South Africa’s Inflation Exceptionalism: Can It Last?
South Africa is often seen as a high beta game, when it comes to financial market risk aversion, political uncertainty and corruption. Yet we have shown considerable exceptionalism over the past year, rarely appearing on the global political risk radar or suffering from capital flight. South Africa, however, stood out on the inflation front.
Together with China, Indonesia and Vietnam, we are one of the few countries where inflation is in line with the official target.
Despite near-record oil and wheat prices, South Africa’s inflation rate has not (yet) exceeded the 6% cap. While this is largely due to the suspension of the fuel tax, which was recently extended, it is still exceptional in the context of high global inflation.
Furthermore, South Africa’s inflation rate is lower than that of the United States, the euro zone and the United Kingdom, where inflation rates are above 8%.
Even in more developed emerging markets, such as the Czechia, Poland and Hungary, consumers are faced with double-digit price increases. And think of Turkey, where prices have risen by 70% in the last year.
Rising prices of raw materials
Consumer Price Index (CPI,% y / y)
What is the reason for this exceptionalism?
The weighting of spending in South Africa’s consumer price index (CPI) basket is similar to that of developed markets, with a relatively low share allocated to fuel and food and a relatively high share allocated to services. This reduces direct sensitivity to global oil and food price dynamics, at least as measured by the CPI.
Structurally lower economic growth since 2015 has reduced the pricing power of firms as weak employment and wage growth have led to more price-sensitive consumers.
Importantly, limited credit growth, due to stricter banking sector regulations in the wake of the 2008/09 global financial crisis and the collapse of African Bank Investment Ltd (ABIL) in 2014, further dampened demand and hence the inflationary pressure. Similarly, attempts at fiscal consolidation through spending cuts and tax increases have exerted further pressure on consumer demand.
While much of the disinflation from 2016 to 2020 reflected weak demand, we should give credit to the South African Reserve Bank (Sarb). Since 2015, under Governor Lesetja Kganyago, prudent monetary policy with an emphasis on inflation expectations has consistently lowered long-term inflation expectations towards the interim target of 4.5%.
Since the start of the Covid-19 pandemic blockade in early 2020, South Africa’s inflation rate has been limited by imported deflation and weak demand. Many national sectors have yet to recover to pre-pandemic levels. This negative output gap, in which economic activity is falling below its potential, has continued to dampen pricing power.
Conversely, many economies in the rest of the world have recovered or are going above pre-Covid levels, thanks to extremely accommodative monetary and fiscal policies. These supportive policies have been maintained in the face of intensifying supply disruptions, which have now been exacerbated by the Russia-Ukraine war. Excessive growth in the money supply has led to the traditional “too much money chasing few goods” in many developed markets, while SARB has maintained tight control of the local press.
But what about the edge?
It is also perplexing that inflation was contained despite the significant depreciation of the rand in March and April 2020. This can be explained by a lower exchange rate pass due to more competition, weaker demand, deflation in import prices and a rapid recovery in the edge. The rand has been trading sideways, certainly in a wide range, since 2015. Furthermore, the inclusion of owner-equivalent rent in the CPI basket in 2009 and its relatively high weight in the index has increased the importance of services and therefore reduced direct sensitivity to the currency.
It can last?
The magnitude of the global inflation shock, particularly in the wake of the Russian invasion of Ukraine, will make it difficult for South Africa to continue reversing the rising trend in inflation. However, how high the rate of inflation rises will depend on a few things. If the rand remains resilient, it will ease some pressure on import prices. If the credibility of the SARB remains intact, which we think it will, longer-term inflation expectations will be limited and so will wage growth.
Although the housing market showed some signs of life following aggressive rate cuts in 2020, this was short lived. The credit channel remains somewhat clogged and the Sarb began its bullish cycle in November last year. Furthermore, there is a growing risk of an even more aggressive early policy tightening. The momentum in house prices has already subsided and rental growth remains subdued. Given the substantial weight of housing costs in the CPI basket, a weak housing market will offset some of the growing pressures on food and fuel prices.
A difficult time to read ahead
Sharp increases in the prices of basic items, such as food and transportation, act as tax hikes for consumers as they cannot easily consume less of these items. This means they have to cut elsewhere to make ends meet. This will reduce economic growth, especially for more discretionary goods and services.
The big debate globally is whether we are seeing regime change as the psyche of inflation adjusts from low and stable inflation to expect higher and more volatile prices in the future.
In South Africa, the SARb is still fighting the inflationary battle on the expectations front. The hawkish attitude of its monetary policy committee is to keep us from returning to the psyche of the high inflation that prevailed before and during the early years of inflation targeting.
A difficult time awaits us as policymakers try to convince us that South Africa must remain exceptional. While the scales are tipped in their favor, we should expect continued hawkish rhetoric and potential action to ensure the message catches on.
Carmen Nel is an economist and macro-strategy at Matrix Fund Managers.