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Some concern regarding the health of the housing market in the United States (US) continued to linger, and intensified in August 2007 when a number of institutions with significant exposure to the risky sub-prime mortgage market in the US ran into financial difficulty. This initiated an international repricing of risk and also reduced liquidity in the credit markets to such an extent that in several of the mature economies, central banks decided to inject liquidity into the financial markets and relax their lending conditions.


In South Africa real economic growth eased slightly from an annualised rate of 43⁄4 per cent in the first quarter to 41⁄2 per cent in the second quarter of 2007 – a rate which is probably well-aligned with the country’s current growth potential, although structural changes which may raise the potential growth rate further are in progress. In the second quarter the construction sector recorded the fastest rate of growth with agriculture, financial services and transport also expanding briskly. Growth waned in the manufacturing sector as the production of vehicles responded to lower domestic sales, along with a deceleration in several other subsectors. Consistent with the slowdown in real final demand, the trade sector also registered slightly slower growth over the period.


Following an extended period of expansion at annualised rates of more than 7 per cent, real final consumption expenditure by households rose at a more sedate pace of 51⁄2 per cent in the second quarter of 2007. Households’ purchases of durable goods contracted during the quarter under review. Final consumption expenditure by government also declined during the second quarter as no expensive military items were procured, unlike in the preceding quarter. Strike action by civil servants also weighed on real expenditure and real production of government services, and simultaneously bolstered the number of mandays lost due to strike action to
11,5 million in the first half of 2007.


During the second quarter capital expenditure rose at a slower pace than before, but nevertheless continued rising strongly, consistent with high levels of capacity utilisation in the economy. Inventories continued to accumulate, although at a slightly slower rate than in the first quarter. Early harvesting of the maize crop supported the inventory investment in the second quarter of 2007.


The deceleration in growth in domestic expenditure was reflected in a slight decline in the volume of imports during the second quarter, alongside a moderate increase in export volumes. Overall import volumes declined despite a significant increase in oil imports during this period. Given a modest improvement in South Africa’s terms of trade, the international trade deficit narrowed significantly in the second quarter of 2007. At the same time net service, income and current transfer payments to the rest of the world rose considerably, offsetting much of the improvement on the trade account. This was mainly due to increased payments of dividends to non-residents who had increased their investment in South African shares over time and were rewarded with strong dividend growth on account of rising corporate profits. The net effect of these developments was a narrowing of the deficit on the current account of the balance of payments to 6,5 per cent of gross domestic product in the second quarter of 2007 – well below the most recent peak of 7,8 per cent in the final quarter of 2006.


The deficit on the current account continued to be more than fully financed by financial inflows from abroad. In the second quarter of 2007 inward portfolio investment dominated the financial flows, as non-residents increased their holdings of both South African equity and debt securities. However, significant amounts in direct and other investment into South Africa were also recorded, partly related to private equity funding and black economic empowerment activity.


South Africa’s net gold and foreign-exchange reserves continued to rise during the second quarter as well as in July and August 2007. The exchange value of the rand displayed limited fluctuations during this period, although the re-pricing of risk on financial markets in August was initially accompanied by a fairly sharp depreciation of the rand – much of which was subsequently reversed.


Partly as a result of the earlier depreciation of the rand in 2006 and partly due to the increases in the international price of oil from January 2007, inflationary forces intensified. This was further fuelled by rising food prices at all levels, from producers in agriculture and manufacturing to the consumer level. From early 2007 twelve-month production price inflation straddled 10 per cent, while CPIX inflation breached the 6-per-cent upper limit of the inflation target band from April 2007 and amounted to 6,5 per cent in July. Furthermore, the acceleration in underlying measures of inflation during the first seven months of 2007 suggested that the price pressures were becoming more pervasive, with a significant risk of sustained second-round effects. Wage settlements also appeared to be drifting higher during the first eight months of 2007.


Assessing the outlook for inflation, the Monetary Policy Committee of the South African Reserve Bank (the Bank) deemed it necessary to raise the repurchase rate by 50 basis points in June and again in August 2007. This brought the cumulative increase in the repurchase rate from the first time policy was tightened in June 2006 to 300 basis points.


In May 2007 the Bank began to accept certain parastatal bonds in its repurchase auctions, thereby expanding the range of assets that may be used as eligible collateral in its refinancing operations.


Growth in the money supply remained at relatively high levels, reflecting continued strength of nominal domestic income and expenditure, buoyant turnover in the financial markets and positive wealth effects. Banks’ extension of loans and advances also maintained strong upward momentum in the second quarter, despite some securitisation transactions which reduced the level of advances stated on the balance sheets of the banks. Mortgage and general advances, in particular, registered strong increases, the former being mainly absorbed by the household sector and the latter by the corporate sector. At least initially, the introduction of the National Credit Act from
1 June 2007 did not appear to have much impact on the extension of loans and advances by banks. As the household debt service ratio edged higher, however, signs of moderation in the pace at which the household debt ratio increased were observed.


House prices continued to rise throughout the first eight months of 2007, although the pace of increase slowed. Bond yields rose considerably during 2007 to date, mainly reflecting a worsening of inflation expectations. Share prices in most parts of the world receded significantly in August 2007, reflecting turmoil in the financial markets in general and concerns regarding exposure to US sub-prime mortgages in particular. South African share prices also receded in sympathy with the global trend. However, some of the losses were later regained as most commodity prices remained firm, corporate profits continued to rise and central banks injected liquidity into the financial markets.


Government finances continued to be supportive of financial discipline and the pursuit of the inflation target. During the first four months of the 2007/08 fiscal year the national budget deficit broadly followed the same pattern as in the corresponding period a year earlier. The generally conservative management of the country’s finances was recognised by two international ratings agencies who changed South Africa’s foreign-currency ratings outlook from neutral to positive in mid-2007.