Spend­ing to slay the in­fla­tion­ary dragon

Finweek English Edition - - Economic trends & analysis - GARTH THE­UNIS­SEN

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.

STRESSED OUT­PUT GAP... CLOS­ING IT COULD TAME IN­FLA­TION

Source: Stan­dard Bank

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