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Paris - South Africa must not change its inflation targeting framework and should return to fiscal prudence once the economy recovers to maintain market confidence, the OECD said on Wednesday.
The Organisation of Economic Cooperation and Development said in its latest economic outlook that keeping investor confidence was a key challenge for the new government, given a recession and financing needs for a large current account deficit. The OECD is an international organisation of 30 countries that accept the principles of representative democracy and free-market economy. Most members are developed countries.
"Continued fiscal prudence, which need not exclude additional stimulus if demand contracts further, will be critical," it said.
"The inflation targeting regime should be left in place, as it underpins monetary policy credibility and has already shown substantial flexibility."
The government of new President Jacob Zuma is under pressure from trade union and communist party allies for more populist policies, raising investor fears of a shift to the left.
They want spending boosted to create jobs and help the poor, are demanding more interest rate cuts and for inflation targets to be scrapped.
Africa's biggest economy slumped into its first recession in 17 years in the first quarter and is on course for a decline in yearly growth.
The OECD said South Africa remained reliant on capital inflows to finance its current account deficit - 7.0% of GDP in the first quarter - raising the threat of risk aversion and negative sentiment.
"The new government that took office in May 2009 must chart its policy course at a time of great economic and social challenges," it said.
"Markets are nervous about a possible resort to economic populism, while many supporters of the government are pressing for more activist policies to address unemployment and poverty."
Zuma's administration has stressed it has not abandoned its previous conservative policy stance and while Finance Minister Pravin Gordhan has said he was prepared to debate inflation targeting, the framework remains in place.
The central bank has cut its repo rate by 450 basis points to 7.5 percent since December and is widely expected to drop it another 50 basis points on Thursday, even though inflation is still outside the 3% to 6% band.
The OECD said annual inflation, which stood at 8.0% in May, was likely to return to target in 2010.
The economy, it added, was seen contracting this year before policy stimulus, a global recovery and the impact of hosting the Soccer World Cup in 2010 lift it back to moderate growth.
- Reuters
