Predicting the Business Cycle in South Africa: Insights from a Real-Financial Activity Gap

Traditional approaches to predicting business cycles are limited by their omission of financial variables, which, in turn, leads to failures to signal financial-sector crises and to misestimate the duration and intensity of economic events. This study addresses this challenge by constructing a real-financial activity gap for South Africa and utilising it to predict the occurrence of economic recoveries. The study examines the period from 1970Q1 to 2023Q4, using real GDP, domestic credit, house prices, and share prices. The dynamic factor model and the Hodrick–Prescott filter are employed to construct the real-financial activity gap. The recursive ADF unit root test is used to assess the presence, frequency, and duration of economic recoveries. To validate the results, a Markov switching dynamic regression model is applied. The results reveal that the new gap tends to produce economic recovery predictions that are less frequent but longer in duration. In contrast, predictions based on real GDP lead to more frequent but shorter recoveries. The new gap suggests that financial variables contribute to stabilising growth over extended periods, whereas real GDP reflects quicker but more volatile economic adjustments. The latest gap offers a more stable basis for forecasting recoveries, aiding policymakers in better anticipating and mitigating economic downturns. Accordingly, the output gap and the real-financial activity gap should be used as complements.