Spending to slay the inflationary dragon
WITH BILLIONS of rand being invested in the economy to bolster South Africa’s infrastructure capacity, economists worry that the massive increase in spending could result in rising inflationary pressure.
However, at least one economist says it’s this very investment boost that will impart a structural improvement in SA’s long-term inflationary outlook.
As it stands, the percentage utilisation of production capacity – a measure of the resources employed in an economy to produce a given level of production – is now at a historic high of 85,83%. That’s according to the December 2006 SA Reserve Bank Quarterly Bulletin.
Standard Bank chief economist Goolam Ballim says a figure as high as 85% essentially implies that the economy is already running at
full capacity because it’s impossible to employ every asset in the economy at full capacity one hundred percent of the time.
“We’ve never had such a squeeze on the economy,” he says.
This squeeze is exacerbated by SA’s low level of fixed investment, as indicated by the figures for gross fixed capital formation which in 2005 amounted to just 17% of GDP.
“That shows that the supply side of the economy is not keeping pace with demand,” says Ballim. “Ideally you want a ratio of at least 20% but preferably 25% of capital investment to GDP,” says Ballim.
However, the concern is not just that SA’s infrastructure is overburdened but that full capacity utilisation generally results in heightened inflation pressure.
This stems from that age-old economic truism: When demand outstrips supply, prices rise.
From a macroeconomic perspective it follows that when productive capacity is unable to keep pace with demand, it results in a stressed output gap, which effectively heightens an economy’s structural susceptibility to inflation (see graph).
Fortunately Ballim says improved investment spending could help to close the output gap, thereby reducing SA’s structural predisposition to inflation.
“The supply side of the economy is responding appropriately and handsomely to the increased demand which will structurally mitigate against any future spurts in inflation,” he says. “In the short term increased investment expenditure will create some inflationary pressure but over the long run it will create more headroom between aggregate demand and aggregate supply, which will bring about a structural improvement in the outlook for future inflationary risk.”
To see Ballim’s point one only need consult the numbers. In 2006 gross fixed capital formation as a percentage of GDP averaged 18,36% for the first three quarters. If the last quarter figure comes in at 19% as Ballim expects it will, then the average for the year should be 18,53% – the highest annual figure since 1989 and vastly better than the lowly 14,3% recorded in 1999.
What’s more, Ballim says he expects gross fixed capital formation to hit 23% of GDP by 2010, which will further sustain the rise in aggregate demand.
If Ballim’s hypothesis is correct, it should also slay any inflationary dragons lurking beneath the billions of rand being pumped into the economy.