Public Information Notice No. 11/115

Public Information Notice: IMF Executive Board Concludes 2011 Article IV Consultation with South Africa

August 25, 2011

On July 25, 2011, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with South Africa.¹

Background

Over the last two decades, South Africa has become increasingly integrated into the global economy, which has allowed output growth to converge to the world average level. But this integration has also exposed South Africa to global business cycles. Prudent countercyclical monetary and fiscal policies, together with a flexible exchange rate, have helped dampen the adverse effects of those global cycles; and sound financial supervision has guided financial institutions in managing the associated risks. And although transfer programs have lifted the most vulnerable from extreme poverty, progress in social indicators has lagged behind macroeconomic achievements.

Over the last year, South Africa’s has continued to recover from the 2008–09 recession led by solid consumption growth. Although its gross domestic product (GDP) now exceeds the pre-crisis peak, output remains below potential. Inflation has remained contained, partly reflecting the negative output gap, rand appreciation, and, until recently, moderate domestic food prices. The current account has strengthened on account of favorable terms of trade, which offset a faster recovery in import than in export volumes.

Fiscal and monetary policies have remained supportive. In cyclically adjusted terms, the deficit swung from a surplus in fiscal year 2007/08 (April-March) to a deficit in 2009/10, and staff estimates the deficit at some 4 percent in 2010/11. Spending growth moderated in 2010, and became more tilted toward current spending, mainly reflecting above-budgeted increases in wages. Monetary policy provided additional stimulus, with a 150-basis-point cut in the policy rate in 2010. These cuts have brought the policy rate to 5.5 percent, its lowest level in more than 30 years.

With public debt at manageable levels and contained demand pressure, the authorities’ fiscal plans call for fairly gradual fiscal consolidation. This would result in gross national government debt peaking at around 43 percent of GDP in 2013/14. Although this path would not pose immediate risks to fiscal sustainability, it could constrain fiscal space to deal with future shocks. On monetary policy, although further interest rate cuts are no longer on the horizon and headline inflation has been picking up, the timing for starting the tightening cycle remains unclear because most of the increase in headline inflation reflects cost-push factors and uncertainty in the external environment is high.

Having come through the recession in reasonable shape, the financial sector is now contending with a period of low credit demand and rising costs. Banks have remained well capitalized and liquid, with well contained market risks. The move toward a “twin peaks” regulatory and supervisory framework over the next few years, which strives to concentrate prudential authority at one peak and market conduct authority at another, bodes well for further improving the consolidated supervision of financial groups.

The medium-term outlook envisages South Africa growing on par with the world economy. Growth should rise to 4 percent a year in 2011 and 2012, underpinned by solid domestic demand. Over the next 12 months, the output gap is set to close and there is a possibility that headline inflation will breach the top of the target range. The expected recovery in investment will likely cause the current account deficit to gradually further widen to about 5–6 percent over the medium term.

Executive Board Assessment

Executive Directors commended the authorities for the prudent macroeconomic policies which, together with a flexible exchange rate and sound financial sector, have mitigated the output drop during the global recession. Directors noted that the key challenges ahead are to support the ongoing recovery and raise growth to reduce high unemployment and inequality. In this regard, Directors welcomed the authorities’ New Growth Path which focuses on these priorities.

Directors supported a broadly neutral fiscal stance for 2011/12 and welcomed the prudent fiscal policy guidelines included in the 2011 budget. They agreed that, over the medium term, a tighter fiscal stance than currently contemplated would be useful to rebuild policy buffers and contain public debt at moderate levels. Directors encouraged the authorities to rebalance the composition of public spending to help support higher potential growth, and called for moderation in public wage growth.

Directors endorsed South Africa’s inflation targeting framework, noting that it has kept inflation expectations well anchored. While recognizing the difficulties in determining the precise timing for starting the tightening cycle in light of the uncertain global environment, Directors encouraged the authorities to remain vigilant about the pass through of high international food and fuel prices. In this context, they noted that a pronounced increase in wages or inflation expectations would call for policy tightening sooner than currently envisaged.

As a policy response to capital inflows, Directors supported continued exchange rate flexibility and further accumulation of international reserves, and a gradual recalibration in the fiscal-monetary policy mix over the medium term. Directors noted that, while capital flow management measures are an option, their costs and effectiveness should be carefully considered.

Directors stressed that increased product and labor market flexibility is critical to improve competitiveness and inequality. They encouraged the authorities to take decisive steps to improve the wage-bargaining framework to better align wages to productivity levels, and to contain public sector wage increases to avoid distortions in the private sector wage setting. They also supported more ambitious efforts to remove barriers to entry in key industries to facilitate greater product market competition.

Directors noted that the banking system remains sound, with banks being liquid and well capitalized. Nevertheless, continued vigilance would be important in light of the moderate impaired advances on bank balance sheets, the banks’ dependence on domestic short-term wholesale deposits, high household indebtedness, and the renewed tensions in the international financial markets. Directors agreed that the shift toward a “twin peaks” regulatory and supervisory framework envisaged over the next few years would further improve the consolidated supervision of financial groups and lift the status of market conduct regulation and supervision.