Month: May 2016

Après the debt crisis, le deluge?

Greek debt was back in the news last week. The news that Eurozone finance ministers had overcome an impasse with the IMF and will disburse €10.3bn to enable Greece to meet its immediate commitments to the IMF and the European Central Bank (ECB) of about €4bn. This still leaves Greece with close to €300bn of debt to be repaid over the next 30 years. A surely impossible task of fiscal adjustment – despite debt relief to date that has amounted to close to €200bn. One can only wonder all over again how Greece managed to run up such debt and why it has so little in the form of productive infrastructure and additional human capital to show for it.

The graphic below, from the Wall Street Journal, reveals Greece’s obligations over the next 40 years:

But this particular odyssey has moved on beyond the Aegean Seas.The Euro debt crisis seems to have faded into the background. Eurobond yields for the most vulnerable of the Euro borrowers are now well below pre-crisis levels, as we show below.

The relief for the bond markets came partly in the form of some modest fiscal austerity but largely, and more importantly, came from the ECB doing “whatever it took” to rescue the bond market with its quantitative easing programme – buying bonds in the market place in exchange for deposits placed by banks with their central banks. It was following the example of the US Fed, the Bank of Japan and the Bank of England in providing extraordinary supplies of central bank money to their banking systems via purchases of government and other debt instruments in the debt markets.As a result, central banks have become major sources of demand for government bonds and as such, have not only relieved the banks of any lack of liquidity but have also, through their actions in the bond markets, have directly led interest rates lower. We rely on the Bank of International Settlements (BIS) for the operational details and balance sheet outcomes shown below.

These central banks are all government agencies and so their assets and liabilities should be consolidated with those of their respective government treasuries. In effect, the net debt of the government (net of central bank holdings) has been to an ever greater degree funded with deposits (cash reserves) issued by their central banks. In the case of the ECB and the BOJ, but not the US Fed, these deposits are penalised with a negative rate of interest. In other words, with cash that is an interest bearing liability of the government. So far, most of the extra cash issued by central banks has been held by the banks rather than used to supply bank credit. Hence aggregate spending by households and firms has remained highly subdued.Deflation rather than inflation has become the feature of the developed world, despite the unprecedented increase in the supply of central bank money. Deflation and, more important, the expectation that inflation will remain highly subdued for the next 30 years at least, has meant persistently low interest rates. In parts of the developed world like Japan and Switzerland, nominal interest rates offered by governments for 10 year loans have turned negative. In other words, lenders are now paying governments to take their savings for an extended period, rather than receiving interest income from them. Another way of explaining such circumstances is that issuing long-dated debt at negative interest rates is even more helpful to governments and their taxpayers than issuing zero interest bearing notes or deposits at the central bank, unless bank deposits held at the central bank also attract a negative interest rate (as they may well do).

Accordingly while government debt has grown – though much less so for debt held outside central banks – interest rates have receded and government’s debt service costs have declined rather than increased. The debt burden for taxpayers has become less rather than more oppressive. Moreover, the global economy continues to operate well below what may be regarded as its growth potential. These conditions make for an obvious political response. They make the case for more government spending, funded by issuing very cheap debt rather than higher tax rates or tax revenues. A call, that is, for government stimulus rather than austerity now that the debt crisis has been dealt with.

The major central banks, other than the Fed, are still doing as much as they can to add to the money stock and to reduce interest rates across the yield curve. But the lack of demand for, as well as reluctance to supply, bank credit has meant persistently weak demand. The temptation for governments to popularly spend more and raise more debt would seem to be irresistible.

The Japanese government, with a gross debt to GDP ratio of as much as 400% (though with much of the debt held by the Bank of Japan and the Post Office Bank) is not resisting. It is postponing an intended increase in sales tax that had been mooted before to close the large fiscal deficit. Where Japan, with its negative costs of borrowing leads, other governments will be encouraged to follow. Will inflation be expected to remain as low as it now does?

Monetary policy: Thanks for the small relief

The Reserve Bank, thankfully and understandably, given the near recession state of the economy, decided not to raise its repo rate at its meeting last week. The Monetary Policy Committee (MPC) statement concluded that:

“The increase in the repo rate at the previous MPC meeting contributed to the improvement in the longer-term inflation forecast, and that move should be seen in conjunction with previous actions in the cycle and the lagged effects of monetary policy. The MPC felt that there is some room to pause in this tightening cycle and accordingly decided to keep the repurchase rate unchanged for now at 7,0 per cent per annum. Five members preferred no change, while one member preferred a 25 basis point increase.

“The MPC remains focused on its inflation mandate, but sensitive to the extent possible to the state of the economy. The MPC will not hesitate to act appropriately should the inflation dynamics require a response, within a flexible inflation targeting framework. Future moves, as before, will continue to be highly data dependent.”

The MPC, as indicated, continues to regard itself as in a tightening cycle. Why further likely interest rate increases will be helpful in reducing the inflation rate any more, than past increases have done, is much less obvious. As we show below, short-term interest rates in SA have risen by 2% since the first 50bp increase in the repo rate was imposed in January 2014. Inflation, having fallen in early 2015, has recently risen sharply above 6%. A very good proxy for expected inflation – inflation compensation in the bond market, being the difference between the yield on a vanilla RSA 10-year bond and its inflation-protected equivalent – also rose sharply in late 2015, as did the difference between RSA 10-year bond yields and US Treasuries of the same duration. This difference may be regarded as the average annual rate at which the rand is expected to depreciate against the US dollar over the next 10 years.

These unfortunate trends have occurred despite higher interest rates and despite a weaker economy, to which higher interest rates have undoubtedly contributed. According to the Reserve Bank forecasting model, every one percentage point increase in the repo rate reduces the GDP growth rates by 0.4% p.a. and the inflation rate by 0.3% over the subsequent 12 months. To put such predicted reactions in some perspective, this means that to reduce the inflation rate by one and a half percent from 6.5% (above the target range of 3% to 6%) to 5%, it would take a five percentage point increase in short term interest rates. Interest rate increases that would be predicted to reduce GDP growth rates by two percentage points, say from plus one to minus one. This is a high price to pay in foregone output and incomes it must be agreed for still high inflation.

The increases in short rates to date will have reduced already anemic GDP growth rates by close to one percentage point. But such outcomes presume that all other influences on the inflation rate and on GDP growth included in the forecasting model will have remained as predicted by the assumptions and feedback loops of the model – a very unlikely outcome indeed, as recent experience will have demonstrated.

The recent increase in the inflation rate owes a great deal to rising food prices- the delayed impact of the drought that so reduced the maize, wheat and other harvests. The much weaker rand and higher administered prices, especially electricity charges, would have added to the pressures on costs and prices. But the pass through effect of a weaker rand on imported inflation and so the CPI, was unusually muted in 2015 given lower oil and commodity prices. Weakness in emerging markets and emerging market (EM) currencies in response to weaker EM growth and less risk tolerance in global capital markets however meant a weaker rand that depreciated against a stronger USD, broadly in line with the other EM currencies. But the events that moved the rand and inflationary expectations higher and added materially to SA risk, and to a still weaker rand expected over the next 10 years, were very South African in origin. President Jacob Zuma’s intervention in SA’s financial affairs was unprecedented and unpredictable. It did much damage to the annual inflation and exchange rate outlook – adding about 2% p.a more to both – such that increases in interest rates, even very significant increases, would not have countered and cannot be expected to counter. Yet they would have damaged the real economy in the predicted way.

The outlook for inflation will continue to be dominated by forces well beyond the influence of Reserve Bank interest rates, making inflation forecasts an unreliable exercise. Politics, the weather and global forces, including degrees of risk aversion accompanying commodity price trends, will be as decisive as they have been to date. Raising interest rates in such circumstances can have only one fairly predictable outcome: to slow down the economy further so making a credit ratings downgrade more likely.

The only justification for ever raising interest rates aggressively in SA would be when aggregate demand is rising strongly enough to put upward pressure on prices. Such pressure on prices will however then be accompanied by strong growth, not the weak growth now experienced. If the economy were growing well, say at a 5% rate and inflation was rising at above target rates, say at 6.5% p.a, then raising interest rates by say 300bp over a 24 month period could make every sense. Inflation could then be expected to come down to below six per cent and growth could slow down to a still satisfactory 4% or so rate.

The distinction between demand side forces acting on inflation that would justify higher interest rates and supply side shocks that drive the inflation rate temporarily higher and simultaneously but reduce demand and growth rates, is an essential one to make. Supply side shocks on prices should be ignored by monetary policy: this is the conventional wisdom. It is a distinction between supply side and demand side-driven higher prices that the Reserve Bank refuses to make. It has cost the economy dearly, while inflation and inflation expected have accelerated for reasons that have had little to do with the Reserve Bank. As I have said before, monetary policy in SA needs a better narrative, one that will preserve the credibility of the Reserve Bank without it having to play King Canute.

Incidentally, if the most recent forecasts of the Reserve Bank for inflation (below target in 2018) and GDP growth (no more than 1.7% in 2018) turn out to be accurate, the case for raising interest rates and any extension of a tightening cycle will remain as weak as it is now. Here’s hoping for better weather, conservative fiscal policy settings and a credible Minister of Finance, and a stable or stronger rand, enough to reverse inflation trends and lead interest rates lower- an essential condition for a cyclical recovery.

Point of View: Artificial intelligence and the productivity conundrum

The world’s first artificially intelligent lawyer has arrived. Called Ross, and built on IBM’s famous cognitive computer called Watson, it has been “employed” by US firm Baker & Hostetler to work in its bankruptcy practice.

According to Futurism.com, Ross can “read and understand language, postulate hypotheses when asked questions, research, and then generate responses (along with references and citations) to back up its conclusions. Ross also learns from experience, gaining speed and knowledge the more you interact with it”. (http://futurism.com/artificially-intelligent-lawyer-ross-hired-first-official-law-firm/)

It’s not just lawyers who should be looking over their shoulders. All sorts of knowledge workers could see their employment prospects and livelihoods threatened by artificial intelligence, including journalists, accountants, portfolio managers, even surgeons and physicians.

With the aid of the internet and easy access to case law and its interpretation, fewer lawyers may be required to resolve a bankruptcy procedure. Fewer analysts may be required to value a company with the aid of Bloomberg data and its accompanying suite of programmes. Lasers directed by unerringly accurate robots may well help reduce the time in the operating theatre and the dangers of doing so.

What is the impact of these newly adapted technologies on productivity in the industry and the economy as a whole? Let’s use the example of the artificially intelligent bankruptcy lawyer above. The productivity of the lawyers in bankruptcy practice can be defined as the number of cases concluded divided by the number of lawyer hours billed to do so*. Presumably the number of lawyers (and legal hours billed) will decline with the aid of Ross. Thus the surviving lawyers working on bankruptcy law in a legal practice will have become more productive in the sense of an increase in the ratio (cases concluded/hours billed). Measuring productivity in this case seems a simple task.

It becomes much more difficult to measure the productivity of a service provider when real output is much trickier, and sometimes impossible, to measure. One would not wish to measure the productivity of an analyst, journalist, artist or inventor of a new video game by the number of words written and published or number of pictures painted or pixels injected. The quality of the work produced is surely more important than the quantity of output and “quality” is recognised in revenues generated. As is admitted by the calculators of productivity, it is impossible to measure the productivity of government officials, because it is not possible to measure how much they produce. All that can be measured is their employment benefits – an input. In the case of an author, composer, copywriter or game developer, only the value of the royalties they have earned can be measured – their revenue line, not the time spent writing the masterpiece. Measuring productivity requires that inputs and outputs can be independently measured, which is not always the case, especially for service providers.

However, looking at the example of the number of bankruptcy cases (which we would regard as an independent measure of output), what if the quality of advice has improved even as the numbers of hours billed declines? The advice may be superior with the aid of Ross’s deep memory bank. How would we adjust for this quality dimension in our measure of legal productivity? The question is apposite for the service sector generally, where computers and data management (and improved knowledge) have presumably enhanced the quality of service provided by lawyers, analysts and other knowledge professions, including the improved offering of physicians supported by bigger data and better statistics. If the quality of advice has objectively improved, then any hour of consulting service will be delivering more in real terms than a case handled in the same time say 10 years before. The output of the consultant will in effect have increased, even if the input of time is the same. But by how much is the leading question. The physicians may be seeing the same number of patients a day, charging them higher fees, but they (their patients) are likely to be living longer and better lives.

In cases like this we will not be comparing like with like, apples with apples or aspirins with aspirins, making any measure of real output and so productivity over time a very difficult exercise and one subject to significant errors in what is measured. For example, your medical insurance may well have become more expensive – or your cover reduced – but are you not getting a better quality of medical service in return? And exactly how much better? In the case of medical insurance, only what you are paying – not your additional benefits – will find their way into the official price indices.

A further aspect is the impact of improved quality on the broader economy. If the bankruptcy cases are resolved with less billable time spent in court and hence with a larger percentage of debt being recovered with reduced legal expenses, this would be a clear gain to the creditors. Creditors would be better off in real terms, with less spent on legal fees and earlier resolution of their claims, meaning that the creditors could spend more on other goods or services or save more. And lawyers competing with each other for work that has become less costly for them to supply, may well charge you less for their time. It is competition for extra revenue that turns lower costs into lower prices – even in the legal profession – provided they do not collude on fees.

Could the GDP deflator, the price index that converts estimates of GDP in money of the day into a real equivalent, hope to pick this up with a high degree of accuracy? Enough to provide accurate measures of GDP or productivity growth over extended periods of time? The deflator used to convert nominal GDP into real GDP, attempts to adjust for quality improvements in the output of goods and, especially, services produced. Yet in South Africa, 68% of all value added is comprised of services of one kind or another the quality of which may well be changing over time, in ways that are very difficult to measure.

Ours is more of a service economy, than one that produces goods, the output of which is much more easily measured in units of more or less constant quality – for example number of bricks or tons of cement or steel. Thus, if we are underestimating quality improvements in the large service sector, we will be overestimating inflation and so underestimating the growth in real incomes, output and productivity.

Your real incomes and your productivity may well have increased even if you are taking home no more pay or other employment benefits. You may be benefitting from an enhanced quality of service as well as a very different mix of services than was available 10 years before, for example easy internet access that has so changed the way we work and play. This has become a particular problem in the developed world where prices as measured are generally falling. Deflation, rather than inflation, is the greater concern and nominal wages are not rising, even if productivity and the standard of living, differently measured and quality enhanced, is improving (though perhaps poorly recognised, as voters in their frustration at their constant money incomes turn to populists who promise a better standard of living). A mere one or two per cent extra a year factored into GDP or productivity growth measures, well within a range of possible measurement errors, would provide a very different impression of how the developed world is doing. A rising real standard of living, if only we could measure it, might well be accompanying stagnant employment benefits, when calculated in money of the day.

*One of the criteria the World Bank uses for measuring the ease of doing business in any country is outcomes in the bankruptcy courts. The tables below measure ease of doing business across a number of categories, and we show the SA and Australia findings where SA compares quite poorly. The ranking is, for example, 120/189 for ease of starting a business compared to 11 for Australia; and 41 for bankruptcy proceedings compared with 14 for Australia. Both countries rank poorly for trade across borders (130 and 89). Note we do much better than Australia when it comes to protecting minority investors: ranked 14 vs 66; and worse for getting credit, 59 Vs 5.

 

Why accurately measuring and anticipating inflation is much more than a statistical exercise

Tim Harford of the Financial Times in an article carried in Business Day 18th May (Big data power up inflation figures) writes of the attempts under way to predict inflation ahead of the official data releases using ‘big data” – in this case observing continuously thousands even billions of prices reported online “by hundreds of retailers in more than 60 countries”

There is however more to this very welcome exercise made possible by modern technology than improving our measures of inflation –or being better able to adjust prices for changes in the quality of the goods and service being priced in the market place- a truly formidable task as Harford suggests. Or for that matter in the practice of in using high frequency data to predict the next GDP announcement, which also comes with something of a time lag. Helping to anticipate the next GDP announcement in the US is an exercise undertaken by one of the branches of the Fed. The Federal Reserve Bank of Atlanta publishes its GDPNow forecasts of GDP that are attracting understandable attention in financial markets.

The primary purpose in being able to more accurately predicting inflation or growth announcements to come is that it helps the forecaster to anticipate central bank policy changes – in the form of interest rate adjustments or doses of money creation- now called Quantitative Easing- that may follow the news about inflation or growth. Past performance tells us that central banks will react in predictable ways to the unexpected, to the surprisingly good or bad economic news to which inflation and GDP announcements make a large contribution. The economic news is important because the central bank regards the news as important. They are mandated to meet targets for price stability and to help the economy realise its growth potential. Knowing what the central bank will do can be very valuable information. Valuable because what central banks can do is move markets. And beating the market- being ahead of the market moves – can be extraordinarily valuable. Just as being behind the new direction of a market can be as damaging to participants in markets who miss-read the signals.

Central banks however can only move the markets in what they may regard as the right directions if they can take the market place by surprise. As is well recognized in the market place- only surprising news matters- the expected is captured in current prices and valuations. And so there is every reason for participants in the financial markets not to be surprised so that they can take evasive action in good time and position themselves for what central banks and the market may do to them. Better forecasting models of inflation or growth – or even of the next inflation or GDP announcements, using new technology- big data- helps market participants to realize profits or avoid losses.

Yet by anticipating central bank action the market place helps void the intended influence of central bank actions on the economy. This makes central banks much less influential over the economy than the still generally accepted conventions allow central bankers about the role they can and should play in managing the business cycle. Robert Lucas of Chicago in 1995 was awarded a Nobel Prize in economics (as were other rational expectation theorists, for this “policy invariance” critique of central banks, including Finn Kydland and Edward Prescott (2004) And one could add to this list of path breaking Nobel Prize winning economists, Edmund Phelps (2006) and even Milton Friedman (1976) honoured for demonstrating that economic growth could not be stimulated by inflation. They showed that any favourable trade-offs of inflation (bad) for more growth (good) were between unexpected inflation (not inflation) and GDP growth- something very difficult to achieve in any consistent way because of inflation avoiding behaviour market participants would be bound to take. The case for more inflation had been made by the famous Phillips curve- a theory that at one stage enjoyed wide support in the economics profession as a justification for engineering more inflation. Inflation (higher prices) it was thought could help overcome price and wage rigidities that were presumed to prevent an economy finding its own path to full employment. It became the essence of Keynesian economics.

Modern central bankers now take inflationary expectations very seriously. So labelled Expected inflation augmented Phillips curves are at the heart of their inflation modelling. (Inappropriately given the history of a failed theory) They attempt through their policy interventions to “anchor” inflationary expectations- as the phrase goes. By anchoring inflationary expectations they hope to avoid inflationary surprises that are well understood to be damaging to the real economy.

Unexpectedly high or low inflation makes it harder for firms and trade unions, with price and wage setting power to make the right output and employment optimizing decisions about wages and prices. Unexpectedly high or low inflation can temporarily confuse them about the true state of the economy and so exaggerate the direction of the business cycle that will in time be reversed as inflation expected adjusts to actual inflation.

But this sensible understanding of the need to avoid inflation surprises does not seem to inhibit the larger ambitions of central banks to manage the business cycle. They still seem to believe that they able to helpfully “fine tune” the economy- manage the business cycle – through appropriate changes in interest rates and QE so that the economy can realizes its full growth potential. But logically or rather illogically this must mean being able to surprise the market place with their policy reactions – a market that is very determined not to be surprised.

In pursuing such grand ambitions to manage more than inflationary expectations, central bankers are perhaps promising more than they can hope to deliver- and so attaching too much attention to themselves. The market place has become increasingly skeptical about central bank delivering on its promises to manage aggregate global spending, demand that remains deficient despite the best efforts of central bankers world-wide. More central bank modesty – as well as more realism in the market place – about what central bankers can and cannot do – is called for.

Can technology rescue the banks from the regulators?

Mervyn King (not the famous South African one) – now Baron Mervyn King of Lothbury – was once a highly influential Professor at the London School of Economics and then the Governor of the Bank of England until 2013, during which time he helped guide the UK successfully through the financial crisis.

(More recently, he resigned from the Board of the Aston Villa Football Club, the team that finished last in the English Premier League this season. Since past performance is no guide to future performance (in football and in financial markets) this surely will be forgiven.)

King has written a book “The End of Alchemy” to express his disquiet with the post financial crisis banking system and how it is being regulated1. To quote King: “The strange thing is that after arguably the biggest financial crisis in history nothing much has really changed in terms either of the fundamental structure of banking or the reliance on central banks to restore macroeconomic prosperity.”

The fundamental problem, King argues, is in the nature of the incentives banks have in taking risks with other people’s money. When the risk taking works out, the bank shareholders and managers get the rewards, while society has to bear the fall out when the risks turn out to have been very poorly managed. But is this heads I win – tails you lose asymmetrical risk-reward nexus that different for banks when compared to all other large listed companies?

The rewards for managers and shareholders in any company who take on sometimes highly leveraged risks of failure and then succeed (against the odds) can be enormous. The losses caused by the failure of a large public company can also be very serious for the economy at large – other suppliers or customers. They may well be sucked into bankruptcy should the firm suddenly have to close its doors and workers and managers will have to seek alternative employment. The larger the company or bank, the larger these potentially damaging knock-on effects. But if a company or bank is growing for good economic reasons, it would be poor policy to prevent this growth in efficiency for fear of subsequent failure.

The direct financial losses of business or bank failure will be typically borne by shareholders, whose stake in the winning or losing enterprise will be a small part of a low risk, well-diversified portfolio. These lower risks means less expensive capital for the risk taking firm and so more incentive to take on risk. Yet without limited liability for losses, very little risk taking would ever be undertaken. Society has every good reason to encourage risk taking by banks and others – it is the source of all economic progress – and to provide limited liability for capital providers.

Yet the long and mostly successful history of banks and other limited liability companies is that the price of success – the willingness to accept and deal with business and banking failure – has been well worth taking. The focus of policy should perhaps be on how to improve the defence against actual failure, rather than interfering with the freedom of banks to usefully put capital at risk, in the hope that this will prevent a crisis, by introducing better bankruptcy laws that can act much faster to get a business back on its feet and convert debt into equity to the purpose. This will provide debt holders – especially less well diversified lenders – with every incentive to monitor risk management by a bank or business and to introduce debt covenants to such purpose. Ordinary shareholders, even well diversified ones, will greatly appreciate such surveillance, making a mix of debt and equity finance a desirable one.

A business may well be worth rescuing if the reason for failure is too much debt rather than a poor operating performance. Furthermore, a reliance on central banks to restore macroeconomic stability when threatened by a financial crisis, that can be impossible to predict or avoid, is an essential and appropriate part of these defence mechanisms. The history of central banking is the history of how central banks, beginning with the once privately owned Bank of England (nationalised only in 1947) coped with financial crises.

Banks are however responsible for the management of the economy’s payments system. The payments system, hence the banks, cannot be allowed to fail; not even temporarily. The consequences would be too ghastly too contemplate, as they are being forced to contemplate in Zimbabwe as we write.

The interest spread between what a bank offers for deposits and receives for loans has helped to subsidise the cost to the banks of running the payments system. The customers of banks do not typically pay transaction fees to cover the full costs of the payments system they utilise. Hence the attractions of cheap funding for the banks in the form of very low interest transaction accounts and attractions for their customers in the form of low cost transactions that make up for low interest rates received. A comparison of bank charges with charges made by vendors using credit card systems or with the percent of the value of a transaction charged by the money changers and transmitters, makes the point. I am told that for every R100 transferred for example to Malawi through the banking system, the receiver will receive R90 at best. How much of the 9% charge goes to the banks, to the money change agents and the government, I do not know.

The business case for bundling bank borrowing, lending, trading and making payments may however be breaking down. Blockchain computing is being used to safely and cheaply move valuable Bitcoins around the world. The technology could extend to transactions effected by specialist electronic money-changers, charging low fees that still cover low costs. Pure transaction accounts could be made fully and always backed by reserves of central bank deposits or notes in the till or ATMs, rather than covered by deposits or reserves held with other more vulnerable banks. If transactional banking can be legally and economically separated from risk taking banking, the all-important payments system can be insulated from the danger of banking failure. Banks, as with other firms, can then be left to manage their own risks. This may well be the way to rescue banks – or rather their risk-absorbing shareholders and debt holders – from the profit-destroying and cost-raising burdens imposed by risk-avoiding regulators.

1These observations were stimulated by an article by Michael Lewis: On The End of Alchemy – A Central Bankers Memoir (Mervyn King Of The BOE), Actually Worth Reading, Bloomberg Business, 6 May 2016

 

Not so Moody after all

Moody’s Investors Service showed its softer side when confirming SA’s investment grade credit rating. The rating agency made it clear that to maintain this grade, SA would need to increase its GDP – that is, simply not fall into recession. A mere 0.5% increase in 2016 would meet Moody’s modest expectation, followed by 1.5% in 2017.

Growth, as Moody points out, not only makes government debt easier to manage. It helps the banks and the households meet their obligations and will also encourage firms to invest more in additional capacity.

To quote the preamble to the report:

“The confirmation of South Africa’s ratings reflects Moody’s view that the country is likely approaching a turning point after several years of falling growth; that the 2016/17 budget and medium term fiscal plan will likely stabilize and eventually reduce the general government debt metrics; and that recent political developments, while disruptive, testify to the underlying strength of South Africa’s institutions.

“The negative outlook speaks to the implementation risks associated with the structural and legislative reforms that the government, business and labor recently agreed in order to restore confidence and encourage private sector investment, upon which Moody’s expectations for growth and fiscal consolidation in coming years — and hence the Baa2 rating — rely.”

Moody’s identifies three drivers that inform its decision. The first, most critical, we would suggest, is that the economy will recover from a business cycle trough:

“..The first driver for the confirmation is Moody’s expectation that South Africa’s economic growth will gradually strengthen after reaching a trough this year, as the various supply-side shocks that have suppressed economic activity since 2014 recede. Specifically, the electricity supply is now more reliable, the drought is ending and the number of work days lost to strikes has shrunk significantly (a trend that planned rule changes are likely to embed further). In addition, the inflation outlook is more subdued, which would suggest fewer interest rate rises ahead than we expected when the South African Reserve Bank saw inflation heading towards 8% by year end. Less severe tightening of monetary policy would alleviate extra pressure on South Africa’s relatively highly-indebted household sector and support growth.

“Alongside the more competitive exchange rate, these improving trends are likely to strengthen growth in South Africa from the second half of this year and thereafter. While we expect the economy to expand by only 0.5% in 2016, we expect growth to rise to 1.5% in 2017. Moreover, ongoing structural reforms and diminished infrastructure bottlenecks offer upside potential for growth over the medium term. The recent rapprochement between the government, business and labor holds promise from the standpoint of identifying areas of mutual concern. A number of benchmark actions related to matters such as the rationalization of state-owned enterprises (SOEs) and the enactment of labor market reforms have been identified in the process. To the extent that implementation of such measures helps boost business confidence, investment and job creation, they would improve prospects for gradually reducing wide economic disparities and high levels of poverty, deprivation and unemployment.”

The second driver for the unchanged rating was “The Stabilization of government debt ratios likely to occur in 2016/17” and the third was “Recent political developments testify to the strength of South Africa’s institutions”.

The rating was placed on a negative watch because such hopeful predictions have still to materialise. Or, to put it bluntly, will the economy grow by 0.5% in 2016 and 1.5% in 2017? These are not demanding outcomes even by SA’s well below average growth performance in recent years. What then could cause SA to fall into recession?

The simple short answer would be a further slowdown in household spending. Since households account for over 60% of all spending, any further reluctance in their willingness or ability to spend more will drag the economy into recession. It will neither encourage firms to invest more in people or capacity nor encourage foreign savers to fund our savings deficit.

It is striking that Moody’s could look to lower rather than higher interest rates to improve the growth outlook and the ratings prospects. To repeat the observation made above from Moody’s:

“In addition, the inflation outlook is more subdued, which would suggest fewer interest rate rises ahead than we expected when the South African Reserve Bank saw inflation heading towards 8% by year end. Less severe tightening of monetary policy would alleviate extra pressure on South Africa’s relatively highly-indebted household sector and support growth.”

We have long questioned the Reserve Bank’s decisions to raise interest rates into higher inflation and a weaker economy. It seems to us that the higher rates can make no predictable impact on inflation or, it may be added, on inflation expected – that has also risen lately despite the weakness of the economy and despite interest rates that have been rising since early 2014. This proves only that inflation and expected inflation is dominated by forces well beyond the influence of higher short term interest rates. That is in particular by the behaviour of the rand, the behaviour of the weather, the behaviour of the President, the behaviour of global commodity and oil prices and Eskom and its regulators, to mention some of the supply side shocks that have driven inflation in SA higher.

Interest rate increases do nothing useful to contain inflation in a world where the supply side shocks are pushing prices higher and household spending lower. What they do is to reduce household spending further than would have been the case with stable or lower interest rates. For every one percent increase in the repo rate, the Reserve Bank forecasts a 0.4% reduction in GDP growth over two years.

This should be emphasised, in the light of the Moody’s report, since rate increases prejudice rather than enhance our credit rating. An independent central bank is one of SA’s institutional strengths. But such independence could have been much better managed than it has been. Lower, not higher interest rates, would have served the economy better (and still can) and helped preserve its growth rates. Moody’s would seem to agree.

Are there other forces at work that could help the economy grow a little faster? The weaker real and more competitive rand finally seems to be helping the manufacturers as well as the tourist business. The latest survey of manufacturing activity, the Barclays PMI, shows a very healthy recovery and positive growth. If the past strong statistical relationship between the PMI and GDP growth is to be relied upon (showed below), this improvement does suggest significantly faster growth to come. The PMI is well up and the GDP growth rates in Q2 can be expected to follow. We thank Chris Holdsworth of Investec Securities for drawing this relationship to our attention:

 

The other helpful influence at work is a much smaller foreign trade deficit recorded over the past two months. Less imported and more exported add to GDP growth rates. A decline in inventories held, especially inventories with import content, may offset these favourable forces on recorded GDP growth. But a combination of a more competitive rand and a more cautious Reserve Bank, more sensitive to the growth outlook, as well as the business cycle trough from which conditions improve rather than deteriorate, should deliver growth of 0.5% this year and 1.5% next; enough to satisfy Moody’s. Raising the growth rates to permanently higher rates of over 3% requires the structural reforms of the labour and other markets that Moody’s appears surprisingly optimistic about. One can only hope that their optimism is justified.

 

The wisdom in foreign exchange control reforms

A notable milestone in SA’s financial history was passed in the second half of 2015. For the very first time, the value of South Africans’ foreign assets has come to exceed the value of the South African assets and debt held by foreign investors. At year end, our holdings of foreign assets, worth over R6 trillion, exceeded our foreign liabilities by as much as R714bn.

 

The buildup in offshore assets legally owned and managed by South African businesses, pension and retirement funds as well as directly by wealthy individuals, began from very modest levels in 1994, when South Africans became acceptable participants in global financial markets.

The growth in foreign assets and liabilities has served South Africans particularly well in recent years as the SA economy has been severely buffeted by a damaging combination of weak growth and higher inflation. Stagflation has accompanied a collapse in the currency, higher charges for utilities a severe drought and, to top all these economic body blows, we have seen (avoidably) higher borrowing costs imposed by the Reserve Bank.

The increasingly large foreign component in SA portfolios of assets therefore has helped significantly to mitigate the shocks to their incomes and balance sheets caused by specifically negative South African events, both political and economic. The protection against their exposure to SA risks has come in large measure from the shares they own in JSE-listed industrial companies whose major sources of revenues and earnings (as well as the costs they incur) are generated outside SA.

The successful industrial companies that began life in SA and have prospered abroad include Naspers (NPN), SAB, British American Tobacco (BTI), Mediclinic (MEI), Richemont (CFR), MTN, Steinhoff (SNH), Brait (BAT) and Aspen (APN) . They have come to dominate the JSE when measured by market value. Up to 50% of the value of the JSE is accounted for by these large firms, that we can describe as Global Consumer Plays (GCPs). Before the rise of these now global companies, investors on the JSE would have been much more exposed to the highly variable fortunes of Resource companies that used to dominate the JSE. Without these opportunities to invest in these world class companies on the JSE, as well as the investments made abroad by these companies and other SA based companies outside of SA, the value of SA pensions and retirement plans might have looked very sad indeed.

An equally weighted Index of 14 of these GCPs on the JSE (including recent underperformers MTN, ASP and CFR) has performed as well as the leading global index, the S&P 500, over the past two years or so, adding about 30% to its rand value of January 2015.

Well-developed liquid capital markets not only provide companies and governments with access to capital. They provide wealth owners, and their fund and business managers, with the opportunity to diversify away firm or country specific risks. A well-diversified portfolio with a full variety of investment opportunities, none of which will dominate the balance sheet and whose individual returns are somewhat independent of each other, makes for a much less risky portfolio, that is a portfolio whose value, while expected to rise over time, will do so more predictably than most of its separate components (especially individual shares) included in the portfolio. The well diversified portfolio provides positive returns with significantly less risk – that is smaller value movements in both directions.

Less risk moreover translates into lower required returns of the investor or wealth owner. Lower required returns also mean lower costs of capital for the firms hoping to raise capital to expand their businesses. Lower required returns in turn will mean more capital invested, a larger capital stock and a stronger economy. This is one of the benefits of a well-developed capital market that can attract capital from savers everywhere and not only domestic ones- as has the SA capital market – where capital inflows have more or less matched capital outflows over the years – as we have shown in figure 1 above.

Human capital effect

But the less risky returns that the opportunity to invest globally provided to South Africans benefits not only the owners of tangible capital but also the owners of intangible human capital committed to the SA economy.

There is always a global shortage of skilled professionals, including managers of businesses, for which competition is intense. By enabling skilled South Africans to invest abroad and diversify away SA risk, their required returns from SA sources have also declined. That is, they are more willing to apply their skills in SA – and therefore are more willing to sacrifice returns, that is employment benefits – because their wealth is better insured against SA risks to their wealth. This now more favourable exchange of less risk for lower returns by owners of a crucial resource- the human capital of skilled professionals- helps to make the SA economy more globally competitive

It has been wise of the SA government to relax exchange control over the years – it has helped the economy retain its skills and so better ride out economic misfortunes.

Were the economy to grow faster over the next few years, the outward flow of capital would be more than matched by inward flows of fixed direct investment (FDI) and portfolio capital. Also, foreign controlled companies would be more inclined to reinvest profits than pay them out as dividends. Growth leads investment by companies in additional capacity and stimulates the flow of funds to support growth. Without faster growth, the flows through the net flows through the SA balance of payments will continue to be more out than in.

The economy would grow faster were global market forces to become more favourable to our emerging, metal price-dependent economy. The rand would then strengthen (as it has lately) and the inflation and interest rates would come down rather than rise to help the economy along. Faster growth over the longer term would respond to more business, employment and wealth friendly policy reforms, of which exchange control reform is a very good and helpful example.

Some details about capital flows

FDI is defined as an investment by a foreign company with a more than 10% shareholding. Portfolio investment is defined as a less than 10% share. As may be seen below, outward FDI has recently come to exceed inward FDI, while inward portfolio investments continue to exceed outward flows – that have become significantly larger.

As important for the SA balance of payments is the flow of dividend receipts and payments. The flows of dividends from portfolios has become a net positive for the SA economy while the flow of dividends from FDI remains strongly in the other direction.