South Africa faces tough choices before winter if it's going to improve its flagging economy. Economic inequality is one of the highest in the world, GDP per capita has fallen, while youth unemployment is going up. The current economic model - consisting of a current account deficit that is higher than most of the other emerging market countries, combined with the rapidly increasing government indebtedness - is unsustainable.

If the next President also insists on the policy of radical economic transformation advocated by President Zuma and parts of the African National Congress (ANC), the country will head towards an economic crash in the next global downturn. The crash will come in the form of a classical current account deficit crisis accompanied by a free-falling currency, double digit inflation, a sharp contraction of GDP and a dramatic increase in unemployment.

Early promise

Everyone had high hopes for a bright future for South Africa when the apartheid system finally collapsed in the early 1990's. I gave the first-ever public speech of my career at an anti-apartheid rally in a blisteringly cold and dark winter day in Sweden.

Sweden was the main economic supporter of the ANC for five decades. Since Sweden had never been a colonial power, support for the African national liberation movement was strong. Many of the ANC leaders would stay for long periods at our beautiful embassy outside Lusaka in Zambia. And despite difficulties, the ANC proved the sceptics wrong.

South Africa went through a period of progress after 1994. In Eastern Cape, one of the poorest provinces, 70% of families did not have electricity in 1996, compared to 15% today. Only 7 million households had access to clean water in 1996 compared to 14.2 million today.

Back in 1996, only 65% of the population had access to formal housing; this rate increased to 80% in 2015. The proportion of children under five years suffering from malnutrition decreased from 15% to 5%. University enrollment numbers increased from 575,000 to 970,000.

Yet South Africa’s economic development has been disappointing since the start of the Great Recession in 2008. There was a time when there was hope that the government would boost lacklustre growth with reforms. When I went to the World Economic Forum's meeting in Cape Town in 2013 as finance minister, the expectation was that the South African government would continue to push forward to modernise the economy. Trevor Manuel, the first South African Minister of Finance I ever interacted with, had just launched a vague but ambitious National Development Plan (NDP) that aimed for 5% growth. Pravin Gordhan, the Minister of Finance in 2013, gave strong support to the NDP.

A change for the worse

Now dark clouds are gathering over South Africa. The political developments of the last few years make the future look increasingly uncertain. President Jacob Zuma reinforced the push for radical economic transformation that comes from the left-Wing faction that includes Rob Davies, Minister of Trade and Industry, and Ebrahim Patel, Minister of Economic Development, whilst internationally respected and capable politicians such as Trevor Manuel and Pravin Gordhan have been pushed out of politics.

At the World Economic Forum's meeting in Durban a few days ago, it became clear that the political narrative has changed for the worse.

The new Minister of Finance, Malusi Gigaba, failed to make a convincing case; he could be headed towards a very steep learning curve. I have never heard so much talk about radical economic transformation in any other previous discussion on South Africa. It is obvious that the government is trying to offset the growing dissatisfaction caused by corruption and crony capitalism by creating a more radicalised political agenda.

In the aftermath of the revelation that President Zuma rebuilt his farm in Nkandla using R236 million of public funds, it has become clear that the ANC leadership see left-wing populism as a solution for their political problems.

GDP growth for the last five years has averaged 1.5%, and given the population growth is 1.5% per year there has been no real GDP per capita growth at all. During 2017 and 2018, while the global economy is recovering, the IMF expects South Africa to grow by 0.8% and 1.6% respectively, which actually means that the country will experience four consecutive years of falling GDP per capita. Some 85% of all other countries are now growing faster than South Africa.

Not stagnating, contracting

The South African economy is not stagnating; it is contracting at a time when the rest of the world is in a cyclical recovery. The problems in the labour market have escalated. Youth unemployment recently peaked at over 55% of the workforce, and general unemployment has been stuck at around 25% of the workforce for the last decade. Underemployment is clearly a structural problem given that South Africa has been struggling with high inflation despite the stagnating growth rates. Inflation has been close to 6% for the last five years, and the IMF forecasts that it will remain at that rate going forward.

The current account deficit has been going up by 5% of GDP per year over the last five years. Wages have increased by 7-8% per year while productivity growth has been close to zero. The unit cost of labour increased by 7.5% per year on average. This means that South Africa’s competitive position has deteriorated rapidly despite its depreciating currency.

South Africa’s economic model now leans towards the type of failed economic nationalism based on import substitution strategy, which has been the main culprit for the economic crises in many African, Asian and Latin American in the last 50 years. State Owned Enterprises (SOEs) as well as high priority domestic industries enjoy protection in the form of regulatory barriers, subsidies and high tariffs.

A small group of privileged workers with strong political clout in unions such as CASATU and NUMSA gain the benefits. However, the overall outcome is cost increases that have crushed employment growth outside the protected sectors. The government recently opted for a rapid increase in public employment to compensate. According to the OECD, the wage bill in the public sector increased to 12% of GDP, far higher than any other middle-income growth economy (China, India, Indonesia and the Philippines spend 2-6% of GDP on the public wage bill).

Africa's Competitiveness Landscape in International Comparison
Image: Global Competitiveness Index 2015 - 2016

The rapid loss of competitiveness resulted in the industrial sector contracting. Unless the pattern is broken, this negative tendency will only get stronger in the next few years. The labour market in South Africa has been incapable of maintaining a sustainable nominal wage increase over the last decade.

The co-operation rate between employers and labour was ranked at the very bottom of the latest World Economic Forum Global Competitiveness Report, and tensions between employers and workers have continued to rise radically in the last decade. A staggering 12 million workdays were lost due to industrial conflicts in 2014 (the average workdays lost per year between 1995-2004 was only two million). The workers employed in the platinum mines were on strike for six months, and the metal workers were on strike for a whole month in 2014. The accumulated effect was the loss of 2% GDP growth.

Regardless of the fact that wage increases have been excessive, the government insisted on pushing for a raised national minimum wage, stricter regulations limiting short-term contracts, increased barriers to labour migration and pushed back on any substantial reform to remedy the unsustainable wage-setting model.

Can African lions catch Asian tigers?

The fact is that in recent decades, South Africa has consistently under-performed in comparison to most other Emerging Market Economies (EME). GDP per capita growth averaged 1.5% per year for the last 20 years (still substantially better than the last two decades of the apartheid regime). If growth had been on a par with the more successful EME’s - i.e. around 5% GDP per capita growth per year - living standards today would have been around US$27,000 per capita (purchasing power adjusted dollars), equivalent to Poland or Russia.

If South Africa continues to grow at the current rate of about 0.5% for the next decade, GDP per capita will only increase to US$13.800. With 4% GDP per capita growth in line with the lion economies of Africa like Côte d'Ivoire, Ethiopia, Rwanda, Senegal, Tanzania or Uganda, the living standard would increase to US$19.500, equal to Mexico, Botswana or Mauritius. If South Africa could achieve the same growth rate of 5-7% as the Asian middle-income group (China, Indonesia, India or the Philippines) the poverty reduction would be even faster. Why shouldn't African lions be able to run as fast as Asian Tigers?

The poor are the ones to pay the price for this dramatic underperformance that resulted in record-high economic inequality. 5% of the population is undernourished, with an average life expectancy of only 57 years. The bottom 10% of households with the lowest income represent only 2.5% of the total income, while the top 10% with highest incomes represent 50% of the total income. The Gini-coefficient (a standard index used to measure economic inequality across the population) for South Africa is among the highest in the world (63.4 compared to 0.35 in the OECD countries and even lower in the Nordic countries).

The poverty rate is also substantially higher compared to other middle-income countries. In South Africa, 16% of the population live on a daily income of USD1.9 or less. The high growth rate countries in the middle-income group have been significantly more successful at poverty reduction. For example, China (1.9% of the population living on USD1), Sri Lanka (1.6%) or Peru (3.7%). To find comparable poverty rates to South Africa, you have to look at countries like the Philippines (13%) or Indonesia (15%), however given that growth in these countries are three to four times higher than South Africa, they are likely to leave South Africa far behind in the coming decade.

An uncertain future

An uncertain road ahead
Image: South African Tourism

The future of South Africa will be decided in autumn. The ANC will select a new leader to succeed President Zuma. Cyril Ramaphosa, Deputy President, and Nkosazana Dlamini-Zuma, Secretary General of the African Union, are portrayed as the two front-runners in the media. However, whether either of them will be able to win a majority is far from certain.

R.W. Johnson, an Emeritus Fellow at Oxford University, asserts in "How long will South Africa survive?”, that the ANC has become more and more dominated by the KwaZulu-Natal-region during Zuma's leadership. KwaZulu-Natal, Free State and Mpumalanga provinces dominate the ANC, and together they control 40% of the delegates in the ANC congress. According to Johnson, Ramaphosa belongs to the Venda people, a minority group that has a lower status within society, which means Ramaphosa lacks a regional support base inside the ANC.

Dlamini-Zuma is almost 70 years old, and she is unlikely to be able to provide the air-coverage that Zuma’s support structures are looking to use to protect their new economic wealth. It is highly likely that an opponent with a stronger standing in the KwaZulu-Natal camp could challenge the media front-runners in due course.

What we can be certain of in the meantime is that if the new ANC leader is to push forward with the radical economic transformation agenda, the consequences will be disastrous. If wages continue to increase in excess of productivity, the current account deficit and the foreign debt will keep on growing, dragging the country deeper into debt. Without fiscal restructuring, the public sector debt will become unsustainable in the coming years.

In the latest IMF report, the so-called Article-IV, i.e. debt sustainability analysis, indicates that the gross debt could reach 70-75% of GDP in 2020. Considering that the debt in the SOE sector adds another 10-15% of GDP to the debt stock, the debt level has become a major vulnerability and risk factor.

In such a scenario, there is a clear risk that growth will continue to remain weak. Interest rates are already high in South Africa. The USA is now in a recovery phase. It is highly likely that the Federal Reserve (FED) will deliver rate hikes of some 25-50bps every quarter during 2017 and 2018. Policy rates would then increase by 200-300bps. This will put increased pressure on the Rand. The current political environment in South Africa, characterised by a high level of uncertainty, means that markets will push the Reserve Bank (SARB) to follow the Fed upwards, which will result in GDP per capita stagnation in the medium-term as well.

It is not clear whether a radicalised government would be willing to allow SARB to raise interest rates to uphold the inflation target. Lesetja Kganyago could be forced out as a Governor of the Central Bank and replaced with a political radical who is willing to ignore high inflation and let the Rand depreciate. The problem with such a scenario is that imported inflation would increase very rapidly and the fall in real value of wages would lead to a even sharper contraction in domestic demand.

A more hopeful scenario

In the alternative scenario, where the ANC elects a leader with the ambition to modernise the South African economy, the prospects would be different. Suppose that this new government would present a front-loaded program focused on correcting the imbalances and restoring competitiveness. That way South Africa could realistically achieve a substantially higher growth rate, possibly 4-5% per capita growth, as we see in other African countries and growth economies elsewhere. With the right policies it would be possible to boost employment and push unemployment back.

The reform programme of a government with the ambition to modernise South Africa would have consist of five essential components:

1) Fiscal restructuring to ensure that the government sector debt level is gradually pushed back down to 40% of GDP during the next 5-10 years. This would imply that the inflated wage bill in the public sector should be cut down substantially and the growing number of social grants needs to be capped. Even if the bulk, let’s say three-quarters, of the restructuring comes from cutting expenditure, it is still necessary to also broaden the tax base. Currently, personal income tax and corporate tax revenues make up 50% of the total tax revenue, and only 6 million out of the workforce of 35 million are obliged to pay taxes.

2) Broad-based labour market reform to increase flexibility. Employment protection legislation should be adjusted to make it more flexible. It is also essential to reform labour relations so that aggressive industrial actions can be moderated. A feasible wage bargain model should be based on the norm that a competitive export industry sets the wage anchor for the domestic sector along with a push for a decentralised wage setting similar to the Swedish or Nordic labour market model. A key factor is to build a stronger base for Small and Medium Sized Enterprises (SMEs), given the key role they play in job creation. South Africa needs to create 1 million new jobs every year throughout the next decade and that can only happen on the back of stronger growth and labour market reforms.

3) Improvement of the business climate. The regulatory burden needs to be reduced and the FDI- regime has to be improved to attract more investments. A key feature has to be a substantial reduction in corporate taxation to provide a strong incentive to raise the levels of investment and the capital stock. Any measures used to protect the domestic sector and specific industries should be dismantled. Sustainable investments in new generation of energy could be financed without being a burden for the public sector if energy prices are deregulated (a third of the power generators are older than 40 years and need to be replaced). South Africa has one of the most costly port administrations in the world and that has to be fixed. It is also essential to create a functioning legal framework where contracts are honoured and disputes are handled in credible and independent courts.

A broad-based deregulation could significantly reduce monopoly prices and push inflation lower. Without the barriers to entry and the juicy monopoly profits, the triggers for corruption would be reduced dramatically. If there are no barriers to eliminate and no rent to be gained, then there is no reason to pay for political protection.

4) Radical overhaul of the education system. The most efficient way of reducing inequality is by providing a good education and promoting social mobility. The current education system has its roots in the apartheid system and a number of intertwining factors such as lack of national leadership; local government interests and teacher union conservatism have so far prevented reforms. This has to be changed. It is also important to introduce vocational training programs based on an apprentice system.

5) Smart redistribution program. The current programs for Black Economic Empowerment (BEE) undermine the country’s ability to attract investors. The key foundation for BEE should be a combination of reinforced education and increased social mobility. For example, the availability of generous grants for university education in South Africa and overseas would contribute to building a meritocratic base for BEE. Providing reinforced early education and childcare in disadvantaged regions would also have significant benefits. An interesting idea would be to sell off some of the large SOEs and use the revenues to create a venture capital fund to support BEE-entrepreneurs.

Can South Africa break the vicious cycle?

Unfortunately, the most likely outcome of the political process in autumn is that South Africa will elect yet another leader from the KwaZulu-Natal region and consequently there will be no major reforms.

There are a number of reasons why South Africa is unlikely to break out of the vicious circle that has taken hold of the country:

1) Politics: There is external pressure from Julius Malema’s Economic Freedom Fighters (EEF) for an even more radical version of the so-called economic transformation. A structural reform program would be heavily criticised by both the EEF and the populist left-wing fraction inside the ANC. A reform program would increase employment and raise real wages going forward, but it would also imply that labour unions would have to accept a reduction of the public wage bill and labour market reforms. For the time being, it is highly unlikely that COSATU and NUMSA would agree to this.

2) Corruption: crony capitalist structures that dominate and profit from the current system. The protected industries would have to be restructured. That would imply that these companies could not afford to pay for benefits. The whole patronage clan based dependence structures would fall apart. Given that corruption and patronage are the key factors that hold together the current structures, this will be violently resisted.

3) Legacy of apartheid: South Africa is a society with a very low trust level. The deep resentment of the white community, who profited from and upheld the apartheid system, and the recent ethnic conflicts between the different indigenous groups, left a deficit of distrust. Structural reforms require a high degree of trust in the national leadership and a willingness to accept short term costs to invest in a better future. South Africa clearly has an apartheid legacy that still prevents it from reaching its full potential for the future. Oppression casts a long shadow.

Few reasons for optimism

The most likely outcome is that South Africa will head towards a Structural Adjustment Program (SAP) with the IMF within the next 5-10 years. The looming crisis may be delayed by favourable international developments. A prolonged global recovery would buy more time. If the recovery of iron ore, coal and platinum prices continues, while oil prices remain subdued, that could do wonders for terms of trade. On the other hand, if the recovery in the USA pushes the international interest rates higher and China, South Africa's most important trading partner, slows down, then the pressure could come much earlier than expected.

A deep crisis for South Africa is not without consequences for the rest of Africa. South Africa, together with Nigeria, sets the image of the continent in the global economy. Even if Tanzania, Senegal, Côte d'Ivoire, Rwanda and Ethiopia post growth rates of 7-8%, there is still a clear risk that the dismal growth rates in South Africa will dominate the agenda. The ANC holds the future of Africa in its hands during the coming months. The renaissance of Africa will be dealt a hard blow by a deep crisis in South Africa.

If South Africa continues the path of economic nationalism and reinforces radical economic transformation it is a matter of time before the imbalances and structural problems leads to a cataclysmic economic crisis. As I took off from the King Shaka airport in Durban with a view of the beautiful landscapes of KwaZulu-Natal, it was impossible to shake off the gloomy mood. Things will get much worse before they get any better. The warm and cozy atmosphere in Durban is in stark contrast to the fact that South Africa is skating further and further out on thin ice with this unsustainable economic model.