End of foreign exchange restrictions in South Africa is everything hunky-dory?

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1 Economic Research Allianz Group Dresdner Bank Working Paper No. 29, 3 January 2005 Author: Dr. Ingrid Angermann End of foreign exchange restrictions in South Africa is everything hunky-dory? South Africa s star is in the ascendant. Its economy is flourishing, its currency has recorded a five-year high, investor confidence is growing and the country is about to see the removal of foreign exchange controls, a relic of the apartheid era. Removal of foreign exchange restrictions Back in October 2004 the government made the most of the opportunity and started by abolishing foreign exchange controls for business investment. That means, for example, that there are now no restrictions on direct investment abroad by South African firms and dividends no longer have to be repatriated. The rules for private individuals were relaxed just a little at first. Although they can purchase unlimited amounts of foreign shares that are listed in Johannesburg, the limits on the transfer of capital abroad (just under 100,000) have been retained for the time being. The government can be expected to lift the remaining restrictions for private individuals in spring 2005, when the tax amnesty for previously undeclared foreign assets expires. Foreign direct investment is needed The removal of foreign exchange controls is a step in the right direction. The country is dependent on new capital coming in from abroad and is generally likely to benefit from deregulation measures. In periods of strong economic growth the current account quickly slides into the red which is also the case in the current economic situation. In 2004 real GDP probably increased by nearly 3.5 %. This was coupled with a strong rand, which triggered a genuine import boom. The fact that the increase in the current account deficit, at 1

2 approximately 2.5 % of GDP, remained moderate is due to the marked growth in precious metal exports. As the world s leading exporter of platinum and an important producer of gold, the country benefited from rocketing precious metal prices South Africa: Economic growth and the current account Real GDP, %, y-o-y Current account balance, % of GDP e Source: Institute of International Finance (iif) As far as financing is concerned, South Africa has so far lacked substantial net inflows of foreign direct investment. Compared with other emerging market economies, South Africa is near the bottom of the list. This nonetheless contrasts with high levels of portfolio investment by international investors in the liquid South African equity and bond markets. However, a large proportion of this investment is short-term capital, which can be withdrawn from the country again very quickly in times of uncertainty. As recently as 2001, when the rand plummeted sharply, South Africa had painful experience of the kind of turmoil that that can entail. 2

3 South Africa: Foreign direct investment and portfolio investment in USD billion Foreign direct investment (net) Foreign portfolio investment (net) e 2005f Source: International Financial Statistics, IMF South Africa also needs the capital inflows, however, to boost growth potential. The growth rates to date are not high enough to reduce the high level of unemployment. The unemployment rate is estimated at between 25 % and 40 %, with the colored population being the most affected. In order to create enough jobs, the economy would have to grow by as much as 4 5 % a year, which would burden the current account as a result of higher imports. More investment would first need a corresponding increase in the supply of capital. At around 16 %, the overall savings ratio is in any case insufficient and foreign investors have so far been hesitant about direct investment. The government has therefore been trying for the past few years to intervene with additional public investment measures but this has so far met with only a modest degree of success. Can South Africa now attract more capital? The question is now whether the government really can smooth the way for long-term capital inflows by removing the foreign exchange controls. The foreign exchange controls actually applied only to residents. Dismantling the foreign exchange restrictions would thus initially lead to an increase in capital exports. Domestic companies, for instance, benefit from the easing of the restrictions which enables them to diversify more strongly. For example, the large mining companies can close down unprofitable mines in the home territory and invest in neighboring countries. This is particularly relevant at present as the prices of precious metals have accelerated rapidly but the simultaneous surge of the rand has largely eroded the associated profits. Initially therefore we are not likely to see any capital inflows, but rather capital outflows as resources are relocated. However, simply being able to send capital 3

4 abroad unimpeded can prompt investors to channel funds into the domestic market. In addition, with the removal of these exchange controls South Africa is facing more intense international competition and therefore has more incentives to improve investment conditions. A look at the investment environment To boost capital inflows, however, the investment climate has to be right. Direct investment is often in export-oriented sectors. However, South Africa is little suited to act as a springboard for exports to the neighboring countries. GDP in the surrounding countries is low and there is also a question mark over the future outlook in countries such as Zimbabwe, for instance. South Africa s export markets are mainly in Europe and the USA. In that respect it needs to be borne in mind that exporters are still obliged to exchange the foreign currency that they have earned for local currency within six months. To be consistent, the government also needs to abolish such regulations. AIDS In addition, the high AIDS rate weighs heavily on the investment climate. The estimated rate of infection among adults is somewhere between 15 and 20 %. As unqualified workers are the ones mostly affected by HIV infections, hardly any extra expenses are incurred because of additional training requirements. Additional training costs can be expected only in the area of skilled employment. Although South Africa wants to improve the low educational level of the colored population, because of AIDS the drop-out rate in the training measures is high. Moreover, companies experience production losses because of absenteeism due to sickness. In addition to the economic costs, the social costs (risk of contagion) should not be overlooked. To improve the investment environment, the government must therefore do more to stop the spread of AIDS. Crime The current restraint among investors is also due to the high crime rate. The causes of the crime rate are to be found, inter alia, in the huge differences in wealth and in the high levels of unemployment among the colored population, where the level of education is also low. 4

5 Transformation after apartheid In South Africa s favor, however, it should be said that, given the challenge, the transformation of the country since the end of apartheid has gone well. Its black empowerment policy, which amounts to positive administrative discrimination in favor of colored labor, has set the government off on a risky course: on the one hand, this can make it difficult to appoint the best people to jobs and can end up slowing productivity growth while, on the other hand, it is intended to dissipate the social tension between whites and blacks, which has advantages for both political stability and the investment climate. Privatization potential Direct investment opportunities are afforded, for example, by privatization, a strategy which eastern European countries, in particular, have implemented successfully. In South Africa, too, there is basically scope for privatization, e.g. in utilities. However, the government has so far held back as it also wants to ensure favorable utilities prices for the broad lower income brackets. Progress in price stability Progress has recently been made primarily in the monetary sphere. While the annual rate of inflation still peaked at 13 % in 2002, it has gone down since then and was 3.7 % year on year in November The upward surge of the rand gave a particular boost to price stability. 14 South Africa: Inflation annual percentage change Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Source: Ecowin Exchange rate A stable currency is part and parcel of an attractive investment environment. Previously, exchange rate volatility had hampered the inflow of direct investment. In early 2004 the 5

6 central bank finally closed its open net currency positions, which previously represented a opening for speculation about the rand. The central bank has since been rapidly building up its foreign exchange reserves. In 2004 alone, the foreign reserves doubled to around USD 12 billion. The building-up of foreign reserves can only promote the stability of the currency, which ultimately also reduces uncertainty for long-term investors. 14 South Africa: Exchange rate development rand vis-à-vis USD Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Source: Ecowin Conclusion Overall, the time is ripe for the removal of foreign exchange controls, but that alone will not promote direct investment in the country. It is rather to be interpreted as a sign of an increase in the government s confidence in domestic and foreign investors and thus acts as a signal. Any country that wants to attract capital must also allow capital outflows. At the same time, the investment climate also has to be right. Things have improved somewhat in that respect in recent years, but there is still room for action. 6