Author: Brian Kantor

Monetary policy: Thanks for the small relief

The Reserve Bank, thankfully and understandably, given the near recession state of the economy, decided not to raise its repo rate at its meeting last week. The Monetary Policy Committee (MPC) statement concluded that:

“The increase in the repo rate at the previous MPC meeting contributed to the improvement in the longer-term inflation forecast, and that move should be seen in conjunction with previous actions in the cycle and the lagged effects of monetary policy. The MPC felt that there is some room to pause in this tightening cycle and accordingly decided to keep the repurchase rate unchanged for now at 7,0 per cent per annum. Five members preferred no change, while one member preferred a 25 basis point increase.

“The MPC remains focused on its inflation mandate, but sensitive to the extent possible to the state of the economy. The MPC will not hesitate to act appropriately should the inflation dynamics require a response, within a flexible inflation targeting framework. Future moves, as before, will continue to be highly data dependent.”

The MPC, as indicated, continues to regard itself as in a tightening cycle. Why further likely interest rate increases will be helpful in reducing the inflation rate any more, than past increases have done, is much less obvious. As we show below, short-term interest rates in SA have risen by 2% since the first 50bp increase in the repo rate was imposed in January 2014. Inflation, having fallen in early 2015, has recently risen sharply above 6%. A very good proxy for expected inflation – inflation compensation in the bond market, being the difference between the yield on a vanilla RSA 10-year bond and its inflation-protected equivalent – also rose sharply in late 2015, as did the difference between RSA 10-year bond yields and US Treasuries of the same duration. This difference may be regarded as the average annual rate at which the rand is expected to depreciate against the US dollar over the next 10 years.

These unfortunate trends have occurred despite higher interest rates and despite a weaker economy, to which higher interest rates have undoubtedly contributed. According to the Reserve Bank forecasting model, every one percentage point increase in the repo rate reduces the GDP growth rates by 0.4% p.a. and the inflation rate by 0.3% over the subsequent 12 months. To put such predicted reactions in some perspective, this means that to reduce the inflation rate by one and a half percent from 6.5% (above the target range of 3% to 6%) to 5%, it would take a five percentage point increase in short term interest rates. Interest rate increases that would be predicted to reduce GDP growth rates by two percentage points, say from plus one to minus one. This is a high price to pay in foregone output and incomes it must be agreed for still high inflation.

The increases in short rates to date will have reduced already anemic GDP growth rates by close to one percentage point. But such outcomes presume that all other influences on the inflation rate and on GDP growth included in the forecasting model will have remained as predicted by the assumptions and feedback loops of the model – a very unlikely outcome indeed, as recent experience will have demonstrated.

The recent increase in the inflation rate owes a great deal to rising food prices- the delayed impact of the drought that so reduced the maize, wheat and other harvests. The much weaker rand and higher administered prices, especially electricity charges, would have added to the pressures on costs and prices. But the pass through effect of a weaker rand on imported inflation and so the CPI, was unusually muted in 2015 given lower oil and commodity prices. Weakness in emerging markets and emerging market (EM) currencies in response to weaker EM growth and less risk tolerance in global capital markets however meant a weaker rand that depreciated against a stronger USD, broadly in line with the other EM currencies. But the events that moved the rand and inflationary expectations higher and added materially to SA risk, and to a still weaker rand expected over the next 10 years, were very South African in origin. President Jacob Zuma’s intervention in SA’s financial affairs was unprecedented and unpredictable. It did much damage to the annual inflation and exchange rate outlook – adding about 2% p.a more to both – such that increases in interest rates, even very significant increases, would not have countered and cannot be expected to counter. Yet they would have damaged the real economy in the predicted way.

The outlook for inflation will continue to be dominated by forces well beyond the influence of Reserve Bank interest rates, making inflation forecasts an unreliable exercise. Politics, the weather and global forces, including degrees of risk aversion accompanying commodity price trends, will be as decisive as they have been to date. Raising interest rates in such circumstances can have only one fairly predictable outcome: to slow down the economy further so making a credit ratings downgrade more likely.

The only justification for ever raising interest rates aggressively in SA would be when aggregate demand is rising strongly enough to put upward pressure on prices. Such pressure on prices will however then be accompanied by strong growth, not the weak growth now experienced. If the economy were growing well, say at a 5% rate and inflation was rising at above target rates, say at 6.5% p.a, then raising interest rates by say 300bp over a 24 month period could make every sense. Inflation could then be expected to come down to below six per cent and growth could slow down to a still satisfactory 4% or so rate.

The distinction between demand side forces acting on inflation that would justify higher interest rates and supply side shocks that drive the inflation rate temporarily higher and simultaneously but reduce demand and growth rates, is an essential one to make. Supply side shocks on prices should be ignored by monetary policy: this is the conventional wisdom. It is a distinction between supply side and demand side-driven higher prices that the Reserve Bank refuses to make. It has cost the economy dearly, while inflation and inflation expected have accelerated for reasons that have had little to do with the Reserve Bank. As I have said before, monetary policy in SA needs a better narrative, one that will preserve the credibility of the Reserve Bank without it having to play King Canute.

Incidentally, if the most recent forecasts of the Reserve Bank for inflation (below target in 2018) and GDP growth (no more than 1.7% in 2018) turn out to be accurate, the case for raising interest rates and any extension of a tightening cycle will remain as weak as it is now. Here’s hoping for better weather, conservative fiscal policy settings and a credible Minister of Finance, and a stable or stronger rand, enough to reverse inflation trends and lead interest rates lower- an essential condition for a cyclical recovery.

Point of View: Artificial intelligence and the productivity conundrum

The world’s first artificially intelligent lawyer has arrived. Called Ross, and built on IBM’s famous cognitive computer called Watson, it has been “employed” by US firm Baker & Hostetler to work in its bankruptcy practice.

According to Futurism.com, Ross can “read and understand language, postulate hypotheses when asked questions, research, and then generate responses (along with references and citations) to back up its conclusions. Ross also learns from experience, gaining speed and knowledge the more you interact with it”. (http://futurism.com/artificially-intelligent-lawyer-ross-hired-first-official-law-firm/)

It’s not just lawyers who should be looking over their shoulders. All sorts of knowledge workers could see their employment prospects and livelihoods threatened by artificial intelligence, including journalists, accountants, portfolio managers, even surgeons and physicians.

With the aid of the internet and easy access to case law and its interpretation, fewer lawyers may be required to resolve a bankruptcy procedure. Fewer analysts may be required to value a company with the aid of Bloomberg data and its accompanying suite of programmes. Lasers directed by unerringly accurate robots may well help reduce the time in the operating theatre and the dangers of doing so.

What is the impact of these newly adapted technologies on productivity in the industry and the economy as a whole? Let’s use the example of the artificially intelligent bankruptcy lawyer above. The productivity of the lawyers in bankruptcy practice can be defined as the number of cases concluded divided by the number of lawyer hours billed to do so*. Presumably the number of lawyers (and legal hours billed) will decline with the aid of Ross. Thus the surviving lawyers working on bankruptcy law in a legal practice will have become more productive in the sense of an increase in the ratio (cases concluded/hours billed). Measuring productivity in this case seems a simple task.

It becomes much more difficult to measure the productivity of a service provider when real output is much trickier, and sometimes impossible, to measure. One would not wish to measure the productivity of an analyst, journalist, artist or inventor of a new video game by the number of words written and published or number of pictures painted or pixels injected. The quality of the work produced is surely more important than the quantity of output and “quality” is recognised in revenues generated. As is admitted by the calculators of productivity, it is impossible to measure the productivity of government officials, because it is not possible to measure how much they produce. All that can be measured is their employment benefits – an input. In the case of an author, composer, copywriter or game developer, only the value of the royalties they have earned can be measured – their revenue line, not the time spent writing the masterpiece. Measuring productivity requires that inputs and outputs can be independently measured, which is not always the case, especially for service providers.

However, looking at the example of the number of bankruptcy cases (which we would regard as an independent measure of output), what if the quality of advice has improved even as the numbers of hours billed declines? The advice may be superior with the aid of Ross’s deep memory bank. How would we adjust for this quality dimension in our measure of legal productivity? The question is apposite for the service sector generally, where computers and data management (and improved knowledge) have presumably enhanced the quality of service provided by lawyers, analysts and other knowledge professions, including the improved offering of physicians supported by bigger data and better statistics. If the quality of advice has objectively improved, then any hour of consulting service will be delivering more in real terms than a case handled in the same time say 10 years before. The output of the consultant will in effect have increased, even if the input of time is the same. But by how much is the leading question. The physicians may be seeing the same number of patients a day, charging them higher fees, but they (their patients) are likely to be living longer and better lives.

In cases like this we will not be comparing like with like, apples with apples or aspirins with aspirins, making any measure of real output and so productivity over time a very difficult exercise and one subject to significant errors in what is measured. For example, your medical insurance may well have become more expensive – or your cover reduced – but are you not getting a better quality of medical service in return? And exactly how much better? In the case of medical insurance, only what you are paying – not your additional benefits – will find their way into the official price indices.

A further aspect is the impact of improved quality on the broader economy. If the bankruptcy cases are resolved with less billable time spent in court and hence with a larger percentage of debt being recovered with reduced legal expenses, this would be a clear gain to the creditors. Creditors would be better off in real terms, with less spent on legal fees and earlier resolution of their claims, meaning that the creditors could spend more on other goods or services or save more. And lawyers competing with each other for work that has become less costly for them to supply, may well charge you less for their time. It is competition for extra revenue that turns lower costs into lower prices – even in the legal profession – provided they do not collude on fees.

Could the GDP deflator, the price index that converts estimates of GDP in money of the day into a real equivalent, hope to pick this up with a high degree of accuracy? Enough to provide accurate measures of GDP or productivity growth over extended periods of time? The deflator used to convert nominal GDP into real GDP, attempts to adjust for quality improvements in the output of goods and, especially, services produced. Yet in South Africa, 68% of all value added is comprised of services of one kind or another the quality of which may well be changing over time, in ways that are very difficult to measure.

Ours is more of a service economy, than one that produces goods, the output of which is much more easily measured in units of more or less constant quality – for example number of bricks or tons of cement or steel. Thus, if we are underestimating quality improvements in the large service sector, we will be overestimating inflation and so underestimating the growth in real incomes, output and productivity.

Your real incomes and your productivity may well have increased even if you are taking home no more pay or other employment benefits. You may be benefitting from an enhanced quality of service as well as a very different mix of services than was available 10 years before, for example easy internet access that has so changed the way we work and play. This has become a particular problem in the developed world where prices as measured are generally falling. Deflation, rather than inflation, is the greater concern and nominal wages are not rising, even if productivity and the standard of living, differently measured and quality enhanced, is improving (though perhaps poorly recognised, as voters in their frustration at their constant money incomes turn to populists who promise a better standard of living). A mere one or two per cent extra a year factored into GDP or productivity growth measures, well within a range of possible measurement errors, would provide a very different impression of how the developed world is doing. A rising real standard of living, if only we could measure it, might well be accompanying stagnant employment benefits, when calculated in money of the day.

*One of the criteria the World Bank uses for measuring the ease of doing business in any country is outcomes in the bankruptcy courts. The tables below measure ease of doing business across a number of categories, and we show the SA and Australia findings where SA compares quite poorly. The ranking is, for example, 120/189 for ease of starting a business compared to 11 for Australia; and 41 for bankruptcy proceedings compared with 14 for Australia. Both countries rank poorly for trade across borders (130 and 89). Note we do much better than Australia when it comes to protecting minority investors: ranked 14 vs 66; and worse for getting credit, 59 Vs 5.

 

Why accurately measuring and anticipating inflation is much more than a statistical exercise

Tim Harford of the Financial Times in an article carried in Business Day 18th May (Big data power up inflation figures) writes of the attempts under way to predict inflation ahead of the official data releases using ‘big data” – in this case observing continuously thousands even billions of prices reported online “by hundreds of retailers in more than 60 countries”

There is however more to this very welcome exercise made possible by modern technology than improving our measures of inflation –or being better able to adjust prices for changes in the quality of the goods and service being priced in the market place- a truly formidable task as Harford suggests. Or for that matter in the practice of in using high frequency data to predict the next GDP announcement, which also comes with something of a time lag. Helping to anticipate the next GDP announcement in the US is an exercise undertaken by one of the branches of the Fed. The Federal Reserve Bank of Atlanta publishes its GDPNow forecasts of GDP that are attracting understandable attention in financial markets.

The primary purpose in being able to more accurately predicting inflation or growth announcements to come is that it helps the forecaster to anticipate central bank policy changes – in the form of interest rate adjustments or doses of money creation- now called Quantitative Easing- that may follow the news about inflation or growth. Past performance tells us that central banks will react in predictable ways to the unexpected, to the surprisingly good or bad economic news to which inflation and GDP announcements make a large contribution. The economic news is important because the central bank regards the news as important. They are mandated to meet targets for price stability and to help the economy realise its growth potential. Knowing what the central bank will do can be very valuable information. Valuable because what central banks can do is move markets. And beating the market- being ahead of the market moves – can be extraordinarily valuable. Just as being behind the new direction of a market can be as damaging to participants in markets who miss-read the signals.

Central banks however can only move the markets in what they may regard as the right directions if they can take the market place by surprise. As is well recognized in the market place- only surprising news matters- the expected is captured in current prices and valuations. And so there is every reason for participants in the financial markets not to be surprised so that they can take evasive action in good time and position themselves for what central banks and the market may do to them. Better forecasting models of inflation or growth – or even of the next inflation or GDP announcements, using new technology- big data- helps market participants to realize profits or avoid losses.

Yet by anticipating central bank action the market place helps void the intended influence of central bank actions on the economy. This makes central banks much less influential over the economy than the still generally accepted conventions allow central bankers about the role they can and should play in managing the business cycle. Robert Lucas of Chicago in 1995 was awarded a Nobel Prize in economics (as were other rational expectation theorists, for this “policy invariance” critique of central banks, including Finn Kydland and Edward Prescott (2004) And one could add to this list of path breaking Nobel Prize winning economists, Edmund Phelps (2006) and even Milton Friedman (1976) honoured for demonstrating that economic growth could not be stimulated by inflation. They showed that any favourable trade-offs of inflation (bad) for more growth (good) were between unexpected inflation (not inflation) and GDP growth- something very difficult to achieve in any consistent way because of inflation avoiding behaviour market participants would be bound to take. The case for more inflation had been made by the famous Phillips curve- a theory that at one stage enjoyed wide support in the economics profession as a justification for engineering more inflation. Inflation (higher prices) it was thought could help overcome price and wage rigidities that were presumed to prevent an economy finding its own path to full employment. It became the essence of Keynesian economics.

Modern central bankers now take inflationary expectations very seriously. So labelled Expected inflation augmented Phillips curves are at the heart of their inflation modelling. (Inappropriately given the history of a failed theory) They attempt through their policy interventions to “anchor” inflationary expectations- as the phrase goes. By anchoring inflationary expectations they hope to avoid inflationary surprises that are well understood to be damaging to the real economy.

Unexpectedly high or low inflation makes it harder for firms and trade unions, with price and wage setting power to make the right output and employment optimizing decisions about wages and prices. Unexpectedly high or low inflation can temporarily confuse them about the true state of the economy and so exaggerate the direction of the business cycle that will in time be reversed as inflation expected adjusts to actual inflation.

But this sensible understanding of the need to avoid inflation surprises does not seem to inhibit the larger ambitions of central banks to manage the business cycle. They still seem to believe that they able to helpfully “fine tune” the economy- manage the business cycle – through appropriate changes in interest rates and QE so that the economy can realizes its full growth potential. But logically or rather illogically this must mean being able to surprise the market place with their policy reactions – a market that is very determined not to be surprised.

In pursuing such grand ambitions to manage more than inflationary expectations, central bankers are perhaps promising more than they can hope to deliver- and so attaching too much attention to themselves. The market place has become increasingly skeptical about central bank delivering on its promises to manage aggregate global spending, demand that remains deficient despite the best efforts of central bankers world-wide. More central bank modesty – as well as more realism in the market place – about what central bankers can and cannot do – is called for.

Can technology rescue the banks from the regulators?

Mervyn King (not the famous South African one) – now Baron Mervyn King of Lothbury – was once a highly influential Professor at the London School of Economics and then the Governor of the Bank of England until 2013, during which time he helped guide the UK successfully through the financial crisis.

(More recently, he resigned from the Board of the Aston Villa Football Club, the team that finished last in the English Premier League this season. Since past performance is no guide to future performance (in football and in financial markets) this surely will be forgiven.)

King has written a book “The End of Alchemy” to express his disquiet with the post financial crisis banking system and how it is being regulated1. To quote King: “The strange thing is that after arguably the biggest financial crisis in history nothing much has really changed in terms either of the fundamental structure of banking or the reliance on central banks to restore macroeconomic prosperity.”

The fundamental problem, King argues, is in the nature of the incentives banks have in taking risks with other people’s money. When the risk taking works out, the bank shareholders and managers get the rewards, while society has to bear the fall out when the risks turn out to have been very poorly managed. But is this heads I win – tails you lose asymmetrical risk-reward nexus that different for banks when compared to all other large listed companies?

The rewards for managers and shareholders in any company who take on sometimes highly leveraged risks of failure and then succeed (against the odds) can be enormous. The losses caused by the failure of a large public company can also be very serious for the economy at large – other suppliers or customers. They may well be sucked into bankruptcy should the firm suddenly have to close its doors and workers and managers will have to seek alternative employment. The larger the company or bank, the larger these potentially damaging knock-on effects. But if a company or bank is growing for good economic reasons, it would be poor policy to prevent this growth in efficiency for fear of subsequent failure.

The direct financial losses of business or bank failure will be typically borne by shareholders, whose stake in the winning or losing enterprise will be a small part of a low risk, well-diversified portfolio. These lower risks means less expensive capital for the risk taking firm and so more incentive to take on risk. Yet without limited liability for losses, very little risk taking would ever be undertaken. Society has every good reason to encourage risk taking by banks and others – it is the source of all economic progress – and to provide limited liability for capital providers.

Yet the long and mostly successful history of banks and other limited liability companies is that the price of success – the willingness to accept and deal with business and banking failure – has been well worth taking. The focus of policy should perhaps be on how to improve the defence against actual failure, rather than interfering with the freedom of banks to usefully put capital at risk, in the hope that this will prevent a crisis, by introducing better bankruptcy laws that can act much faster to get a business back on its feet and convert debt into equity to the purpose. This will provide debt holders – especially less well diversified lenders – with every incentive to monitor risk management by a bank or business and to introduce debt covenants to such purpose. Ordinary shareholders, even well diversified ones, will greatly appreciate such surveillance, making a mix of debt and equity finance a desirable one.

A business may well be worth rescuing if the reason for failure is too much debt rather than a poor operating performance. Furthermore, a reliance on central banks to restore macroeconomic stability when threatened by a financial crisis, that can be impossible to predict or avoid, is an essential and appropriate part of these defence mechanisms. The history of central banking is the history of how central banks, beginning with the once privately owned Bank of England (nationalised only in 1947) coped with financial crises.

Banks are however responsible for the management of the economy’s payments system. The payments system, hence the banks, cannot be allowed to fail; not even temporarily. The consequences would be too ghastly too contemplate, as they are being forced to contemplate in Zimbabwe as we write.

The interest spread between what a bank offers for deposits and receives for loans has helped to subsidise the cost to the banks of running the payments system. The customers of banks do not typically pay transaction fees to cover the full costs of the payments system they utilise. Hence the attractions of cheap funding for the banks in the form of very low interest transaction accounts and attractions for their customers in the form of low cost transactions that make up for low interest rates received. A comparison of bank charges with charges made by vendors using credit card systems or with the percent of the value of a transaction charged by the money changers and transmitters, makes the point. I am told that for every R100 transferred for example to Malawi through the banking system, the receiver will receive R90 at best. How much of the 9% charge goes to the banks, to the money change agents and the government, I do not know.

The business case for bundling bank borrowing, lending, trading and making payments may however be breaking down. Blockchain computing is being used to safely and cheaply move valuable Bitcoins around the world. The technology could extend to transactions effected by specialist electronic money-changers, charging low fees that still cover low costs. Pure transaction accounts could be made fully and always backed by reserves of central bank deposits or notes in the till or ATMs, rather than covered by deposits or reserves held with other more vulnerable banks. If transactional banking can be legally and economically separated from risk taking banking, the all-important payments system can be insulated from the danger of banking failure. Banks, as with other firms, can then be left to manage their own risks. This may well be the way to rescue banks – or rather their risk-absorbing shareholders and debt holders – from the profit-destroying and cost-raising burdens imposed by risk-avoiding regulators.

1These observations were stimulated by an article by Michael Lewis: On The End of Alchemy – A Central Bankers Memoir (Mervyn King Of The BOE), Actually Worth Reading, Bloomberg Business, 6 May 2016

 

Not so Moody after all

Moody’s Investors Service showed its softer side when confirming SA’s investment grade credit rating. The rating agency made it clear that to maintain this grade, SA would need to increase its GDP – that is, simply not fall into recession. A mere 0.5% increase in 2016 would meet Moody’s modest expectation, followed by 1.5% in 2017.

Growth, as Moody points out, not only makes government debt easier to manage. It helps the banks and the households meet their obligations and will also encourage firms to invest more in additional capacity.

To quote the preamble to the report:

“The confirmation of South Africa’s ratings reflects Moody’s view that the country is likely approaching a turning point after several years of falling growth; that the 2016/17 budget and medium term fiscal plan will likely stabilize and eventually reduce the general government debt metrics; and that recent political developments, while disruptive, testify to the underlying strength of South Africa’s institutions.

“The negative outlook speaks to the implementation risks associated with the structural and legislative reforms that the government, business and labor recently agreed in order to restore confidence and encourage private sector investment, upon which Moody’s expectations for growth and fiscal consolidation in coming years — and hence the Baa2 rating — rely.”

Moody’s identifies three drivers that inform its decision. The first, most critical, we would suggest, is that the economy will recover from a business cycle trough:

“..The first driver for the confirmation is Moody’s expectation that South Africa’s economic growth will gradually strengthen after reaching a trough this year, as the various supply-side shocks that have suppressed economic activity since 2014 recede. Specifically, the electricity supply is now more reliable, the drought is ending and the number of work days lost to strikes has shrunk significantly (a trend that planned rule changes are likely to embed further). In addition, the inflation outlook is more subdued, which would suggest fewer interest rate rises ahead than we expected when the South African Reserve Bank saw inflation heading towards 8% by year end. Less severe tightening of monetary policy would alleviate extra pressure on South Africa’s relatively highly-indebted household sector and support growth.

“Alongside the more competitive exchange rate, these improving trends are likely to strengthen growth in South Africa from the second half of this year and thereafter. While we expect the economy to expand by only 0.5% in 2016, we expect growth to rise to 1.5% in 2017. Moreover, ongoing structural reforms and diminished infrastructure bottlenecks offer upside potential for growth over the medium term. The recent rapprochement between the government, business and labor holds promise from the standpoint of identifying areas of mutual concern. A number of benchmark actions related to matters such as the rationalization of state-owned enterprises (SOEs) and the enactment of labor market reforms have been identified in the process. To the extent that implementation of such measures helps boost business confidence, investment and job creation, they would improve prospects for gradually reducing wide economic disparities and high levels of poverty, deprivation and unemployment.”

The second driver for the unchanged rating was “The Stabilization of government debt ratios likely to occur in 2016/17” and the third was “Recent political developments testify to the strength of South Africa’s institutions”.

The rating was placed on a negative watch because such hopeful predictions have still to materialise. Or, to put it bluntly, will the economy grow by 0.5% in 2016 and 1.5% in 2017? These are not demanding outcomes even by SA’s well below average growth performance in recent years. What then could cause SA to fall into recession?

The simple short answer would be a further slowdown in household spending. Since households account for over 60% of all spending, any further reluctance in their willingness or ability to spend more will drag the economy into recession. It will neither encourage firms to invest more in people or capacity nor encourage foreign savers to fund our savings deficit.

It is striking that Moody’s could look to lower rather than higher interest rates to improve the growth outlook and the ratings prospects. To repeat the observation made above from Moody’s:

“In addition, the inflation outlook is more subdued, which would suggest fewer interest rate rises ahead than we expected when the South African Reserve Bank saw inflation heading towards 8% by year end. Less severe tightening of monetary policy would alleviate extra pressure on South Africa’s relatively highly-indebted household sector and support growth.”

We have long questioned the Reserve Bank’s decisions to raise interest rates into higher inflation and a weaker economy. It seems to us that the higher rates can make no predictable impact on inflation or, it may be added, on inflation expected – that has also risen lately despite the weakness of the economy and despite interest rates that have been rising since early 2014. This proves only that inflation and expected inflation is dominated by forces well beyond the influence of higher short term interest rates. That is in particular by the behaviour of the rand, the behaviour of the weather, the behaviour of the President, the behaviour of global commodity and oil prices and Eskom and its regulators, to mention some of the supply side shocks that have driven inflation in SA higher.

Interest rate increases do nothing useful to contain inflation in a world where the supply side shocks are pushing prices higher and household spending lower. What they do is to reduce household spending further than would have been the case with stable or lower interest rates. For every one percent increase in the repo rate, the Reserve Bank forecasts a 0.4% reduction in GDP growth over two years.

This should be emphasised, in the light of the Moody’s report, since rate increases prejudice rather than enhance our credit rating. An independent central bank is one of SA’s institutional strengths. But such independence could have been much better managed than it has been. Lower, not higher interest rates, would have served the economy better (and still can) and helped preserve its growth rates. Moody’s would seem to agree.

Are there other forces at work that could help the economy grow a little faster? The weaker real and more competitive rand finally seems to be helping the manufacturers as well as the tourist business. The latest survey of manufacturing activity, the Barclays PMI, shows a very healthy recovery and positive growth. If the past strong statistical relationship between the PMI and GDP growth is to be relied upon (showed below), this improvement does suggest significantly faster growth to come. The PMI is well up and the GDP growth rates in Q2 can be expected to follow. We thank Chris Holdsworth of Investec Securities for drawing this relationship to our attention:

 

The other helpful influence at work is a much smaller foreign trade deficit recorded over the past two months. Less imported and more exported add to GDP growth rates. A decline in inventories held, especially inventories with import content, may offset these favourable forces on recorded GDP growth. But a combination of a more competitive rand and a more cautious Reserve Bank, more sensitive to the growth outlook, as well as the business cycle trough from which conditions improve rather than deteriorate, should deliver growth of 0.5% this year and 1.5% next; enough to satisfy Moody’s. Raising the growth rates to permanently higher rates of over 3% requires the structural reforms of the labour and other markets that Moody’s appears surprisingly optimistic about. One can only hope that their optimism is justified.

 

The wisdom in foreign exchange control reforms

A notable milestone in SA’s financial history was passed in the second half of 2015. For the very first time, the value of South Africans’ foreign assets has come to exceed the value of the South African assets and debt held by foreign investors. At year end, our holdings of foreign assets, worth over R6 trillion, exceeded our foreign liabilities by as much as R714bn.

 

The buildup in offshore assets legally owned and managed by South African businesses, pension and retirement funds as well as directly by wealthy individuals, began from very modest levels in 1994, when South Africans became acceptable participants in global financial markets.

The growth in foreign assets and liabilities has served South Africans particularly well in recent years as the SA economy has been severely buffeted by a damaging combination of weak growth and higher inflation. Stagflation has accompanied a collapse in the currency, higher charges for utilities a severe drought and, to top all these economic body blows, we have seen (avoidably) higher borrowing costs imposed by the Reserve Bank.

The increasingly large foreign component in SA portfolios of assets therefore has helped significantly to mitigate the shocks to their incomes and balance sheets caused by specifically negative South African events, both political and economic. The protection against their exposure to SA risks has come in large measure from the shares they own in JSE-listed industrial companies whose major sources of revenues and earnings (as well as the costs they incur) are generated outside SA.

The successful industrial companies that began life in SA and have prospered abroad include Naspers (NPN), SAB, British American Tobacco (BTI), Mediclinic (MEI), Richemont (CFR), MTN, Steinhoff (SNH), Brait (BAT) and Aspen (APN) . They have come to dominate the JSE when measured by market value. Up to 50% of the value of the JSE is accounted for by these large firms, that we can describe as Global Consumer Plays (GCPs). Before the rise of these now global companies, investors on the JSE would have been much more exposed to the highly variable fortunes of Resource companies that used to dominate the JSE. Without these opportunities to invest in these world class companies on the JSE, as well as the investments made abroad by these companies and other SA based companies outside of SA, the value of SA pensions and retirement plans might have looked very sad indeed.

An equally weighted Index of 14 of these GCPs on the JSE (including recent underperformers MTN, ASP and CFR) has performed as well as the leading global index, the S&P 500, over the past two years or so, adding about 30% to its rand value of January 2015.

Well-developed liquid capital markets not only provide companies and governments with access to capital. They provide wealth owners, and their fund and business managers, with the opportunity to diversify away firm or country specific risks. A well-diversified portfolio with a full variety of investment opportunities, none of which will dominate the balance sheet and whose individual returns are somewhat independent of each other, makes for a much less risky portfolio, that is a portfolio whose value, while expected to rise over time, will do so more predictably than most of its separate components (especially individual shares) included in the portfolio. The well diversified portfolio provides positive returns with significantly less risk – that is smaller value movements in both directions.

Less risk moreover translates into lower required returns of the investor or wealth owner. Lower required returns also mean lower costs of capital for the firms hoping to raise capital to expand their businesses. Lower required returns in turn will mean more capital invested, a larger capital stock and a stronger economy. This is one of the benefits of a well-developed capital market that can attract capital from savers everywhere and not only domestic ones- as has the SA capital market – where capital inflows have more or less matched capital outflows over the years – as we have shown in figure 1 above.

Human capital effect

But the less risky returns that the opportunity to invest globally provided to South Africans benefits not only the owners of tangible capital but also the owners of intangible human capital committed to the SA economy.

There is always a global shortage of skilled professionals, including managers of businesses, for which competition is intense. By enabling skilled South Africans to invest abroad and diversify away SA risk, their required returns from SA sources have also declined. That is, they are more willing to apply their skills in SA – and therefore are more willing to sacrifice returns, that is employment benefits – because their wealth is better insured against SA risks to their wealth. This now more favourable exchange of less risk for lower returns by owners of a crucial resource- the human capital of skilled professionals- helps to make the SA economy more globally competitive

It has been wise of the SA government to relax exchange control over the years – it has helped the economy retain its skills and so better ride out economic misfortunes.

Were the economy to grow faster over the next few years, the outward flow of capital would be more than matched by inward flows of fixed direct investment (FDI) and portfolio capital. Also, foreign controlled companies would be more inclined to reinvest profits than pay them out as dividends. Growth leads investment by companies in additional capacity and stimulates the flow of funds to support growth. Without faster growth, the flows through the net flows through the SA balance of payments will continue to be more out than in.

The economy would grow faster were global market forces to become more favourable to our emerging, metal price-dependent economy. The rand would then strengthen (as it has lately) and the inflation and interest rates would come down rather than rise to help the economy along. Faster growth over the longer term would respond to more business, employment and wealth friendly policy reforms, of which exchange control reform is a very good and helpful example.

Some details about capital flows

FDI is defined as an investment by a foreign company with a more than 10% shareholding. Portfolio investment is defined as a less than 10% share. As may be seen below, outward FDI has recently come to exceed inward FDI, while inward portfolio investments continue to exceed outward flows – that have become significantly larger.

As important for the SA balance of payments is the flow of dividend receipts and payments. The flows of dividends from portfolios has become a net positive for the SA economy while the flow of dividends from FDI remains strongly in the other direction.

The rand: A global opportunity

Global rather than SA forces have taken the rand and the JSE higher. There is still much scope for improved SA fundamentals to add further strength to the rand and the economy

The rand has regained all the ground lost since December 2015 when President Zuma shocked the markets. How much of this recovery can be attributed to South African specifics (better news about the political state of SA) and how much can be attributed to global forces (less risk priced into emerging market currencies bonds and equities of which SA is so much a part of)? The answer is that to date almost all of the improved outcomes registered on the JSE and in the exchange value of the rand is the result of less global, rather than SA, risk.

The positive conclusion to draw from this is that were SA itself to be better appreciated in the capital markets on its own improved merits, there would be further upside for the rand – and for the SA economy that can only escape its current malaise with a stronger rand and the lower inflation and interest rates that will follow.

We show below that the rand has recovered in line with emerging market equities, represented by the benchmark MSCI EM. This index and the JSE indices are now also more valuable than they were in early December 2015. The JSE All Share Index (ALSI) in rands is also now ahead of its December value. MSCI EM is up about 20% from its recent lows of mid-January 2016 while the rand has gained about 15% since then. The JSE, when valued in US dollars, has performed even better than the average emerging market equity market, having gained about 25% since its lows of 18 January.

 

The higher SA-specific risks attached to the value of the rand in December are shown by the performance of the rand against other emerging market currencies since. As may be seen below, the rand has yet to recover its value of early December when measured against the Brazilian and Turkish currencies that have also strengthened against the US dollar over the period. On a trade weighted basis, the rand has lost about 4% since December.

A model of the daily value of the USD/ZAR that uses the USD/AUD and the emerging market bond risk spreads as predictors, with a very good statistical fit since 2012, indicates that without the Zuma intervention, the USD/ZAR might now have cost closer to R13 than the R14.7 it traded at yesterday (18 April), given the recovery in commodity currencies and the narrowing emerging market spreads.

That the recovery of the rand and the JSE has more to do with emerging markets rather than SA forces is shown below. Risk spreads attached to emerging market bonds and RSA dollar-denominated bonds have declined in recent months. However the difference between higher emerging market spreads over US Treasury yields and RSA spreads has narrowed. The wider this difference, the better the relative rating of SA bonds: the SA rating was at its relative high in late 2014 and has deteriorated since, though it is little changed from its rating of early December 2015.

A comparison of risk spreads attached to Brazilian and SA debt made below, shows how Brazilian credit has benefitted both absolutely and relatively to SA from the prospect that its President will be forced out of office. It should also be recognised that both Brazilian and SA debt are currently trading as high yield bonds. Investment grade bonds offer up to about 2.7% p.a more than five year US Treasuries.

When we turn to the bond market itself, we see that the yield on RSA 10 year rand-denominated bonds has fallen below 9% p.a but is still above the yields offered in early December. The spread between 10 year RSA rand rates and US 10 year Treasury Bond yields however remain above 7% p.a. This is a further indication that SA-specific risks priced into the bond markets remain highly elevated. They reveal that the rand is still expected to weaken by about 7% p.a against the US dollar – implying consistently high rates of inflation in SA over the next 10 years.

There remains every opportunity for SA to prove that the markets are wrong about the inflation and exchange rate outlook, with policies that convince the world that we will not be printing money to fund government spending and that our policies will be investor friendly. Of more importance, a stronger rand and lower interest rates would help lift GDP growth rates, to the further surprise of the markets and the credit rating agencies.

 

A Marie Antoinette moment – let them eat more expensive bread

The Treasury has just increased the duty on imported wheat by 34%, from R911 to R1 224 per tonne. Some 60% of SA’s demands for wheat are met from abroad. Accordingly the price of bread is predicted to increase by some 10%.

This is another bitter blow for the poor of SA, some 34% of the population, according to the World Bank. One might have thought that such a step that will benefit a few farmers at the expense of a huge number of impoverished consumers of bread, makes no sense at all. But apparently the Treasury had no choice in the matter at all, being bound by an agreed automatic wheat price formula, and was forced to act when threatened by High Court action taken by Grain SA. But the responsibility for the formula is that of the government and the formula may well be adjusted in the months to come, altogether too late to relieve poverty.

And were the farmers wise to exercise their rights at a time like this? They may well end up with lower duties or better still for the economy – no duties at all on a staple most of which is imported.

In the figures below we compare in rands the global (US dollar Chicago-based price of wheat) and local prices of wheat, having converted bushels to tonnes* and dollars to rands at current exchange rates. The local price is the price quoted on SAFEX for wheat, delivered in three months. The difference in the price of wheat, global and local, is the extra that South Africans pay for their wheat, a mixture of duties and shipping costs.

SA is not self-sufficient in wheat, hence the local price of wheat takes its cue from the cost of imports. Not that self-sufficiency in food or grains is a useful goal for policy because it must mean higher prices for wheat and other staples for which the SA climate and soils are not helpful. And higher prices for staples then lead to higher wages to compensate for higher costs of living that make all producers in SA less competitive with imported alternatives. Higher prices for wheat (or rice or sugar or barley or rye) mean less land planted to maize and so higher prices for maize, in which SA is normally more than self-sufficient for all the right reasons and where local prices usually take their cue from prices on global markets, less rather than plus transport costs to world markets. The current drought in SA and its expected impact on domestic supplies, has lifted maize prices towards import price parity – another, but unavoidable, blow to consumers. Also less land now under wheat, barley or rye is given to pasture and grazing that might otherwise have held down the price of meat.

A competitive economy is one that exploits its comparative advantages to export more and import more. It does not protect some producers at the expense of all consumers, nor those producers who could hold their own in both global and domestic markets without protection. A competitive economy also will not lack the means to import food, both the basic stuff and the more exotic varieties at globally determined prices. South Africa needs more, not less, competition to help reduce poverty and stimulate faster growth. Raising barriers to trade not only harms the poor today but it also undermines their prospects of escaping poverty over the longer run.

*For more on how to convert bushels to tonnes: https://www.agric.gov.ab.ca/app19/calc/crop/bushel2tonne.jsp

The rand: A welcome question of specifics

Is the recovery of the rand for global or SA reasons? Whatever the explanation, it is surely very welcome.

A recovery of the SA economy needs a stronger rand. A stronger rand will mean less inflation to come and lower interest rates. Unfortunately a weaker rand leads interest rates in the opposite direction making it just about impossible for the business cycle to turn higher. A combination of higher prices on the shelves and the petrol station forecourts following rand weakness, depresses household spending. And the higher interest rates that follow add to the inability of households to spend more – and to borrow more. Household spending, which accounts for over 60% of all spending, leads the economy in both directions. Without a recovery in the propensity of households to spend more, the best the SA economy can hope to do over the next 24 months would be to avoid recession.

The foreign exchange value of the rand responds to both global forces – that is global risk appetites that drive emerging markets and currencies lower or higher (including the rand) – and SA-specific risks that encourage capital flows to and from SA.

An obvious example of SA-specific risks driving the rand weaker and interest rates higher was provided by President Jacob Zuma in December. The week of Zuma interventions in the Treasury saw the rand sharply weaken and sent long term interest sharply higher. These interventions added about R2 to the cost of a US dollar – according to our model of the rand – and about 100bps or more to the cost of raising long-dated government debt.

Our model of “fair value” for the USD/ZAR relies on two forces, the USD/AUD and the emerging market risk spread. Had Zuma not acted as he did, the US dollar might well have cost no more than R14 in early December 2015. With the recent recovery in the USD/AUD and emerging market bonds, the current fair value for the rand would be closer to R13 than R14. This suggests that the Zuma danger to the rand has not left the currency or bond markets. And that the welcome recovery of the rand is mostly attributable to global rather than SA forces. We attempt below to isolate the impact of global from SA-specific risks on the exchange value of the rand and show that the recovery of the rand is mostly global rather than SA specific.

If indeed the recovery of the rand is mostly attributable to global rather than SA forces, there is the possibility that a revived respect for SA’s fiscal conservatism – demonstrated in the Pravin Gordhan Budget for 2016-17 – can still prove more helpful to the SA bond market and the rand, global forces permitting.

In the figure below we compare the performance of the rand to other currencies including a basket of emerging market currencies. The rand weakened against all currencies in 2015 – including other emerging market currencies. Furthermore the significant recovery of the rand in 2016 is in line with that of other commodity and emerging market currencies. This suggests again that global rather than SA forces explain the recent rand recovery.

A similar impression of predominant global forces is provided by the bond market. The spread between RSA 10 year bond yields and US Treasury Bond Yields of similar duration have stabilised at more than 7% p.a. having widened dramatically in December 2015. These spreads are significantly wider than they were in early 2015. This spread may be regarded as a measure of SA specific risk, or more particularly as a measure of expected rand weakness. The rand has weakened – and is expected to weaken further. An alternative measure of SA specific risk is provided by the CDS spread paid to insure SA US dollar denominated debt against default. This spread has moved very much in in line with the interest rate spread.

The recent narrowing of this insurance premium has however also been accompanied by a narrowing of the more general emerging market CDS spread, reflecting global forces at work. The gap between the higher emerging market CDS spread and the lower RSA spread narrowed sharply in December 2015, indicating a deterioration in SA’s relative credit standing. This relative standing has not improved much in 2016, as may be seen by a difference in spreads of only about 120bps. Note that the wider this spread, the better SA’s relative standing in the global credit markets.

The spread between RSA rand yields and their US Treasury yields of similar duration are by definition also the average rate at which the rand is expected to depreciate over the next 10 years. The fact is that the rand has weakened and is expected to weaken further – despite the wider interest carry in favour of the rand.

Given these expectations of rand weakness it is not surprising and entirely consistent that inflation compensation provided by the RSA bond market being the difference between an inflation linked yield and a nominal yield. This is a very good measure of inflation expected and has also risen and remains above 7% p.a.

The Reserve Bank pays particular attention to inflationary expectations, believing that these expectations can drive inflation higher. But without an improvement in the outlook for the rand, it is hard to imagine any decline in inflation expected. It is also very hard to imagine how higher short term interest rates can have any predictable influence on the spot or expected value of the rand and therefore on inflation to come. As we have emphasised the risks that drive the rand are global events or SA political developments, for which short term interest rates in SA are largely irrelevant.

The only predictable influence of higher short term interest rates in SA is still slower growth in household spending. Less growth without any predictably less inflation is not a trade off the Reserve Bank should be imposing on the SA economy, even though but may well continue to do so. The only hope for a cyclical recovery is a stronger rand – whatever its cause, global or South African.

A revolutionary proposal to transform the prospects of the SA economy – eliminate company tax

There seems little hope of permanently raising GDP growth rates. Persistently slow growth in SA threatens fiscal sustainability. It also threatens social stability. It prolongs the agony of widespread poverty. Something radical is called for to stimulate growth – and by radical I do not mean potentially disastrous expropriation of wealth or the introduction of a National Minimum Wage that, even if it relieves the poverty of those who manage to keep their jobs, will leave many more out of work and even more dependent on informal (illegal) employment and welfare provided by taxpayers.

The radical proposal to transform the prospects of the SA economy is to completely eliminate corporate income tax and replace it with a mixture of additional payroll and wealth taxes. Zero rating company earnings would provide a large boost for saving, capital expenditure, employment and the GDP growth rate. The sums involved are not trivial: corporate income tax yields about R200bn per annum or close to 20% of all government revenues.

The significant amount of tax saved adds to the case for eliminating the tax. Companies would save and invest in plant machinery and people much of the extra R200bn they would save in taxes. It would be a boost to the competitiveness of SA companies and could lead to lower prices. It would attract foreign capital because required returns – after taxes – directly investing in SA based enterprises, would be much reduced. It would make SA a haven for the establishment of head offices. Taxable income from global companies newly established in SA would be transferred in rather than out – as was a major concern of Davis Tax Committee.

Zero taxes for companies would eliminate all the distortions created when companies are taxed additionally and separately from their owners. Taxes on all income distributed by companies would be taxed at the income tax rates that apply to their owners, as is the case with any partnership. All the shareholders in SA companies would become what is known in the US as Master Limited Partners, enjoying the advantages of limited liability for debts but taxed as individuals or institutions at the same tax rates.

Dividends would be taxed as would rental or interest income when received, at the same rate applied to all income. There would be no double taxation of company income and dividends as there would be no relief for interest or any other expense incurred by the company. There would be no deduction for depreciation or amortisation. How much to allow as a deduction from earnings would be company business alone, as would be the decision to retain or pay out cash, with due regard for economic depreciation and the economic income of the company.

The company could be required to collect a withholding tax on all dividends and interest or rent paid out by a company to its capital providers at say a 25% rate, to secure a consistent predictable flow of revenue to the SA Revenue Service (SARS). Owners would credit such payments in their tax returns. Pension and retirement funds as agents of owners and capital providers should be made subject to the same withholding tax. Individuals and their retirement plans, including all their collective investment schemes, would be dealt with in exactly the same way when taxed on income received, including taxes on realised capital gains that should be treated as income.

This would eliminate the major distortion caused by taxing individual savings plans at a much higher rate than that of the collective investment schemes. Personal income tax incentives to contribute to savings plans would not be prejudiced by zero company tax nor would direct subsidies to companies. Yet subsidies are much more transparent to the taxpayer than income tax concessions – a further advantage of zero company tax.

There is in fact no good economic reason to tax the income of companies separately from the income of their owners. Taxing companies probably happened originally because it was administratively very easy to do so. That a tax is convenient to collect, rather than is easy to impose the collection duties on a company collecting tax on behalf of SARS, does not make for a good tax – one that treats all taxpayers equally – and does as little harm to the workings of the economy as is possible.

Dividends and the tax collected on dividends is very likely to increase significantly as company earnings rose – especially if dividends and interest and rent paid to pension and retirement funds were to be included in the tax net as they should be – taxed at say a 25% rate.

A social security tax at a low starting rate could help make up for the losses of company income tax. As indicated in the Budget Review, total payrolls in SA are of the order of R2 300 billion. 5% of this is over R120bn. In the first instance this is paid by employers, but in the long run the payroll tax likely to be paid, in effect, by employees as a wage or salary sacrifice. South African assets in the form of homes, pension funds shares etc. are of the order of R10 000 bllion. Assets in the form of homes are already taxed at market value by municipalities. Wealth in the form of shares in businesses and pension funds etc. could be taxed at the same rate. A 2% wealth tax could bring in as much as the corporate income tax, about R200bn.

With the elimination of company income tax, wealth in the form of shares in businesses, incorporated and not incorporated, would get an immediate boost, an extra inflation-protected R200bn a year in extra earnings – capitalised at a more friendly rate of say 4% – because of the business friendly tax reforms. The R200bn permanently saved by business owners in taxes might be worth 25 times R200bn or more than R5 000 billion to its owners. In other words, more than enough to compensate pension funds and their like for higher taxes on their income.

A wealth tax would also have a popular redistribution flavour to it. But a combination of a wealth tax and an elimination of company taxes would do more than redistribute wealth. It would help create wealth and income and transform the prospects of the SA economy.

 

 

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

Point of View: The optimum competition policy

Is there a true public interest in employment retention, either at Optimum Coal Mine or anywhere else in the economy?

The controversy surrounding the purchase by Tegeta Exploration and Resources, a Gupta controlled company, of Optimum Coal Mine for R2.5bn from Glencore has been grabbing the headlines in the local media. Optimum Coal Mine supplies Eskom and enjoys a near 10% share of the Richards Bay coal export terminal.

Part of the controversy was about the alleged role of Mineral Resources Minister Mosebenzi Zwane. According to a report in Business Day by Natasha Marrion on 23 February: “Mr Zwane said his only interest in the deal was to ensure that no jobs were lost under the new owner.”

Business Day further reported “that the Competition Tribunal has cleared the way for the Gupta-controlled Tegeta Exploration and Resources to acquire Optimum Coal, on condition there are no merger-specific job losses. The approval comes as the Treasury is reviewing all of power utility Eskom’s coal and diesel contracts.”

There is heightened public interest in the terms of this deal, for many reasons. What is of interest in this instance though is that the Competition Commission and Tribunal however chose to interest themselves only in the employment implications of the deal, following their mandate to consider the public interest as well as the competition implications of any deal of this magnitude. As the Appeal Court indicated in its precedent making judgment in 2011 on the Massmart-Walmart merger, the task of Competition Policy is to determine:

1. Whether or not the merger is likely to substantially prevent or lessen
competition;
2. If the result of this inquiry is in the affirmative, whether technological,
efficiency or other pro-competitive gains will trump the initial
conclusion so reached in stage 1 together, with the further
consideration based on substantial public interest grounds, which in
turn, could justify permitting or refusing the merger; and
3. Notwithstanding the outcome of the enquiries in 1 or 2, the
determination of whether the merger can or cannot be justified on
substantial public interest grounds.
The legislature sets out specific public interest grounds in s 12 A (3):
“(3) When determining whether a merger can or cannot be justified on
public interest grounds, the Competition Commission or the
Competition Tribunal must consider the effect that the merger will
have on –
(a) a particular industrial sector or region;
(b) employment;
(c) the ability of small businesses, or firms controlled or owned by
historically disadvantaged persons, to become competitive;
and
(d) the ability of national industries to compete in international
markets.”
Clause 3d, “the ability of national industries to compete in international markets”, as well as clause 3b “employment” might well have also have been used to examine the contract. Clearly the competitive terms on which Eskom sources its coal will affect its costs and the prices it will ask the regulator to approve. The ability of all SA industry to compete effectively depends on the price and availability of electricity.

That the Treasury is apparently also investigating this Eskom contract, among other Eskom contracts, might be a reason for the competition authorities to have ignored this public interest in the terms of the contract. Be that as it may be, the Competition Commission’s determination of the mandated public interest as in 12a clause 3 of the Act, in employment retention, following that of the Competition Appeal Court judgment in the case of the Walmart Merger, and further pursued in the Tegeta case, needs to be seriously examined.

The case of the entry of WalMart to the SA economy. The welcome mat was not laid out.

An important case for competition law in SA, resolved in 2011 on Appeal to the Competition Appeal Court headed by Judge Dennis Davis, involved the purchase of a majority stake in a local JSE-listed retailer and wholesaler, Massmart, by the largest retailer in the world, Walmart. Approval of the deal was given by the Competition Tribunal because it was “common cause” – to quote the Judgment of the Competition Appeal Court, on the Tribunal – “that there was no threat to competition”. Indeed it was so conceded by the counsel for the parties contesting the approval of the merger in Court, to quote a report on the proceedings: “Paul McNally, who submitted closing arguments on behalf of the union… said his clients accepted that there would be lower prices as a result of the acquisition, but that these would come at the expense of local jobs.” 1

Surely this common cause should have been sufficient to approve the merger and to extend a warm welcome to Wal-Mart, especially from SA consumers, who were bound to benefit from more competition for their spending power. Given the importance of foreign capital for the economy and its growth prospects, a warm welcome too might have been extended in recognition of the confidence that the world’s largest retailer was expressing in the SA economy. This friendly response to an important investor in the SA economy might well have encouraged more direct foreign investment that is very obviously in the broad public interest.

The Competition Tribunal however surrounded its approval of the deal with a number of onerous and complicated conditions. Such conditions were highly sympathetic to the arguments made by the trade unions interested in the merger, but costly to Walmart and therefore its ability to compete in the market place with other retailers and wholesalers.

The conditions required of the merged entity by the Tribunal included restrictions on retrenchments, preferences for previously retrenched workers when employment opportunities presented themselves and R100m to be invested in a programme to support local business, combined with a requirement to train local South African suppliers on how to do business with the merged entity and with Wal-Mart with the programme and its administration to be “advised by a committee established by it and on which representatives of trade unions, business including SMMEs, and the government will be invited to serve”.

However the merger was taken on appeal to the Competition Appeal Court by the concerned unions and Ministers of State who sought to have the merger disallowed on public interest grounds. The Appeal Court agreed to allow the merger but decided to largely support the Tribunal by surrounding the deal with the conditions as had been recommended by the Tribunal (somewhat modified) but clearly not to the advantage of Wal-Mart as a competitor.

This seems a very unhelpful and unlikely course to take for a body designed to promote competition. Mergers and acquisitions, friendly and especially hostile ones, are among the more important ways in which businesses realise economies of scale that allow them to become more efficient more profitable and by definition more competitive in the interest of its customers of whom they wish to win more over. Any synergies to be realised in a larger, combined entity almost inevitably involve retrenchments of staff. Indeed, the ability to avoid duplication of personnel and systems and to reduce operating costs and improve margins is often the prime motivation for any merger or acquisition.

A vibrant economy is one where, over time, workers and managers are continuously being allocated and reallocated to more efficient purposes. This requires that some firms will be reducing their complements of workers while others are increasing theirs and net employment gains are registered for a growing potential labour force. Without job losses, there would be far fewer job gains made possible. A system that made it very difficult to retrench workers is one that discourages hiring in the first place. It makes for a stagnant economy, with a feudal style labour market that treats jobs as an entitlement, not at all easily discarded and highly discouraging to job creation.

A flexible labour market, by contrast, gives firms a high degree of freedom to hire and fire and allows workers to freely choose their employers and move easily from one job to another. The favourable outcomes of such freedoms enjoyed over time can be observed in the US or UK, with a highly productive and well paid labour force and a significant rate of turnover of jobs.

The South African labour market, or at least the labour employed in the formal sector of the economy that provides the much prized, so-called “decent jobs”, is highly inflexible. Job retention, rather than job growth, has become the primary objective of labour market regulations and it would appear also competition policy. The prospect of an extended period of unemployment is an unhappily realistic one for many of those threatened with retrenchment.

This is a weakness of the labour market that policies for competition should be addressing, not reinforcing. The competition authorities, by their rulings on job retention, have made the economy less efficient and competitive than it could be. By setting these precedents, it also makes efficiency enhancing investments and acquisitions less likely and so the efficient use of capital and labour less likely.

There is a public interest in a more competitive and efficient market for goods and services and for labour. There is only a private interest in avoiding particular retrenchments. Competition policy misuses the public interest in employment. The public interest is in employment growth and a more productive labour force to which mergers and acquisitions can make a very important contribution.

1 http://mg.co.za/article/2011-05-31-walmartmassmart-deal-approved-with-conditions

The Hard Number Index: Hope rests with the rand

The SA Business Cycle, a call on interest rates – which is a call on the rand. Here’s hoping for lower interest rates

The release of new vehicle sales and the note issue for February 2016 allows us to update our Hard Number Index (HNI) of the current state of the SA economy. The HNI has proved to be an accurate leading indicator of the Reserve Bank Business Cycle Indicator that is now only updated to November 2015.

The HNI for February is little changed from the January reading and indicates that the currently slow pace of economic activity is being maintained. See the figures below, where the HNI is compared to the Reserve Bank Business Cycle and extrapolated to February 2017. As may be seen below, the forecast is for but marginally higher levels of activity this time next year. The good news is perhaps that no obvious further deceleration in the pace of economic activity was recorded in February 2016.

New unit vehicle sales continued to decline slowly last month. The time series forecast is for sales to decline from the current annual rate of 607 000 units to an annual rate 582 540 new units sold into the SA market in February 2017, a decline of 6.8%. This would represent a modest cyclical decline when compared with past downturns in the vehicle cycle. This atypical, low amplitude new vehicle sales cycle will have had much to do with the current, comparatively low amplitude uptick in the interest rate cycle.

The other component of the HNI, the cash cycle, adjusted for inflation, has also turned lower, mainly the result of higher inflation. As may be seen in the chart below, current growth rates are of the order of 2% per annum and are forecast to remain at this rate, consistent with the GDP growth outlook.

The cash cycle possibly captures the influence of the informal economy. The vehicle cycle reflects the spending on capital goods, the cycle of firms and the household’s demands for consumer durables. This includes motor vehicles as well as washing machines, furniture, appliances etc that are financed with credit. Very few new vehicles are now exchanged for cash. Therefore market interest rates are possibly the largest influence on the cost of leasing (renting) a new motor vehicle.

The other important influences on the cost of ownership will be the value of any used vehicle traded in, or the residual value agreed to. The higher the residual value or the longer the repayment schedule, the lower will be the monthly rental payment. And the monthly payment may well be offset by the separately itemised charge for the motor plan. It is the highly negotiable gross monthly payment that will be the key influence on demands for new vehicles, rather than the theoretical list price, as is also the case with many other large ticket items bought by households.

Unfortunately it is this mostly theoretical vehicle list price that will rise with rand weakness and be reflected in the CPI and to which the Reserve Bank may react with still higher interest rates.

It would be a much more accurate measure, of the possibly less inflated monthly cost of owning a vehicle, were it reflected in the CPI by this leasing charge, rather than by new vehicle prices, as is the case with the CPI treatment of the cost of owning a home. This is correctly reflected in the CPI as an implicit rental charge to the owner occupier, rather than by house prices themselves. And so, the key influence on vehicle sales and house prices will be short term interest rates – though monthly payments may well be held back by more intense competition to make sales and issue motor plans.

For the sake of the motor manufacturers and dealers, and for the sake of the economy generally, the hope must be for lower, not higher interest rates. Such hopes rest with the behaviour of the rand, over which, it may be added, short term interest rates will have very little influence, judged by past performance.

The hope for lower interest rates in SA and a cyclical upswing rest with the exchange value of the rand. The rand will take its cue from the attraction of interest rates at the long end of the yield curve. Any improved flow into emerging markets will also attract funds into the RSA bond and equity market and strengthen the rand, as will any diminution of SA specific risks.

The risks of presidential intervention in fiscal policy have not dissipated, though they have declined compared from levels first reached with the dismissal of Finance Minister Nhlanhla Nene in December 2015. The risk premiums attached to RSA debt remain elevated accordingly. Furthermore, emerging market risks more generally have declined both absolutely and relatively to the SA CDS spread, as we show below. The gap between more risky emerging market debt and RSA debt has narrowed, even as both spreads have declined. The wider this spread gap, the better the SA rating. So it may be concluded that much of the recent improvement in RSA credit ratings is attributable to global, rather than SA, specific events.

The upside is that these SA risks are overstated and that President Jacob Zuma will prove them so by allowing Finance Minister Pravin Gordhan the essential freedom and authority to manage fiscal policy in the conventional way. If this happens, then the rand can strengthen further. This would help to put downward pressure on the inflation rate as well as on long term RSA interest rates. Less inflation and less inflation expected may well bring lower interest rates. The next cyclical recovery, including a recovery in the vehicle market, depends upon a stronger rand and the lower interest rates that will accompany rand strength.

Budget 2016: Austerity is not enough

Austerity will not be enough to improve the RSA credit rating. Privatisation will be essential to achieve this.

The 2016-17 SA Budget to be presented on 24 February is set to be an austere one. A mixture of higher tax rates and faster growth in tax revenues seems bound to accompany slower growth in government expenditure. The objective will be to reduce the debt to GDP ratio and to impress the rating agencies accordingly.

But fiscal austerity, accompanying higher interest rates imposed by the Reserve Bank, coupled with more inflation, will not help the SA economy to escape its growth malaise. In the short term, taken on its own, such austerity is likely to inhibit any cyclical recovery.

Fiscal austerity may be necessary for securing a better credit rating for SA and lower costs of funding government debt. But it will not be sufficient – and the rating agencies may well come to remind the Treasury that the greatest risk to the SA economy is persistently slow growth. Something more than fiscal austerity is required to improve the national balance sheet and impress the global capital markets, as well as to improve confidence in the prospects for the SA economy.

A commitment to privatisation of state owned and funded enterprises is urgently called for. Asset sales to private owners and operators would reduce national debt and interest payments while relieving the tax payer from further calls on their cash that has far more useful alternative applications.

Private ownership and responsibility for operating failures would absolve the regulators from conceding abnormally high increases in electricity or water tariffs as an alternative to the hard pressed Treasury raising additional debt or equity to keep the public enterprises going. But such higher tariffs – tariffs that are by now more than high enough to secure private capital to supply the essential services – are taxes by another name. They reduce disposable incomes by as much as any indirect tax increase would and, by lifting the rate of inflation, they unfortunately and unnecessarily encourage the Reserve Bank to add to the misery by raising interest rates even further. Exchange rate shocks, tax shocks and drought are very poor reasons for raising interest rates – but are a likely outcome given the Reserve Bank’s modus operandi.

The national balance sheet would benefit greatly from a willingness to sell off (at any price) rather than continue to support failing public enterprises with bail outs in the form of taxpayer cash or guarantees of the debt issued by public enterprises. The scope for the better management of what are now publicly owned and funded enterprises is very large. The political will to do so would be very well received in global capital markets. There would be no lack of foreign capital to access the opportunities a well-designed process of privatisation would offer.

The sale (fully or partially) of SAA comes to mind – as does a listed private share in the Airports Company of SA. The other sea ports of SA are also very valuable assets that would benefit from private owners, while their customers would benefit from competition between them. The generating capacity of Eskom could be unbundled and sold off to a variety of owners and managers, who would then be subject to the full discipline of a competitive market for energy – and a cost conscious regulator.

Such reforms would add value to the rand and reduce inflation and interest rates. A recovery in the rand and lower interest rates would be a great stimulus to the economy. An upswing in the business cycle would follow and the structural reforms of failing public enterprises would raise the long run growth potential of the economy.

The state of the markets

The State of the Nation speech delivered by President Jacob Zuma to Parliament on Thursday 11 February revealed a more open and pragmatic approach to the prospect of privatisation. The capital markets so far have not registered any marked approval of such intentions. The sovereign risk spreads and the outlook for inflation have not yet improved in any immediately obvious way.

The spread between RSA long term interest rates and their US equivalents remain elevated, albeit below the levels recorded when President Zuma intervened in fiscal policy and sacked the then Minister of Finance, Nhlanhla Nene, on 9 December. This risk spread, currently over 7% p.a. is, the rate at which the rand is expected to depreciate over the next 10 years. What is to be gained by a US dollar investor in the form of higher yields is expected to be perfectly off set by exchange rate weakness in the market for forward exchange. If this were not the case, then arbitrage opportunities to make certain profits in the bond and currency markets would open up.

The market is clearly expecting a high rate of further rand weakness. Consistently, given the expected weakness in the rand, the expectation of more inflation to come over the next 10 years, remains equally elevated. A weaker rand must be expected to bring more inflation with it. The compensation for inflation provided in the RSA bond market thus remains at about the same level of over 7% p.a. Vanilla bonds, which are vulnerable to unexpectedly high inflation, still offer over 7% p.a more than the inflation protected variety yields of under 3%. This yield spread can be regarded as an objective measure of inflation expected.

In the figures below we show how the gap between RSA yields and US Treasury Bond yields widened significantly on 9 December. They have since receded but spreads remain elevated, as has inflation compensation. They do not appear to have reacted favourably to the State of the Nation speech.

A somewhat similar picture emerges when we compare the risk spreads on RSA dollar-denominated debt. The cost of insuring an RSA Yankee dollar-denominated five year bond moved sharply higher on 9 December and has widened further since then. But the risk spreads on even higher risk emerging market debt have also widened. This indicates that the higher risks associated with RSA debt have not been a purely SA event. Global risk aversion has also been an influence on credit ratings. However the current RSA credit default swap (CDS) spread of over 350bps, already effectively gives SA debt junk status.

We therefore compare the emerging market spread with the SA spread. The wider this difference the better the relative credit rating of SA debt. As may be seen on the right hand scale of the figure below, this difference narrowed sharply on 9 December, indicating an immediately inferior SA credit rating. But the SA credit rating then improved in a relative sense, given the larger difference between average emerging market yields and RSA equivalent debt. Encouragingly, this spread has increased further in recent days, indicating an improving SA credit rating – when compared to a peer group.

We await with great interest the detailed Budget proposals. Not only will the plans for government spending, tax and debt issues be influential. The plans for asset sales, that is for privatisation, may prove even more important. A combination of fiscal austerity with credible privatisation plans could have a profound influence on SA’s credit rating, the rand and the longer term growth prospects for the SA economy.

The rand and the SA economy: All about the dollar

Markets are all about the mighty US dollar at the moment – weakness rather than strength is the hope for the SA economy. But rand strength could follow the right SA responses to our impaired credit rating

The markets this year have been most concerned about the danger of the Fed raising interest rates as US growth prospects were deteriorating. A strong US dollar, in such circumstances, posed a particular threat to emerging market currency, bond and equity markets. The presumed greater risk of a global recession was increasingly reflected by significantly lower commodity prices and the shares of the companies that produce them. Emerging market equities, bonds and currencies markets all revealed these increasingly risk averse sentiments.

The highly correlated and not co-incidental weakness in commodity and emerging markets continued until the last week in January as we show below. The Commodity Research Bureau Index (CRB) shown below includes about a 27% weighting in oil. A further figure compares the prices of particular metals to the emerging market (EM) equity index (MSCI EM). Price weakness until late January 2016 and a recovery since is revealed in the figures below.

The previously strong US dollar however weakened this week, as the danger of higher interest rates in the US faded away. Dovish interest rate comments by the Chairman of the New York Fed led the dollar lower. It was a spark that lit up the shares of the mining companies. The shares of leading mining companies listed on the JSE responded dramatically to a weaker US dollar. As at Friday afternoon 5 January, Anglo leads the pack and is up about 36% since the Monday close on 1 February.

The rand and the JSE as a whole responded as it usually does to the global forces that move EM markets. SA had earlier revealed particular dangers to its policy settings that led to a significantly weaker rand and higher risk spreads, compared to its EM peers. But these SA-specific risks were a December event, though the EM influence is apparent throughout the extended December to February period with a degree of extra SA risk revealed in December.

The striking impact of the stronger rand on the long end of the RSA bond market is shown below. The rand – as influenced by global forces, as it usually does – overwhelmed the impact of higher short term rates on the bond and equity markets, as imposed by the MPC of the Reserve Bank on Thursday 28 January.

In the figure below we compare alternative measures of SA risk that reveal a very similar pattern of SA risk aversion. The difference between RSA and USA bond yields compensates investors for the expected weakness of the USD/ZAR exchange rate. This risk premium jumped up sharply on 10 December 2015 when Finance Minister Nene lost his job. The risk premium has since declined, helped by the stronger rand and lower interest rates since. Yet the SA risks priced into the markets remain highly elevated as is shown by the wider five year CDS spread, both absolutely and relative to the spread on equivalent Turkish dollar-denominated debt. This spread, equivalent to the difference between the running yield on RSA US dollar denominated debt and its US equivalent, represents the cost of insuring against RSA debt default.

The SA economy is growing very slowly. The decision by the Reserve Bank to further increase its repo rate will add to the contractionary pressures acting on the economy. Fiscal austerity seems very likely to be introduced in the 2016-17 Budget to be presented later this month. The hope must be that the painful demonstration of fiscal conservatism will lower the risk premium attached to SA debt and equities, so attracting more capital to SA and so add to the value of the rand.

Only a stronger rand, bringing lower than expected inflation and lower interest rates, can reverse the cyclical direction of the economy. A weaker dollar and stronger flows into EMs will be a great help to the rand. But it will take more than a credible commitment to fiscal conservatism to reduce the SA-specific risks holding back the rand and the economy. A recognition by the government that the partial privatisation of underperforming state-owned enterprises would improve the performance of the economy and the quality of the RSA balance sheet, is essential to reducing the risk premium added to the returns of investments in SA.

Point of View: Credit anxiety

There is much anxiety about how much poor South Africans are paying in interest for the credit they receive. Newly shocking to observers is the fact that if a good is purchased on credit the monthly payments may amount to much more than the purchase price. For example, if a fridge had a face value of R10 000 to a buyer on credit, paying 25% p.a interest and repaying the capital sum over 10 years, the buyer would be making monthly payments of R227. And so over the life of the loan would have paid in interest and capital repayments an amount of R27 299 of which R17 299 would have been interest. Had the loan been a five year loan at the same 25% rate of interest, the monthly payments would have been higher, R294 per month, meaning lower total payments of R17 611 of which much less, R7 611 would have been the interest expense.

Why then would anyone borrow for a longer rather than a shorter period if it costs so much more? One could however ask an even more obvious question. Why would anyone buy on credit rather than pay cash, especially when the cash price is very likely to be a lower discounted one? The answer should be obvious. They buy on credit because they do not have the wherewithal to pay cash.

Without access to credit they would be denied the essential services of the fridge. Further saving the R294 minus R227 (R67) per month might mean a fridge fuller with essential food. The value of the fridge to the household borrower is in fact what they are willing to pay for it, the R227 or R294 per month. They are consuming the services of the fridge for which they are clearly willing to pay. For the lender, shorter repayment periods, higher monthly payments and less interest accrued becomes a less risky transaction, one they otherwise might wish to encourage. Borrowers however have to be judged as credit worthy enough to enjoy extended credit terms. The choice of extending the repayment period, paying more interest, may in fact be a limited one- unfortunately.

The cash buyer will not be paying interest, but nevertheless will be foregoing the opportunity to earn interest or dividends on the cash they have allocated to a particular asset. It might well be a good decision for them to rent or lease an asset rather than pay cash and put the cash to better use elsewhere. For example, to rent rather than buy a home and do something much more valuable with the cash invested, perhaps even to pay the deposit on a house bought to rent with a mortgage loan.

As with the fridge, somebody buying a home on credit pays out a lot more in interest and capital repayments than the purchase price of their home. A R1m home bought on mortgage credit at a low 10% per annum paid off over 20 years, will mean a monthly payment of R9 650 and will accumulate total payments of R2 316 052 – more than twice the purchase price paid. But the proud home owner would have saved rental payments over the period and the home will have a market value after 20 years, unlike some household appliance.

The house bought on credit will have provided a flow of services, accommodation services, similar in nature to the services provided by a fridge or TV – benefits that are received in exchange for interest and principal paid. Also, such leverage may prove to be a very good financial deal if the house more than maintains its after inflation value. Access to such credit provides a rare opportunity for salaried homeowners to add to their wealth through leverage. Such lending and borrowing on terms agreed to by borrowers and lenders surely deserves every encouragement, even if, as is bound to be the case, interest paid apparently means a more expensive house over time.

Household appliances do not provide the lender with anything like the same protection against losses should the borrower default – hence the higher charges required by lenders competing for the business. These charges reward the dealer who incurs the costs associated with the bundle of goods and services associated with any transaction concluded on credit. Charges that will be intended to cover the interest costs of supplying credit, the costs of goods supplied with the credit, and the services associated with the goods, for example the rent paid for trading space and the working capital invested in an inventory of goods from which customers can choose. This bundle of benefits – goods and services including credit services supplied to a customer – may come with a single charge, for example for a dress bought on credit at a given price to be paid off over time. Yet the price of the dress is very likely to incorporate a very high, but unknown to outsiders, profit margin intended to cover all the associated costs including the risks of non-payment. There is fortunately very little comment about regulating gross profit margins on goods supplied on credit.

There is much comment however about the apparent inequity when the terms of the transaction are in a mix of separately itemised charges – some combination of listed price, interest charges, delivery and insurance charges etc. may be specified. And complained about if one or other of the charges, considered alone, appears exorbitant. But what will matter to all buyers paying a single charge or multiple charges is how much they will be required to pay each month and whether or not it is worth making the monthly payment. And what will matter to the seller of the mix of credit and goods supplied, is whether the revenues they collect – perhaps is a variety of itemised charges – will cover their costs, including a return on capital invested appropriate to the risks incurred. If the returns exceed the required returns, more competition to supply goods and credit can be confidently expected. But if some of the charges made are controlled on an apparent cost-plus basis, such as insurance charges, any loss of revenue will have to be made up in one or other of the other charges (if the goods and credit are to be supplied in the same volume and variety). If the loss of revenue cannot be made up, less credit will be supplied.

The SA government has however decided not to leave the outcomes in credit markets to be determined by market forces. They have regulated the terms of the contracts by more than what willing lenders and equally willing borrowers might otherwise agree to. Loans, including mortgage loans, may be forced to be limited to some proportion of wage incomes and the terms of the loan, including the interest rate agreed to or charges for insurance arrangements, may be subject to regulation.

Treating borrowers in this way, as less than capable of looking after themselves, as adults managing their credit affairs, has consequences. So too has not trusting potential lenders to compete with each other with loan facilities that will compete away excess risk adjusted returns in providing credit. Such interventions in the credit market mean less credit supplied. It means fewer fridges, TVs, computers and furniture in homes, less clothing in the wardrobe, all understandably very important to the household. It also means fewer houses owned by the occupier.

Regulations of this kind may protect some less than responsible borrowers and lenders from borrowing and lending more than they should have. Yet by imposing regulations on the potentially credit worthy, as judged by willing lenders, they frustrate the plans of potentially worthy borrowers to gain access to credit that is valuable to them, credit that might be supplied to them on terms they would be willing to agree to. In the absence of credit from established businesses with reputations to protect and repeat business to encourage, desperate borrowers may well be forced into the clutches of the informal payday lenders and their ilk. Lenders who will charge much higher rates of interest for loans of typically very short duration, with repayment secured violently if necessary.

The regulators appear only aware of the costs of poor credit decisions, rather than the benefits of many more good ones made, under the discipline of market forces. Access to credit has played a very important role in improving the standard of living of many South Africans with improving income prospects but little wealth to draw upon. It is in reality a South African success story.

The self- regulatory capabilities of a market place, including those of a credit market, receive too little respect in South Africa. The costs – intended and unintended – of the flood of additional rules and regulations that prevent agreements between willing sellers and buyers, willing borrowers and lenders, are too easily ignored by an ambitious bureaucracy. These ever growing regulatory burdens on market participants are an important part of the reason why the SA economy is stagnating.

How fares the SA economy? An update to December

With new vehicle sales and the Reserve Bank note issue for December to hand, we can update our Hard Number Indicator (HNI) of the state of the economy at year end. The economy maintained its sedate pace in December. The forecast is for more of the same in the year ahead, that is for slow but not negative growth in 2016. Our HNI serves as a useful leading indicator of the Reserve Bank Business Cycle Indicator updated only to September 2015.

The HNI and the Reserve Bank coinciding business cycle indicator measure the level of economic activity. When these are converted into rates of change, we show below that the growth rate in the HNI has been declining since 2010 and is currently barely positive and is forecast to remain barely so. It is of some consolation to notice that the weak growth outlook has not deteriorated and is forecast no to do so. The consistent way in which growth in the HNI leads the Reserve Bank cycle helps to confirm its usefulness. It has the advantage of being very up to date and based on hard numbers not sample surveys.

Sales of new vehicles of all sizes in the SA market (that make up half of the HNI) are shown below. While sales are 4% down on a year before, sales volumes, which have averaged over 50 000 units a month, must be regarded as very satisfactory, given the state of the overall economy, especially for the SA manufacturers who also delivered 337 748 units to foreign markets in 2015, 20.5% up on a year before.

The other half of the HNI is made up of the growth in the real supply of and demand for cash. These demands for cash have been growing at a real 4% p.a as we show below. However the cash cycle appears to have peaked earlier in 2015, helped by lower inflation. The demands for cash, to spend on holidays and presents, rise strongly in November and December, though growth slowed this December off a very high base established in December 2014. The growth in demands for cash in SA, despite the heavy and growing use of electronic alternatives to cash, speak eloquently of the important role the informal economy plays in SA – a role however that is not reflected in official estimates of the size of the informal sector, as about 5% only of GDP.

The outlook for domestic spending has deteriorated, with the collapse in the exchange value of the rand. Higher rand prices for goods with high import or import replacement content or export potential will further discourage spending by households. That the oil price in dollars has declined by even more than the dollar value of a rand has been a welcome source of relief for households and firms. The inflation outlook has therefore not deteriorated as much as it would ordinarily have done with a rand this heavily damaged.

Hopefully this lesser inflation outlook will help restrain the Reserve Bank from raising interest rates as much as they would otherwise have done. Higher interest rates will do little to help the rand; they have not helped the rand to date that has been driven by global and SA forces well beyond the influence of monetary policy and interest rates. However higher interest rates will be sure to add to the contractionary forces slowing the economy- and undermine further the case for investing in SA. Is it too much to hope for a sanguine Reserve Bank- one that will allow the exchange rate to absorb the economic shocks- and not to add to them? And to happily surprise the market accordingly.

From Shanghai to Johannesburg – More than the weak rand at work

The JSE has, over the years, become less a play on the SA economy and much more a play on the global economy. This degree of independence for investors from the ups and downs of the SA economy and the value of the rand is provided by an important group of companies listed on the JSE that we describe as global consumer plays (GCPs). They comprise principally Richemont (CFR), SABMiller (SAB), British American Tobacco (BTI), Naspers (NPN), which has become largely a Chinese internet company through its 35% holding in Tencent, listed in Hong Kong, and MTN, which generates much of its revenues and incurs costs outside of South Africa. To these we added Steinhoff (SNR), Aspen (APN), Mediclinic( MDC), Netcare (NTC) and Intu (ITU), a London based property company.

We combine these companies into an Index, using their Swix weights (the proportion of their shares on the SA register) as the basis of their inclusion in our GCP Index. This gives NPN by far the largest weight in our Index. Foreign owners of NPN hold their shares in NPN on the JSE register because NPN shares are not listed on other exchanges. This is not the case when the shares are also primarily listed on other exchanges, as is the case with BTI, CFR and SAB, where only a small proportion of SA owners would be registered as such by the JSE.

Such independence is helpful to shareholders when the rand weakens. It is even more helpful when the rand weakens for particularly South African reasons, as it did in December 2015. In these circumstances the dollar value of these shares is likely to be little affected by events in SA and so their dollar values translate into rands at a higher USD/ZAR rate. When the rand weakens in line with all emerging market currencies, because of increased global risk aversion, the dollar value of these shares may well come under pressure, giving them less of a rand hedge quality. In such circumstances the rand can weaken by less than the decline in the dollar value of such shares, meaning that their rand value can go down even as the rand weakens. Nonetheless their rand values are likely to hold up better than the purer SA economy plays. Thus it is better to describe these shares as South African economy hedges than as rand hedges.

In the figure below, we compare the performance of the GCP Index with that of the S&P 500, also measured in rands. The comparison was highly favourable to the GCPs until this year. It has become very unfavourable in January 2016 as the chart shows. The S&P 500, in devalued rands, continues to move ahead while the GCP Index has gone backwards.

The main reason for this recent underperformance has been the NPN share price. As we show below, NPN outperformed the S&P 500 over a long period, but this has not been the case since mid-2015. The Shanghai market weakness would appear to have extended to Tencent and so to NPN. The links between Shanghai and other global equity markets has become much stronger recently and NPN is clearly affected by this.

Some of the other important components of our GCP Index have done significantly worse than NPN, as we show below where we compare total returns over the past 12 months to 15 January 2016. The distinct underperformers are APN and MTN and the distinct outperformer SAB. Clearly as with any company, firm specific risks as well as market risks including risks to the rand can greatly affect performance – as they have done with APN and MTN in 2015.

In the figure below we compare the performance of other sectors of the JSE with that of the GCP Index. Both the group of Top 40 SA Industrials and the SA interest rate plays have also had a very poor January. The commodity price plays (excluding the gold mines) continue to underperform both absolutely and relatively. The weak rand and the higher interest rates that are expected to follow a weaker rand are unhelpful market forces for SA economy plays.

The one consolation in all this JSE weakness across the board is that the oil price has fallen by more than the rand (see below). Thus the inflationary pressures that usually follow a weaker rand and usually higher fuel and transport costs, are not present. This means less inflation to come. Interest rates in SA may not rise as much as they are expected to rise. If this turns out to be the case, the depressed SA plays may well offer value over the next 12 months.

Monetary policy and the MPC: Recognising the facts

The members of the Monetary Policy Committee (MPC) of the Reserve Bank will be even more perturbed about the behaviour of the rand than the rest of us. However they have had (and will have) as little influence over its direction as you or me. The link between short term interest rates that they control and the USD/ZAR exchange rate is shown in the chart below. As may be seen, they began a rate hiking cycle in January 2014 and since then, the higher the rates, the weaker the rand has been. It is very hard to argue that the rand would have been any weaker than it now is had interest rates remained on hold over this period.

There is no good reason to believe that this relationship between interest rates and the rand will be any more predictable in the year ahead than it has been. What is predictable is the impact of interest rates on spending and so GDP growth. Higher interest rates have served to slow the economy down over the past 24 months. Still higher rates will mean even slower growth – without necessarily supporting the rand – and perhaps might even encourage further rand weakness. The slower the growth, the less reason foreign and domestic owners or managers of capital have to invest in South Africa. Growth expected leads the capital flows that determine the value of the rand.

The sooner the members of the MPC fully recognise these facts of SA economic life, the less likely they are to damage the growth prospects of the economy. The exchange value of the rand and so the inflation rate and the expectation of inflation (that take their cue from the exchange rate, for good reasons also incorporated into the Reserve Bank forecasts of inflation) is beyond their influence. Raising interest rates at a time like this because it may support the rand makes no sense at all. The rand may or may not strengthen – for altogether other reasons – especially sentiment about the investment case for emerging markets generally.

More global risk tolerance will mean a stronger rand and vice versa as usual. But the rand has not behaved as usual since President Jacob Zuma intervened so dramatically in SA’s fiscal affairs last month. Without such intervention, the rand, given global risk appetites, would have been much closer to 14 to the US dollar than 17. Zuma’s actions caused financial markets to raise significantly the doubts it has about SA’s ability and willingness to fund its government expenditure without printing money – and so causing inflation.

Hence not only did the rand weaken dramatically, but the expected value of the rand weakened even further. The spread between RSA and US Treasury bond yields, that indicate the compensation for expected rand weakness in the bond market, widened with rand weakness. A weaker rand has resulted in an even weaker rand to come- expected to lose value vs the US dollar at an over 7% p.a rate on average over the next 10 years.

Furthermore the risks of default on SA’s dollar denominated debt widened significantly – enough to take SA dollar bond yields into junk territory. SA dollar-denominated interest rates have risen ahead of equivalent junk-rated Russian debt but are still below those on even more vulnerable Brazilian foreign currency denominated debt.

The newly appointed Minister of Finance, Pravin Gordhan, has committed himself and the country to fiscal sustainability. The market place should believe him, in my judgment. But the market as yet is not giving him the benefit of their doubts. They are going to take a great deal of convincing that SA can live within its means by sticking to the strict limits on government spending that it has set for itself. The role the Reserve Bank can play in this is a limited one. Monetary policy settings will not make much of a difference to perceptions of fiscal policy. They can make a difference to the state of the economy with their interest rate settings. Slower growth makes the task of funding the fiscal deficits even more difficult. They will not be doing Gordhan or you and me any favours hiking interest rates.

SA markets: The Zuma shock wave has not passed through

The Zuma shock wave of Wednesday 9 December 2015, when Nhlanhla Nene was replaced by the little-known David van Rooyen, only to be replaced that weekend by Pravin Gordhan, has had time to be absorbed by the markets.

As we show below, some recovery from the events of that day have been registered on the share, bond and currency markets. As may be seen below, the JSE All Share Index has recovered best: at one point in late December it was almost back to its month end November levels. The RSA bond market, represented by the All Bond Index, with a duration of about six years, was the most deeply affected at the time, but then recovered and is now trading at about 94% of its 1 December value. The trade weighted rand is worth about 8% less than it was on 1 December.

That the Zuma intervention in our fiscal affairs is not regarded by the market as a temporary aberration but more as a permanent danger, is fully reflected in the extra costs of insuring against a RSA default of its obligations on its foreign currency denominated debt. The five year Credit Default Swap (CDS) spreads on RSA debt widened sharply on 9 December and have remained at a highly elevated level of over 350bps. This spread has also increased sharply when compared to the spread on the Emerging Market Bond Index (EMBI – indicated by a narrower difference between the EMBI and RSA spreads) and also when compared to Russian spreads. SA is now regarded as more likely to default than Russia and Brazil. Our credit rating in the market place is thus of junk status. It appears to be only a matter of time before the credit rating agencies catch up with the market place.

Unless the SA government can convince the market place very soon that SA’s fiscal intentions have not changed permanently for the worse, the Zuma shock will prove very expensive for SA’s taxpayers who have to service significantly more expensive debts to come as current debts are matured. Nkandla is very small change compared to this potential bill. The market place will need assurance that SA’s tax base can withstand the higher interest expenses incurred. Evidence that the growth in government expenditure, especially the growth in spending on government sector employment benefits, is slowing down sharply, would be helpful to this end. More important still is any indication and that the growth outlook for SA is improving to help generate more tax revenue to ease the pain of higher taxes rates. The chances of more fiscal discipline seem better than a meaningful pick up in GDP growth. Though the dramatically more competitive rand could and should be helpful to this end, strikes and unhelpful policy interventions permitting. The Barmy Cricket Army are an advance tourist guard doing their best to improve export earnings.

The spread between the RSA 10 year bond yield and the yield on a 10 year US Treasury also widened sharply, to over 8% on the fateful day and has since narrowed to about 7.2% as may be seen in figure 5. This spread indicates that the rand is expected to depreciate by about 7.2% a year, on average, over the next 10 years.

The reactions in the market place to date indicate that the rand continues to respond to the usual daily forces, but off a significantly weaker base. The weaker emerging equity and bond markets are, the weaker the USD/ZAR exchange rate will be and vice versa. Commodity price trends will also be an influence on exchange rates. But these forces are acting off a weaker base, as we show below. The rand is now much weaker than would have been predicted before December 2015 using the Aussie / US dollar exchange rate and the EMBI spread as predictors. A value closer to R13 than R16 might have seemed more reasonable before 9 December. The question then arises: can we confidently expect the base value of the USD/ZAR to improve any time soon?

The answer appears to be an unfortunately negative one, absent an equally dramatic development on the political and economic policy fronts. It does not take much to imagine what that would have to be. The government however will be under few illusions that SA’s dependence on foreign capital remains as heavy as ever. Given the currently low base and highly depressed expectations of SA, the benefits of surprising the markets with good news could have an unusual upside. Good, credible news about fiscal sustainability and more market respecting (business friendly) dispositions- maybe even some privatisation of publicly owned assets to reduce public debt and improve economic efficiency, could much improve the mood. Call them public private partnerships if you have to. But actions and better intentions towards market forces, both inside and outside the country, are urgently called for.

The SA economy at month end November 2015. Do we thank the informal (unrecorded) sector?

We have received some useful information about the state of the SA economy at the end of November 2015. New motor vehicle sales and cash in circulation at month end November present something of a mixed picture. We examine both below and combine them to update our Hard Number Index (HNI) of the current state of the SA economy.

Vehicle volumes in November came in marginally ahead of sales a year before and on a seasonally adjusted basis were also slightly ahead of sales in October 2015. But the sales cycle, when seasonally adjusted and smoothed, continues to point lower, albeit only very gradually so.

The local industry is delivering new vehicles at an annual rate of about 600,000 units and the time series forecast indicates that this rate of sales may well be maintained to the end of 2016. Such an outcome would be regarded as highly satisfactory when compared to peak sales of about 700,000 units back in 2006. (See below) For the manufacturing arm of the SA motor industry, exports that are running at an impressive, about half the rate of domestic sales, are a further assist to activity levels. This series may be regarded as broadly representative of demand for durable goods and equipment.

New Unit Vehicle Sales in South Africa

Source; Naamsa, I-net Bridge and Investec Wealth and Investment.

The demand for and supply of cash in November by contrast has been growing very strongly. By a 10.6% p.a or 5.7% p.a rate when adjusted for headline inflation of 4.6%. This represents very strong growth in the demand for cash- to spend presumably. Though as may also be seen the cash cycle may have peaked.

The extra demands for cash presumably come mostly from economic actors outside the formal sector. The formal sector has very convenient electronic transfer facilities as alternatives to transferring cash. Electronic fund transfers have increased from a value of R4,919b in 2009, that is nearly 5 trillion, to R8.4t in 2014 or at a compound average rate of 8.9% p.a over the six years. Over the same period credit card transaction increased from R142,198b in 2009 to R258.6 by 2014 or by a compound average rate of 9.9% p.a while the use of cheques declined from a value of over R1.1t in 2009 to a mere R243b by 2014.

The supply of notes issued by the Reserve bank have grown from R75.2b in November 2009 to R134.7b in November 2015, that is at a compound average rate of 9.7% p.a. That is the demand for and supply of old fashioned cash has grown in line with the growth in electronic alternatives. Clearly there is a great deal of economic activity in South Africa that escapes electronic action or surveillance. We show the respective nominal and real note cycles below. Both show a strong acceleration in 2015.

The Cash Cycles- annual growth in the note issue.

Source; SA Reserve Bank; I-net Bridge and Investec Wealth and Investment.

The note issue cycle and the retail sales cycle in money of the day are closely related as we show below. The advantage of observing the note issue is that it is a much more up to date statistic than is the estimate of retail sales, the most recent being for September 2009. The strength in the note issue in November 2015 bodes rather well for retail sales in December and perhaps especially so for sales made outside the electronic payments system.

The cash and retail cycles. Current prices

Source; SA Reserve Bank; I-net Bridge and Investec Wealth and Investment.

When we combine the vehicle cycle with the cash cycle we derive our Hard Number Index (HNI) of economic activity in SA. As may be seen the HNI indicates that the SA economy continues to maintain its current pedestrian pace, helped by strength in the note issue and not harmed too severely by the downturn in unit vehicle sales.

As indicated 2016 seems to offer a similar outcome. The HNI is compared to the Reserve Bank Business Cycle Indicator that has been updated only to August 2015. The HNI can be regarded as a helpful leading indicator for the SA economy-more helpful than the Reserve Bank’s own Leading Economic Indicator that consistently has been pointing to a slow down since 2009 – a leading indicator belied by the upward slope of the Business Cycle itself- and the HNI. ( See below)

S.A. Business Cycle Indicators (2010=100)

Source; SA Reserve Bank; I-net Bridge and Investec Wealth and Investment.

The slow pace of economic growth in SA is partly attributable to the dictates of the global business cycle. The weak state of global commodity and emerging markets remains a drag on the SA economy. Any business cycle recovery in SA will have to come from a revival in emerging market economies linked to a pick-up in metal and mineral prices that will be accompanied by a stronger rand and less inflation and perhaps lower interest rates. This prospect now appears remote. Though a mixture of stronger growth in the US and Europe with less fear about the Chinese economy would be very helpful to this end. South Africa could help itself with growth improving, market friendly, structural reforms. This prospect unfortunately appears as remote as the recovery in global metal markets.