The Risks for South Africa if Meltdown Continues

Among the more striking omissions of the Reserve Bank’s recent quarterly economic report is any reference to the commodity price meltdown that the world is experiencing. This omission is all the more surprising given South Africa’s still very high dependence on commodity-based trade. As a result of this omission, the Reserve Bank appears to be overly sanguine about the rand’s prospects in the period ahead. For similar reasons, the Bank seems to be underestimating the Herculean task with which it will soon be confronted to keep inflation in check. Over the past few weeks, there has been a dramatic sell-off in internationally traded commodities as the world’s major central banks continued to drain liquidity.

Resident Fellow Desmond Lachman

Indeed, the Reuters-Jefferies CRB Commodity index–which is a very broad measure of world commodity prices–has plunged 20% from its peak this May. This plunge more or less parallels that for gold, which last May was trading comfortably above $700/oz, and today is languishing below $600/oz. It also broadly parallels oil’s plunge over the same period, from $78 a barrel to about $62.

What has to be of particular concern to a commodity-exporting nation such as South Africa is the fact that the recent plunge in commodity prices–significant as it might have been–has barely made a dent in the spectacular run-up in international commodity prices over the past three years.

Fuelled by ample global liquidity, strong demand, hurricanes and uncertainty in the Middle East, both oil and non-oil commodity prices surged to dizzying heights.

According to the International Monetary Fund’s (IMF’s) latest World Economic Outlook, metal prices have risen a staggering 180% in real terms since 2002, while oil prices have increased 160% over the same period.

This could all mean significant further falls in international commodity prices in the period ahead if the world is indeed heading for a US housing-led economic slowdown. Any further fall in international commodity prices would be of considerable moment for South Africa’s balance of payments.

A recent study by the IMF suggested that the run-up in non-energy commodity prices since 2002 had strengthened South Africa’s balance of payments by as much as a full two percentage points of gross domestic product (GDP), while the run-up in energy prices over the same period only weakened the balance of payments by one percentage point of GDP. The upshot is that South Africa’s balance of payments could easily be weakened by a full percentage point of GDP in the event that commodity prices reverted to their 2002 levels as world economic growth slowed.

What is most disturbing about the prospect of a further fall in commodity prices is that the South African balance of payments is already in a weak position. Indeed, the Reserve Bank now estimates that in the first half of this year, the external current account deficit was as wide as 6,25% of GDP. This is a level with no historical precedent in South Africa.

It is also a level that exposes the country to the vagaries of the international capital market, especially given that the country did not sufficiently build up its international reserves during the good years.

The real risk now confronting the Bank is that global capital flows dry up as world financial markets become more risk-averse in the face of slowing world economic growth.

Were that to occur, the Reserve Bank would have little alternative but to aggressively raise interest rates to choke off the excessive domestic consumer demand that is a principal factor underlying the country’s external imbalance.

It would also need to raise interest rates aggressively to prevent a further decline in the rand from leading to a breach in the Bank’s 3%-6% inflation target. In that respect, the Reserve Bank will be mindful of the fact that with the country’s imports as high as 30% of GDP, a sustained 10% depreciation of the currency could add at least three percentage points to inflation.

One has to pity the Reserve Bank as it is now faced with the prospects of a less benign international environment. But then one has to ask whether the Bank was not perhaps derelict in its duties by allowing the rand to get far too strong in the first place.

One also has to ask whether the Bank did nearly enough to fortify the country’s exchange-rate defenses by building up its international reserves while the sun was still shining.

Desmond Lachman is a resident fellow at AEI.