South Africa has been experiencing a golden economic period, with economic growth of 5% and even more at times. In the minds of analysts and investors, the vexing question is: "is this a structural shift in growth or a temporary boom which will eventually display the typical cyclical behaviour of the last twelve years?"

The proponents of the structural shift view often argue that the sound state of government finances and the rising expenditure on infrastructure (and 2010) should ensure that current growth rates are sustained for at least another four or five years.

There is no doubt that the current strong economic growth is closely linked to international developments. Surging commodity prices and an almost insatiable investor appetite for emerging markets are providing massive tailwinds for the local economy, particularly via an almost unprecedented inflow of foreign capital. With net capital inflows exceeding 8% of GDP, it is not surprising that the strong local growth is primarily demand driven and not the typical Asian export-led growth.

However, a closer analysis of the nature of these capital inflows indicates a heavy reliance on portfolio capital and a dearth of net foreign direct investment. Unfortunately portfolio capital flows are inherently volatile. Any change in international portfolio management attitude towards commodities, emerging markets and risky investments in general, can easily slow down or even halt these inflows. With the unusually large deficit on the local current account, any such a disruption of the capital inflows would put significant downward pressure on the rand and further upward pressure on interest rates. In such a scenario it would be impossible to maintain current growth rates.

Historically, domestic demand driven economic growth cycles, in medium sized open economies, have typically proved to be unsustainable. The economic history of Latin America is strewn with many such examples, while the export-led economic growth strategies of Asia have generally proved sustainable.

Currently the local economy is displaying many characteristics of an overheating domestic demand driven boom. Firstly, domestic demand is receiving a boost from credit based spending. Significant growth in household debt gathered pace from 2004 and since 2006 household savings dipped into negative territory. In fact, household debt growth has been running at more than double household disposable income growth for a number of years and this source of demand should diminish in the next year or so.

Secondly, the growth in domestic spending has been the primary cause of the deficit on the current account of the balance of payments reaching beyond 6% of GDP, despite a historic upsurge in commodity prices. Such a deficit is indicative of excessive spending and at some point markets could lose their appetite for financing the deficit. Any change in the current international trends of higher commodity prices and positive emerging market sentiment could easily lead to such a financing shortfall.

Any overheating economy will typically experience growing inflationary pressures. Recent consumer inflation data strongly point towards this. Other inflation indicators, such as PPI, GDP and fixed investment deflators, are also indicating growing and broadening inflation pressures in the local economy beyond the usual suspects - oil and food prices.

Lastly, recent sentiment surveys from the Bureau for Economic Research at Stellenbosch University highlight the growing pressure on the skilled and semi-skilled segments of the local labour market. Such skill shortages will put upward pressure on salary and wage costs and ultimately on inflation. Well contained unit labour costs have been a positive feature of the current economic upswing, but this scenario could well be drawing to a close. Recent labour strikes probably worsened the situation.

Although the local economy has undoubtedly moved to a higher growth trend, the mounting evidence of typical demand-led overheating cautions against predicting a continuation of current growth rates for the next four to five years. Some cyclical slowdown to below 4% (and perhaps 3%) is likely in the next two to three years.

ISSUED BY:

CITADEL

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Daleen Cornelissen
Media Liaison
Tel: (012) 470 2500 or 083 302 0827
daleenv@citadel.co.za

OR

Dave Mohr
Chief Investment Strategist
Tel: (021) 940 7200 / 082 922 3420
E-mail: davem@citadel.co.za