The local economy is currently displaying many contradicting trends. For example real retail sales are booming at about 10%, but manufacturing volumes are shrinking. In 2003 domestic spending grew 4.5%, but GDP growth surprised on the downside at 1% (these growth rates are from the last quarter of 2002 to the last quarter of 2003).

Domestic house prices are surging at roughly 20%, but inflation was zero to negative, depending whether it is measured at consumer or producer level.

The last year also saw the biggest boom in commodity prices, but a surplus of 0.7% of GDP on the current account of the balance of payments plunged to a deficit of almost 2% of GDP in the four the quarter of 2003.

Lastly, recent unemployment statistics showed the domestic unemployment rate remains in the stratosphere, but since the start of 1999 the local wage bill has risen more than 60% in US dollar terms.

These diverging trends vividly illustrate that some relative prices in the South African economy are out of line. We believe the key distortion is the international value of our currency. Against the US dollar the real value of the rand (adjusted for inflation differences) is back to 1997 levels. Effectively we have wiped all the potential competitive advantage of the painful depreciation of the rand since 2000.

Economic history is strewn with examples of major economic crises caused by overvalued currencies. The conflicting trends highlighted earlier indicate the danger of South Africa becoming another example of this story.

Currently the surge in commodity prices is supporting the rand. However, the problem rearing its head is "Dutch disease" - a commodity windfall destroys the non-commodity or manufacturing sector of the economy. Current statistics suggest this danger is real.

Interest rate tends since mid-December 2003 point to a potential rate rise later in this year. The driving force behind these interest rate expectations is twofold. Firstly the booming spending trends are raising inflation fears. Secondly, recent trends in food and oil prices are also fuelling fears of inflation and rate hikes.

However, the risk is that such a hike in rates, or merely the expectation thereof, will continue to fuel the rand to new highs and exacerbate the current distortions in the economy.

Furthermore a deeper analysis of the PPI and CPI statistics shows that the goods producing and employment creating sectors of the economy are firmly in deflation and any further appreciation will worsen their position.

Internationally most central banks are recognising real dangers of deflation, failure to do so locally could cause long-term damage to the economy. Against this backdrop we believe a hike in interest rates could be premature.

ISSUED BY: CITADEL

For further information please contact:

Dave Mohr
Chief Investment Officer
Tel: (021) 940 7200
davem@citadel.co.za

OR

Jan van Niekerk
Investment Strategist
Tel: (021) 940 7200 / 083 285 6596
janvn@citadel.co.za