Month: June 2017

An exercise in persuading South Africans that a much better economic way is open to them

My book Get SA Growing (Jonathan Ball 2017) hopes to persuade South Africans that there is a clear and highly realistic way out of our poverty trap. And that is to let all our people exercise much more freedom to help themselves improve their economic circumstances. Or in other words for the economy to rely much more on highly competitive market forces, to determine output, incomes, jobs and wages. There is overwhelming support from economic history, especially from the recent immense poverty reduction achievements of many Asian economies, of how it is possible, using the power of the market place, to lift billions of people out of absolute poverty.

South Africa could be playing much more helpfully to its objective strengths – and that is the competence and competiveness of established businesses and new entrants to business to effectively deliver goods and services and employment and incomes. And are highly capable of doing much more for their stakeholders. Not only for their owners, but for their numerically much more important customers and employees.  And their owners, often pension and retirement funds who manage most of our savings, are rapidly becoming as racially representative of the work-force. Something ignored so opportunistically by the politics of empowerment.

The book tries to build trust in and respect for market forces by examining and explaining what goes on in our economy and how and why it could be better organized for the benefit of nearly all of us- and especially the many desperate poor. It is written by an economist for my fellow South Africans who share my frustration with our economic failure.

We should have more respect for the rights of individuals to make their own decisions and bear the consequences of them. And we should not allow adults who have the power to elect their government to be treated as if they were children in need of close supervision- an assumption often convenient for politicians and the officials who direct government spending on their behalf. Private providers of goods and services, now supplied by government agencies, would treat people much more as valued customers rather than as supplicants.

Privatization of the delivery of benefits – currently funded by the taxpayer – would produce much better results- especially in education – where the spending and tax burden is a heavy one and the outcomes so disappointing. The extra skills that would command employment and higher incomes are simply not emerging nearly well enough. Radical reforms are required that would make public schools and hospitals private ones. And convert public enterprises into more efficient private ones that would not convert losses and poor operating procedures into ever increasing public debts. Privatization could be used to pay off the expensive public debt.

A much greater reliance on and encouragement for the free play of market forces is called for in South Africa Much less should be expected from well-meaning national development plans or from even honestly governed state owned corporations to deliver the essential jobs and goods and services. Perhaps even more dangerous to the well- being of all South Africans would be to provide even greater opportunity for doing government business, funded by taxpayers, on highly favourable (non-competitive) terms with the politically well-connected few. The newly promulgated Mining Charter is an exercise in extreme crony-capitalism that will undermine the future of mining in SA and its ability to create incomes, jobs and tax revenues.

Faster economic growth would be truly transformational.  Building on the strengths we have- on our skilled human capital that is globally competitive – and so very vulnerable to emigration – and on the proven ability to raise financial capital from global markets when the prospects are favourable – faster growth would greatly stimulate the upward mobility of an increasingly skilled black South Africans. The upper reaches of the economy could soon become as racially transformed as have the ranks of the middle income classes. And the very poor and less skilled (now mostly not working) would benefit greatly from increased competition for their increasingly valuable and scarce services. Forcing transformation of the leaders of the SA economy would have the opposite effect. It would mean further economic stagnation and increased resentment of higher income South Africans.

The hope is that the book will make it more likely that the economic future of South Africa will be decided in a less racially charged way- with more reliance on meritocratic market forces. South Africa in fact undertakes an extraordinary degree of redistributing earned incomes, unequal because the valuable skills that command high incomes are so unequally distributed. That is unusual amounts of income is currently taken from the very well off to fund government expenditure – judged by the practices of other economies with comparable incomes per head. But economic stagnation has now severely limited the capacity to help the poor. More of the higher incomes that come with growth can then be redistributed to the least advantaged -hopefully with much more help from private suppliers of the benefits provided.  Growth and redistribution is very possible for South Africa- should we change our ways and grow faster – as the book hopes to persuade South Africans to do.

Interpreting the political messages from cyberspace

Cyberspace has revealed the modus operandi of a group of SA businesses that have excelled (if that is the right term) at doing business with the SA government. We now know just how profitable these favoured procurement exercises have been.

The large modern state, which includes state owned business enterprises with genuine monopoly powers, has significant economic powers to contract for goods and services from private suppliers. Such contracts, we would surely agree, should be determined in an objective way and be subject to genuine competition for such potentially valuable business opportunities.

If objectivity is not to be the guiding principle, the waste incurred is not only in the form of hard-earned tax revenues or borrowing powers supported by the tax base. It also means a sacrifice of the alternative benefits that might have been better provided for – including spending on the least advantaged of society. That officials of government, responsible for such negotiations, might directly benefit from such contracts, is always a possibility, to be guarded against by appropriately vigilant and transparent procedures.

Government practice, anywhere in the world, does not always conform to best practice. A case can therefore be made for not only better, and more honest government, but also for less government. This argues for a smaller, less intrusive role for government as a supplier of goods and services (as opposed to funder of benefits). This would leave space for private hospitals or private schools, for example, to compete for demanding patients or pupils, funded partly or fully by the taxpayer. It would also call for the privatisation of public enterprises, with the proceeds used to pay off government borrowing.

In some societies the degree of corruption can be such as to not only destroy the practice of good government itself, but to undermine the efficiency of the greater economy. Economic growth itself, of the inclusive kind, becomes much more difficult to realise and is replaced by exclusive growth that benefits mainly those in power and their politically-favoured hangers on.

One term that describes such a failing economic system is ‘state capture’. Another is crony capitalism. South Africa is in grave danger of more crony capitalism and of undermining the growth prospects for our economy and benefits for the poor that a competitive market led economy could deliver.

Cyberspace has also revealed that the notion of ‘white monopoly capitalism’ is a creation of a PR company employed by the same group of SA businesses that have benefited so greatly from state largesse. But the notion of white monopoly capital is a politically and racially charged canard. It is an attack on well-established enterprises that compete actively and effectively for customers and employees, and which effectively service their stakeholders – who are mostly black South Africans. If these enterprises are JSE-listed enterprises, their shareowners will be pension or retirement funds, the beneficiaries of which will increasingly be black South Africans. It is convenient for crony SA capitalists and their supporters to ignore such ownership claims in conventional measures of empowerment.

Any constraints on these established businesses to compete freely for customers, skills or capital will harm their many owners, customers and employees. It will also harm the employment and income prospects of many poor South Africans. And by reducing the growth of the economy, they limit the tax base that could be used to support them.

How Orwellian it is to find the enemy in established businesses that are the most capable and competitive element of our economic structure. Arguments are raised to increase the scope for crony capitalism, rather than diminish it. The newly released Mining Charter is unfortunately a charter for more crony capitalism. However its terms of engagement make it very unlikely that more capital will be allocated to risky exploration or mining developments. Giving up 50% or more of the upside in any venture, for no protection on the downside, is a severe impediment to risk taking. Not only will potential employment or income or taxes from mining in SA be sacrificed, the very few intended beneficiaries (the potential cronies) will find the takings hard to realise – if there is no investment. 23 June 2017

The views expressed in this column are those of the author and may not necessarily represent those of Investec Wealth & Investment.

The author makes the full case for genuine capitalism in South Africa in his recently published book, ‘Get South Africa Going’ – Jonathan Ball Publishers, Johannesburg and Cape Town, 2017.

Monetary Policy in SA; Exchange rate volatility and exchange rate risks – that should best be ignored

[The text has been revised to correct an earlier version that failed to recognise the sharp reduction in interest rates after the Global Financial Crisis]

The Reserve Bank kept interest rates on hold in May because, as it explained, there were upside risks to the exchange rate. The risk was that if the rand weakened significantly it might have called for an immediate reversal of any interest rate reductions. Since then the Bank has provided further helpful detail of how its Monetary Policy Committee (MPC) goes about its risk adjusted exchange rate forecasting. We quote extensively from a recent address by Brian Kahn, Advisor to the Governor. [1]

To quote Mr.Kahn:

“How do we deal with the exchange rate in our (inflation) forecast? We make a simplifying assumption of a stable real effective exchange rate over the forecast period. That implies an expectation of a rand depreciation over that period in line with inflation differentials with our major trading partners. We then use our judgement to assign a risk to this assumption, which then feeds in to the overall risk to the inflation forecast…”

 And to quote further

“….It is not just the forecast itself that is of importance, but also how we perceive the risks to the forecast. Any particular forecast trajectory could have a different policy outcome depending on how we assess the risks. MPC members may have differing views of these risks, which explains to some extent why we do not always have unanimity in the decision-making process…”

And on the forecasting method itself Mr Kahn explained

“…The critical issue then is the level of the starting point. As a general rule, we set it at the prevailing index level of the real exchange rate. However, if we feel that the exchange rate is clearly over- or undervalued at that point, we may adjust that level. In other words, should we regard the current strengthening or weakening of the rand as being temporary, we may not adjust the assumption fully until we have greater confidence of its persistence at those levels. The level that we choose has an important implication for the forecast. In 2016, for example, we saw a progressive improvement of the inflation forecast over the year. Most of this was due to revisions to the exchange rate assumption, following a recovery of the rand ……”

Mr Kahn made it clear that

“…While the exchange rate is one of the important variables in our inflation forecast, it is not the only one and we have to look at its impact in conjunction with the movement of other variables. And we certainly do not conduct monetary policy with a view to impacting on the rand itself…”

Forecasting the ZAR is easier said than done. In reality it is an impossible task to fulfil with any degree of confidence.  If past performance of the USD/ZAR is anything to go by the chances of the rand going up or down is statistically about the same. This is not surprising given the size of the market in the ZAR and the advantages an accurate forecast would offer any professional currency trader. In practice all that might be known by professional traders about what might determine the value of the ZAR in the future, will already have been incorporated in the current price of a US dollar. And so the exchange rate moves randomly from day to day, or minute to minute, as more information about the forces that influence the exchange rate are continuously revised.

Daily percentage moves in the USD/ZAR since 2006 and June 2017 have averaged very close to zero, .000230% per day to be exact. The worse day for the ZAR over this period was a 16% fall on the 15th October 2008 during the height of the Global Financial Crisis and the best a 7.5% gain registered on the 28th of that fateful October 2008. Monthly moves in the ZAR are also a random walk with a weaker long term bias. On average since January 1995, the USD/ZAR has declined by 0.59 per cent per month, the worst month being October 2008 when the ZAR lost 20% of its value and the best month was April 2009 when the rand gained over 11% against the USD (See below)

The real rand exchange rate – that is the value of the rand adjusted for differences in inflation between SA and its trading partners – indicates some tendency to revert to its Purchasing Power Parity (PPP) value over an extended period of time. Or in other words faster inflation that follows a weaker ZAR helps to strengthen the real rand given enough time. Given also some stability in or absolute strength in the nominal ZAR.  On these grounds and given the recent level of the real rand this might have led the MPC in a less rather than more risk reverse direction.  But on a day to day, or even year to year basis, the value of the real rand will be dominated by much wider movements in the nominal, that is the market determined, exchange rates, rather than by differences in more stable inflation rates. An exchange rate that as we have pointed out that fluctuates randomly and so for which the best estimate of tomorrow’s price of a USD value is today’s rate.

In figure 3 below we show how the USD/ZAR exchange rate has deviated from its PPP equivalent value since 1970. Exchange rate shocks- when the exchange rate moved sharply away from its PPP value can be identified in 1985, 1998, 2001, 2008 and also 2011. Though between 2011 and mid 2016 the real rand was subject to an extended period of growing weakness. This was a period of persistent USD strength and weakness of most other Emerging Market currencies.

As may be seen the USD/ZAR has been persistently weaker than would be predicted by the ratio of the Consumer Price Indexes in the two economies since 1995. In 1995 the SA economy was permanently opened to capital flows that had been tightly controlled before – with a brief interlude of freedom from capital controls for foreign investors between 1983 and 1986. It is of interest to note that when capital flows to and from SA were tightly controlled, the exchange rate, conformed very closely to PPP- truly levelling the trading field for importers and local producers competing with them. This currency, used for foreign trade purposes, was known as the Commercial Rand to distinguish it from the consistently less valuable Financial Rand used for transactions of capital undertaken by foreign investors in SA. After 1995, variable flows of capital to and from SA have come to dominate movements in the market determined unified ZAR exchange rates. Any assumption that these exchange rates would conform to PPP would not be a realistic one given the record of exchange rates since 1995- as shown in figure 3 and 4.

This real weakness was largest in percentage terms in 2001 and the real rand was again very weak in 2016. (See figure 3 below) The real trade weighted rand, as calculated by the Reserve Bank, varies about 100 to conform to PPP, as it was assumed to do in 2010. Real strength is represented by increases in the real exchange rate. The real trade weighted rand is compared with the real ZAR/USD exchange rate that uses the respective CPI Indexes In figure 4. The figure indicates a very strong real USD/ZAR exchange rate in the late seventies and early eighties when the USD itself was very weak on its own trade weighted basis. The real trade weighted ZAR rate has a current value of 89 compared to a less valuable 83 for the real USD/ZAR exchange rate.

As Mr.Kahn has explained the exchange rate has a very important influence on the SA inflation rate in SA given the openness of the SA economy to imports and exports- that together amount to over 50% of the GDP. Ideally from the perspective of monetary policy and appropriate interest rate settings, the ZAR exchange rate would be well behaved. Well behaved in the sense that exchange rate trends would closely follow domestic inflation and help maintain the level trading field when exchange rates largely compensate for differences in inflation – that is PPP more or less holds. That is movements in exchange rates compensate for differences in inflation rates between trading partners to neither add to or subtract from the competitiveness of local suppliers in either the local or foreign markets.  If so the price of a dollar (and so the rand value of exports or imports) would be determined by the same forces that simultaneously determine the prices of all the goods and services that make up the CPI. In which case prices might rise faster or slower and the exchange rate would depreciate  in line. When demand exceeds supply prices, including the rand price of a USD would tend to rise faster – and vice versa. Too much demand and the inflation and exchange rate weakness associated with it would obviously call for higher interest rates. And too little demand- associated with low rates of inflation and a stronger rand would call unequivocally for lower interest rates.

But unfortunately for SA the ZAR exchange rate is not well behaved. It often takes an unpredictable course set quite independently of the forces of demand and supply in the economy. Inflation – depending on the exchange rate and other forces- then follows more or less closely the independent direction of the exchange rate.  And interest rates in SA then follow inflation, usually higher sometimes lower, regardless of the causes of inflation and the prevailing state of the economy. They therefore may rise even though domestic spending is growing ever more slowly- as they have done in SA since 2014. These higher interest rates in turn help depress spending further that is already under pressure of higher prices. These forces are known in the economics literature as supply side shocks to prices- less supply means higher prices – as they would in a drought that reduces supplies to the market place and raises price. And supply side shocks, according to the same literature, are considered to be reversible with temporary not permanent effects on inflation- and not to call for monetary policy responses

As Mr.Kahn has explained the current weakness of demand in SA makes it harder for firms to pass on higher costs to their customers- so reducing inflationary pressures to a degree- but simultaneously making it all the more difficult for the firms to invest more or hire more workers. This repression of domestic demand has added to the other recessionary forces under way. Without having any predictable influence on the exchange value of the rand – which as Mr.Kahn has also indicated, is anyway not a target for monetary policy.

The sooner the Reserve Banks lowers interest rates the better the chance of the economy recovering from recession. Delaying the interest rate reductions for fear of what might happen to the exchange rate prolongs rather than relieves the economy agony. There is surely much more at stake than forecasting the exchange rate accurately- a task surely well beyond the capabilities of the MPC or indeed any other forecaster.

There is an obvious way out of this dilemma – of having to increase interest rates to fight inflation, when interest rates have had nothing to do with the exchange rate and the inflation under way. And higher interest rates can only slightly inhibit inflation by further depressing spending that is already depressed. The alternative is for the policy makers to treat exchange rate shocks to inflation as what they surely are – a temporary supply side shocks that will increase prices perhaps for a year and then fall out of the CPI, off a higher base level.

The narrative that suggests all inflation-  whatever its cause- demand or supply side – needs to be met with higher interest rates needs to be a very different one. Not raising rates in the face of a supply side shock should moreover not be allowed to indicate any tolerance for higher inflation rates over the longer run. But it would be a narrative that would not allow inevitably risky exchange rate forecasts to influence interest rate settings that induce recessions. Monetary policy should allow a volatile exchange rate to help absorb the pressure of more adverse economic circumstances, not to exacerbate them

South Africa has a very poor record managing exchange rate shocks. The response to the emerging market shock to the ZAR in 1998 was one such particularly disastrous example. The interest rate increases that followed the 2001 exchange rate collapse was also not an appropriate response. Interest rate increases that were then sharply reversed after 2004 when the ZAR recovered and the economy picked up boom like momentum.  A less severe hiking of interest rates prior to the 2008 Global Financial Crises, that was accompanied by ZAR weakness might have served the economy better. Though when the rand strengthened markedly soon after the crisis  interest rates were lowered very sharply by as much as 7%. This undoubtedly helped the economy overcome a brief recession. Furthermore would inflation been any higher had interest rates not been increased after 2014 – in response to rand weakness and higher inflation and the recession perhaps avoided? (See figure 5 below)2

Had these exchange rate shocks to inflation been ignored, it can be strongly argued that SA inflation over the longer run would not have been very different and that growth rates would have been on average higher and less variable. The logic of inflation targeting – in the presence of un-predictable exchange rates that do not conform to purchasing power parity – needs to be seriously re-considered. The impaired logic of inflation targeting in SA can surely be reassessed without appearing soft on inflation.

Given that any immediate change in monetary policy philosophy is unlikely the improved outlook for inflation is such and further improved by recent stability in the ZAR- that lower interest rates will follow at the next MPC meeting in July 2017. The pace of further declines in the repo rate will follow inflation lower. The chances of a cyclical recovery in the economy depend crucially on lower short term interest rates – the sooner they come and the steeper the reductions the better.

 1 “Check in” from the South African Reserve Bank

Address by Brian Kahn, adviser to the Governor,

to the 6th Annual Nedgroup Investments Treasurer’s Conference,

Summer Place, Hyde Park, 8 June 2017; www.resbank.co.za

 2 This paragraph in italics corrects an earlier version that failed to recognise the sharp reduction in interest rates after the Global Financial Crisis 

Making sense of a sideways moving JSE

Making sense of a JSE moving sideways and the conditions necessary to send the trajectory upwards

The recent performance of the JSE will have been disappointing to many South African shareholders. Since 1995, the JSE All Share Index has had its severe drawdowns. But these were more than compensated for when it came to the buy and hold investor. Since 1995 average annual returns, calculated monthly, were 12.9% compared to average headline inflation of 6.2% over the same extended period.

The worst months were when the JSE All Share Index was down by more than 30% in August 1998, 34% in 2003 and were as much as 43% down in February 2003. The best months came in the aftermath of these severe declines. Total 12 month returns were 40% in January 2001, 41% in July 2005 and 37% in March 2010.

By sharp contrast, between January 2016 and May 2017, the share market has moved very little in both directions, with comparatively little movement about this low average. The worst month over this recent period was February 2016, with negative annual returns of 4.4% and the best the close to 10% that were realised at January month end, 2017. (See Figure 1 below)

The JSE, since early 2016 however, presents very differently when the All Share Index is converted into US dollars. In dollars the Index itself (excluding dividends) is up by 24% since January 2016, a gain that compares very well with that of the emerging market benchmark (up 28%) over the same period and the 19% gain achieved by the S&P 500. (See figure 2 below)

 

In US dollar terms the JSE has, over the past two years, sustained its very close correlation with the EM Index of which it is a small part, perhaps 8%. Or in other words, the EM indices on average have recovered ground lost vs New York between 2011 and mid-2016, but have realised much more in US dollars than in local currencies, including the rand, which has strengthened materially against the US dollar since mid-2016. The JSE in 2017 to date (8 June) has gained 3% in rands; the EM Index is up 10% in rands, while the S&P 500, at record levels in US dollars, has gained but a mere 2% this year, when converted to the rand (now R12.84).

 

The rand has gained 6.3% vs the US dollar this year and is 20% stronger than its worst levels of R16.85 of early January 2016. The rand has also gained ground against most EM currencies over the same period. The rand blew out against the EM peers in December 2015 on the initial Zuma intervention in the Treasury. But it then recovered consistently against its peers as well as the US dollar after mid-2016 and is almost back to the level of 2012. The second Zuma intervention in Treasury affairs in late March 2017, when he sacked Minister of Finance Pravin Gordhan, has had very little effect on the USD/ZAR and on the value of the rand compared to a basket of eleven other EM currencies that have gained Vs the USD. (See figure 4 below)

Judged by this performance of the rand compared to other EM currencies shown in figure 3, the risks of doing business in SA rose significantly in December 2015 – but have receded markedly since. Moreover the spread between the yields offered in US dollars by the South African government, compared to the yield offered by the US Treasury, an explicit measure of country risk, is now no higher than it was before December 2015. The RSA, five year Yankee (US dollar-denominated) bond currently offers a yield of 3.7%. The safe-haven five year Treasury currently offers 1.75%. This risk spread rose from about 1.9% in mid-2015 to 3.7% in January 2016. It is currently about 2% or back to where it was before the Zuma threat to SA’s fiscal stability first emerged in December 2015 (see figure 5 below).

The Zuma interventions in South Africa’s fiscal affairs have clearly influenced the rating agencies. They have downgraded SA debt. The market place, it may be concluded, has largely got over the threat. The market must have concluded, rightly or wrongly, that the influence of President Zuma and the threat he represents to SA’s ability to service its debts is in decline. As it is often said, time (and perhaps leaked e-mails) will tell.

It should be appreciated that rand strength, considered on its own, is not directly helpful to about half the stocks listed on the JSE. These are the global companies with a listing on the JSE whose major sources of revenues and profits are outside the country. As such they are rand hedges and perhaps more important, hedges against SA specific risks. A combination of rand strength, especially for SA specific reasons, is not likely to be helpful to their rand values. A given dollar value for their shares, largely established by the global investor outside South Africa, will then automatically translate into lower rand values. Another way of making this point is to recognise that when the rand gains 20% against the dollar, it would take a more than 20% annual appreciation in the US dollar value of a stock to translate into an increase in the rand value of a dual listed company. This 20% or so is a very demanding US dollar rate of return.

This is a rate of return that Naspers, but few others of the global plays listed on the JSE, have been able to meet. Indeed, some of the important global plays listed on the JSE have suffered from weaknesses very specific to their own operations. For example MTN (Nigeria exposure), Richemont (luxury goods) and the London property counters (sterling) as well as AB-Inbev (the beer market) and Mediclinic (regulations in Dubai) have all had earnings problems of their own. Enough to drag back the JSE All Share Index in US dollars and even more so in the stronger rand.

But while rand strength is a headwind for much of the market, it can be a tailwind for the other half of the JSE much more dependent on the fortunes of the SA economy. But to help them, the strong rand and less inflation that follows need to be accompanied by lower interest rates. Lower interest rates stimulate extra household spending and borrowing that then becomes helpful for the earnings of retailers and banks. This move in interest rates has been delayed by the Reserve Bank, despite the recessionary forces that higher interest rates since January 2014 have helped to produce. But the recession coupled with the strong rand and the outlook for less inflation would make lower interest rates irresistible.

These recessionary forces have also been revealed by the earnings reported by industrial and financial companies listed on the JSE. Trailing Findi earnings per share are not yet back at 2015 levels – though they are now growing. In US dollars, Findi earnings per share are yet to recover to levels realised further back in 2011. (See figure 6 below)

These reported earnings moreover do not suggest that the Findi is undervalued – given current interest rates. They suggest the opposite, a degree of overvaluation that will need to be overcome by sustained growth in reported earnings. Naspers, with a weight of 27.3% in this index will have to play a full further part in this earnings growth. A regression model of the Findi, using reported earnings and short term interest rates as explanations run with data captured from 1990, explains the level of the index very well. The model suggests that fair value or model predicted value for the Findi was only 59 964 compared to the actual level of 72 732 at May 2017. That is, the model suggests that the Findi is now some 20% overvalued and has remained so for an extended period of time since 2013. This theoretical valuation gap has grown despite the stagnant level of the market as shown in figure 7 below.

The market has implicitly remained optimistic about a recovery of earnings, a recovery now under way but, that has taken an extended period of time to materialise given recession-inducing higher interest rates in SA. Lower interest rates – perhaps significantly lower rates – would be essential to justify current market levels. They will help by discounting current earnings at lower rates, but help more by stimulating currently very depressed levels of household spending and borrowing.

A stronger global economy will also help improve the US dollar value of the global plays listed on the JSE and, depending on the USD/ZAR, perhaps also their rand values. A weaker rand may help the rand values of the offshore dependent part of the JSE. But rand weakness might (wrongly) delay lower interest rates. The best hope for the JSE is a strong global economy, combined with a strong rand and a recession-sensitive Reserve Bank. Is this all too much to hope for?