November 2016 – ZA Economist

Will a national minimum wage help the poor? We beg to disagree with the expert panel

The National Minimum Wage for South Africa (NMW) – will it be helpful or harmful to the poor of SA? We beg to disagree with the expert panel.

A reality check

It is always salutary to be reminded just how dire are the economic circumstances of the average South African and how slowly their economic conditions have been improving. Over 51%, some 29,733,210 of our people, live on less than R1,036.07 per month. These and many other shocking statistics are reported by the Panel of Experts appointed to recommend the level of a National Minimum Wage (NMW) and on a process for its effective implementation (“Recommendations on policy and Implementation; National Minimum Wage Panel report to the Deputy President”).

The table calculated by the panel, included below, provides helpful detail about the lack of income and the associated unemployment.

The panel has no doubts about the helpfulness of an NMW in principle – only reservations about practice

The panel seems to have no doubts that a NMW would be a very helpful policy intervention in principle. To quote selectively from its substantial report of 128 pages”

“On its own it will not solve all of the challenges we face, but it is an implementable policy which is designed to have a measurable and concrete benefit on the poor. The minimum wage is therefore seen as one of the tools to close the wage gap, including between the genders, and thereby to overcome poverty.

“Furthermore, under the correct conditions and at the correct wage level, it is possible for minimum wage policies to contribute to improving economic growth. ……Given that the national minimum wage is essentially a policy to help the poor, it is generally accepted that exemptions and exclusions should be kept to an absolute minimum.”

Striking a balance – recognising employment dangers in scenario exercises

The panel was required by the social partners in Nedlac, who agreed to an NMW, to recommend an appropriate level for the NMW. Since it recognised a relationship between wages and employment the MNW had to strike a balance between the effects of increasing wages to a higher prescribed minimum level and its consequences for additional unemployment of which SA already has a great abundance. Some 26% of the labour force, those in work or looking for work, are currently unemployed, while many more potential workers have been discouraged from looking for work and have fallen out of the labour force. Adding them to the work force would imply a more broadly defined national unemployment rate well into the 30% plus range.

The panel recommended a NMW of R3500 per month or R20 per hour to be phased in by 2020 with 90% of the NMW to be applied in agriculture and 70% in Domestic Service provided to Private Homes. It also recommended annual reviews of the NMW and a gradual move to uniformity across all sectors of the economy. Using a so-called Computable General Equilibrium model of the SA labour market (as described and developed by Professor Harron Bhorat of UCT) that included assumptions (not predictions based on past performance) about the trade-offs between percentage increases in minimum wages and percentage reductions in employment (the relevant employment elasticities in economic speak) .

The aggregate employment losses were estimated as between 100,000 and 900,000 jobs lost in exchange for the recommended NMW. Clearly in the view of the Panel, the NMW had to be set high enough to make its contribution to poverty relief and yet low enough to be able to treat the extra unemployment as the acceptable price to the panel members of them doing such good for society. Another argument for breaking eggs to make omelettes from those unlikely to be harmed by the action and who might even benefit from helping to give effect to a new dispensation.

However the panel did qualify its judgment. It noted correctly:

“…..that there is no research or data that can accurately predict the outcome of any policy intervention. It is for this reason that strong emphasis has been placed on the need for good solid research to support the work of the NMW institution into the future. Any future changes to the level of R3,500/R20 per hour should be based on solid evidence of the impact of the national minimum wage.”

Would it be unkind to recognise that this would also be more grist for the economist’s mill?

The relationship between minimum wages and employment – what may be self-evident to the panel is not so to the society at large

It would have been helpful had the panel used the report to explain more fully why employment offers are negatively related to the wages or rather employment benefits provided by employers in exchange for hours worked. The relationship is much less self-evident than the panel may have presumed it to be – especially by members and leaders of trade unions who are inclined to attribute wage differences much more to political forces and bargaining power and even to race – than to the differences in skills and therefore of the contributions to output made by the well and poorly paid. And they are very inclined to believe that the wage gaps can be easily closed, with little consequence for economic growth by taking more from the well paid and giving to the poor. And so for ever higher NMW.

The relationship between skills, incomes and employment

The panel is well aware of an obviously important and highly consistent relationship to be observed of the SA labour market between measures of skills and wages earned. And as statistically significant is the relationship between incomes and employment. The lowest income South Africans have the highest rates of unemployment. The full income and employment details are shown in the table below (Table 5 Household Indicators of the Panel Report). Other reports from Stats SA have demonstrated the links between educational attainments and income and employment.

It may be seen in the Table, that of the 16,306,000 people in Quintile 1, 31.2% of the population with the lowest share of income, only 15,9% are employed, 25% strictly unemployed and the broad unemployment rate of this group is estimated as 65.8%. The average wage of those employed in quintile 1 is only R1017 per month. The second poorest quintile counts for a further 24.6% of the population, has a lower unemployment rate, a much higher participation rate in the economy and average wage incomes of R1707 per month. A large improvement but still a very low average wage.

The top income quintiles present very differently. Unemployment rates are much lower and participation rates and average incomes from work of the employed are much higher and well above the recommended NMW. Though it should be noted that the average wage income of those employed who fall into Quintile 3 of R2651 per month, is still well below the R3500 per month recommended NMW.

The implications of a NMW set so far above average wages- is there precedent that can help us predict the employment effects with any confidence?

This begs the question – is there any precedent for a NMW or a sectoral minimum wage determination –be set so far above average earnings – and if so what have been the consequences for employment? Or put in another way is there reason given the facts of the labour market to think that the employment elasticities in SA are a lot more negative than the range of assumptions considered by the models. Time will tell much more about the consequences of the recommended NMW as the Panel complacently assumes and adjustments can then made to the model and the recommendations. But who will care for the unemployed and their dependents in the meanwhile?

How can an NMW help the poor – who are now mostly not employed?

It is very difficult to understand why the Panel should believe that the NMW can be helpful to the poor of South Africa or reduce inequality. Because fundamentally the poorest South Africans those in first and second quintiles, are mostly not employed. And when employed they are able to only command wages far below those of the recommended NMW that still leave them objectively poor.

The recommended NMW will surely make it even more difficult for them to find work that might for some, especially young workers, prove a path out of poverty. Thus the NMW is very likely to increase further the unemployment of low skilled potential workers in SA and to widen the gap between the average incomes of the high earners and the low earners, mostly no earners of the population. The poor of SA deserve better opportunities to work and more so the opportunity for their children to acquire the education and skills that would help them qualify for and find well paid work. They do not need further interference in their search for work.

Employers will make the adjustments that will confuse the observers

Though to complicate the numerical outcomes to be observed in due course, structural adjustments to employment practice will be made by employers in response to higher minimum wages. The adjustments will include more reliance on mechanisation and automation- requiring more carefully selected and skilled employees, forces that substitute capital for labour, especially less skilled labour, that are already well at work in the economy.

Other adjustments employers will make will be to offer fewer hours of work and significantly less by way of other important employment benefits, food and accommodation and contributions to pension and medical aid for example, the cost to employers and value to employees the panel refuses to recognise in its money wage only determination. Evidence of such reactions so unhelpful to low income workers comes from previous minimum wage adjudications in the agricultural sector. Fewer workers were employed permanently – less accommodation was offered on the farm – and higher transport costs was incurred byr workers busing in from informal settlements. And there is also bound to be less compliance with the law given the availability of cheaper labour and additional employment offered to illegal immigrants.

Why does the labour market only work well for the higher income earners? Is it because they are much less encumbered by regulations and collective bargaining?

A further observation of the inconvenient and uncomfortable truths of the SA labour market is that the supply and demand for labour are very well matched for the well paid and very poorly matched for the low paid. A very high unemployment rate – a large number of potential workers unemployed at current wages – is surely evidence of wage levels that are too high rather than too low to the important purpose of providing work for those who would wish to work- at prevailing wage rates.

These are not considerations that receive much attention from the panel. Other than a presumption of “structural imbalances” or why these structural forces that discourage employment do not apply to the most expensive of workers in SA who are so readily employed?

It is to be conceded that employment at low wages for those with limited skills cannot overcome the poverty of the working poor. But then what can – other than them acquiring the valuable skills that are in short supply and well worth hiring. Wishful thinking- waving magic wands in the form of un-affordable to potential employers of high minimum wages will not solve their problem.

But unemployment makes their condition more onerous and denies them the employment and low wage benefits that they would be willing to accept. A willingness demonstrated by their seeking work. And being unemployed prevents the potential worker from acquiring skills on the job and the opportunity to demonstrate their capabilities that add to their employment credentials. These opportunities are particularly important to young, unskilled entry level workers whose unemployment rates are regrettably but understandably well above average unemployment rates as is well recognised by the panel.

The panel might have sought an explanation of the high rates of unemployment of low income South Africans in the structural impediments to their employment in South Africa. Barriers to employment offered or accepted in the existing highly pervasive regulations of their employment contracts. It is not as if minimum wages have not been tried in SA. They are widely practiced and have surely had their effect on the employment of the lowest paid and least skilled.

The current regulatory barriers to employment in SA

There are in fact 124 separate such sectoral minimum wage determinations. They cover approximately 5m workers and 33% of those employed leaving only 35% of workers uncovered including presumably many of the better paid also without Union representation. The lowest such monthly determinations in 2015 ranged from R1813 for Domestic Workers to R2844 per month per Contract Cleaner in the lowest grades. The highest sectoral minimum determinations – for more skilled work- were R6155 for workers in private security and R6506 per month in Retail and Wholesale businesses.

The newly fashioned NMW is intended to remove all this administrative complexity – and presumably also the possibility of recognising very different labour market conditions – supply and demand – that may apply in the different sectors and regions of the economy. Conditions that participants in specific labour markets, unencumbered by regulations would be much better informed about than even diligent officials to the advantage of workers and their employers.

The case for best leaving the determination of an employment contract to willing buyers and sellers of labour does not get any hearing from the panel. While the collective bargaining process in SA that can easily be shown to protect the established interests of employees and their employers – the insiders – at the expense of the employment opportunities of the outsiders – receives nothing but uncritical approval from the panel- and with an appeal for the wider application of collective bargaining arrangements.

The influence of welfare on employment

Nor did the influence of SA’s extensive welfare system on poverty and employment receive much more than perfunctory and rather condescending attention from the Panel as follows.

5.43. “While wages are low relative to living levels, there are arguably some offsetting effects from the social wage spending by Government. About 35% of South Africa’s budget is spent on programmes targeted at the poor, including free basic education, health care, water and electricity, and income support grants for children and the elderly”.

They may, as did the Davis Committee on Tax Reforms, have referred to a report of the World Bank on the influence on incomes and their distribution of SA of its welfare system. To quote this study:

“But while incomes earned in South Africa may well be the most unequally distributed in the world – the distribution of expenditure is much less unequal. The World Bank shows, in a recent study, that South Africa does more to redistribute income in cash and kind to the poor than its developing economy peers with similar average incomes , Armenia, Brazil, Bolivia, Costa Rica, El Salvador, Ethiopia, Guatemala, Indonesia, Mexico, Peru, and Uruguay (South Africa Economic Update Fiscal Policy and Redistribution in an Unequal Society, World Bank, November 2014).”

As this World Bank study also reports:

“South Africa ranks as one of the most unequal countries of CEQ (Commitment to Equality Methodologies applied by official statisticians in income measurement) participant countries, if not among all middle-income countries, given its Gini coefficient of 0.69. The proportion of the population living in poverty at 33.4 percent measured by the international benchmark of $2.50 a day(purchasing power parity, PPP, adjusted) — is also higher than in many other middle income countries with similar levels of GNI per capita. For example, the poverty rate is 11 percent in Brazil and 4 percent in Costa Rica”

To quote further from the World Bank report:

“Briefly, this Update has two main findings. First, the burden of taxes falls on the richest in South Africa, and social spending results in sizable increases in the incomes of the poor. In other words, the tax and social spending system is overall progressive. Second, fiscal policy in South Africa achieves appreciable reductions in poverty and income inequality, and these reductions are in fact the largest achieved in the emerging market countries that have so far been included in the CEQ. Yet despite fiscal policy being both progressive and equalizing, the levels of poverty and inequality that remain are unacceptably high. South Africa is currently grappling with slowing economic growth, a high fiscal deficit, and a rising debt burden. In this context, addressing the twin challenges of poverty and inequality will require not only much-improved quality and efficiency of public services but also higher and more-inclusive economic growth to help create jobs and lift incomes.” (p22)

These income transfers and benefits in kind may moreover, influence the willingness to supply labour services at prevailing wages – especially when wages on offer are very low. By providing an alternative source of benefits welfare raises the reservation wage – the wage at which it makes good sense to work or to seek work, work that may well be physically demanding and less than enjoyable for its own sake. The panel might have paid much more attention to the supply side of the SA to help explain low rates of labour force participation. Also to help explain why immigrants from Africa are much more likely to be employed – at market related wages.

Economic growth and employment – ignoring the evidence

The panel remarks somewhat self-evidently that:

“An additional problem faced by the country is that there is evidence that the growth in the demand for labour in South Africa has not been sufficient to keep up with the much larger growth in labour supply.”

The panel quotes with seeming approval a study that apparently shows growth and job creation are not well correlated. To quote the Panel:

“Recent empirical work by Mkhize (2016) finds that the economy’s capital intensity undermines its ability to generate jobs in times of economic growth. He finds that, in the long run, growth and job creation are not correlated, although there is some sectoral variation. This points to the broader economic policy challenge facing South Africa, which is that there are structural barriers that exacerbate unemployment, the solutions to which require more than economic growth”.

A surprising conclusion it would be thought, given the fact that in the developed world incomes (GDP), population and the size of the labour force have grown together, as indeed it did in SA until the 1980s – as our own work has shown (see below), though such work on the relationship in SA between GDP and numbers employed is complicated by the absence of an official continuous long time series of numbers employed. Though the structural break in the relationship in the 1980s is easy to recognise and to be self-evidently explained by the increasing degree to which the SA labour market came to be regulated and the increasing bargaining power conceded to trade unions in the 1980s.

The recommended NMW represents more of the same lack of faith in market forces that encourage regulation, rather than regulatory interventions to generate growth and employment.

Another case I would suggest of economists as are the governments they usually serve, being part of the economic problem rather than the solution. 28 November 2016

Assessing markets after the US elections

The market reacts to a surprising US election. Is more growth expected in the US consistent with less growth in emerging economies? Perhaps not.

Donald Trump’s ascension to the White House surprised the financial markets. The bond markets have recorded the largest surprises. A heavy dose of shock and awe was registered in the Treasury bond market and the shock waves were also felt in emerging bond markets, including the market for RSA bonds. US 10 year Treasury yields ended last week over 30bps higher (as we write on Monday 14 November, the yield is 2.21% p.a). The RSA 10 year also ended the week higher at 9.11% p.a (now 9.17%) or 44bps higher, meaning a slightly wider SA risk spread of 6.95% p.a. – equivalent to the average rate the rand is expected to depreciate against the US dollar over the next 10 years.

The higher rates in the US were not confined to vanilla bonds. Inflation linked yields (TIPS) also moved higher on Wednesday 9 November, revealing that the Trump presidency was expected by market participants to not only bring more inflation but also faster growth; faster growth that was expected to increase the competition for capital, so making capital more expensive in real terms.

RSA yields indicated that more SA inflation came to be expected as real bond yields remained largely unchanged through the week. This indicated that little change in the SA growth outlook was expected. The wider spread between nominal and real RSA bond yields indicated more inflation expected that was consistent with the faster rate at which the rand was expected to weaken. More rand weakness, other things equal, means higher rates of inflation in SA (See figures 1-4 below).

Higher bond yields were also registered in Europe. German 10 year Bund yields that had been negative in October increased from 0.08% p. a. on the Monday to 0.235% by the Friday close, but not by enough to prevent the spread Vs US Treasuries from widening in favour of the US dollar, which made gains against the euro and much more significant gains vs emerging market currencies.

The rand was an underperformer within the world of weaker emerging market currencies. R13.35 bought a dollar on the Monday, but by Friday the USD/ZAR was R14.29, a decline of 6.8% (now R14.39) compared to our equally weighted basket of 11 other EM currencies that declined by a mere 3.8%. The currency market would appear to be pricing in additional SA-specific risks, perhaps associated with Zuma resilience revealed in the no-confidence in the President motion in the SA Parliament that failed on the Thursday.

Other signs that US growth assumptions were being revised upwards came from the market in high yield or junk bonds. These yields remained largely unchanged as the high risk spread narrowed even as Treasury yields rose. Faster growth reduces the risk of credit defaults and the market in high yield credit appeared to be drawing this conclusion.

Other signs of faster growth expected came from the metals market. While the gold and oil prices expressed in the stronger US dollar fell away, the CRB Index of Industrial Metals in US dollar increased by about 5% in the week while the weaker rand compensated to some extent for lower US dollar prices.

The stock markets also told the story of faster growth expected in the US and slower growth expected in emerging economies. The SA component of the emerging market equity benchmark lost over 6% in the week compared to the MSCI EM that ended the week 3.5% weaker. The large cap US S&P 500 Index gained 3.8% while the small cap index did significantly better, gaining over 7%. This move too could be regarded as supportive of faster growth that improves the prospects for riskier small companies.

The best performing sectors on the S&P 500 and the JSE in the week of 7 to 11 November proved to be the highly cyclical plays. Materials and resource companies did much better than the consumer-facing companies that had offered predictable dividend yields, yields and dividend growth that had compared well with what had been very low interest rates. The same direction could be seen on the JSE with the Global Consumer Plays, despite the weaker rand, proving distinct underperformers.

It is however not at all obvious why faster US growth should be associated with less growth expected fromemerging market economies; nor why strength in metal prices should be associated with a deteriorating outlook for emerging economies, including the SA economy. The opposite conclusion might have been drawn as appears to be the case for the Australian economy, which is highly dependent on metal exports.

The growth prospects for the SA economy would not have been improved by the changed outlook for short term interest rates. As we show below, the short term yield curve, as reflected in the Forward Rate Agreements (FRAs) offered by the banks, moved sharply higher last week. The money market, having much reduced the chances of higher short term rates earlier, has reversed course. The market is now expecting a further 75bp increase in the Reserve Bank repo rate. Such increases, where they to be imposed on the already hard-pressed SA economy, would eliminate almost any possibility of a recovery in household spending, a necessary condition for a cyclical recovery. The bond market is expecting more inflation to come and the weaker rand expected is consistent with such a view.

Yet the USD/ZAR, while now weaker, is stronger than it was in early 2016, indicating stable import prices. Furthermore the outlook for much lower food price inflation should see headline inflation and Reserve Bank forecasts of inflation recede well below the upper band of the inflation target in 2017. The case for higher policy-determined interest rates, given a further slowdown in the economy, is even weaker than it has been, even though the market may now believe otherwise of the Reserve Bank.

Lower inflation, should it materialise, will lead inflation expected in the same lower direction. The causation runs from inflation to inflation expected and not the other way round as the Reserve Bank has argued. Inflation takes its cue from the exchange rate and is much affected by the weather and the actions of the President. These are forces over which interest rates and the Reserve Bank have no predictable influence. The Reserve Bank should concentrate on what it can do to assist the growth prospects of the economy and that is to lower interest rates. Inflation is beyond its control; a fact of economic life in SA that is overdue official recognition but may yet receive it. 15 November 2016

The market is a lot less scared of Trump than the pundits

The punditry not only greatly underestimated the presidential chances of Donald Trump, they also misread the implications of the known election outcomes for the financial markets. Far from the predicted rush for safety in the US dollar, US Treasuries and defensive stocks, the market, when given the opportunity, pushed US bond yields higher, indicating that faster growth and more inflation was to be expected post Trump (the 10 year Treasury yield initially increased from 1.85% to 2.08%, though it closed at 2%).

Further evidence of positive expectations of faster growth came with the outperformance of resource companies, including those listed on the JSE. The performance of the 12 sectors that make up the S&P 500 is shown below. Financials and Healthcare (expected to benefit from less obtrusive regulation and executive action) as well as Materials ( to benefit from growth and investment in infrastructure) were outperformers while sectors that offered protection against a weaker economy, including Consumer Discretionary and Staples underperformed as did interest rate sensitive sectors of the New York stock market.

Emerging markets, a risk off trade, did come under initial pressure, led by the Mexican peso, a currency especially vulnerable to any protection provided for US manufacturers, lost 8.8% of its US dollar value on the day. The rand ended 1.8% weaker while the Brazilian real was 2% weaker. The 10 year RSA yield moved higher, from 8.64% to 8.78%, leaving the risk premium vs US bonds at an unchanged and recently improved 6.79%. The MSCI Emerging Market (EM) benchmark in US dollars ended 2.5% weaker on the day, compared to the JSE that was 1.3% weaker in US dollars and 0.5% up in rands.

These outcomes must be regarded as satisfactory for EM financial markets, including those measured in rands. The exchange value of the rand has held up more than well enough to sustain a forecast of lower inflation and interest rates to come- essential for faster growth in SA.

What the pundits missed is that while Hillary Clinton represented business as usual for the US and its allies, business as usual under Obama had become increasingly less friendly to business. US and global business have come under increasing suspicion and hostility from more ambitious and obstructive officials emboldened with ever greater executive powers. The Trump administration, with the aid of a friendly Congress, could achieve some quick wins for US business by annulling or at least amending financial and environmental legislation and practice, as Trump had promised to do. The grossly dysfunctional US corporate tax system is an obvious target for a complete restructuring in ways that would be helpful to the owners of business in general and to the economy at large – though these are not necessarily synonymous.

Free trade for example (against which Trump argued and which helped him bring in the vote on the rust belt) is very good for consumers and their standard of living. Cheaper and better air conditioners produced in China have made living in the US South a lot more comfortable, for example. But they have not been helpful to the owners of air conditioning factories in the US or to the employment benefits of their employees. Protection unfortunately can be good politics and good for business owners, but not necessarily for their customers. Though if free traders are seeking consolation they may find it in the prospect of freer trade in services, with a far larger role in the economy (including the SA economy) than manufacturers. Exchanges conducted not over the waters but over the internet and are much more difficult to tax.

The Trump triumph, it should be appreciated, represents a successful attack on the conventional wisdoms and actions that have guided social and economic policies in the US and Europe. How wise and fair this consensus actually is, is a matter of very divided opinion as the US election has demonstrated. Given the opportunity provided by the highly unorthodox Trump, large numbers of Americans voted in effect against the comforts of the ruling establishments inside and their supporters outside Washington DC. Their discomfort in recent events is understandable and clearly geo-political risks are enhanced. Perhaps even the risks to the environment have increased. But the risks to doing business in the US and its growth prospects have as clearly declined, as the market has told us. 10 November 2016

The SA economy: The view from the rear view mirror is not encouraging

The SA economy: The view from the rear view mirror is not encouraging. Can we look down the road more happily?

The pace of the SA economy appears to be slowing down rather than picking up momentum – judged by the very latest data releases for October 2016. New vehicle sales and cash in circulation indicate that a trough in the business cycle, that is when economic conditions have begun to improve rather than deteriorate, has not been registered though may possibly be in sight.

New vehicle sales are nevertheless somewhat more encouraging than the latest money supply data. While new vehicle sales are well down on a year ago, sales volumes in October represented a modest improvement over sales made in August and September 2016, especially when viewed in seasonally adjusted terms, as we show below. When current vehicle sales are extrapolated, using a time series forecasting process, a cyclical trough, is indicated for early 2017. As noticed in figure 2 negative, year on year growth rates, may also have reached a low point.

By contrast the demand for and supply of cash still indicates weaker propensities of households to spend more. The demand for cash, as may be seen, is not keeping pace with inflation. Though, as may also be seen, the forecast is that the real demand for cash is about to turn marginally positive, indicating more rather than less spending to come.

When these two series are combined to form our Hard Number Index (HNI), its direction has turned lower after moving sideways for much of the year, indicating declining levels of economic activity. Extrapolating the HNI however also suggests an improvement in activity levels in 2017. As may be seen, the HNI based on two very up to date hard numbers – rather than based upon sample surveys – is a good predictor of the Business Cycle that is calculated by the Reserve Bank, for which the latest data point is for July 2017 (of somewhat distant memory given all that has happened to society and the economy).

The broader measures of money supply and of bank credit and retail sales volumes, updated to September 2016, indicate a similarly weak backdrop for the SA economy, as we show below. The growth in M3 (to September month end) has become negative in real terms while bank credit supplied to the private sector is somewhat more robust. Perhaps bank credit is being used to a degree, to fund offshore rather than domestic growth. As we also show in retail sales volumes shows a declining growth trend that is forecast to continue in 2017.

The hope for a cyclical recovery in 2017 must rest upon the inflation trends. A Reserve Bank forecast of lower inflation would allow for lower interest rates, which are essential to the purpose of a cyclical recovery. As may be seen in figure 6, the time series forecast of the CPI, using the latest data, is for less inflation to come. Recent data releases for the CPI (the latest being for September), do indicate a much shallower trajectory for the CPI. Between July and September 2016, the CPI was largely unchanged as we show below. A degree of exchange rate strength has helped restrain inflation. A normal harvest in 2017 would do more of the same. South Africans, under severe economic pressure, would be justified in praying for more rain combined with strength in emerging market currencies, including the rand.

Bonds vs equities redux – including the outlook for inflation

Just under two weeks ago, we noted that 2016 has proven to be a very good year for investors in RSA (government) bonds (see Special focus). We revisit and update the topic in the light of recent events.

Bonds have outperformed equities and cash by a large margin this year. By 28 October, the All Bond Index (ALBI) had delivered a total return (including interest reinvested) year-to-date of 14.2%, compared to 2.7% provided by the All Share Index (ALSI) of the JSE. The inflation-linked RSA Bond Index (ILBI) had returned 8.1% by 28 October, while the money market would have returned 6.2% over the period (though it should be appreciated that bond yields had weakened sharply in December 2015 as had the rand in response to the President Zuma-inspired turmoil in the Ministry of Finance). On a 12 month view to 28 October 2016 – from 1 November 2015 the ALBI had returned 5.5% and the ILBI 7%; while R100 invested in the JSE ALSI on 1 November would have lost value and have been worth (with dividends reinvested ) R97.2 on 28 October 2016.

The JSE, when measured in US dollars, has performed very strongly this year, increasing some 14% this year (to 28 October), in line with a similar increase in the MSCI EM Index and well ahead of the S&P 500 Index, which is up by about 4% this year (see figure 2 below).

The strength in emerging market equities has given impetus to emerging market currencies, including the rand, as more capital flowed towards emerging markets and their currencies. Less global risk aversion and the capital flows that drive the MSCI EM Index higher are generally helpful for the rand as well as for the US dollar value of the ALSI. SA-specific forces acting on the rand can be identified by the ratio of the USD/ZAR exchange rate to the USD/EM basket exchange rate as we do below. A weaker rand relative to other emerging market currencies, indicated by an increase in the ratio of the foreign exchange value of rand to other emerging market currencies, represents extra SA risks and a lower ratio, less the SA risk that is priced into the exchange value of the rand.

The performance of the rand and other emerging market currencies is shown below, as is the relative performance of the rand. All emerging market currencies weakened against the US dollar between 2012 and 2015, though rand weakness was especially pronounced by year-end 2015. The rand not only strengthened in 2016 in line with other emerging market exchange rates, but has recovered some of this relative weakness vs the emerging market basket after mid-year. As may be seen in figure 3, the ratio of the rand to the equally weighted EM currency basket declined from 1.25 at the 2015 year-end to the current ratio (31 October) of 1.1 This indicates generally less SA-specific risk in 2016 – helpful to the bond market also, as expectations of inflation recede somewhat with rand strength and long term interest rates accordingly decline.

Recent interest rate trends are shown in the figure below. Long term interest rates in SA are significantly lower than they were in January – though are still above the lows of mid-August 2016. Hence the good returns realised in the bond market to date (though it should also be appreciated that the SA risk spread, being the difference between 10 year RSA Bond yields and the US Treasury 10 year yields, rose significantly in 2015 and spiked in December when President Zuma replaced his Minister of Finance. The spread is still significantly wider than it was in 2014 and before).

This spread is now 7.01% p.a. and is also by definition the expected depreciation of the rand over the 10 year period. In other words, the rand is expected to weaken on average by 7% p.a. over the 10 years. Any greater or lesser premium in the cost of buying dollars for delivery in 10 years would provide an opportunity for riskless profits – for borrowing dollars and lending rands, or vice versa – while securing the dollars or rands for future delivery at a known exchange rate, which eliminates the risk of the exchange rate depreciating or appreciating excessively . This spread is known as the interest carry, though it is one that can only be earned or helpful to borrowers taken on debt at lower rates, when taking on exchange rate risk. If this exchange rate risk is not accepted and the currency risk is fully hedged, the cost of borrowing or lending in the one or other currency will be approximately the same.

It is of interest to recognise that weakness in the USD/ZAR exchange rate is typically associated with a widening of the interest rate spread. Or, in other words, weakness in the USD/ZAR as registered in the currency market is associated with still further weakness expected. The evidence is demonstrated below in the scatter plots – those between the level of the rand and the interest spread on a daily basis since January 2015. The correlation between the levels of these two series is 0.70. We also show a scatter of daily changes in the interest spread and daily changes in the USD/ZAR. The correlation of these daily changes is also a high 0.56 (the 10 year spread is described in figure 6 as YGAP10).

Such a relationship is not intuitively obvious. Why would more weakness in an exchange rate today be associated with still more weakness tomorrow? It might be thought that a lower price (exchange rate) today would improve the prospects of a higher price tomorrow rather than weaken its prospects? For the developed market currencies a wider spread would ordinarily be associated with improved prospects for a currency under pressure and lead to currency strength rather than weakness.

Irrespective of the forces driving exchange rate expectations, more exchange rate weakness would surely be associated with more inflation to come and the reverse: a stronger rand today associated with less inflation to come. In figure 7 below we show the strong and understandable link between the risk spread, or the expected depreciation of the rand, with inflation compensation offered in the RSA bond market. Inflation compensation is the difference between the yield on a vanilla bond and the real yield provided by an inflation-linked RSA bond of the same duration, and is a very good proxy for inflation expected in the market place.

The rand has strengthened this year in line with other emerging market currencies and has also benefitted, as we have indicated, from improved sentiment about SA political trends in recent months. The decision today to withdraw fraud charges against Minister of Finance Gordhan has added further to rand strength relative to the other emerging market currencies. Accordingly, the outlook for inflation in SA will have improved. The outlook for lower interest rates therefore will also have improved, to the advantage of JSE-listed companies with full exposure to the SA economy, that stands to benefit from lower interest rates. RSA bonds clearly also have this character.

The chances of a cyclical recovery rest with the behaviour of the rand, with inflation and inflation expected and with the interest rate responses of the SA Reserve Bank. The recent news flow has clearly improved the prospects for less inflation and faster growth for SA. These improved prospects are helpful for investors in conventional bonds and for SA economy plays, like banks and retailers that benefit from lower inflation and lower interest rates as are revealed on the JSE. Rand (SA economy) plays do well with (unexpected) rand strength. They do even better in a relative sense when rand strength can be attributed to less SA specific risk. 1 November 2016

The SA economy needs a level playing field

A key role in a growing economy is played by the start-up enterprise. They introduce new ways of doing business- supply new products and services – that challenge established business practices and so help make the economy a more productive one. They can start small but if they get it right, and execute well they can become large and successful.

They do so by serving their customers better than the competition did or sometimes could not have imagined. They also have to satisfy the interests of their employees who could work elsewhere and they also have to meet the interests of other suppliers of services or goods to them, including those of the suppliers of capital, for which they have to compete with all other firms. Most important is that by by attracting custom and covering their costs they can provide their owner-managers with benefits and returns on their savings (capital) far superior to those they might have realised working for somebody else.

But their chances of such success are not good ones. The owner-managers of most start-ups, even most small businesses, do not realise well above average returns for their founders- ahead of what they might have earned elsewhere or from their savings plans. This means judged by past performance these true entrepreneurs are not deterred by the prospect of low average rewards but are inspired by the (small) chance of realising exceptional rewards. This makes them risk lovers rather than risk averse and society has every good reason to encourage their unusual appetite for taking on risk. And so not to impose regulations that favour the large firm. Those large enough to afford specialised human resource and legal departments that keep key managers out of the time consuming mediation procedures – and able to employ skilled accountants that can complete complicated tax and other returns. Should it however be easy for new entrants into the market place to succeed? Easy pickings would reflect an undesirable lack of market efficiency. If the market is working well it should be difficult to beat the market.

Better than promoting or discouraging small over large or large and established firms over smaller rivals would be to ensure that all firms can contend freely and openly in the market place. The proverbial level playing feel serves the interests of all the consumers, workers and taxpayers who will always be far more numerous than the owners or senior managers or professionals who engage with them. .

But such freedoms to compete will always be threatened by the established producers who have a large and easily measured economic interest in limiting the competition through laws and regulations favourable to them. In the old SA a minority of suppliers of goods or services enjoyed such protections. Most others, as consumers and taxpayers and workers suffered from import and capital controls and maize and banana boards etc. that put some producers and some white workers and professionals first in line for jobs to the disadvantage of their potential competitors and the customers who stood to benefit.

It needs to be recognised that the producer interests that now tilt the playing feel against consumers and workers and taxpayers in SA and against the interests of perhaps more worthy beneficiaries of government spending, are those of the owners of black businesses and skilled black professionals. They are being favoured with higher prices and rewards by affirmative action. As before it is the economic interests of a minority of producers that are being served by regulation and law. As before, the politics of such actions are easier to understand than their economic consequences. Though the low growth trap that has now caught the SA economy should concentrate minds on the costs and benefits of interfering with competition.