Month: June 2020

The Reserve Bank should follow the lead of its developed market peers (and some emerging market peers) in its response to the Covid-19 crisis

It seems that investors in emerging markets hold their governments and central banks to a much higher fiscal and monetary standard than is expected of their increasingly indebted developed market peers.

What is deemed to be right for the increasingly indebted developed world hoping to recover from the coronavirus – that is massive doses of extra government spending and money creation in support of government debt – is treated with suspicion when proposed or attempted by increasingly indebted emerging market economies, including SA.

We have argued that economies such as our own, which have suffered even more damage from the lockdowns, thanks to more widespread poverty and in the absence of capital reserves accumulated by households and businesses, need all the unconventional help they can get.

Not all emerging market central banks have taken the chastity vow. In Indonesia, as the Financial Times (FT) reported on 15 June: “Finance Minister, Sri Mulyani Indrawati, says quantitative easing and other policies are restoring confidence. Indonesia is at the forefront of emerging markets in implementing monetary policy that was once seen as the preserve of developed economies.”

The minister said that “Indonesia will use unprecedented quantitative easing and other emergency monetary and fiscal policies for as long as it takes to recover from the coronavirus pandemic, according to the country’s finance minister.  With the private sector in retreat after weeks of lockdown, massive state spending was needed to shore up the economy”, adding that Indonesia would not rely on central bank financing in the long run: “That is not good policy practice.”

Brazil, according to the FT in another report (8 June) has granted its central bank extraordinary powers for the next 12 months, even though the Bank seems somewhat reluctant to employ them. Central bank President Roberto Campos Neto said he would not employ such measures until traditional tools had been exhausted:

“We still think we have monetary space on the traditional policy. If you start using unconventional policy before you exhaust the conventional policy, you create noise that makes the central bank lose credibility.”
However, according to the FT, the central bank has slashed Brazil’s benchmark Selic interest rate to a historic low of 3% and is expected to cut by a further 75 basis points this month. Campos Neto said there was now greater clarity on the extent of the damage likely to be wrought by the coronavirus pandemic and that “uncertainty regarding the extreme cases has diminished”. The Bank in March launched a US$300bn financial liquidity package — equivalent to 16.7% of the country’s GDP — to mitigate the efforts of the broad economic shutdown caused by the coronavirus pandemic. “I don’t think any other country has done anything close to that,” Campos Neto said.

The case for extraordinary policies is clear enough. When economies are allowed to normalise, hopefully extra demand will match extra potential supplies that then become available. Extra spending to accompany extra output can be assisted by extra government spending – on income relief and relief for lenders and borrowers. Money creation by central banks can make it cheaper to issue more government debt and to encourage banks to lend more freely. In the absence of stimulus, the willingness of firms to increase output and to offer employment on normal terms would be more compromised. They are unlikely to hold optimistic forecasts of revenues and profits upon which to budget. The case for stimulus is thus every bit as strong in the less developed world, including SA.

There is as yet no indication that the SA Reserve Bank sees the crisis as calling for anything like such a vigorous a response. It remains largely in conventional inflation-targeting mode. The supply of central bank money, notes in circulation together with the cash deposits of the banks with the Reserve Bank, defined as the money base or M0, sometimes more evocatively described as high powered money, did not increase at all since the end of last year to May 2020.

Money base to May 2020

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Source: SA Reserve Bank Balance Sheets and Data Bank, and Investec Wealth & Investment

This unchanged level of the money base through the crisis occurred despite the purchase by the Reserve Bank of a modest extra R22bn of RSA bonds in the secondary market (modest by comparison with the other assets held by the Bank that are dominated by its foreign exchange reserves). In May 2020, as a result of drawing on its large deposits with the Bank to make payments abroad, the foreign assets of the Bank declined. Despite the limited QE designed to smooth volatility in the debt markets rather than to stimulate, and despite a significant increase in Reserve Bank loans to banks, net-net the money base has not increased during this time of grave crisis. We show the trends in the assets of the Reserve Bank and its liability to the government in the chart below.

Government deposits are not part of the money base held by the public and the banks. An increase in government deposits reduces the money base and a decline will do the opposite, provided the drawdown is used to fund spending or debt repayments in SA. If, as appears to have been the case in May 2020, the payments by the government (drawing down its deposits) went to foreign creditors and so foreign banks, the SA banks will thus not have seen an increase in their cash reserves and deposits with the Reserve Bank. In May, the loans to private banks declined sharply – also reducing the money base. Thus, despite the purchase of an additional R10bn of government stock by the Reserve Bank, the money base in May was practically unchanged and no larger than it was in December.

In the charts below, we show the Reserve Bank balance sheet over the period since December  and the monthly changes in some of the key items that move the money base – the notes in circulation plus the deposits of the banks with the Reserve Bank.

The money base in SA and its sources (December 2019 to May 2020)

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Source: SA Reserve Bank Balance Sheets and Data Bank, and Investec Wealth & Investment

Reserve Bank balance sheet – monthly movements affecting the money base (December 2019 to May 2020)

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Source: SA Reserve Bank Balance Sheets and Data Bank, and Investec Wealth & Investment
SA desperately needs the same extraordinary interventions to counter the impact of the lockdown now underway in the developed world, and as we have indicated, also in some developing economies. Given the responses of the SA Treasury and Reserve Bank to date, it is not surprising that the consensus forecasts of market analysts are for a below average reduction in SA GDP in 2020 of 6%, but thereafter for a well below increase in GDP in 2021, a pedestrian 2%.

What is called for is firstly a properly vigorous response to the crisis. It also calls for a credible commitment to a return to fiscal and monetary normality when the crisis is over, and when the economy is operating at something like its potential. That long-term growth potential surely has to be above 2% annual growth. To realise permanently faster growth, needs more than effective crisis management. It calls for reforms of the economy.

The rand and growing the SA economy. How not to waste the crisis.

 

Post the lock downs the patterns of household spending are widely expected to change permanently. How it will change is of overwhelming importance to almost all business that supply households or are once or twice or three times removed from making sales directly to households. The demand to fly to some holiday destination not only affects hotels, B&B’s, restaurants, airports, travel agents, airlines and car rental companies taxi companies and all they employ or contract with – it will have the most profound implications for Boeing and Airbus and all their component suppliers.

Household spending accounts for 60% of all spending in SA and 70% in the US and other developed economies. Absent the control and command of governments (very active in the lockdowns) the decisions of households to spend or save or borrow to spend always moves the economy in the one direction or another. The market-place, post-covid19, will make the same call on its suppliers to adapt profitably to changing tastes. And to innovate successfully. That is to lead household spending to their own portals, real or virtual, depending on what will work best and be rewarded accordingly.

There is every reason for governments and their central banks to ameliorate the economic damage of their own making and offer compensation for the loss of incomes from work- including for the owners of businesses. Governments have every reason to encourage the demand for all goods and services when they allow firms after the lockdown to do what comes so naturally to them. That is to freely compete for custom and for the resources, labour and capital and premises to help them do so. There is no more reason for governments to get involved trying to pick post-covid business winners or losers than they would have at any other time.

And to leave future taxpayers with as little a burden of interest to pay on the additional government debt that is being incurred. Printing money rather than issuing expensive debt (when debt is as expensive as it is for the SA taxpayer) makes very good sense. The inflation in SA that might ordinarily come with money creation is a long way away- that is until supply and demand, both so damaged by the crisis, can recover to something like their potential.

They say no crisis should be wasted. The crisis does provide an opportunity to stimulate what would be the most helpful source of growth for SA. That is export and import replacement led growth. The much weaker rand has made SA potentially much more competitive than it was only a few months ago. Adjusted for differences between SA and USA consumer price inflation the rand at USD/ZAR 17.50 is now about 50% undervalued Vs the dollar and about 18% more competitive with the US exporter or importer than it was at year end. A purchasing power equivalent dollar would now cost no more than R8.70 (See figure 1 below)

 

Fig.1; The USD/ZAR exchange rate and its Purchasing Power Equivalent[1] to May 27th 2020.

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Source; Bloomberg, Investec Wealth and Investment

There is a strong case for retaining this competitive advantage. It is very easy to inhibit exchange rate strength should it materialize. The Reserve Bank can buy dollars with the rands it has an unlimited supply of. The Swiss National Bank does this all the time to hold back the Swiss franc. Furthermore buying dollars with rands would add to the supply of rands – it would be another form of money creation. And very helpful when every extra rand may encourage more spending and lending – so urgently needed for the recovery.  Preventing exchange rate weakness should never be attempted.

In figure 2 below we chart the relationship between the purchasing power value of the rand and its market value. This relationship represents the real exchange value of the rand with lower values indicating real rand weakness, or equivalently greater competitiveness for SA producers, and vice versa. We compare the real rand dollar exchange rate using the Consumer Price Indexes for SA and the US and the real rand exchange rate as calculated by the Reserve Bank. This real exchange rate is adjusted for the prices of manufactured goods of our 20 largest trading partners (weighted by their importance in our trade) using the prices of manufactured goods as the basis of comparison. This ratio has not been updated since year end. Given the stronger dollar the depreciation of the real rand so calculated is generally less severe than the real dollar exchange rate. The nominal trade weighted rand has declined by 20% since year end and so the real rand is likely to have declined by a similar degree this year.

 

Fig2. The real rand Vs the US dollar and SA’s trading partners. (2010=100)

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Source; Bloomberg, SA Reserve Bank and Investec Wealth and Investment

 

The value of the real rand is totally dominated by changes in the market value of the rand that fluctuates so widely and unpredictably. We compare quarterly movements in the market trade weighted value of the rand and its inflation adjusted value. As may be seen it is very much a case of the market exchange rate leading and the direction of inflation following. Rather than inflation leading to compensating changes in the market value of the rand. The so called pass- through impact of a weaker or stronger rand on prices in SA depends also on the direction of import prices in USD.

Especially important for the price level in SA is the dollar piece of oil that makes up a large percentage of SA imports- up to 40% at times. With oil prices as low as they are now the pass-through effect on SA prices and inflation is likely to be very subdued. Exporters from SA especially of metals and minerals that still make up a large percentage of SA exports are largely price takers established in US dollars. The weaker rand translates automatically into higher rand prices and vice versa. How much the weaker rand drives up the costs of our exporters and those suppliers who compete with imports depends very much on the direction of SA inflation. This is likely to remain subdued for now given the general weakness of demand for goods, services and labour.

It is not only the level of the real rand that matters for the real economy. Movements in the market value of the rand and hence its real value of great importance for operating profit margins are also of great relevance. The USD/ZAR and the Euro/Rand exchange rate has been almost twice as variable on average as the USD/Euro exchange rate. This year is no exception. We show below how the volatility of these exchange rates on a daily basis this year.

Managing this volatility of the rand exchange rate is a burden carried by SA exporters and importers and those who compete with exports and imports.. It adds to their costs of hedging exchange rate risk and the pure uninsurable uncertainty about the actual direction of the rand demands a discouragingly higher expected return on their investments.

 

Fig.3 Quarterly per centage movements in the Nominal and Real Trade weighted rand – lower numbers indicate rand weakness.

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Source; Bloomberg, SA Reserve Bank and Investec Wealth and Investment

 

Fig.4; Volatility of the USD/ZAR, the USD/ZAR and the Euro/USD Daily Data 2020 to May 25th[2]

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Source; Bloomberg and Investec Wealth and Investment

 

There should be two objectives for exchange rate policy during and after the crisis. Firstly, should the opportunity present itself, to inhibit rand strength to encourage domestic production and consumption. Especially since inflation will be looking after itself well enough and interest rates do not need a stronger rand to decline further. The very weak domestic economy is reason alone for still lower interest rates.  Secondly, and a much more difficult longer-term exercise, would be to seek ways to inhibit exchange rate volatility that is such a burden on foreign trade.

 

[1] The PPP rand is calculated as USD/ZAR in December 2010 (USD/ZAR=6.31) multiplied by SA CPI/US CPI) 2010=100

 

[2] Volatility is calculated as the 30 day moving average of the Standard Deviation of daily percentage movements in the exchange rate