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The current account vs. the capital account - where should the emphasis be
Date: 10 Nov 2008
Jac Laubscher, Group Economist: Sanlam Limited
The current account of South Africa's balance of payments has constantly been in the news recently. It has been argued ad nauseam that the current account deficit makes the country overdependent on a sustained inflow of foreign capital.
This is not inappropriate – the weaker outlook for the global economy in response to the international financial crisis has already resulted in a large-scale withdrawal of capital from emerging markets, which South Africa has not escaped. Portfolio investments of around R50 billion has already been withdrawn since the crisis started in August last year. No wonder the rand has depreciated by approximately 30% against the American dollar during this period.
The question is what, if anything, needs to be done about it. Some analysts are of the opinion that interest rates should be increased further in order to dampen domestic demand and imports. Others believe the flexibility of the rand exchange rate will ensure an automatic correction, especially by improving the balance of trade. Imported goods are now more expensive and exports more competitive.
However, things are not that simple – the trade account is not equal to the current account. In fact, it represents only about a quarter of the current account deficit, which makes it difficult to reduce the latter simply by reducing imports.
Imports of consumer goods, especially durables, have already declined and private sector imports of capital goods are expected to continue declining as companies curtail their investment plans. However, infrastructure spend will put further upward pressure on imports owing to a relatively high imported content – Eskom, for example, has indicated that machinery and equipment imports and foreign contractors will account for about 70% of its capital expenditure.
It also seems as if oil and fuel imports have moved to a permanently higher level, inter alia as a result of Eskom's need for diesel to drive its gas-turbine generators.
Reducing imports to the extent that it will constrain the current account deficit sufficiently will thus require drastically higher interest rates. Every percentage point improvement in the trade balance improves the current account balance by only a quarter percentage point.
The second component of the current account is net service payments and revenue, including tourism, transport and insurance, which account for around 20% of the current account deficit. The weaker rand is expected to make a difference in this regard – more foreigners should visit South Africa, and fewer South Africans should travel overseas. The expected contraction in international trade should also reduce payments for transport and insurance.
The third (and largest) component is net income payments and receipts, which comprise mainly dividends and interest. These represent not less than 40% of the current account deficit. The unbalanced way in which exchange control was relaxed previously contributed to the negative balance on the revenue account by making it easier for foreigners to acquire South African assets than for South Africans to acquire foreign assets. From 2000 to 2006, South Africa's net foreign liabilities rose from R51 billion to R287 billion.
It follows as a matter of course that dividend and interest payments to foreigners will increase more quickly than the corresponding receipts by South African investors. However, the selling of South African portfolio investments by foreigners will reduce this outflow (by an estimated R1,5 billion), while lower profits will also result in reduced dividend payments.
The fourth component is the transfer payments to member countries of the Southern African Customs Union, which represent around 15% of the current account deficit. I have previously contended that these payments do not create a corresponding need for foreign financing as they are rand denominated and are made mainly to countries in the rand monetary area, but the markets do not make this distinction. Should the Customs Union be terminated and the payments to neighbouring states be replaced with foreign aid, it would make an immediate difference to the perceptions of South Africa's need for foreign financing.
The conclusion, therefore, is that it will be very difficult to significantly reduce the current account deficit without plunging the economy into ruin. But perhaps this is the wrong point of departure – should the focus not rather be on ways to improve the capital account?
South Africa's foreign debt is relatively low – for example, according to the 2008 Medium-term Budget Policy Statement the foreign component of government debt amounts to only 3,7% of GDP. It would therefore be in order to rely more on foreign loans, if necessary, in this time of portfolio investment outflow. (In any case, owing to the extent of unrecorded transactions, it is difficult to fully understand the nature of capital flows to South Africa.)
The government's argument that the cost of foreign loans has increased substantially in recent times, with the risk premium on South Africa's foreign debt having increased in line with emerging markets as an asset class by about 400 basis points, is of course valid. However, risk premiums have risen from abnormally low levels, which were not sustainable in any case, and they are already declining as global liquidity improves.
It is also true that the domestic capital market will be able to finance the public sector borrowing requirement of around 3% of GDP in the next few years. However, this does not change the fact that South Africa will still need foreign exchange to pay for the imported content of the infrastructure programme.
But what about the availability of foreign loans? Are we not perhaps too pessimistic about this before we've even tested the water?
Firstly, it is not only about South Africa's access to international financing, but also about that of the enterprises with which it does business. They are surely institutions of note, and therefore the situation need not necessarily be so bad given the gradual improvement in credit extension by banks. Perhaps the governments of the relevant countries could also be approached for assistance with, for example, credit guarantees.
Secondly, the financing of infrastructure development in developing countries is an important function of the World Bank and South Africa should be able to gain access readily to these funds. In addition, there is the special financing facility being developed by the IMF for countries currently excluded from international financial markets in spite of the fact that their economic policies are basically sound.
In an attempt to lessen the stigma attached to IMF aid, the IMF itself will apparently identify the countries that qualify for this facility. Judging by the positive tone of the recent IMF Article IV report on the South African economy, South Africa is likely to be among those on the list.
In my opinion South Africa should be pragmatic under the current conditions and make use of all available sources of financing, including the World Bank and the IMF. This should be regarded purely as a bridging measure, which could be replaced in time by other typical financing as global capital markets improve.
The current curtailment of the availability of international financing will only be temporary, as in the past. In a recent report of the Institute of International Finance (IIF), the IIF pointed out that international capital flows move in 5- to 6-year cycles. We are currently in the downward phase of the cycle, but it will be followed by the next upward phase in due course.
Every upward phase focuses on a specific asset class that promises to deliver exceptional returns. According to the IIF the commodity extraction sector is the strongest candidate for attracting capital in the next upward phase, inter alia because the global theme of a commodity shortage still holds despite the global financial crisis. Other reasons include the heightened inflation risk because of negative real interest rates in response to the global financial crisis, as well as the favourable (and probably durable) shift in perceptions of relative risk in commodity producing countries in view of the difficulties in G7 economies. Therefore the medium-term outlook for capital flows to South Africa might not be as bad as is currently believed. The IIF's view is in sharp contrast to that of the prophets of doom who believe we have seen the end of emerging markets as an asset class.
In summary: the depreciation of the rand will boost the adjustment in South Africa's foreign accounts over time. Little more can be done to reduce the deficit, except to stop the infrastructure programme in its tracks – which would definitely not be a good idea. South Africa should rather focus on exploiting alternative sources of foreign capital as a bridging measure until the tide turns again. In the meantime we should prepare ourselves so as not to miss out on the next commodity upsurge as we did in 2002 – 2007.
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