross gold and foreign exchange reserves, which rose from US$23,0 billion at the end of March 2006 to US$24,0 billion at the end of June, accordingly inched higher to US$24,4 billion at the end of August.
From mid-May 2006 the exchange value of the rand depreciated significantly alongside the currencies of several other emerging-market economies. The depreciation was largely sustained over the ensuing months, with the nominal effective exchange rate of the rand at the end of August some 15 per cent lower than at the beginning of May. This, together with high oil prices in the international markets, rising food prices and strong domestic demand conditions contributed to an acceleration in inflation. Production price inflation, in particular, accelerated strongly from the second quarter of 2006. CPIX inflation also picked up significantly but remained well within the target area of 3 to 6 per cent, its sensitivity to movements in the prices of goods at the production level moderated by the more subdued behaviour of services prices. Wage settlements edged slightly higher in the first half of 2006 compared with those in 2005.
The deterioration in the short-term outlook for inflation was acknowledged by the Monetary Policy Committee of the Bank. After a period of 14 months of an unchanged monetary policy stance during which nominal short-term interest rates were maintained at their lowest levels since 1980, policy was tightened in order to ensure conformity of inflation with the target range over the medium term. The repurchase rate was raised from 7 per cent to 7.1⁄2 per cent in early June 2006 and to 8 per cent in early August. Other money-market interest rates moved higher, both in anticipation of and in reaction to increases in the repurchase rate.
The relatively low interest rate levels, buoyant income and expenditure, lively conditions in the financial markets and generally rising trend in asset prices created conditions conducive to sustained brisk increases in money supply and in banks’ credit extension. Growth in the money supply was exceptionally strong during the second quarter of 2006, dragging the income velocity of circulation of M3 to another record low. At the same time, banks’ loans and advances recorded vigorous increases, with mortgage advances in particular displaying strong momentum. This supported activity and prices in the real-estate market, which in turn reinforced the demand for and supply of mortgage finance. While the pace of increase in average house prices decelerated, these prices continued to rise at double-digit year-on-year rates. In the luxury market, however, strong buyer resistance developed, resulting in muted price increases.
Government finances continued to be supportive of a disciplined monetary policy environment. The robust increases in the tax revenue of the national government which had been recorded in fiscal 2005/06 were broadly maintained in the first four months of fiscal 2006/07, consistent with the buoyant performance of the economy. With government expenditure rising more strongly than revenue during the period April to July 2006, the deficit widened somewhat in comparison with the same period of the previous fiscal year, but nevertheless remained well contained. The deficit was readily financed, mainly by issuing bonds and Treasury bills in the domestic financial market but also to a limited extent through recourse to the international capital market.