Author: Brian Kantor

The global economy remains hostage to a volatile US dollar

The US dollar continues to serve as the primary international unit of account and as the pre-eminent reserve currency held by central and other banks, yet the rate at which the US dollar is exchanged for other currencies remains vulnerable to large moves in both directions, so adding risks to all financial transactions that make reference to it. In figure 1 below, we show the performance of the US dollar against its developed market peers (The US dollar index or DXY). We also show the real dollar exchange rate against the same major trading partners. The real exchange rate adjusts the nominal trade-weighted exchange rate for differences in inflation rates. We discuss the economic importance of real exchange rates further below. However, it should be noted that the real and nominal US exchange rates have followed a similar pattern.

Figure 1: The trade-weighted real and nominal exchange value of the US dollar (1975=100)

Sources: Bloomberg, The Federal Reserve Bank of St. Louis (Fred Data Base) and Investec Wealth & Investment

In figure 2, we show the performance of the US dollar against its developed market peers, an index of emerging market exchange rates since 2010 that excludes the rand, and the rand/US dollar rate.

Figure 2: The US dollar vs. major currencies, an emerging market currency basket and the rand (higher numbers indicate exchange rate strength), monthly data (2010=100)

Sources: Bloomberg, The Federal Reserve Bank of St. Louis (FRED database) and Investec Wealth & Investment

The extraordinary strength of the US dollar in 2014 was associated with a high degree of emerging market (and rand) exchange rate weakness. Also note that a degree of US dollar weakness that begins in mid-2016 has been associated with a recovery in the emerging market basket (and the rand). US dollar volatility poses particular challenges for monetary policy in emerging economies. We return to this important issue below.

The real exchange rate is what matters for real business activity

Inflation can make a producer or distributor of goods or services less competitive in home and foreign markets. However, a weaker exchange rate can protect operating margins against those rivals subject to less inflation. What may be gained or lost in the ability to compete on price – when expressed in any common currency – can be offset by changes in the rate of exchange.

When the offset is complete, the exchange rate will have weakened or strengthened by the percentage differences in inflation in the home country and that of its trading partners. If such circumstances, the exchange rate would be said to conform to purchasing power parity (PPP). Thus, PPP is regarded as a theoretical equilibrium to which exchange rates will converge in time.

The deviations from PPP-equivalent exchange rates are used to calculate a real exchange rate. It is this real exchange rate that defines the competitiveness of prevailing market-determined exchange rates. A real exchange rate with a value of more than 100 indicates an overvalued exchange rate and a value less than 100 indicates a competitive or undervalued exchange rate. The direction of the real exchange rate towards or away from 100 shows whether domestic producers have become more or less internationally competitive.

The calculation of a real exchange rate can include multiple exchange rates and an equivalent number of inflation rates – weighted by the share of imports and export held by different trading partners. The prices of relevance for the calculation of inflation and the real exchange rate are usually derived from prices charged for the manufactured goods that are presumed to dominate international trade.

The history of flexible exchange rates in SA shows that, the USD/ZAR exchange rate as well as the trade-weighted rand exchange rate, have consistently deviated from PPP-equivalent exchange rates and in varying degrees (see figures 3 to 5). This indicates that when SA firms engage in foreign trade and have to compete on the domestic market with imports this is a risky activity, given the variability of the real exchange rate and operating margins.

Measuring real exchange rates – a focus on South Africa

These divergences from PPP-equivalent exchange rates, i.e. fluctuations in the real rand exchange rate, are large and variable. This real rand exchange rate volatility for the rand is linked to the removal of exchange controls on foreign investors that were effectively withdrawn in 1995. There was a brief period of real exchange rate volatility, between 1983 and 1985, when foreign investors were also free to move funds into and out of South Africa. A further source of capital flows has been the progressive relief on the exchange controls applied to South African residents.

Freer capital flows rather than trade flows have dominated the demand for and supply of rands exchanged for US dollars and other currencies, and has introduced significantly more rand exchange rate volatility . It is the flow of global capital that has similarly dominated exchange rate trends in all economies that are open to this free flow of capital.

As we show below, using January 1970 as the starting point, the USD/ZAR exchange rate diverged significantly from PPP in 1985, then conformed to PPP between 1988 and 1995, whereafter the divergence has been continuous, though still highly variable. Heavy shocks to the USD/ZAR exchange rate are to be observed in 2001-02, 2008 and 2014. These sharp deviations from PPP have been followed by movement back towards PPP.

Sensitivity to the base year

Notice too that the PPP calculation is sensitive to the base year used to calculate the price indices. When 2010 is taken as the starting point for the calculation, the absolute deviations from PPP exchange rates are of a different magnitude. However, the movement away from or back towards PPP-equivalent exchange rates takes the same direction in both versions of PPP-equivalent exchange rates.

The starting point for any such calculation should be when the actual exchange rate approximates PPP, as it did in 1970. By 2010, the base year for calculating the current real exchange rate, the USD/ZAR exchange rate had moved far away from PPP, using a 1970 base year. When the base year is taken to be 2010, the rand appears as less undervalued generally and even as overvalued in 2010 – when the USD/ZAR traded at less than its PPP equivalent (2010 prices).

Figure 3: Market and Purchasing Power Parity exchange rates (USD/ZAR) (1970=100)

Sources: Stats SA, Federal Reserve Bank of St. Louis (FRED Data Base), Investec Wealth & Investment

Figure 4: Market and Purchasing Power Parity exchange rates (USD/ZAR) (2010=100)

Sources: Stats SA, Federal Reserve Bank of St. Louis (FRED database) and Investec Wealth & Investment

In figure 5 below we show the ratio of the PPP-equivalent USD/ZAR exchange rates to the market-determined USD/ZAR, using 1970 or 2010 as the base year. This ratio may be regarded as representing the real USD/ZAR exchange rates. Values above 100 indicate an overvalued (less competitive) nominal exchange rate and values below 100 indicate the opposite – the nominal exchange rate has changed by more than the difference in inflation in SA and the US.

Using 2010 prices and exchange rates, the rand was overvalued for much of the period from 1970 to 1995 and for some years afterwards. The strong real rand was supported in the 1970s by rising gold and metal prices in US dollars. The picture using 1970 prices as the basis of the calculation is different, revealing a consistently undervalued rand after 1985.

Figure 5: USD/ZAR – the ratio of PPP to market exchange rates; a measure of the real exchange rate using different base years

Sources: Stats SA, Federal Reserve Bank of St. Louis (FRED database) and Investec Wealth & Investment

Real exchange rates considered more widely – the international evidence

In the figures below, we show a variety of trade-weighted real exchange rates for the period 1995-2017, as calculated by the Bank for International Settlements and the SA Reserve Bank. All these real exchange rates are highly variable, including those of the US. The real US dollar demonstrated continuous strength between 1995 and 2002, then weakness to 2008, whereafter the safe haven status of the US dollar in a time of crisis added some real strength to the trade-weighted exchange rate. A further period of pronounced real dollar strength ensued after 2014. Not coincidentally, the real trade weighted rand moved in very much the opposite direction, as seen in figure 6.

It should be recognised that the real rand, for all its volatility and the risks to which it has exposed SA business, has not in fact been more variable than the real dollar. As a relatively small economy that is very open to foreign trade, real exchange rates are, of course, more important for the South African economy. The value of exports and imports for South Africa is equivalent to about 50% of GDP. The exposure to imports and exports in the US is equivalent to about 30% of GDP.

As may be seen in the figures below, the real euro and real sterling have also been highly variable since 1995, while the Brazilian real has been more variable than most. The summary statistics for these real exchange rates are provided in Table 1.

The conclusion, therefore, is that the volatility of the real rand that so complicates the business of exporting from and importing to SA is not exceptional. The same complications and risks of doing business across frontiers, or rather exchange rate regimes, apply across the modern world of flexible exchange rates. It should be recognised that flexible exchange rates have added generally to the risks of doing international business everywhere. As such, these risks are presumed to have increased the required returns on capital invested in servicing global markets.

One can also determine whether there is a general tendency of exchange rates to revert to PPP and foreign trade-neutral real exchange rates. In other words, can one conduct a statistical test of whether real exchange rates are mean reverting?

The answer is that they don’t pass this statistical test with any degree of statistical confidence. The Chinese and Japanese real exchange rate trends since 1995 are most conspicuously not mean reverting to the theoretical 100 as may be observed in figure 9. The real yuan has a distinct and persistently stronger trend while the real yen moves persistently weaker.

Figure 6: Real exchange rates 1995-2017, South Africa and the US (2010=100)

Source: SA Reserve Bank, Federal Reserve Bank of St. Louis (FRED database) and Investec Wealth & Investment

Figure 7: Real exchange rates 1995-2017, South Africa and Brazil (2010=100)

Source: SA Reserve Bank, Federal Reserve Bank of St. Louis (FRED database) and Investec Wealth & Investment

Figure 8: Real exchange rates 1995-2017, UK and Eurozone (2010=100)

Source: SA Reserve Bank, Federal Reserve Bank of St. Louis (FRED database) and Investec Wealth & Investment

Figure 9: Real exchange rates 1995-2017, China and Japan (2010=100)

Source: SA Reserve Bank, Federal Reserve Bank of St. Louis (FRED database)and Investec Wealth & Investment

Table 1: Real exchange rates summary statistics

The importance of capital rather than trade flows in determining nominal and real exchange rates

The notion that exchange rates will trend, over time, back towards some kind of competitive equilibrium, as imports and export volumes adjust to the real exchange rate effects on operating margins, therefore does not hold. The volatile behaviour of both nominal and real exchange rates is driven by unpredictable capital flows rather than by flows of currencies generated by the international trade in goods and services.

These capital flows that are based upon changing expectations of future returns, move the rate of exchange stronger or weaker. Inflation rates then react, but not rapidly or sufficiently enough to sustain PPP.

The exchange rate therefore leads inflation and the nominal exchange rate leads the real exchange rate – because inflation rates are much more stable than exchange rates. This stability is partly the result of the convention that measures inflation as the year-on-year change in consumer or other price indices, rather than as price moves over shorter periods of time. For example, a one or three month trend in consumer prices would indicate much more variability. The variability of real exchange rates has, in practice, almost everything to do with shocks to nominal exchange rates rather than price.

The shocks to the real exchange rate observed in the charts above therefore have very little to do with shocks to inflation rates. The openness of an economy to imports of staple commodities reduces the impact of harvests that are subject to unfavourable climatic conditions. Droughts and famines might otherwise have pushed prices temporarily much higher, providing a price shock to the economy.

As we show in figure 10 below, annual moves in the nominal ZAR/USD exchange rate dominate the moves in the real rand exchange rate that are so important for operating businesses and their operating profit margins. Similar results could be found for many other economies and their currencies as was found to be true of the US demonstrated in Figure 1

Figure 10: Annual changes in the USD/ZAR nominal and real exchange rates

The impact of exchange rates on prices and inflation

Exchange rate shocks will have implications for the domestic price level. Other things being equal, the price of imported goods and the prices realised for exports in the local currency will rise or fall with the price of a US dollar. Other things may not remain unchanged and may also effect the prices charged domestically. For example, the US dollar price of imported oil may be rising or falling as might other imported commodities.

Dollar strength might well mean downward pressure on prices set in US dollar and dollar weakness might have the opposite effect. The state of the domestic economy will also have an influence on prices. The more or less buoyant domestic spending is, the greater or lesser the pressure on domestic prices will be. However a weaker exchange rate and the higher prices that are likely to accompany it will, in themselves, act to reduce spending power. They may also undermine the confidence of households and firms in their economic prospects, and their willingness to spend more or less of their incomes.

How should monetary policy react to exchange rate shocks?

How then should monetary policy and interest rates react to exchange rate shocks that are so difficult to anticipate? We would argue the best approach to exchange rate shocks is not to react to them at all. This is because such shocks are temporary rather than persistent. If such exchange rate shocks really are temporary – even perhaps rapidly reversible – the impact they have on inflation will be as temporary. They therefore will not be expected to permanently add to inflation and therefore will not add to expected (forecast) inflation.

It should nevertheless be recognised that dollar strength and other currency weakness can persist for an extended period of time. Persistent US dollar strength – against its developed economy peer currencies and against most emerging market currencies – explains much of the nominal and real rand weakness observed between 2014 and 2016.

The difference between rand weakness against the dollar and the weakness of other emerging market currencies vs. the US dollar represents additional SA specific risks to the returns expected from SA domiciled assets. We show these global and SA influences on the rand in the figure below. The USD/ZAR and the equally weighted Index of nine other emerging market currencies generally move in the same direction. The ratio of the USD/ZAR exchange rate to the USD/EM basket indicates South Africa-specific risks at work. These South Africa-specific risks spiked significantly in 2001, 2008 and 2015, when they added to rand weakness for global reasons. In other words, a weakness against the US dollar was shared by the other emerging market currencies.

Figure 11: The US dollar vs the rand and the EM Basket (LHS); and the Ratio rand/EM (RHS)

Source: Bloomberg and Investment Wealth & Investment

Thus, much of the persistently high rates of inflation over the period between January 2014 and June 2016 (an average of 5.5% per annum) can be explained by dollar strength and its impact on the rand prices of imports, exports and alternatives for both in the production and price choices firms make. Inflation remained at these levels despite increases in interest rates and near recessionary conditions.

South African inflation over this period cannot be explained by the extra demands exercised by local households or businesses. Aggregate spending remained highly depressed over this period, which was also due to the inflation of prices charged to them. A drought proved to add another supply side shock to the rand prices of staple foods.

Only persistent and permanent increases in the demands for good and services, fueled by persistent increases in the supply of money and credit, will lead to continuous increases in prices and, sooner or later, increases in the price of foreign exchange. Interest rate expectations and capital flows will, in such circumstances of highly accommodating monetary policy settings, come to anticipate more inflation and help weaken the exchange rate.

A central bank charged with securing permanently low inflation would have to react to demand side pressures of this kind on prices. But they are strongly advised not to react to exchange rate shocks, especially when they occur in the absence of excess domestic demand over domestic potential supplies.

To react this way is to make monetary policy hostage to the variable and difficult to predict, nominal and real US dollar exchange rate. It is a risky exposure that businesses engaging in international trade cannot easily avoid. But monetary policy would do well to do what it can to moderate the shocks that emanate from the foreign exchange market. Unfortunately, the SA Reserve Bank added higher interest rates to exchange rate misery over the 2014-2016 period. We regard these as errors of monetary policy that reduced growth rates without any obvious reduction in inflation rates or inflation expected.

The implications of exchange rate volatility for investment portfolios

The volatile dollar can easily lead to such monetary policy errors of judgment – as in the case of South Africa. Emerging market economies, particularly those with significant exposure to foreign trade, are especially vulnerable to fighting exchange rate shocks, that is US dollar-driven shocks, with higher interest rates, which further damage the prospects for local businesses.

These are errors the US is much less likely to make, given that the dollar is likely to be the source of the exchange rate shocks. Monetary policy in the US understandably does not react to the exchange value of the dollar. Therefore, when investing abroad, a bias in favour of dollar based investing seems appropriate.

It may be concluded that the volatility of the real rand (that so complicates the business of exporting from and importing to SA) is not exceptional. The same complications and risks of doing business across frontiers and exchange rate regimes apply across the modern world of flexible exchange rates. It should be recognised that flexible exchange rates have added generally to the risks of doing international business everywhere.

The alternatives to fiduciary currencies and flexible exchange rates

The alternative to flexible exchange rates is fixing the rate at which a domestic currency may be converted into another currency. For example, the Hong Kong dollar has been fixed at 7.8 to the US dollar for many years. This fixed exchange rate link demands that inflation and interest rates in the two currencies will be very similar, to protect the sustainability of the fix. However, this also means that the real USD/HK exchange rate has been as variable as the real USD exchange rate.

An alternative form of fixing an exchange rate that was practiced widely before 1970 elsewhere including in the US, would be to fix the rate of exchange to the price of gold or silver at some predetermined local currency price of gold. For example, between 1933 and 1970 the dollar could be converted into gold at 35 US dollars per troy ounce.

This gold convertibility requirement restrained central banks from increasing the supply of cash issued to banks – held mostly in the form of deposits with the central bank – that could be converted into gold in the days of the gold standard. Constraints on the growth in the supply of central bank cash in turn helped to sustain low rates of inflation in normal times.

In abnormal times of large balance of payments outflows, this convertibility of local currency deposits into gold (that could be exercised by foreign central banks after 1945) might break down, as it did for the US in the early 1970s. This breakdown, or not enough central bank stocks of gold to meet the demands for gold by other central banks, might lead to either a new fix of the rate of exchange of gold for the local currency, or lead to inconvertible currencies. This would be a move to flexible exchange rates and the abandonment of the gold standard.

This is what the US chose to do in 1971 under pressure to convert dollar liabilities into gold that came from the French government particularly. The French strongly objected to the reserve currency role played by the US dollar that increased demands for dollars that they argued added to the economic power of the US.

It might be recalled that the IMF, established immediately after the end of the Second World War to assist a global economic recovery, effectively restored the gold standard and reaffirmed the convertibility of US dollar into gold. The IMF, however, also allowed for and supported orderly adjustments to fixed exchange rates under conditions of “fundamental disequilibrium”.

The intention was to avoid a series of competitive devaluations and ‘beggar your neighbour’ policies that were such a damaging feature of international economic relations in the depressed 1930s.

The problem that fixed exchange rates after 1945 could not resolve, was when a global shortage of dollars became a surplus of dollars. In effect, the US as the dominant economic power that supplied the reserve currency was unwilling to play the gold standard game and limit the supply of dollars to sustain convertibility at a fixed rate. And so the global economy has had to cope with flexible exchange rates that do not necessarily trend to PPP-equivalent exchange rates. The price paid for allowing flexible and market-determined exchange rates to absorb the shocks caused by highly variable capital flows, has been to add to the risks of cross border trade flows

Below follows an update on this piece from Monday. 

The immediate outlook for the economy depends on who governs SA after December 2017. Will it be the Zuma faction or some other ANC coalition calling the shots? That is the essential question for the economic outlook and the value of the financial claims on it.  The market in SA assets has made its preferences for much less of President Zuma very clear. RSA risk premiums rise and fall as the expected Zuma influence on policy gains or loses momentum.

On Thursday and Friday last week the market suddenly came to reverse recently very unfavourable trends to register less SA risk. The rand strengthened, not only against the USD, but more meaningfully, also gained against other EM exchange rates.[1] Furthermore not only did RSA bond yields decline late last week – they declined relative to benchmark US yields. Still less SA risk has been registered this week in the foreign exchange markets. The ratio of the USD/ZAR to the USD EM basket (Jan 1^st 2017=1) had moved out to 1.104 on the 13^th November is 1.065 a relative SA gain of 3.6%

The behaviour of these foreign exchange indicators in 2017 is shown in figure 1 below. As may be seen, despite this recent improvement in sentiment, 2017 has not been a good year for the ZAR. The USD/ZAR weakened relative to its EM peers when Finance Minister Gordhan, in public dispute with the President over spending plans, was sacked in March 2017. It also suffered in response to the Budget statement presented by his successor, Milusi Gigaba in late October, as may also be seen.

The budget disappointment was perhaps not in the details about the revenue shortfall  – this was well telegraphed – but that no revised plan to address the widening fiscal deficit was offered. The concern was presumably that Zuma and his cohort would soon announce more government spending, on nuclear power or students, rather than less,  regardless of the fiscal constraints.

Fig.1; The USD/ZAR and the USD/EM exchange rate basket in 2017. Daily Data January 1^st=100 to November , 23^rd  OR ratio (LHS) =1

Source; Bloomberg and Investec Wealth and Investment

Though perhaps a little longer perspective on SA risk indicators is called for, as is provided in figure 2 below. There it may be seen that the ratio of USD/ZAR exchange rate to the USD/EM currency basket, weakened significantly in December 2015, when Finance Minister Nene was so surprisingly sacked. However as may be seen in the figure, the rand in a relative and absolute sense did very much better in 2016. Perhaps because the decision Zuma made under pressure from colleagues and the business community to immediately reappoint Pravin Gordhan, indicated less rather than more power to the President. A sense perhaps that the market had gained of Zuma overreach and a degree of vulnerability.   Just how vulnerable is President Zuma remains to be determined- hence market volatility.

Fig 2; The ratio of the USD.ZAR to the USD/EM currency basket (January 2017=1) Daily Data

Source; Bloomberg and Investec Wealth and Investment

The indicators derived from the Bond market make the same statements about SA risk. As shown in figure 3 below the spread between RSA and USA government bond yields, the so called interest rate carry that reveals the expected depreciation of the USD/ZAR exchange rate, widened sharply as the rand weakened in late 2015. They then narrowed through much of 2016, stabilized in 2017 until the Budget disappointment pushed them higher. The difference however between RSA rand bond yields however has widened gain to 7.2% p.a. and is back to levels recorded on the 14^th November. The default risk premium attached to five year RSA dollar denominated bonds though has declined further from 208 b.p on the 14^th November to 187 b.p on the 23^rd November

In figure 4 it may also be seen how the RSA sovereign risk premium has behaved in 2017. Sovereign risks are revealed by the spread between the yield on a USD denominated RSA (Yankee)  Bond and its US equivalent. As may be seen this spread has been variable in 2017 – that it increased by 40 b.p. in October – and then declined sharply in the week ending on November 17^th.  These spreads indicate that SA debt is already being accorded Junk Status by the market place, ahead of any such ruling by the rating agencies. The spread on the lowest Investment Grade debt would be of the order of 1.6%.

In figure 5 we show the interest carry- the rate at which the USD/ZAR is expected to weaken over the next ten years and inflation expectations. These are measured as the spread between a vanilla bond that carries inflation risk and an inflation linker of the same duration that avoids inflation risk. As may be seen more inflation expected is strongly connected to the rate at which the ZAR is expected to weaken. It should be recognized that the weaker the rand the more it is expected to weaken further. It will take a stronger rand to reduce inflation expected- a welcome development that is beyond the influence of interest rates themselves.

Fig.3; The USD/ZAR and the Interest Rate Spreads. Daily Data 2015 to November 23, 2017

Source; Bloomberg and Investec Wealth and Investment

Fig.4; The RSA sovereign risk premium and the interest carry. Daily Data 2017.

Source; Bloomberg and Investec Wealth and Investment

Fig.5: The interest rate carry and inflation compensation in the RSA bond market. Daily Data 2017.

 

The market place, as well as the bookmakers, will continuously update the odds of one or other candidate for the Presidency of the ANC ( now very probably) being determined in December 2017.  The odds offered by Sportingbet at 13h00 on November 20, 2017 are shown in the Table below. (www.sportingbet.co.za ) They have not changed since- indicating perhaps a lack of betting activity. These odds imply a 40% chance of Dlamini-Zuma winning the nomination and a 45% chance for CR. As they say in racing circles- the favourite does not always win- but don’t bet against it.

Lower South African risks and the stronger rand and lower interest and inflation rates associated with rand strength are good for the economy and all the businesses and their stakeholders dependent on the economy. One prediction can be made with some degree of conviction. That is without less SA risk any cyclical recovery in the SA economy is unlikely.

 

 

Additional Figures

Equity performance in 2017 to November 17^th Daily Data

Credit Default Swap Spreads over US Treasuries 5 year;  Daily Data 2015-2017

Credit Default Swaps over US Treasuries, 5 year Daily Data to November 17^th 2017.

[1] Our construct for Emerging Market exchange rates that exclude the ZAR  is an equally weighted nine currency basket of the Turkish Lire, Russian Ruble, Hungarian Forint, Brazilian Real, Mexican, Chilian and Philippine Pesos, Indian Rupee and Malaysian Ringit

 

 The outlook for the SA economy depends on who governs after December 2017. Will it be the Zuma faction or some other ANC coalition calling the shots? That is the essential question for the economy and the value of the financial claims on it.  The market in SA assets has made its preferences for much less of President Zuma very clear. RSA risk premiums rise and fall as the expected Zuma influence on policy gains or loses momentum.

On Thursday and Friday last week the market registered less SA risk as the rand strengthened, not only against the USD, but more meaningfully the rand also gained against other EM exchange rates.[1] Furthermore not only did RSA bond yields decline late last week – they declined relative to benchmark US yields. The political developments that actually moved the market are however not that obvious.

The behaviour of these indicators in 2017 is shown in figure 1 below. As may be seen 2017, despite this recent improvement in sentiment, has not been a good year for the ZAR. It weakened relative to its EM peers when highly respected Finance Minister Gordhan was also sacked in March. It also suffered in response to the Budget statement of his successor in late October, as may also be seen.

The budget disappointment was perhaps not in the details about the revenue shortfall  – that were well telegraphed – but that no revised plan to address the widening fiscal deficit was offered. The concern was presumably that Zuma and his cohorts would soon announce more rather than less government spending regardless of the fiscal constraints.

 

Fig.1; The USD/ZAR and the USD/EM exchange rate basket in 2017. Daily Data January 1^st=100 or ratio (LHS) =1

 

 

Source; Bloomberg and Investec Wealth and Investment

 

Though perhaps a little longer perspective on SA risk indicators is called for, as is provided in figure 2 below. There it may be seen that the ratio of USD/ZAR exchange rate to the USD/EM currency basket, weakened significantly in December 2015, when Finance Minister Nene was so surprisingly and ignominiously sacked. However as may be seen in the figure, the rand in a relative and absolute sense did very much better in 2016. Perhaps because the decision Zuma made under pressure from colleagues and the business community to immediately reappoint Pravin Gordhan, indicated less rather than more power to the President. A sense perhaps that the market had gained of Zuma overreach and a degree of vulnerability.   Just how vulnerable remains to be determined- hence market volatility.

Fig 2; The ratio of the USD.ZAR to the USD/EM currency basket (January 2017=1) Daily Data

Source; Bloomberg and Investec Wealth and Investment

 

The indicators derived from the Bond market make the same statements about SA risk. As shown in figure 3 below the spread between RSA and USA government bond yields, the so called interest rate carry that reveals the expected depreciation of the USD/ZAR exchange rate widened sharply as the rand weakened in late 2015. They then narrowed through much of 2016, stabilized in 2017 until the Budget disappointment pushed them higher. In figure 4 it may also be seen how the RSA sovereign risk premium has behaved in 2017. Sovereign risks are revealed by the spread between the yield on a USD denominated RSA (Yankee)  Bond and its US equivalent. As may be seen this spread has been variable in 2017 – that it increased by 40 b.p. in October – and then declined sharply in the week ending on November 17^th.  These spreads indicate that SA debt is already being accorded Junk Status by the market place, ahead of any such ruling by the rating agencies. The spread on the lowest Investment Grade debt would be of the order of 1.6%.

In figure 5 we show the interest carry- the rate at which the USD/ZAR is expected to weaken over the next ten years and inflation expectations. These are measured as the spread between a vanilla bond that carries inflation risk and an inflation linker of the same duration that avoids inflation risk. As may be seen more inflation expected is strongly connected to the rate at which the ZAR is expected to weaken. It should be recognized that the weaker the rand the more it is expected to weaken further. It will take a stronger rand to reduce inflation expected- a welcome development that is beyond the influence of interest rates themselves.

 

Fig.3; The USD/ZAR and the Interest Rate Spreads. Daily Data 2015-2017

Source; Bloomberg and Investec Wealth and Investment
Fig.4; The RSA sovereign risk premium and the interest carry. Daily Data 2017.

Source; Bloomberg and Investec Wealth and Investment 

Fig.5: The interest rate carry and inflation compensation in the RSA bond market. Daily Data 2017.

The market place, as well as the bookmakers, will continuously update the odds of one or other candidate for the Presidency of the ANC ( probably) being determined in December 2017.  The odds offered by Sportingbet at 13h00 on November 20, 2017 are shown in the Table below. (www.sportingbet.co.za ) As they say in racing circles- the favourite does not always win- but don’t bet against it.

Lower South African risks and the stronger rand and lower interest and inflation rates associated with rand strength are good for the economy and all the businesses and their stakeholders dependent on the economy. One prediction can be made with some degree of conviction. That is without less SA risk any cyclical recovery in the SA economy is unlikely.

 

[1] Our construct for Emerging Market exchange rates that exclude the ZAR  is an equally weighted nine currency basket of the Turkish Lire, Russian Ruble, Hungarian Forint, Brazilian Real, Mexican, Chilian and Philippine Pesos, Indian Rupee and Malaysian Ringit

Inflation in SA rose to 4.8in August- up from 4.6% in July 2017. However in August 2017 prices were largely unchanged, rising by a mere one tenth of one per cent in the month. The statistical anomaly is that a year ago Consumer Prices had actually fallen by about the same 0.1 per cent. And so a monthly increase in August this year of 0.1% was enough to raise the year in year increase in Consumer Prices by 0.2%.

Of further and greater importanc% e is that the Consumer Price Index has been largely stable since April 2017. In April prices increased by 0.1%, in May by a still minimal  0.3%, in June by 0.2% and in July by 0.3%. Helped by a consistently stronger rand compared to a year before, and stable food prices following the drought of last year, the direction of inflation has been decidedly lower. Thus as we show below the increase in prices, measured over consecutive three month periods, has declined sharply. Were such trends to continue headline inflation would fall to three per cent. A time series forecast indicates a much lower rate of inflation next year of about 3%.

 

 

 

 

 

 

 

 

 

 

The Reserve Bank forecasting model of inflation, upon which it will determine its interest rate settings, is not a time series extrapolation of recent trends. It will have the trade weighted rand and food prices as amongst its more inputs. Chris Holdsworth of Investec Securities runs a simulation of the Reserve Bank model that suggest that the forecast rate of inflation for Q1 2018 will have declined marginally and would imply a further reduction in interest rates .[1] He remarks as follows

• Since the last MPC meeting CPI inflation has dropped from 5.1% in June to 4.6% in July. The MPC’s previous forecast was for CPI inflation to average 4.8% for Q3. The slightly lower than expected print should marginally lower the MPC’s estimate of the inflation trajectory.
• PPI has dropped from 4.8% in May to 3.7% in July. The fall in PPI inflation should further lower the inflation trajectory.
• We don’t expect the MPC to make meaningful adjustments to its ZAR and oil price assumptions.
• Subsequent to the last MPC meeting SA GDP growth for Q2 has come out at +2.5%, up from -0.6% in Q1. Given our understanding of the MPC’s macro-economic model, that should imply a small upward revision to the MPC’s growth assumption for the year (currently 0.5%). This should see a reduction in the expected output gap and an associated increase in the inflation trajectory but we expect the effect to be minimal.
• The net result is that we expect a minor reduction to the SARB’s inflation trajectory over the medium term. We expect that the SARB will forecast inflation to reach 4.4% in Q1 next year.

A further reduction of 25 basis points in the repo rate therefore seems likely. Especially given the continued absence of any demand side pressures on prices. And so given to the near recession state of the economy. And were the stability of the rand to be maintained and a normal harvest delivered in 2018 the current underlying trends in consumer prices in SA  would be sustained and lead to further reductions in headline inflation and forecasts of it and be accompanied by still short term interest rates. Rates that could fall further and until very welcome strength in spending by households and firms becomes manifest. The conditions for a normal cyclical recovery are falling into place. One can only hope that political developments do not reverse the direction of the rand and the SA risks spreads that have also been receding. Presumably on the belief that better government is in prospect.

It is perhaps worth making an observation about inflation – measured as a year on year increase in prices and – and the advantage in identifying underlying trends in prices within a twelve month period that may be much lower. And portend lower headline inflation to come. The problem for inflation watches and commentators on it – and drawing implications for interest rates- is that 12 months is a long time in economic life. That much of importance can happen to prices or any monthly series within a year that makes year on year comparisons out of date. This is illustrated in a hypothetical example shown below. We show a case of a sharp increase in the price index after a period of stability and low inflation and how this may lead to more and then sharply lower inflation after twelve months.

In the figure below we show a sharp 5% increase in the CPI in early 2016. An increase in the VAT rate or a collapse in the ZAR might be responsible for such a sharp increase.  Thereafter prices are assumed to stabilise for an extended period of time. Perhaps this is because he exchange rate recovers somewhat and the VAT and other tax rates do not increase further. As we show inflation – measured as a year on year increase in prices – initially increases sharply to about 6% p.a and remains at these elevated levels for a full twelve months- where after it collapses back to about zero inflation.

Thus the impact on inflation of an inflation shock will be very temporary provided the underlying trend in prices is a very stable one. Presumably also inflationary expectations as well as models of inflation are fully capable of see through a temporary price shock.  One would hope that monetary policy settings can also see beyond temporary year on year changes in prices. As we hope the SA Reserve Bank is looking ahead rather than behind and will take the opportunity to help stimulate a recovery in spending that is desperately needed.

 

 

 

 

 

 

 

 

 

[1]

Forecasting the MPC’s forecasts; Quantitative Strategy, Investec Bank September 18th 2017

 

South Africans would benefit greatly if the country’s state-owned enterprises were to be privatised. Full story as published in FinWeek here.

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

Slides presented at the Denker Conference on Eradicating Poverty held Thursday 20th July available here