ENCOURAGING NEWS ON CAPITAL FORMATION IN SOUTH

UNCLAS SECTION 01 OF 02 PRETORIA 000095 SIPDIS SENSITIVE SIPDIS E.O. 12958: N/A TAGS: ECON SF SUBJECT: ENCOURAGING NEWS ON CAPITAL FORMATION IN SOUTH AFRICA REF: 06 PRETORIA 5056 AND PREVIOUS PRETORIA 00000095 001.2 OF 002 ¶1. (U) This cable is sensitive but unclassified; not for internet distribution. ¶2. (SBU) Summary: Capital spending in South Africa is at its highest level since 1990, driven by strong domestic demand, high capacity utilization rates, and parastatal spending. The long investment slump that commenced in the early 1980s may be at an end. Increased investment will raise the growth potential of the economy. However, achieving sustained GDP growth rates of 6 percent per year will require significant further increases in investment. End Summary -------------- The End of the Long Slump? -------------- ¶3. (U) Spending on capital goods (gross fixed capital formation) is growing robustly in South Africa, according to data published by the South African Reserve Bank (SARB) in December 2006. The data indicate that capital spending in the third quarter of 2006 was almost 19 percent of GDP, or the highest level since 1990. Many analysts hailed the news as proof that the long investment slump that began in the early 1980s -- when capital spending peaked at 28 percent of GDP -- may be at an end. As one bank economist wrote, "Given the data since the middle of 2002, it appears that the downward trend (in the investment/GDP ratio) that commenced in the early 1980s following the boom in the gold price is now well and truly over." ¶4. (U) According to SARB, capital spending in the third quarter of 2006 expanded across the entire economy -- in the private sector, general government, and parastatals. The strongest growth was registered by parastatal corporations (especially Transnet),which expanded their spending on machinery and equipment. Their performance was paralleled by stepped-up general government spending on roads and other fixed assets. The pace of capital formation likewise quickened in most sectors of the private economy, especially in agriculture, manufacturing, construction, commerce, and transporation. (Capital expenditure in the private sector has made up about two-thirds of total fixed capital formation over the last 10 years.) -------------- Looking Back -------------- ¶5. (U) From 28 percent of GDP in 1982/83, capital spending declined steadily over the next 10 years, bottoming out at less than 15 percent of GDP at the time of the democratic transition in 1993/94. The decline in public sector capital spending was especially sharp during these years, as parastatals lost access to foreign capital markets (because of sanctions) and the government was forced to divert revenues to current expenditures such as pensions and the military. Low business confidence depressed private sector capital formation as well. Unfortunately, the picture did not improve after the ANC took power in 1994. Investment hovered around 15 percent of GDP throughout the 1990s, as the public sector -- where the bulk of infrastructure spending occurs -- brought fiscal deficits under control and struggled with slow implementation of projects. However, capital spending has picked up steadily since 2002. -------------- Looking Ahead -------------- ¶6. (U) Analysts at Standard Bank believe that investment will remain robust for the foreseeable future. They cite strong domestic demand, business optimism, and planned increases in parastatal spending as factors supporting increased investment. In particular, the Asian hunger for commodities and high levels of capacity utilization (according to SARB, the manufacturing sector is now operating at "full" capacity) augur well for increased capital spending. According to these analysts, investment in South Africa is relatively insensitive to interest rates, and the possibility of further hikes in SARB's policy interest rate (reftel) should not have a huge impact on investment, if other factors remain positive. -------------- PRETORIA 00000095 002.2 OF 002 Comment -------------- ¶7. (SBU) As consumer spending cools in the wake of recent interest rate hikes, capital spending is poised to pick up the slack and become a vital driver of the economy. More importantly, increased investment will boost South Africa's growth potential and help to relieve infrastructure and supply bottlenecks that cause the economy to overheat when growth approaches 5 percent per year. Many economists believe that South Africa needs to invest 24 percent of GDP per year to achieve the SAG target of 6 percent annual growth. (The IMF also cites 24 percent as a benchmark for optimal performance of the economy.) Whether this level of investment is attainable is an open question, given the low rate of national saving (gross savings is about 14 percent of GDP) and the dependence on foreign capital inflows to finance domestic investment. However, even sustained investment rates of only 20-22 percent of GDP per year would herald a new era of higher growth. BOST