Month: April 2023

There was no good reason for the Reserve Bank to have surprised with a 50 basis point increase in its repo rate. There is in fact no good reason at all to subject the beleaguered SA economy to any further increases in interest rates. Given the bank’s own assessment of the state of the economy. To quote the statement of the Monetary Policy Committee of the 30^th March. “Turning to inflation prospects, our current growth forecasts leaves the output gap around zero, implying little positive or negative pressures on inflation from expected growth”. The output gap is the estimated difference between potential growth in the economy (the supply side) and the growth in demand expected. The expectations for both growth in demand and supply are depressingly slow- no more than 1% p.a. over the next two years.. But clearly there are no demand side pressures on the price level.

The Bank’s forecasting model indicates that every 1 per cent shock to the repo rate will reduce GDP growth by 0.17% on an annual basis with the peak impact two or three quarters after the interest rate shock. While inflation is predicted to decline by 0.12% two years after the shock. While these are the estimated impact of higher or lower interest rates, other things equal, other things are very likely to change in highly unpredictable ways. For example exchange rates, or food prices or electricity tariffs or export prices- supply side shocks – over which the Reserve Bank has no control, nor any superior ability to predict. And which are as likely to move higher or lower over the forecast period and therefore should be ignored when setting interest rates. The strong focus of policy attention should be on the demand side of the economy- on the potential output gap over which the Bank does exercise influence. And without excess demand price increases cannot continue in an ever-higher direction- irrespective of recent inflation. Why the Bank would risk even slower growth by imposing still higher short term interest rates is hard to appreciate.

Since its January meeting the Bank, by no means alone, has been surprised by global inflation, by food prices, by rand weakness etc, enough to have taken recent headline inflation rates above what was predicted at earlier meetings. Though the longer term expected trend in headline inflation remains as it was – pointing distinctly lower below the targeted band. Incidentally the core inflation rate that excludes energy and food prices – large supply side shocks – has behaved almost exactly as expected. All further reason to have stood pat.

SA Headline Inflation. Actual and forecast by the Reserve Bank

Source; SA Reserve Bank and Investec Wealth and Investment

SA Core Inflation. Actual and forecast by the Reserve Bank

Source; SA Reserve Bank and Investec Wealth and Investment

There is perhaps more to the decision to raise interest rates than the usual focus on prices. The MPC statement and the Q&A session after the meeting cast unusual concern about the foreign financing needs of the SA economy. To quote the MPC statement again – “South Africa’s external financing needs are expected to rise. With a sharply lower export commodity price index, stable oil prices and somewhat weaker growth in export volumes, the current account balance is forecast to deteriorate to a deficit of 2.7% of GDP for the next three years. Weaker commodity prices and higher sate-owned enterprise financing needs will put pressure on financing conditions for rand-denominated bonds. Ten-year bond yields currently trade at about 11.2%, despite the expected moderation of inflation over the forecast period”

It therefore appears to me that higher interest rates to attract foreign capital interest rates may have played a decisive role in the MPC decision. The rand and the long end of the bond market did benefit from a wider interest rate spread in a modest way.  But such experiments in exchange rate management are surely not to be recommended, given all else that can happen to exchange rates.  I thought we have learned (expensively) to leave exchange rates and long-term interest rates to sort out balance of payments flows – and yet still to learn to set interest rates with the domestic economy front of mind.

RSA 10 year bond yields and the USDZAR – before and after the decision to raise the repo rate by 50 b.p.

The demise of Silicone Valley Bank (SVB) the 15^th largest US bank, with an important systemic role in the roll out of US Tech happened quickly. In less than 24 hours it was all over for shareholders as the regulators took over to prevent banking contagion. By offering insurance not only on the deposits of all denominations of SVB, but effectively on all deposits with US banks, should it be needed.

It was not a run on the banking system – depositors were not lining up to cash in their deposits- as they might have done in primitive times before. They were acting online, transferring their deposits as quickly as they could to their accounts with the banking behemoths JP Morgan, and their like.  As the venture capitalists and their many subsidiary companies did with their deposits with SVB,

It was clear what caused the panic withdrawal of deposits from SVB. It was a sudden loss in the share market value of SVB to which the depositors acted as they did. They may not have known what was going on but they took fright. It is the market value of a company and its capital raising potential that protects creditors and this protection had fallen away. For reasons that had everything to do with decisions taken by SVB itself on surely very poor advice, that investors in SVB had recognized as destroying the market value of SVB.

The problem for SVB and other banks was that the fixed interest rate yield on their essentially sound  assets had been  rising steadily, causing their values to decline, even as the interest rates paid on deposits were edging higher in response to Fed tightening. Accordingly, the net interest income earned by the banks and their earnings per share were in decline.  A trend clearly uncomfortable to earnings conscious and presumably earnings growth incentivized managers of SVB.  

The advice was to mark the portfolio to market values, and recognize the capital losses on the balance sheet. To raise additional share capital in the market to restore required capital to asset ratios and to invest the capital in higher yielding government and other securities. By so doing improving net interest income and the earnings outlook and the share price.

There was no regulatory compulsion to recognize the losses on their portfolio. The alternative was to have let the assets run off as they became due and to accept the consequent decline in earnings for the next three years or so and the possibly negative reactions of the capital market to a well understood and unavoidable economic reality. There would then have been no need to raise additional capital.

The capital market would surely have been capable of seeing beyond the decline in earnings and focused on the inherent quality of the SVB balance sheet and its potentially durable business model. The problem for SVB was that the capital market clearly did not think that the proposed plans for the balance sheet made good sense and that two billion dollars of extra capital required could be raised on reasonable terms.  Doubts that put pressure on the share price that undermined the possibility of raising the additional capital.

The protection in the form of market value for depositors and shareholders in SVB and beyond fell away dramatically and the bank went down. All because of a false belief in managing earnings per share and the failure to recognize how companies are properly appreciated and valued on the share market. Concerns that extend well beyond the short-term prospects for accounting earnings. Adjusting wisely to Covid 19 and its aftermaths has proved difficult enough for the great growth companies with the strong balance sheets. It is even more difficult for banks, with high degrees of leverage, to wisely adjust their balance sheets in such unpredictable circumstances. SVB clearly failed to do so.

Published Business Day March 10^th 2023

Makawber’s principles apply to National as well as household budgets. Expenditure less than revenue equals happiness. Expenditure that consistently exceeds income brings misery. Iin the form of ever rising and more expensive levels of debt, the service of which takes an ever-larger share of the revenue collected and of all expenditure.  Paying interest and repaying capital maintains your credit rating -more or less-  it does not buy votes.

South Africa has been on this spendthrift path, without pause, ever since the Global Financial Crisis. Since fiscal year 2008-09 to date real government expenditure has grown by an average 3.2% p.a. Government revenues have lagged, growing by an average 2% p.a. after inflation. This extra 1.2% of spending makes a large difference to debt levels over time. Real GDP has grown by an immiserating 1.2% p.a. average since 2009.

Government debt net of cash was a manageable R483.2b in 2007/8 and equivalent to 20% of GDP. The net debt this past financial year is nearly ten times higher at R4483b and equivalent to over 67% of GDP. Servicing this debt took 8.8% of all government revenue in 2008-09. This share of revenue grew consistently to 18.8% in Covid year 2021 as revenues collapsed with the lockdowns. This depressing ratio fell back to 17.1% in 2021/22 as the inflationary comeback from Covid brought hundreds of billions of extra unexpected taxes from SA mining companies. A mixed blessing as these companies remained reluctant to invest more in SA and so paid more tax.

Not only did the volume of debt incurred rise, but interest rates both paid by the government and by private borrowers also rose well ahead of inflation to compensate investors in SA government and private debt for the dangerous trajectory of our debt. Such trends could easily be extrapolated into a debt crisis and be expected to do so. That if not corrected could lead to a desperate eventual resort to the central bank as a lender of last resort and its money printing press. That is to a default by inflating away the real value of the debts incurred. A not uncommon event in monetary history of the world.

The 2023-04 Budget has made an essential, praiseworthy attempt to reverse the direction of spending and revenue. Over the next three years all government spending is planned to grow by 8.5%, and more slowly than government revenue which is expected to increase by 10.4%. The extra borrowing, the fiscal deficit would then decline from the current 4.2% of GDP to 3.2% by 2025/06 despite very modest expected growth in GDP. If the plans materialize, the debt to GDP ratio will stabilize in the low 70% range and the debt service ratio will be contained below 20% of all revenues. A path to fiscal sustainability has been opened.

The issue of how well or badly the government spends the money collected or borrowed and then allocated across the spending departments and state sponsored enterprises, and how onerous is the tax regime, clearly influence economic growth. Fiscal responsibility of the kind, hopefully to be demonstrated, almost balancing the books, is vitally necessary for economic stability but is not sufficient to the purpose of faster economic growth. It is the larger task for government to get value for taxpayers income it extracts.

The economic dust seldom settles in South Africa. The Budget was soon overtaken by De Ruyter’s last stand. Yet judged by the muted reactions in the financial markets the Budget did little to change what we pay to raise capital, public and private. RSA 5 year bonds still yield well over 9% p.a. or a very expensive real 5% p.a. after expected inflation of 5.5% p.a. Judged by the difference between RSA and USA Bonds, the rand is still expected to weaken – by a punishing 5% p.a. over the next five years and about 7% a year on average over the next 10 years.  SA dollar denominated, 5 year debt, now yields 6.56% p.a. representing a default risk premium of 2.3% p.a. and more than double investors in Mexican debt pay for the same insurance. Clearly the market and the economy need much more convincing that we have permanently changed our ways.

Measures of SA Risk; Daily Data 2022- 2023.

Source; Bloomberg and Investec Wealth and Investment