Hidden threat to interest rate cuts in South Africa

Interest rates have fallen in South Africa for the first time since late 2021, signaling the beginning of the Reserve Bank’s cutting cycle.

However, this cycle will not be plain sailing for the bank, as numerous threats to the inflation outlook over the next months and years exist. 

Many of these are well-known, such as the weakening of the rand, which makes imports more expensive, or a sharp rise in oil prices, which increases the price of fuel. 

Other global issues that have an outsized impact on South Africa include supply chain disruptions and escalating geopolitical tensions. 

When announcing the 25 basis points cut to the repo rate last week, the Reserve Bank’s Monetary Policy Committee (MPC) touched on another risk – the rise in prices of government-administered services.

Portfolio manager at Allan Gray, Thalia Petousis, pointed out that the MPC has been flagging these issues for over a year. 

Price regulation, whereby an independent body or the government sets prices, can be used to enhance the performance of monopolies. 

If implemented correctly, they can ensure a lack of competition does not result in inefficiencies or abuse of market power.

Essentially, they can incentivise monopolies to operate as efficiently as they would in a competitive environment. However, in South Africa, this is not the case. 

Administered prices have outstripped inflation over the last decade. Electricity, water, fuel, and property costs have skyrocketed. 

The cost of electricity shot up by 15.2% in the first five months of 2024 compared to the same period in 2023, and it has not risen below 6% for many years.

The cost of water rose by an average of 7.9% in the first five months of 2024, education by 6.1% and medical aid by 10.6%.

Petousis noted that these price increases threaten to offset a stronger rand, lower oil prices, and declining food inflation. 

Earlier in the year, a leaked document showed that Eskom planned to apply to increase the electricity tariffs it charges municipalities by up to 44% in 2025. 

Rising electricity and water tariffs naturally bleed into the cost of production and raise the prices of local goods and services.

Despite all these risks, SA’s current inflation prints have been coming down, with a stronger rand allowing August’s CPI print to moderate to 4.4%. 

Given that inflation is by its nature a year-on-year calculation and can almost always be expected to disinflate in the short term when base prices are high, Petousis warned. 

The Reserve Bank’s model, which is not strictly implemented, indicates a further 100 basis points of interest rate cuts before the terminal rate of 7% is reached. 

Another upside risk to inflation is the government’s large debt load, which is closely related to its relatively high level of spending. 

In an earlier note, Petousis said government spending is growing at a rate faster than tax revenue – pushing it to issue debt to cover the shortfall. 

This growing deficit, which has to be funded by borrowing money, raises the country’s risk premium as it will increase the government’s already substantial debt burden. 

The elevated country risk premium entrenches itself in borrowing costs as foreign investors demand a higher interest rate to invest in the growing supply of South African government debt.

This could result in a more restrictive interest rate than in the past, with the repo rate unlikely to return to pre-pandmic levels. 

Furthermore, it contributes to a weaker rand-dollar exchange rate and, consequently, higher imported price inflation. 

There are some signs that this problem is beginning to be addressed, with the government running its first primary budget surplus in over a decade earlier this year. 

This means the government’s spending was less than its tax revenue for the year – excluding debt-servicing costs. When these are added, the government still ran a budget deficit for the past financial year. 

Government spending is unlikely to come down any time soon, with significant investment needed to clear infrastructure backlogs, complete the transition to a low-carbon economy, and fund its ambitious projects. 

This will add upward pressure to inflation.