Month: July 2017

Out with the credit regulator

I have a very radical policy proposal, which is to repeal the National Credit Act. Repeal would allow lenders and borrowers complete freedom to contract with each other for credit on any terms they found agreeable. It would help transform the economic prospects of many South Africans who do not benefit from regular incomes and so do not qualify for credit under current regulations.

Freer access to credit would be particularly helpful to informal traders and aspirant farmers and entrepreneurs. By saving the significant costs of complying with current regulations, a repeal might well lead to less expensive borrowing terms for the many who currently receive credit. Strong competition for potential credit business would convert lower compliance costs of providing credit into lower charges for all borrowers. The reputation of the lenders for fair treatment of its customers would become even more critical in attracting new and repeat credit business. A lender would not have to proclaim it is an authorised financial service provider as if this were some kind of guarantee that absolves borrowers or lenders of the need to undertake proper diligence.

The importance of maintaining reputation – brand value – in which so much is invested, including training employees to deliver their services better than their rivals, is what keeps profit-seeking businesses honest and efficient. It attracts the most valuable type of business, repeat business.

Perhaps, given their knowledge and experience, the regulators and compliance officers that would be rendered unemployed should my proposal come to pass, could be converted into useful predictors of the ability of potential borrowers to deserve the credit on offer. Identifying much more accurately and easily the credit rating of any potential borrower would allow for well-targeted, attractive offers of credit – perhaps initiated at very low cost over the internet. Credit markets are particularly well-placed to apply the new science of big data management that is revolutionising all business.

There is a long history of limiting (defined as usurious) interest rates that may be charged to borrowers, which has disturbed and complicated the contracts borrowers and lenders agree to – and in turn has encouraged regulation of these complicated terms. If lenders were free to declare all revenues they expect to receive from a borrower as simply interest or capital repayment, at whatever rate agreed to, borrowers could easily make comparisons of the costs or benefits on offer. This is the case when a motor car is leased for a monthly payment. How much of this payment pays for the car and how much for the motor plan is irrelevant to the driver. It is simply a question of how much car the monthly payment buys. The benefits of the transaction to the motor dealer, the lessee and the lessor are bundled into one convenient monthly payment. We do not pay a hotel separately for towels, linen, or air conditioning – ‘free’ breakfast may even be included in the daily rate. And no regulator (yet) tells the hotel to itemise its menu or what services they are allowed to charge for and how much they can charge

The National Credit Regulator however allows the lender only clearly defined fees and payments that include the repayment of the principal debt; an initiation fee, a service fee, interest, the cost of any credit insurance, default administration charges and collection costs. It has argued that a fee charged to retail customers to join a club of customers cannot be levied. The jury or, rather, the judges are out on this one.

Club fees, delivery, insurance or other charges are all contributions to the lender’s revenue, in addition to interest payments that are controlled. Reducing the lender’s ability to raise revenues from explicit interest charges or to protect themselves with capital repayments leads inevitably to a complicated array of fees to supplement interest received. Restricting the flow of revenues therefore means less credit supplied to well- qualified borrowers. This is an unsatisfactory outcome that an unregulated credit market would overcome. 7 July 2017

Rand strength surprise

A shorter version of the below article was published in the Business Day – Available here

The rand does not always perform as expected, thanks to the US dollar, to which we should always pay close attention

Rand strength almost always surprises the market. The large spread between SA interest rates and US or other developed market interest rates indicates that the market expects the rand to weaken consistently against the US dollar and other developed market currencies. By the close on 18 July this spread for 10 year money was 6.43%. To put it another way, the rand was expected at that point to lose its exchange value in US dollar at the average annual rate of 6.43% over the next 10 years.

This difference, or interest carry, is also by definition the annual cost of a US dollar or euro to be delivered in the future. And so, the forward rate of exchange for the USD/ZAR to be delivered in a year or more always stands at a premium to the spot rate. This year, the daily interest spread on a 10 year government bond has varied between 6.4 and 5.94 percentage points while the USD/ZAR has varied between a most expensive R13.20 to a best of R12.42, using daily close rates of exchange. It should be noticed in figure 1, that while the interest spread- or expected exchange rate has a narrow range – the two series move together. That is a stronger rand leads to less rand weakness expected (less of a spread) and vice-versa.

Another way of putting this point is that the weaker the rand the more it is expected to weaken further and vice versa. This is not an intuitively obvious outcome. Normally the more some good or service falls in price the more, not less attractive it becomes to buyers. This is the case with developed market exchange rates – dollar strength vs the euro tends to narrow the carry. But this is not the case with the rand exchange rate and perhaps also other emerging market exchange rates. For the USD/ZAR exchange rate, rand weakness is associated consistently with still more weakness expected and vice versa as figure 1 and 2 indicates. It would seemingly therefore take an extended period of rand strength to improve the outlook, as indeed was the case between 2003 and 2006 when the spread narrowed to about 2% with significant rand strength (See figure 2).

 

While a more favourable direction for the USD/ZAR may well come as a surprise – the explanation of rand strength or weakness should be more obvious than it appears to be, judged by much of the commentary offered on changes in the exchange value of the rand. The reality demonstrated below is that the behaviour of the USD/ZAR exchange rate to date has had much less to do with South African events and political developments and much more to do with global forces than is usually appreciated. And such global forces affect the exchange value of the rand and other emerging market currencies in similar ways.

Unless the future of SA economic policy is very different from the past, this is still likely to still be the case in the months ahead. In other words, rand strength or weakness in the months ahead, will have a great deal more to do with what happens to the US economy and the strength or weakness of the US dollar against other major currencies, than political and economic developments in SA. Predicting the USD/ZAR accurately therefore will require an accurate forecast of the US dollar vs mostly the euro, and also to a lesser extent the yen, the Swiss franc, the Swedish kroner and the Canadian dollar.

We show below in figures 3 and 4 below how the USD/ZAR exchange rate moves closely in line with those of other emerging market (EM) currencies. Furthermore it is also shown how all EM currencies strengthen when the USD weakens against other major currencies and vice versa. That is US dollar strength vs its peers is strongly associated with EM exchange rate weakness generally and so also USD/ZAR weakness.

In the correlation matrix below, using daily data from 2012, it may be seen that the correlation between the trade weighted US dollar vs developed currencies, and the JP Morgan Index of emerging market currencies is a high and negative (-0.82) (dollar strength = emerging market weakness) The correlation of the US dollar with our own emerging market nine currency basket (US dollar/EM) that excludes the rand, is even greater at ( 0.98) The correlation of daily exchange rates between the USD/ZAR and the trade-weighted dollar index is (0.89). In other words, the stronger the trade-weighted dollar, the higher its numerical value, the more expensive the US dollar has become. As may also be seen in the table below, the correlation between the USD/EM nine currency basket and the USD/ZAR is also very high (0.95).

These relationships are also indicated in figures 3 and 4 below. In these charts the trade-weighted dollar in these figures is inverted for ease of comparison – higher values indicate weakness and lower values strength. It may be seen that US dollar strength after 2014 was closely associated with emerging market and rand weakness. Very recently, since June 2017, it is shown how a small degree of US dollar weakness has been associated with emerging market and rand strength.

 

In figure 4 below we show the ratio of the USD/ZAR to our Investec nine currency basket (USD/EM) since 2012. This ratio (2012=1) widened sharply after President Jacob Zuma sacked Minister Finance Nhlanhla Nene, only bring in Pravin Ghordan a few days later. This ratio then narrowed sharply after the second quarter of 2016, indicating much less SA-specific risk was gradually being priced into the rand.

(The nine currencies: Equally weighted Turkish lira, Russian ruble, Hungarian forint, Brazilian real, Mexican, Chilean and Philippine pesos, Indian rupee and Malaysian ringgit.)

The second Zuma intervention in March 2017, when Gordhan was in turn sacked by Zuma, had less of an impact on the relative value of the rand. In figure 5 below, we show a close up of this ratio in June and July 2017 after the independence of the SA Reserve Bank was called into question by the SA Public Protector, Busisiwe Mkhwebane. The ratio initially widened on the statement by the Public Protector, to indicate more SA risk.  But the rand and its emerging market peers both strengthened as a result of a degree of US dollar weakness against the other major currencies, as is shown in figures 5 and 6 below.

Given the history of the USD/ZAR it should be appreciated that betting against the rand at current rates is also mostly a bet on the value of the US dollar vs the euro and other developed market currencies. Hence the causes of dollar strength or weakness needs careful consideration. The US dollar strengthens US growth beats expectations, leading to higher interest rates in the US relative to growth and interest rates in the likes of the Eurozone as well as to US dollar strength. Emerging market currencies and the rand can be expected to weaken in this scenario. A weaker US dollar and stronger euro will tend to have the opposite effect, as we have seen recently.

Relatively slower US growth and a more dovish Fed can be very helpful to emerging market exchange rates (like the rand) over the next few months. This is providing the political economy of SA is not to be radically transformed. The financial markets, judged by the ZAR/EM exchange rate ratio and the yield spreads, are currently strongly demonstrating a belief in policy continuity in SA. 19 July 2017

Separating the influences of politics and economics

These are fraught times for South Africans. The Public Protector has attacked the constitutional protection provided to the Reserve Bank and the inflation targeting mandate prescribed for it by the Treasury. The (false) notion of white monopoly capital – introduced to counter the critics of state capture – has become a constant refrain and irritant to white South Africans who play such a crucial role in our economy. The tale of corruption at the highest levels of the state is being continuously reinforced by extraordinary revelations out of cyberspace.

They further drain the confidence of businesses and households, whose reluctance to spend has led the economy into recession. The election of a new head of the ANC and presumptive President is being be contested on the issue of corruption and who bears the responsibility for it.

The ANC is currently debating economic policy. Appointed economic commissions have debated the issues and will reveal soon just how the governing party’s economic policy intentions have changed.

These uncertainties could be expected to influence the value of the rand and of SA equities and bonds listed on the JSE. Such would appear to be the case with a recently weaker rand and upward pressure on bond yields. JSE-listed equities, when valued in rands rather than US dollars, may behave somewhat differently in response to SA political risks. Given that many of the companies listed on the JSE (with large weights in the calculation of the All Share and other indices) derive much of their revenues and incur much of their costs outside of SA, their rand values tend to benefit from rand weakness, especially when this is associated with additional risks specific to South Africa. There are other risks to the share market that are common to the global economy and emerging markets generally. These forces are likely to effect the US dollar value of these companies, mostly established on offshore stock markets that are then translated into rand values at prevailing exchange rates. Rand strength since mid-2016 has been associated with improved global economic prospects identified by higher commodity and metal prices and increases in the US dollar value of emerging market (EM) equities generally.

It is possible to identify SA-specific risks by observing the performance of the rand relative to other EM currencies. Further evidence can be derived from the spreads between RSA bond yields and the equivalent yields offered by developed market governments and other EM issuers of US dollar-denominated bonds. We provide such evidence in figure 1 below.

It should be appreciated that bond yields in the US and Europe all kicked up very sharply last week (Thursday 29 June) after ECB President Mario Draghi indicated a much more sanguine view of the outlook for growth and inflation in Europe. The prospect of higher policy-determined interest rates accordingly improved, as did the likelihood of an earlier, rather than later, end to quantitative easing (QE) in Europe and its reversal, or tapering. This led to a degree of euro strength and dollar weakness – but as we shall see EM currencies, not only the rand, lost ground to the weaker US dollar. An early hint of US tapering in 2013 had led to US dollar strength and EM currency weakness and the responses in EM bond markets did have a mild hint of these earlier taper tantrums, as we will demonstrated. Better news about US manufacturing this week helped the US dollar recover some of its losses against the euro. Late on Friday (30 June) the euro was trading at 1.1426 – early yesterday (5 July) it was being exchanged at 1.132.

As we show in figure 1, the USD/ZAR exchange rate has moved mostly in line with the EM currency basket since 20121. The rand is well described and explained as an EM currency. As demonstrated by the ratio of the rand to the EM basket, the rand did relatively poorly for much of the period under observation, and especially after the first President Jacob Zuma intervention in the SA Treasury in December 2015. Then the rand, at its worst, weakened by as much as 25% more than had the average EM currency.

However through much of 2016, the rand did significantly better against the US dollar than the EM basket, with the ratio ZAR/EM (1 in 2012) back again to 1 in 2017, indicating less SA-specific risk. However the second Zuma intervention, the sacking of Finance Minister Pravin Gordhan in March 2017, reversed some of this improvement in the relative performance of the rand against other EM peers – but then was followed again by a degree of further rand strength compared to the EM average.

This improvement in the relative value of the rand was interrupted again in modest degree towards 27 June, as we show more clearly in figure 2 below. The ratio of these exchange rates, based as 1 in early 2017, was 1.02 midday on 5 July. However at the time of writing (late 5 July) the rand has weakened further against the US dollar and the other developed market currencies and presumably also against other EM currencies.

The impact of the most recent news flow, including the news leak on the morning of 5 July that the ANC had called for state ownership of the Reserve Bank, led to about a 1% decline in the rand against other EM currencies by midday yesterday, 5 July. By then the USD/ZAR had weakened from an overnight R13.2 to R13.398, with more weakness following. The EM currency basket had also weakened that morning of 5 July but by only about 0.42% against the US dollar. It should be recognised that much, of the rand weakness in 2017was caused by global forces reflected widely in the EM financial markets.

We await further news about the resolutions adopted by the ANC gathering and pointers to the election of a new ANC leader. The interpretation of these political developments will reveal themselves in the financial markets in the same direction as they have to date. The change in ownership of the Reserve Bank is symbolic and without operational substance. The operations of the Bank are determined entirely by the executive directors and managers who are appointed by the State. The 600 private shareholders (of whom I happen to be one with 100 shares), receive a constant predetermined 4% annual dividend and have the right only to appoint seven of the central bank’s 10 non-executive directors and to attend the AGM. But as we have noticed, symbols have significance and do point to the future direction of economic policy. Any threat to Reserve Bank independence or to fiscal conservatism is a threat to the rand and to the bond market, but less, as we point out below, to the rand value of the equity market.

 

When we turn to the bond markets a similar picture emerges: a modest increase in the SA risk premiums in late June and early July. Long term interest rates have all moved higher in response to the words of central bankers in Europe. However the spread between RSA yields and US yields has not widened materially, perhaps by only 8 basis points.

This spread incidentally is now as low as it was in early 2015, despite the downgrading of RSA debt by the rating agencies. It may be concluded from these generally favourable developments in the currency and bond markets, that the market is discounting the threat to SA’s economic policy settings posed by President Zuma. The market may well have been anticipating the end of the Zuma presidency.

 

The spread between RSA and other EM bond yields has also been well contained – despite political developments in SA. The five year RSA Yankee bond’s Credit Default Swap (CDS) spread vs the US – very similar to the spread between the RSA Yankee bond yield and the Treasury bond yield – has moved marginally higher. The spread between other high yield EM and RSA CDSs has narrowed marginally, indicating a somewhat less favourable (relative) rating for RSA debt in recent days. RSA CDS swap spreads over US Treasuries are compared below in figure 6 to those applying to dollar denominated bonds issued by Turkey, Brazil and Russia. Little change in EM credit ratings, that is what it costs to insure such debt against default, can be noticed.

JSE-listed equities by contrast have significantly underperformed their EM peers in recent weeks, as may be seen in figure 7 below. The strong rand has been a head wind for the JSE, given the preponderance of companies with offshore exposure and whose US dollar values are determined on offshare markets and translated into rands at prevailing exchange rates. Over the longer run the US dollar value of the JSE and the EM benchmarks track very closely, helped by similar exchange rate trends as well as earnings trends.

The SA economy plays on the JSE have not yet had the benefit of lower interest rates that usually accompany a stronger rand and lower inflation. So what has been a headwind for the rand values of the global plays has not yet turned into a tailwind for the SA economy plays: the retailers, banks and especially the mid- and small-cap counters that have trailed the market in general.

A cyclical recovery of the SA economy cannot occur without reductions in short term interest rates. One can only hope that the Reserve Bank does not wish to assert its independence of politics by further delaying reductions in interest rates. These are urgently called for and have every justification, even given its own very narrowly focused inflation targeting modus operandi, of which incidentally, I have also been highly critical of. 6 July 2017

1 Equally weighted Turkish lira, Russian ruble, Hungarian forint, Brazilian real, Mexican, Chilean and Philippine pesos, Indian rupee and Malaysian ringgit.

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