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Excerpt from The Missing Piece: "A Country’s Most Valuable Asset is a Sizeable and Vibrant Business Sector"

The Missing PieceThe Missing Piece: Solving South Africa’s Economic Puzzle by Stanlib chief economist Kevin Lings seeks to address the structural problems plaguing South Africa’s economy.

In the following extract Lings evaluates the first three pieces of the country’s economic puzzle – internationalising South Africa, implementing fiscal and monetary policy and redressing the country’s high income inequality – and he introduces the fourth missing piece: “the inadequate support and encouragement of the business sector”.

Read the excerpt:

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Introduction

At the time of South Africa’s first democratic elections in 1994, everyone agreed that poverty had to be uprooted, inequality reduced and the conditions for sustainable economic growth established. It was clear that the structure of the country’s economy had to change, and that land ownership, employment opportunities and access to essential services had to match more closely the needs of the entire population; otherwise it would be difficult to achieve lasting political and social stability.

In the twenty years since 1994, South Africa’s economic growth rate has comfortably exceeded the country’s average population growth. Income per person has increased meaningfully, and well in excess of South Africa’s average annual inflation rate. Unfortunately, the distribution of income and wealth remains extremely unequal by global standards and has actually worsened since 1994, while the unemployment rate has remained exceedingly high, especially among the youth.

Achieving sustained high economic growth that included a meaningful rise in employment but also addressed the vast array of social and economic backlogs required the country to focus on four key pieces of economic policy. These comprised internationalising the country after years of isolation; instigating sound macroeconomic policy; vastly increasing the provision of social goods and services; and encouraging the modernization and competitiveness of the business sector. In 1994, it was clear that South Africa’s success in developing these four policy pieces would determine its progress in meeting the aspirations of the population.

Implementing the required policy changes was never going to be easy. The financial and trade sanctions imposed in the 1980s had done an effective job of isolating the country, while the extent of the socioeconomic backlogs was massively underestimated, especially the lack of basic services. In addition, prior to 1994 government debt had ballooned alarmingly, while inflation had become entrenched at well above 10%.

The first piece of the puzzle

The process of internationalising South Africa after years of isolation and sanctions has been extremely successful. The country managed to lower import duties in line with the requirements of the World Trade Organization, and to conclude a number of important trade agreements, especially with the EU and the US. Although the rapid increase in imports since 1994 disrupted and undermined a component of South Africa’s industrial sector, it also provided vital access to enhanced technology and crucial machinery and equipment needed to modernise key sectors of the economy, including mining, manufacturing, healthcare and telecommunications. The government embarked on a process of obtaining an investment-grade international credit rating, which quickly allowed South Africa increased access to global capital markets. This provided the government, as well as the corporate sector, with a diversified source of funding to potentially expand capacity, including key infrastructural development.

It also allowed the South African Reserve Bank to steadily build up its holding of foreign exchange reserves from less than one and a half months of imports in 1994 to over six months of imports in 2013.
The process of internationalising the country was not confined to economic integration, but included establishing strong political links with numerous other countries. These links are reflected in South Africa’s membership of the Southern African Development Community in August 1994, the establishment of the African Union in May 2001, South Africa becoming a member of the G20 when it was first convened in September 1999, and being asked to join the BRICS in 2010. The country also actively integrated its sporting activities with the rest of the world, which has become an important part of South African culture and social identity. Over the past twenty years, South Africa has successfully hosted a truly impressive array of global sporting competitions and international conferences. These and other events helped to lift domestic and international confidence in the country, showcasing South Africa’s social, political and economic transformation since 1994.

Second piece of the puzzle

In the early 1990s there were many concerns about how South Africa’s economic policy would evolve once the political transition was effected. Some of these concerns focused on the implementation of fiscal and monetary policy. In particular, would the incoming government manage to institute fiscal discipline given the already extremely poor state of government finances that included a huge budget deficit? For many economic and political analysts, this seemed unlikely given the huge socio-economic backlogs in areas such as basic sanitation, health, education and housing, as well as the socialist policies advocated by many members of the ANC. In terms of monetary policy, there was a deep concern that inflation would not be controlled, and that the country would not be able to attract the necessary foreign capital to build up foreign exchange reserves.

These uncertainties were highlighted in 1996, when Trevor Manuel was appointed minister of finance and the rand exchange rate weakened by around 22% against the US dollar. At the time, the IMF argued in their Article IV consultation (which is an economic analysis of the country required by Article IV of the IMF’s Articles of Agreement) that this weakening in the currency ‘mainly reflected concerns about the future course of financial and structural policies and represented a stark change in investor sentiment’.

However, within a few years fiscal discipline had clearly been achieved. Inflation had been reined in, and an inflation-targeting policy had been set. Since 1994 the country’s inflation rate has averaged 6%, and then 5.3% once the inflation target was introduced in 2000. The sustained lower inflation rate allowed for a systematic reduction of interest rates, and a lowering of the cost of capital for both households and business. The government was able to radically improve the process of tax collection, which led to significant increases in tax receipts in eleven of the last fifteen tax years.

Utilising the so-called democracy dividend, which included the benefits of dismantling an extremely expensive and highly inefficient apartheid system, the fiscal authorities were able to reallocate government expenditure to key social services, including the provision of education, healthcare and welfare. At the same time, the government transformed a persistent and substantial fiscal deficit into a budget surplus in the period from 2006 to early 2008, and ensured that the fiscal deficit remained at less than 3% of GDP for most of the past fifteen years. The improvement in fiscal discipline allowed government debt to ease from almost 50% of GDP in 2006 to a low of 27% of GDP in 2009, while at the same time more than halving the government’s debt service ratio. This is a truly astounding set of policy achievements.

Third piece of the puzzle

South Africa’s high income inequality and its enormous shortfall of social goods and services in 1994 needed to be redressed as quickly as possible following the first democratic elections. Although the government and various academic researchers tried to estimate and articulate the extent of the backlogs, most of these estimates tended to understate the true extent of the social deficit. Furthermore, although the government was able to reprioritise government spending away from defence and other apartheid-related expenditure towards the upliftment of social services and increased welfare payments, they faced two very significant constraints.

Remarkably, despite a number of constraints and glaring mistakes, the government made meaningful strides in addressing some of the key deficiencies. Among the achievements were the supply of electricity to millions of households, the subsidised provision of formal housing, increased access to water and sanitation, reduced levels of malnutrition, a substantial rise in welfare payments and increased access to free education.

The missing piece

The fourth and final piece of South Africa’s economic puzzle, and the area of greatest concern, is the inadequate support and encouragement of the business sector. Expanding and strengthening the business sector requires a relatively wide range of support measures. These include the availability of skills, access to appropriate economic infrastructure (especially energy, road, rail, port and airport systems), the rule of law, a consistent policy framework and equal opportunity to compete for business. Unfortunately, some of the most critical ingredients needed to expand the business sector have been absent. These include a shortage of electricity capacity, ageing port and rail infrastructure, a rapid rise in the cost of logistics, a complex set of industry regulations that makes it increasingly difficult to do business, a lack of technical skills, and a relatively volatile labour market.

While it is extremely common for businesses around the world to encounter operational difficulties, the combination of factors negatively impacting South Africa’s business sector has led to a general reluctance to expand and increase employment. Furthermore, initiatives to encourage new business ventures have struggled to gain momentum. The behaviour of certain sectors of the business community, especially collusion and uncompetitive pricing, has also accentuated the problem.

A country’s most valuable asset is a sizeable and vibrant business sector. A large and growing business sector increases employment, reduces the social burden on the state and generates the revenue that underpins the tax base, providing government with the tax receipts to achieve its social and political objectives. While this may sound obvious, many governments, especially in Europe, have stumbled because they have found themselves overburdened by social demands, and have lacked the tax revenue to meet the aspirations of the electorate. In many instances, the growth in the size of government has come about because the authorities have been determined to direct the functioning of a large portion of the economy, which tends to crowd out or stunt the development of the private sector, thereby undermining the tax base. The message is clear: governments should spend as much time worrying about where their tax revenue will come from as they spend worrying about how to use taxpayers’ money.

Negative feedback loop

Looking back over the past twenty years, there is little doubt that the South African economy has made impressive progress in three of the four key building blocks needed to lift growth and employment, and to meet the aspirations of the population. Furthermore, in some instances the achievements have far exceeded what could realistically have been expected in 1994, especially in the areas of monetary and fiscal policy.

The distinct lack of progress in developing the fourth piece of the economic puzzle has meant that South Africa’s economic growth has ultimately been below expectations and employment growth has been staid. More importantly, this constraint has now begun to undermine the other three pieces of the economic puzzle, creating a negative feedback loop. If left unchecked, this can derail the South African economy, leading to increased unemployment, an outflow of foreign investment and rising social tension.

This negative feedback loop is evident in a number of sectors of the economy. For example, the shortage of electricity capacity has stunted private sector expansion; the neglect of water-treatment facilities is now undermining the delivery of water in many municipalities, leading to increased service-delivery protests; the ageing of the municipal road infrastructure is limiting domestic tourism, leading to increased frustration and declining confidence as well as a rise in road accidents; and the increase in business regulation is restricting small-business development and job creation. Unfortunately, this negative feedback loop is also starting to impact monetary and fiscal policy. For example, the rising level of corruption is hindering infrastructural development and undermining the efficacy of public sector spending. This increases the strain on government finances, which in turn persuades the credit rating agencies to either downgrade South Africa or place the country on a negative credit watch. A lower credit rating accentuates the pressure on the rand exchange rate, which increases the risk of inflation, necessitating a rise in interest rates.

Looking forward

South Africa urgently needs to improve a number of microeconomic components of the economy. These include key aspects of the country’s economic infrastructure, such as the lack of infrastructure maintenance within many municipalities, the shortage of critical technical skills, the over-regulation of business, the unacceptably high level of corruption, an overly complicated set of industrial policies and the need to more fully embrace technology in the development of the business sector.

In outlining the way forward, there is a tendency to set numerous economic and social goals that are to be achieved simultaneously through multiple policy initiatives across most sectors of the economy. While this type of strategy approach appears comprehensive, it also tends to be complex, unwieldy and largely unattainable. Under these circumstances, there is the risk that attention and resources are diverted away from alleviating the economy’s most crucial constraints.

There is also a tendency to ignore the importance of sequencing or prioritising policy initiatives. For example, an appropriate port, rail and energy capacity is needed before a policy to expand industrial production can be successful. Furthermore, South Africa has limited skills, especially engineering and other technical skills. This suggests that crucial infrastructural projects need to be coordinated to make sure the resources are available when required and that vital projects are not unnecessarily delayed.

It seems sensible to narrow the number of policy objectives to a few key initiatives that can be successfully implemented and that are critical to stimulating business investment and job creation. These initiatives can be divided into realistic short-term goals and longer-term structural changes. This is the approach outlined in the final third of the book.

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