Of higher metals prices, inflation and (hopefully) better years to come

Higher metals prices in previous times have been good for the SA economy. There is little reason to believe this will not be the case again, even if global inflation rises.

Inflation is busting out all over the world. The US dollar prices of industrial metals traded in London are up 30% and commodity prices are up 20% this year. These higher prices are not a cause of inflation. They are inflation. Larger amounts of money have stimulated demand and supply is struggling to catch up. Too much money chasing too few goods is the obvious explanation of higher prices.

Rising prices and interest rates absorb excess holdings of cash and, sooner or later, will slow down demand and the pace of growth. Governments might respond to this slowdown with yet more money and spending. If that happens, a temporary phase of rising prices will morph into a much longer phase of continuously rising prices. The US jury is out on this and when they return, South Africans should hope for a guilty verdict – guilty of causing more inflation and the rising metal prices that come with it.

Metal and commodity prices in 2021 graph

Converting the SA mining sector price index (the mining deflator) into US dollars helps identify these important global forces at work on our economy. In the 1970s, the dollar prices of the metals we produced (then mostly gold), increased by 10 times. Metal prices then fell away sharply after 1981 and remained depressed until the early 2000s. Thereafter they exploded by nearly five times, in what was a super cycle, until rudely interrupted by the Global Financial Crisis (GFC) in 2008.  Hard times for SA followed the consistent downward pressure on metal prices after 2011. The recent modest recovery of SA metal prices, off what became a low base, is thus especially welcome.
The South African mining deflator in US dollars graph
Good times for the SA economy follow when metal prices rise much faster than prices in general – as they are doing now. The extra income earned by mining in SA, the profits earned, the dividends, wages and royalties and taxes paid, rise faster and (conversely) fall further with this cycle. In the 1970s, the real price of SA metals, the ratio of the metal price index over consumer prices, increased by nearly five times. Between 1981 and 1996, it then more than halved, damaging the economy severely in the process.

The one genuine recent SA boom between 2003 and 2008 followed a doubling of SA’s real metal prices.  Real national incomes grew on average by 5% a year over these six years, until interrupted by the GFC. Chinese stimulus helped hold up metal prices until 2011 but their decline until 2016 made for more difficult local economic conditions. A degree of relief came from a recovery in metal prices after 2016, a prospective recovery that was overtaken in turn by the lockdowns of 2020. The advances on the metal front make the outlook for the coming years promising for the SA economy.

Metals, consumer goods and services prices in SA and their relationship graph
Real growth in SA national income and the metal price cycle in US dollars graph
The exchange rate takes its cue from the global forces that drive metal prices. And the inflation rate in SA, with variable lags depending on global prices (especially the oil price), follows the exchange rate.  Interest rates follow inflation – in both directions. These forces strongly reinforce the metal price effects on the direction of the SA economy.
The SA mining price cycle (US dollars) and the rand cycle graph
The exchange rate cycle, interest rates and inflation in SA graph
Much of what drives the SA business cycle, metal prices, our international terms of foreign trade and the exchange rate is unpredictable and beyond our control. What matters is how we react to such circumstances. Our policies should be anti-cyclical and focus on moderating the direction of spending.

Exchange rate strength both stimulates domestic demand and dampens prices, led by the price of imports. Exchange rate weakness does the opposite. It weakens demand by pushing up prices.

Interest rates should not respond to exchange rate shocks on inflation in either direction: they work themselves out over a year or two. The stagnation of the economy post-2014, the depressing effect of lower metal prices and a weaker rand, was intensified by exchange rate weakness. This weaker rand led to higher prices and to higher interest rates, which in turn were kept consistently too high, given the weakness of demand.

The cause of higher prices was a weak rand and the effect was to depress spending and interest rates. This placed further pressure on demand. The economy paid a high price for countering an inflation rate that had nothing to do with the demand side of the price equation, in fighting so-called second round effects of inflation for which there is no evidence. Economic actors are more than capable of differentiating between temporary and permanent increases in inflation. The permanently higher rates of inflation come from too much demand, not too little supply. They are waiting to make that judgment about inflation in the US.

Hopefully the next phase will be one of faster growth with low inflation that will accompany a strong rand. The risk then may then be of interest rates being kept too low for too long. This was possibly a monetary policy error committed between 2005-2008, a case of too much rather than too little stimulus. It will however be a much higher-level problem to have to deal with in the years to come. Let us hope for such a challenge.

The rand is no tale of mystery

Movements in the exchange value of the dollar itself explains the direction of emerging market exchange rates.

South Africans are inclined to regard the highly variable foreign exchange value of the rand as a deep mystery. Yet there is nothing mysterious about the currency’s behaviour.

The daily dollar value of a rand has been closely tied to the value of other emerging market currencies ever since 1995, when SA opened up to global capital flows. When the ratio trends above or below the emerging market line the direction of the rand predictably reverts back to the average relationship of one to one. We have done no worse or better against the US dollar than the average emerging market economy.

Rand exchange value graph
The correlation between the daily rand-dollar exchange rate and a basket of other emerging market exchange rates — an equally weighted mix of the dollar exchange rates against the currencies of Brazil, Chile, Hungary, India, Malaysia, Mexico, Philippines, Russia and Turkey — has been close to one since 1995.

Changes in SA-specific risks can help explain temporary differences between the rand and the other emerging market exchange rates, but more important is the force that has moved all such currencies, including the rand, in the same direction. The movements in the exchange value of the dollar itself explain the direction of emerging market exchange rates.

Dollar comparison graph
Relative dollar strength vs the euro and other developed market currencies has brought emerging market weakness, and vice versa. And exchange rate weakness brings more inflation. Exchange rates lead inflation. It is not the other way round.

The greater difficulty is explaining the exchange value of the dollar. The problem for all businesses that trade globally is that the exchange value of the dollar itself is highly variable. However, it too has had a strong tendency to revert to square one relative to other developed market exchange rates, though the time taken varies.

The behaviour of the rand since March conforms well to these forces. The dollar weakened until very recently, emerging market currencies gained ground, and the rand did a little better than the average emerging market until late April, after which  it has moved back into line.

Compared with a year ago these exchange rate movements are dramatic. The US dollar index (DXY), a measure of the value of the dollar relative to a basket of other currencies, is down 8%; the rand has gained 23% against the dollar; and the average emerging market currency is now worth about 6% more than the dollar.

The rand appears to be a high beta exchange rate. It does worse than the average in more difficult times, as it did during the global financial crisis, and does relatively well after the crisis appears to have been resolved, as has been the case since the global lockdowns.

Exchange rates graph
These exchange rate patterns are likely to persist, though SA can help itself by adopting a set of policies that are more sympathetic to suppliers of capital. A reduction in still exceptionally high long-term interest rates would also be helpful — they continue to reflect a persistently large risk premium and the expectation of rapid inflation.

The SA government pays more than 2% more per annum to borrow dollars for five years than does the US, because of doubts about our fiscal responsibility. The accordingly high cost of capital discourages the capital expenditure by private business that is so necessary for faster growth.

Yet something is stirring to improve the outlook. Much higher metal prices are boosting SA incomes and tax revenues. Higher growth rates in nominal GDP and tax revenues will improve the critical debt-to-GDP ratio. Sticking firmly to government expenditure targets will further improve our fiscal reputation and help reduce the risk premium. The future is in our own hands (partly at least), not only written in the stars.

Building a better tomorrow – the economics of preserving historic buildings

The destruction by fire of historic buildings on the campus of my alma mater, the University of Cape Town, has brought home for many the cultural and societal value that lives in so many historic buildings.

It’s not just runaway fires that destroy beautiful old buildings though. Humans willfully do so too. My wonderful wife Shirley and I frequently regret the demolition of those interesting older Cape Town inner-city buildings we fondly remember; buildings that have been replaced by non-descript office blocks. The ornate faux Granada, Alhambra, on lower Riebeeck Street that doubled as a cinema and was our largest concert venue (seating about 3,000), provides one set of memories of times past.

It was replaced by a very conventional and boring office block that now looks and will probably soon qualify for demolition or conversion into apartments. It has no redeeming architectural features and I would suggest not even decent rentals to justify its survival or maintenance.

The willing – and at the time quite uncontroversial – destruction of many an iconic Cape Town building was a reflection of a very limited cultural sensitivity. The redevelopment and widening of lower Adderley Street, a once charming, essentially narrow main shopping street for the city, to make way for a new railway terminus, was a particularly egregious example of insensitive narrow-minded urban planning.

Master plans that often go wrong are a danger to the natural evolution of the built environment, as it proved to be, for inner city Cape Town. The old Cape Town railway terminus was a Georgian masterpiece. It was demolished to make way for an expanse of uninteresting, and completely out of place, a bit of lawn, for looking at not sitting down upon.

Are preservation orders a fair process?

The cost of preserving an interesting building should be borne by the taxpayer not its owner. In other words, full market value should be offered when making a compulsory purchase of a building of historical interest, a market value that would include the value of the redevelopment opportunity. The loss of wealth that would come with freezing the development opportunity, so reducing the value of the house or commercial building, should not be imposed on the owner. Owners who will see the value of their home, perhaps representing a large part of their savings that they were depending on for retirement, decline significantly because redevelopment of the site has now become impossible.

Scarcity that comes with time and redevelopment can add value to an older structure

A particular building style that was once commonplace, for example Victorian, Georgian or Cape Dutch homes that were the fashion of their day, become less common over time with redevelopment and the introduction of newer, more favoured styles. Styles change understandably and naturally in response to newly available technologies and materials. This fading away of the past and the falling number of structures that reflect the past therefore should add to the rarity (and scarcity value) of traditional buildings and hence their resistance to redevelopment.

Scarcity and the higher rents the iconic building might attract can add to the business case for preserving at least the facades of such increasingly rare and admired buildings. The more valuable the building, the less likely it will be demolished.

I think of the attractive facades of the still many art deco apartment blocks in Vredehoek, an inner city suburb of Cape Town, that must make them more desirable to rent and therefore more valuable to their owner-occupiers (Incidentally, the particular walk-up block of flats in Vredehoek where I spent my first five years (1942- 47) is still intact).

I wonder how well these then unusual art deco blocks of flats were received in the 1930s and 1940s when they were constructed, on mostly vacant land. Perhaps they were welcomed as representing worldly progress, not resisted as a threat to established land and home owners.

The economics of redeveloping property and the case for demolition

The test of the quality of any building or architectural feature will be its ability to command interest and respect from later generations. Most new buildings are commissioned with an expected economic life of about 20 years, given current interest rates. A building would be given a much longer life to prove itself, if the interest rates and political and inflation risk premiums incorporated in high borrowing costs in SA were lower. If an investment in a new structure in SA cannot be justified with 20 years of expected rental income, enough net rental income to cover the costs of a new building, plus the costs of purchase of the land or the building to be demolished, it will not now be built. If it can last beyond 20 years, it will be evidence of the superiority of the original design that will have added value to the building.

A building might be demolished when it is worth less than the land it occupies. A building would be valued as the present value of the expected or implicit rental income it could generate when owner-occupied, and discounted by prevailing interest rates (or more generally discounted by the returns available from similarly risky investment opportunities, by so called capitilisation rates). Demolishing the building releases the land for alternative use. It makes new buildings possible, with the potential to create a greater stream of net rental income with a higher present value: a present value of net rental income value that would have to be expected by some risk-taking developer to be high enough to make a profit. In other words, a building whose subsequent market value would exceed the value of the lost income from the existing structure, after adding demolition costs and to recover the cost of the new building.

At any point in time, the vast majority of buildings do not qualify in this way for redevelopment and demolition. Hence, as can be observed, older buildings mostly remain standing for much longer than the 20 years of economic life that brought them into being. A burst of property redevelopment activity is always a good sign of economic progress under way. It informs us that the land is becoming more productive and capable of commanding higher rental incomes, or the equivalent, capable of bearing higher implicit rentals for their owner-occupiers. It is a trend that’s helpful to property owners but a threat to those hiring accommodation or intending to enter the ranks of owner-occupiers.

How to deal with the “nimby” crowd and facilitate value-adding property developments

Therefore politics, plus the expected higher costs of renting or owning, may frustrate the intending developer. The “nimby” crowd (“not in my back yard”), may not favour redevelopment because it threatens the value of their own real estate nearby. But frustrating the conversion of land from less to more productive uses, as with all such interventions that prevent value adding innovations, will mean wasted opportunity and slower economic growth.

I have long thought that the higher wealth tax receipts that come with more valuable real estate should be shared in part with the owners of property in the neighbourhood. Extra revenue generated by higher wealth taxes collected on more valuable property can be shared with the local owners as compensation for the extra noise or traffic that the redevelopments may bring. Tax revenue that could be used to improve local parks or provide better local security or better access roads, in an obviously earmarked way, would help reduce resistance to redevelopment of the back yard that then becomes more desirable. This will mean more valuable buildings and gains in wealth for the owners of surrounding property.

It is also my contention that every generation of architects and builders should have the opportunity to impress upon the world the strength and beauty of their designs. Not all changes in design will be for the worse. Many may turn out for the better – only time can tell. A city must live and evolve – it cannot be frozen in time and kept as a museum for tourists. And a lively, economically successful city that can sustain good services to its citizens, with a mixture of the new and not-so-new structures, that have been allowed to respond to essentially market forces, can surely attract visitors as well as migrants from other cities.

Property development is part of an evolutionary process that will add to the capabilities of the city to provide additional work and income earning opportunities. Developments can add to the value of real estate to be shared between its owners (paying higher wealth taxes) and the local authority, applying additional tax revenue in generally useful ways.

Still chasing the corporate tax tail

Written after being fully frustrated listening to an Interview on how we can and should collect more taxes from SA companies that Michael Avery conducted with Keith Engers, Edward Kieswetter and Dennis Davis on Business Day TV Tuesday 20 th April 2021.

Janet Yellen the US Secretary of the Treasury wants to collect more tax from US corporations She is lobbying for the same minimum rate of corporate tax to be applied everywhere to prevent competition between different tax regimes. Edward Kieswetter, SARS Commissioner, as unsurprisingly, also wishes to collect more tax from companies who do international business from SA. But he knows better than to believe that standardising tax rates would mean more tax collected. He points out that the amount of taxable income these companies report is much more important than the rate at which they are taxed. He intends to employ more skilled tax collectors, armed with more powerful algos to closely examine the company spread sheets, to ensure more income is reported. To make sure that local costs are not inflated by off-share head office levies or by overstated imports – or indeed overstated exports that are not included in value added and so on and so forth ad infinitum, given the ingenuity of the CFO’s.

What would be required to eliminate the competition is an internationally code of generally agreed standard to measure taxable income. But more important, for any economy, is how well will taxable income as defined for tax purposes, accord with the after-tax income that drives the income and wealth producing actions of the economic decision makers? How consistently does it treat investment allowances that can exceed or fall well short of the decline in the market value of any asset employed be treated that can make a large difference to true economic income? Or how will incentives of one kind or another, tax concessions made to employ more workers, and employ more of them in special zones, or differences in the tax treatment of R&D expenditure be managed? It all calls for a standardisation of fiscal policy that seems very unlikely.

Furthermore, will the calculation of business income under a new standard include an allowance for the opportunity cost of employing equity capital in a business, as it does for interest paid on debt? An unlikely but essential treatment of business costs that are not only measured in cash paid out. Such irrationality about the treatment of economic, as opposed to cash costs, is meat and bread and taxable income to the legion of analysts and investors who know better. Only by providing true economic returns that cover all costs including opportunity costs of own capital employed, is a business likely to gain market value. And provide capital gains- including unrealised gains, which is as useful a form of income as any other even if not paid out in cash. And is only taxed when realised and so best postponed, or used as collateral to fund spending or investments. And helpfully too the interest incurred on the extra borrowings may be regarded as a business expense. And then the gains in cash are only taxed when realised by the private investor or company, not by the pension funds and other investment collectives who own most of the large, listed companies.

If we are to reform our tax system sensibly, the truth to be recognised is that taxes of all kinds are ill suited for redistributing income. They end up influencing pre-tax incomes and so the prices of goods and services, including wages and salaries. It is the distribution of government expenditure that should be used to help the poor and deserving. To tax the corporation, as well as its beneficiaries, the dividend receivers, some more than others, is unnecessary, inconsistent, and harmful to the economy.

The corporation can be treated as a limited liability partnership and be required to act as an efficient tax collector. By withholding tax from all the dividend, interest and rental payments it makes to all parties, without exception, as it does now from its employees and its suppliers. With the tax collected reconciled in tax returns as is the case with PAYE. The lesson to be learned from the tax havens, and how best to compete with them, is to adopt the same zero rate of corporate tax. It then becomes a simple matter for the tax authority to measure what is paid out, and it will not have to police the tax legitimacy of revenues or costs. No well-paid tax sleuths need be employed. The tough measurements of economic returns and what should be done with them, how much cash should be retained and how much paid out are then well left to the business organisation. They will know very well how well they have really done for their shareholders and will measure their results accurately. Economic rationality will rule. Not after-tax rationality. With very helpful consequences for the economy. More will be invested wisely, more paid out in dividends and wages and salaries and more wealth (capital gained) will be created. And the tax base of the economy would become a much wider one. The tax dog, however pedigreed, having to chase the tail of corporate income will be of the past.

But alas do not hold your breath that SA will adopt policies that are truly radical and useful. Our ability to think creatively for ourselves is not well developed.

Why property rights matter

Property rights underpin wealth creation and are essential for attracting investment and helping communities to escape deprivation.

I once asked a meeting of law students if they knew why we have laws to protect our wealth and enforce the sanctity of contracts. They appeared to have little idea why, other than that it was morally wrong to steal, to perpetuate a fraud or not to be true to your word. Nobody had told them that protecting the rights to wealth was essential if wealth was to be created in the first instance.

If you saved and invested in a home, farm, mine or business enterprise, and somebody, stronger than you, could simply take it away, there would be no reason to save and invest in productive, long-lasting assets. Protection of wealth to encourage wealth creation is essential if any community is to become more productive and escape deprivation.

The power of a government to take what might be yours, gained fairly in exchange, is one of the obvious dangers to be averted in the public interest of increasing saving and capital expenditure. While there might be good cause for a compulsory purchase to advance a broad public interest, it should be facilitated by offering the market value of the asset as compensation. No compulsory expropriation without compensation is enshrined in our Constitution and legal practice, for good, income-enhancing reasons.

Having to offer full compensation to any owner is something of a deterrent to exercising any compulsory purchase order. The taxpayer, who also has political influence, will have to pay up for the assets. It’s an influence that is resented by those who have ambitions to change the world for what they believe will be the better and are frustrated by the lack of the means to do so. Just pay for what you wish to take, is the principle we should defend and honour.

South Africans are not just reluctant taxpayers. We are reluctant savers and maintain an unsatisfactory rate of capital accumulation. We still have to rely on foreign savings on a significant scale. We are dependent on capital that can be freely invested anywhere and is easily frightened off by threats to its being taken away by expropriation, or by changes in regulations affecting its market value.

The mere hint of expropriation of land and real estate, without compensation, makes foreign capital more expensive. Foreign investors command high expected returns to compensate for the risk of our taking it away or interfering with it. Hence our low rate of capital formation. An on-average risky JSE-listed company, to justify any addition to its plant and equipment, would have to offer a return of over 15% a year, or about at least a real 9% after expected inflation of about 6%. These are returns that few companies can confidently budget for.

Hence businesses are investing less, and saving less, by paying out more of their earnings in dividends. The ratio of JSE earnings to dividends has halved since 2010. They are retaining less because they are investing less in capex, for understandable reasons.

Figure 1: Ratio of JSE All Share Index earnings per share to dividends per share

Ratio of JSE All Share Index earnings per share to dividends per share chart

Ratio of JSE All Share Index earnings per share to dividends per share chart
Source: Iress and Investec Wealth & Investment, 12/04/2021

It has taken Covid-19 to bring the low rate at which South Africa saves above the dismal rate at which we are currently adding to plant and equipment, adding capital at the rate only of 12% of GDP in 2020. Accordingly, we have become a net lender to the world.

Reducing the risks of investing in SA will encourage more capital expenditure and savings in the form of earnings retained by business. We could then attract the necessary foreign capital at a lower cost than we are paying now. Reducing risks means sensibly reducing the threat of taking, not adding to it.

 

Figure 2: South African annual net foreign borrowing (-) or lending (+), 2000-2020 (R billion)

South African annual net foreign borrowing (-) or lending (+) chart

Source: SA Reserve Bank and Investec Wealth & Investment, 12/04/2021
Figure 3: South African ratio of annual capital expenditure and gross savings to GDP, 2000-2020

South African ratio of annual capital expenditure and gross savings to GDP chart

Source: SA Reserve Bank and Investec Wealth & Investment, 12/04/2021

Inflation expectations will determine the success of the US stimulus package

Thanks largely to low interest rates, the US’s stimulus package is fiscally manageable. Fiscal restraint will be required however, to ensure it remains so.
The US not only has old-fashioned cheques (checks), but checks in the post (mail) nogal. No fewer than 90 million cheques worth $1,400 each have been mailed so far to Americans earning less than $400,000, with more to come.  The dollars will find their way out of the Federal Reserve Bank (Fed) into individual banking accounts, or cashed in, which will add to both bank deposits and the cash reserves of the banks with the Fed. Deposits with US banks are up by 26% since January 2020 and the cash reserves of US banks are up by 92%. Both represent huge firepower for additional spending on goods and services, and bank lending over the next year.
US growth in cash reserves of the banking system and growth in bank deposits
US growth in cash reserves of the banking system and growth in bank deposits chart
Source: Federal Reserve Bank of St Louis and Investec Wealth & Investment
The debt-to-GDP ratio will rise to over 130% and the fiscal deficit will soon approach 30% of current GDP. But interest rates remain exceptionally low – the average interest paid on all US debt is only 2% a year and interest payments account for 9% of all federal spending. In 1990, interest payments accounted for 23% of the federal budget at an average interest rate on the debt of about 10%. In short, these are now comfortable fiscal conditions. These ratios improved appreciably in the 1990s, thanks to lower deficits. The borrowing requirements of governments can and indeed have to be restrained by some mixture of spending less and taxing more – both hard to do.  Another $3 trillion of US government spending on so-called infrastructure is coming down the pike. There will be no fiscal crisis for the US on the horizon, if US borrowing costs remain low. But can they?
Average interest paid on US debt and Interest paid as a percentage of all Federal government spending
Average interest paid on US debt and Interest paid as a percentage of all Federal government spending chart
Source: Federal Reserve Bank of St Louis and Investec Wealth & Investment
It will depend on how much inflation is expected over the next 10 years. The higher the expectation of inflation, the higher the cost of raising government debt will be. Interest rates rise with higher inflation expectations in an almost lockstep way. The expected annual inflation rate over the next 10 years in the bond market is of the order of an unthreatening 2.2%. The higher the cost of borrowing, the more likely governments may resort to printing more money to fund their spending, which in turn will reinforce spending and increase the rate of inflation (and raise expectations of inflation).

All will depend on the scale of US borrowing expected over the next 10 years.  It will have to slow down to something like normal to prevent the US Budget from being overwhelmed by higher interest rates. Janet Yellen, the Treasury Secretary, told Congress that taxes will have to rise to pay for the extra $3 trillion. Will they, or will the unpopular prospect of higher taxes restrain spending ambition? It will take more than taxing the rich to pay the piper.

US ratio of Federal government debt and fiscal deficits to GDP
US ratio of Federal government debt and fiscal deficits to GDP chart
Source: Federal Reserve Bank of St Louis and Investec Wealth & Investment
US Federal government deficits
US Federal government deficits chart
Source: Federal Reserve Bank of St Louis and Investec Wealth & Investment
Fed Chairman Jerome Powell is relaxed about inflation for now and he remains determined to help the US economy get back to full employment. He is waiting to see what will happen and he believes he has the tools to dial inflation back should it rise temporarily – as is widely expected.

So what are these tools? Mainly, it is the power to control short-term interest rates by adding or taking away dollars from the system. He does not however control how much the government spends, how much it taxes and how much it will have to borrow. The higher he sets short-term interest rates, of course, the less popular he will become. His political independence should not be taken as a permanent given.

Powell is confident that inflation is well anchored around the current 2% annual rate, the Fed target for inflation. Actual inflation however depends on expected inflation and on the difference between actual GDP and potential GDP – the output gap. Powell believes the Fed has this gap under control. But without active co-operation from fiscal policy to restrain government spending over the long run, this inflation anchor could easily slip away. As with the Fed, we will wait and watch.

National Treasury’s tax epiphany

There is more to tax than what appears on the surface – ask National Treasury and South African homeowners.

National Treasury has had an epiphany. It has acknowledged that higher taxes can lead to slower growth and that lower taxes can lead to faster growth. Hence the decision to forgo R40bn of planned income tax increases and to propose a reduction in the corporate tax rate to 27%. All in the interests of faster growth. Hallelujah.

The Budget Review recognises that taxes have complicated feedback effects. It recognises that the burden of higher corporate taxes ends up being passed on to consumers of goods and services, in the form of higher prices and lower incomes for those who provide labour and other services to the corporation. The supply of capital to the SA enterprise and hence the supply of goods, services and the demand for labour and land, is determined by the required after-tax returns of investors. Higher taxes will reduce expected returns and so the supply of capital, goods, services and the demand for labour. The supply of capital for SA is sourced globally and the required returns are determined in the global market, as the Review recognises.

The Review could have added that personal income tax rates have supply side effects. It is the after-tax benefits provided to taxpayers by governments that establish the standard of living, which in turn determines the willingness to supply labour to an economy. The more internationally mobile the providers of labour services are, the more of a global market South African firms have to compete in for the supply of indispensable skills. Raising income tax rates at the margin drives the emigration of human capital and leads to higher prices to cover higher after-tax costs of inputs. Lower taxes could help do the opposite, that is increase supply of capital and skills. Faster growth becomes possible with a lower tax burden.

The share of income of those who will report taxable income of more than R1.5m in 2021-02 (a mere 113,192 taxpayers) are in the highest of nine tax brackets. They report 12% of all income and will pay over 26% of all personal income tax. Only when annual incomes are above R500,000 does the share of income taxes paid exceed the share of incomes earned. The numbers of high earners and taxpayers in SA have been stagnating. We need more of them to help grow the economy and provide for the relief of poverty.

It is the mix of taxes and the benefits supplied by governments that determines the standard of living and that drives the migration of labour and capital. The burden of income taxes in South Africa is highly progressive, as are the benefits of government spending. Higher income earners in South African pay much of the personal income tax and draw very little on government benefits provided.

Figure 1: Population by the nine income tax brackets (millions)

Population by the nine income tax brackets (millions) chart

Source: Budget Review 2021-2020, Chapter 4 Table 4.5, Investec Wealth & Investment, 24/02/2021

Figure 2: Share of income and income tax paid of the nine income tax brackets (percent)

Source: Budget Review 2021-2020, Chapter 4 Table 4.5, Investec Wealth & Investment, 24/02/2021

Share of income and income tax paid of the nine income tax brackets chart

Figure 3: Average income tax saved (rand per annum) per member of each tax bracket (total income tax saving = R51bn)

Average income tax saved (rand per annum) per member of each tax bracket chart

Source: Budget Review 2021-2020, Chapter 4 Table 4.5, Investec Wealth & Investment, 24/02/2021

For evidence of the relationship between taxes paid and benefits provided by government, one need only compare residential property prices in Cape Town with those in the other cities and towns. They can watch the business television channels, to be aware that magnificent homes in Johannesburg or Durban can be had for the price of a small two-bedroomed apartment in Cape Town. This is because of the more favourable mix of higher property taxes (not necessarily higher wealth tax rates) that are paid in return for comparatively good services provided by the local government.

Homeowners should be aware that higher taxes can more than pay for themselves when there is good government. And higher taxes will destroy their wealth when the service is inadequate for the taxes paid.

What higher global inflation could mean for South Africa

Higher commodity prices could bring about higher global inflation. That would not necessarily be bad news for South Africa.

There is a hint of inflation in the frigid northern air. It’s being reflected in the long-end of the bond markets, the part of the yield curve that is vulnerable to signals of high inflation and the higher interest rates and lower bond values that follow. The compensation offered for bearing the risk that inflation may surprise on the upside is reflected in the spread between nominal and inflation-linked bond yields. These spreads have been widening in the US, and in low inflation countries like Germany and Japan.

This spread for 10-year bonds in the US was as little as 0.80% at the height of the Covid-19 crisis, was 1.63% at the end of September, and at the time of writing is at 2.14%. It has averaged 1.97% since 2010. The spread has widened because investors have forced the real yield lower, to -1.03%, further than they have pushed the nominal yield higher now, to 1.15%. This is still well below the post 2010 daily average of 2.25% (see figure below).

US 10-year nominal and inflation-protected bond yields

Source: Bloomberg and Investec Wealth & Investment, 11 February 2021

Investors are paying up to insure themselves against higher inflation by buying inflation linkers and forcing real yields ever more negative. Clearly, the nominal yields continue to be repressed by Fed Bond buying (currently at a $120 billion monthly rate). One might think it’s easier to fight the Fed with inflation linkers, than via higher long bond yields, to which the currently low mortgage rates and a buoyant housing market are linked.

The Fed is insistent that it is not even thinking yet of tapering its bond purchases. The Treasury, now led by Janet Yellen, previously in charge of the Fed, insists that a new stimulus package of US$1.9 trillion is still needed for a US recovery.

Metal and commodity prices, grains and oil are all rising sharply off depressed levels. Industrial metals are 45% up on the lows of last year, while a broader commodity price index that includes oil is up 51% off its lows of 2020.

Industrial metals and commodity prices (January 2020=100) chart

Source: Bloomberg and Investec Wealth & Investment, 11 February 2021

These higher input prices will not automatically lead to higher prices at the factory gate or at the supermarket. Manufacturers and retailers might prefer to pass on higher input costs. But they know better than to ignore the state of demand for their goods and services. They can only charge what their markets will bear, which will depend on demand that in turn will reflect policy settings.

Higher inflation rates cannot be sustained without consistent support from the demand side of the economy. Yet supply side-driven price shocks that depress spending on other goods and services can become inflationary, if accommodated by consistently easier monetary and fiscal policy. In the 1970s, it was not the oil price shocks that were inflationary. They were a severe tax on consumers and producers in the oil importing economies, which in turn depressed demand for all other goods and services. It was the easy monetary policy designed to counter these depressing effects that led to continuous increases in most prices. That was until Fed chief Paul Volker decided otherwise and was able to shut down demand with high interest rates and a contraction in money supply growth that reversed the inflation trends for some 40 years.

The financial markets will be alert to the prospects that demand for goods and services will prove excessive and inflationary in the years to come – and that they may not be dialed back quickly enough to hold back inflation.

There is consolation for South Africa should global inflation accelerate. It will be accompanied by higher metal prices and perhaps bring a stronger rand to dampen our own inflation. It may also help reduce the large South Africa risk premium that so weakens the incentive to undertake capital expenditure as well as the value of South African business. Our inflation-linked 10-year bonds now yield a real 4.13%, a near record 5.15 percentage points more than US inflation linkers of the same duration. Any reduction in South African risk would thus be welcome.

The real South African risk premium chart

Source: Bloomberg and Investec Wealth & Investment, 11 February 2021

To be grateful for not so small mercies

January 27, 2021

There is some very good news to cheer South Africans up. They are a lot wealthier than they were when the lockdowns were announced in March. And wealthier than they were on January 1st 2020. If their wealth has been diversified through the JSE, the average shareholder will be 70% better off than they were in March. And 13% up on their portfolios of the 1st January 2020. The All Bond Index has returned 31% since March and 9% since January 2020. Those with shares off-shore would also have done well, but not as well. They would be up 59% if they held an MSCI EM benchmark tracker or 46% if they had tracked the S&P 500 March. That foreign holiday plan sadly disrupted in March would now be about 16% cheaper in USD. Since the ZAR/USD bottom of April the mighty ZAR has also done a lot better than the average EM currency.

Screenshot 2021-02-03 194750 Screenshot 2021-02-03 194805

To what should South African wealth owners attribute their much improved financial condition? The usual global suspects can be interrogated. A weaker dollar in a more risk on environment and so buoyant EM stock markets, to which the JSE is umbilically attached, is a large part of the explanation. A rising S&P 500 is a tide that lifts all boats, though some higher than others, as we have seen of the JSE and the ZAR.

But there are more than global risk-on forces at work. SA specific risks, as measured in global bond markets, have declined, notably so since October. They have also have declined relatively, by more than the risks attached to Brazil, Mexico and Russia bonds of the same duration. In April, at the height of market turbulence, the yield on RSA USD denominated 5y bonds had risen to over 7% p.a. And the risk spread, the extra yield over US Treasuries, was about 6.5% p.a. These bonds now offer 3.1% p.a. and an extra 2.7% p.a. over US T Bonds, less than half their levels in March 2020 with much of the improvement also registered after October. Insuring RSA Yankee bonds against default now costs but 1.1% p.a. more than it would cost to insure the average of Brazilian, Mexican and Russian debt. This extra insurance premium to cover SA default SA was 1.5% in October.

Screenshot 2021-02-03 194821 Screenshot 2021-02-03 194838

The reasons for lower SA risks are not at all as obvious as the benefits. By reducing risk and helping to add to the wealth of South Africans they encourage more spending needed to encourage output and employment. Lower risks moreover reduce the returns required of business adding to their capital stock in SA, so much more of which is needed to permanently raise output employment and incomes. And tax revenues rise with income.

Such improved prospects will be completely reversed by an additional wealth tax. It will not be expected to be a once off event. It will mean more SA risk and demand higher returns on the cash firms invest, meaning still less capex. It will reduce the value of SA companies so that they can meet such higher required risk adjusted returns for investors and immediately reduce the rewards for saving and the value of pensions. It will encourage the export of the savings of tax paying wealth owners and the emigration of skilled taxpayers. Tighter controls on capital flows would inevitably have to follow that would undermine the depth of our capital markets. Have those who advise wealth tax increases estimated how much collateral damage will be done to tax revenues over the longer run?

The sensible way to fund an unavoidable increase in government spending is to call further on the R160b of Treasury cash held at the Reserve Bank. And to raise a temporary overdraft from the Reserve Bank to supplement this cash balance, should this become at all necessary.  Adding more money to the wealth portfolios of South Africans, including to their deposits at the banks, created this way, would further stimulate spending, income growth and tax revenues. It would be growth enhancing and therefore risk reducing.

Vaccines and vacuity – the true costs of not securing vaccine supplies

The failure to secure a large supply of vaccines to help South Africa to reach herd immunity quickly, reveals a vacuity in thinking about the cost to the economy.

The fiasco over the supply of vaccines reveals fully the vacuity of South Africa’s approach to Covid-19. The deposit of R283m to secure a supply of vaccines was not budgeted for because we didn’t have the money for it – even though money for much else was found in the adjusted Budget.

In this context, I observe that the Treasury deposits at the Reserve Bank amounted to R160bn in October, boosted by loans from the IMF and other agencies with anti-pandemic action front of their minds. Has anyone in the Treasury or government attempted to calculate how much additional income will be lost for want of the vaccine – and how much tax revenue the Treasury will not be able to collect?

It will be many times more than the R20bn to be spent on the vaccine. Bear in mind too, that R7bn of this is to be funded by members of medical schemes, which in effect makes it a tax increase or expropriation by any other name, unhelpful given the state of the economy.

Yet a supply of additional money could have been made available by the Reserve Bank, in the same way that money is being created on a large scale by central banks all over the world to fund the extra spending that the lockdowns have made imperative. And the Bank could still do so, to help the Treasury fund the vaccine and the money cost of rolling it out. The idea of raising taxes to fund the extra spending when the economy is under such pressure makes little sense. A higher tax rate or taxing specific incomes will slow the economy even further and might lead to lower tax revenues of all kinds.

Moreover, there is little prospect of more inflation to come. Should inflation emerge at some point, a reversion to normal funding arrangements would be called for. The danger then is that central banks like our Reserve Bank might not act soon enough and inflation picks up. But it is a danger that pales into insignificance when compared with the present danger posed by the pandemic.

Governments around the world know enough economics to know that spending more to help employ workers (and machines) who would otherwise be idle was a costless exercise – costless in the true opportunity cost sense. But South Africa seemingly cannot bring itself to think through the problem this way. The upshot is that South Africa lacks the essential self-confidence to do what would be right now.

The monetary and financial market statistics tell us how unready the economy is to sustain any recovery of output and employment. The supply of extra Reserve Bank money in the form of notes and deposits by banks with the Reserve Bank, what is described as the money base or M0, rose by 8% in 2020. There was a flurry of extra such money in March and July 2020, since reversed. In the US, the money base is up by 43% (See figure 1).

Figure 1: Annual growth in central bank money, SA and US

Annual growth in central bank money, SA and US

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

The SA banking system is hunkering down, not gearing up. Bank deposits have been growing at about an 8% rate, while lending to the private sector is up a mere 3%. The banks are building balance sheet strength, raising deposits and are cautious about lending more. They are relying less on repurchase agreements made with the Reserve Bank and other lenders, reserving more against potential bad debts while not paying dividends and hence adding to their reserves of equity capital. All of these act to depress growth.

Figure 2: SA bank deposits and lending (R million)

SA bank deposits and lending (R million)

Source: SA Reserve Bank and Investec Wealth & Investment

Figure 3: SA banks – adding to equity capital

SA banks – adding to equity capital

Source: SA Reserve Bank and Investec Wealth & Investment

The financial metrics continue to paint a grim picture of the prospects for the SA economy. Long-term interest rates remain above 9%, even as inflation is expected to average 5% over the next 10 years. This makes capital expensive for potential investors who are therefore less likely to add to their plant and equipment. The difference between borrowing long and short remains wide, implying sharp increases in short-term interest rates to come and expensive funding for the government (that is taxpayers) at the long end. The risk of South Africa defaulting on its US dollar debt demands that we pay an extra 2.3% more a year than the US government for dollars over five years.

Figure 4: Key financial metrics in 2020-21

Key financial metrics in 2020-21

Source: Bloomberg and Invested Wealth & Investment

Poorly judged parsimony and monetary conservatism have brought SA great harm in the fight against Covid-19. They have made the prospects for a recovery in GDP and government revenue appear bleak. It is not too late to change course. We should be funding the extra unavoidable spending on the vaccine and its roll out by drawing on the cash reserves of the government or by raising an overdraft form the Reserve Bank.

Hard truths about pandemic spending

The government can call on the central bank to provide money but is not trusted to do the right thing

When or rather if economies return to their pre-shock growth paths, the cost-benefit analysis of the lockdowns is unlikely to bear favourable witness to the responses made to the Covid crisis by SA.

The cost is the difference between GDP on its pre-Covid path (which was on a regrettably moderate incline) and what is likely to be produced and earned before we get back on that path. My own back-of-envelope calculations came to a very large number, equivalent to possibly R1-trillion in money of the day, or equivalent to a quarter of pre-Covid GDP. Certainly, a very large amount of potential income will have been sacrificed. The benefits in the estimate of the value of years of life saved by the lockdowns will be much harder to calculate.

The more precise calculations of costs and benefits dealing with any future pandemic could go as follows. First, estimate the losses of income and output caused by any potential lockdown. These costs in the form of income and output foregone should then be compared with the cost of providing a reserve of medical capacity sufficient to prevent the medical system from being overwhelmed by pandemic demands — which is the case for imposing a lockdown, as we have been reminded.

Hoping to eliminate death is not a realistic option for medical and economic reasons. Minimising the difference between the costs and benefits of any policy should be the objective and is a judgment call. Yet the cost of building and maintaining an adequate medical reserve will be much lower than the sacrifice of income caused by any compulsory lockdown. But this cost will be explicit on any budget that current taxpayers would be liable for. And they and the immediate beneficiaries of alternative government spending clearly attach much present value to lower taxes and other welfare benefits. Future benefits that are uncertain in time and scale are always heavily discounted. But it is a trade-off that is resolved whenever a forward-looking society invests in a reserve to defend itself against any potential invader.

But what happens when war or a pandemic breaks out? The future, after the war, then becomes largely irrelevant compared with the immediate task of winning the war. The task is to spend enough and well enough to immediately increase resistance or medical capacity. Any failure to have built a medical reserve will make it practically difficult to do enough, quickly enough. The crisis, however, becomes too important for money to stand in the way. And where will or can the extra spending money come from?

Raising tax rates will be self-defeating. Less not more tax will be collected. Raising additional government debts may prove very expensive for taxpayers to pay for and repay in the future.

There is another way. A government under great pressure to spend more can call on its own central bank to immediately provide the money to spend. The central bank can create as much money for its government as it chooses to do. It provides extra cash for the government by buying government debt in the market or providing the government with an overdraft to spend on a large enough scale. This is what the developed world is doing on a very large scale: creating much more money to fund extraordinary increases in spending to fight the crisis. The policies are expected to be reversed when or should inflation rear its ugly head.

They have done what SA has been unwilling, not unable, to do. For want perhaps of a full understanding of opportunity costs, we have not spent enough. But more so because our government is not trusted to do right for our society and economy: in the short run spend more and in the long run spend less. Tragically so.

A Holiday post-Covid19 message – Believe in successful (economic) evolution

There is one constant that applies pre- during and post-Covid. Market driven economies adapt continuously to the changing tastes of consumers and the opportunities technology provides to supply them more profitably. Best practice
evolves so that firms can attract their essential business partners, their workers, supervisors, and capital providers on market driven terms.

Businesses and their supply chains including their supplies of labour and skills have sometimes to respond to circumstances that are beyond their control and they could not have anticipated. As with the Covid lockdowns. They
were an extreme form of government interference in the roles economic agents may ordinarily choose to play. With outcomes that few would describe as predictable or fair.

This forced households and businesses to adjust rapidly to dramatically changed circumstances to minimize losses as best they could. The Covid economy offered grave dangers and some opportunity. It accidentally produced a few big
winners and many more losers for whom income or debt relief from their governments, who caused them so much damage, seems only fair. Businesses as usual will be doing all they can, to accurately anticipate our preferences and
actions as consumers, as suppliers of labour and skills, and as providers of capital.

The Covid economy has proved that if your job is to deliver a service and the only machine you need with which to combine your labour and intelligence, is a computer, you can work anywhere, including home. And connectivity to other
computers is bound to improve and become less expensive. Wider choices have therefore presented themselves to both sides of the employment nexus.

Trade-offs of income for other benefits including the quality of the working environment have always to be made. Who indeed pays for the Google campus and how valuable are its benefits? Ask Google. The requirements and solutions for
business success will differ from firm to firm. Yet first mover advances in the right new direction are very valuable. It takes time for the competition to latch on, catch up and compete away the temporarily high returns to owners and the
superior benefits they may provide to attract “best of breed”.

In the post-Covid economy how much of our incomes will be earned from our homes? And how much will we play in or outside, in restaurants, resorts and cruise-liners. (Merely mentioning them makes me salivate in anticipation of happier
times) Will our output, be higher or lower working from home, or higher in face-to-face collaboration with colleagues and fellow workers at a more or less distant work-place? The owner of a business, to survive, is compelled to measure
what employees deliver, wherever they may deliver it or wish to deliver.

Potential and actual employees will also be estimating the extra benefits and extra space costs working from home. Benefits that include more time for leisure or to bring up their children? Clearly very little is produced commuting to
work. Potential income and leisure are sacrificed in the time commuting, or higher actual or owner equivalent and market rentals are incurred reducing the time and costs of getting to the office, factory or warehouse. The savings in
time and money and office or house rentals are open to trade-offs, experimentation and ultimate resolution. The providers of transport, cars, busses, trains above and below ground, aircraft and highways, not to mention office
buildings, will be predicting and observing the outcomes.

Workers would have to accept less pay to work at home should they prove less productive there and prefer to do so. They can expect to earn more if the opposite proves true. Or will employers have to offer them more to get them to

come to the office, to bear the extra costs of commuting? Should they be expected to be more productive and creative in F2F collaboration. Which may well be a lot more fun and even worth sacrificing some income and leisure and time at
home for. We will find out what mix of income and salary and working conditions work best and for whom. There will be no cookie cutter solutions. We should be confident that the process can best be left to work out in the usual, successful,
evolutionary way.

How to solve SA’s unemployment woes

Many South Africans are condemned to a lifetime of inactivity for want of experience and the good habits acquired by having jobs. What are some of the practical steps that can be taken to solve SA’s unemployment problems?

In a well-functioning labour market, the number of employees who quit their jobs for something better will match those who are fired. The unemployed will then be a small proportion of the labour force. And it will not be a stagnant pool of work seekers. The number of new hires will roughly match the new work seekers, slightly more or less, depending on the state of the business cycle. Most importantly, the labour market will be reassigning workers to enterprises that are growing faster, from those that are growing slower or going out of business. It is a dynamic process that makes for a more efficient use of labour, and leads to faster growth in output and higher incomes from work over time.

To state the obvious, the above scenario does not describe the current state of the SA labour market. The unemployment rate since 2008 (the first year the current employment survey of households was released) and up to the just released for Q3 2020 survey, has averaged well above 20%. It was 23% in 2008 and 30.1% before the Covid-19 lockdowns. The army of the unemployed grew from 4.4 million in 2008 to 7.1 million in Q1 2020, compounding the problem at an average rate of 4% a year.

The numbers employed grew from 14.4 million to 16.4 million over the same period, at a 1.1% annual average rate, but therein lies the rub. The numbers of South Africans of working age who are neither working nor seeking work, nor are economically active, and therefore not counted as part of the labour force, numbered 15.4 million in Q1 2020. This is up from 12.74 million in 2008, having grown by 1.6% a year on average over the period.

The ability of the economy to absorb a growing potential labour force, defined as numbers employed divided by the working age population, now 39 million, declined from a low 45.8% in 2008 to 42.1% in early 2020. Even more concerning is the inability of the economy to absorb young people into employment. Of the 10.3 million between the ages of 15 and 24 years, 31.9%, or only 3.2 million, were working or seeking work. The economically inactive numbered 7.5 million. The absorption rate for the cohort fell from 17% in 2008 to 11% in early 2020. The economically inactive part of this group numbered 8.2 million in September. Of the cohort aged 15 to 34, the proportion who were not economically active was 40.4%.

A lifetime of inactivity
There is thus a large number of South Africans condemned to a lifetime of inactivity for want of experience and the good habits acquired on the job. What is going so very wrong in the SA labour market? We observe how vitally important it is for those with jobs to retain them. The struggle to hold onto well-paid jobs at state-owned enterprises (SOEs) such as SAA and the SABC is an understandably bitter one with so much at stake. And the sympathies of the politicians are with the threatened workers rather than with the attempts to sustain the economic viability of these SOEs in the face of an ever more padded payroll.

Being unemployed, especially for those retrenched form the public sector, is not part of a temporary journey to re-employment on similar terms. It is almost bound to be destructive of lifetime earnings. Even the competition authorities, who you might expect to focus on efficiency rather than job retention, make retaining jobs a condition for approving a merger or acquisition. Yet despite the large numbers of the unemployed and the economically inactive, the real earnings of those with jobs in the public sector have grown significantly and much faster than outside of it – by an average 2.2% a year after inflation compared with 1.52% for the privately employed. This perhaps explains why the SOEs have had such difficulty in balancing their books.

A system in SA has evolved that reinforces the better treatment of the insiders – those with jobs that are entrenched by law and practice – when compared with the outsiders who struggle. Many therefore give up the struggle to find “decent work”. A National Minimum Wage (NMW) is set at a level – R3500 per month – that regrettably few South Africans earn or are capable of earning. This is a major discouragement to hiring unskilled and inexperienced workers, particularly outside of the major cities. You would have to go well into the seventh decile of all income earners to find families with per capita incomes above this prescribed minimum wage.

It is possible to dismiss or retrench workers or managers in SA. But in addition to any regulated retrenchment package, it is not a low cost exercise to fire underperforming workers of all grades. Employers have to satisfy the Commission for Conciliation, Mediation and Arbitration (CCMA) to do so. Funding a human resources department, with skilled specialists well versed in employment and unemployment procedures, to whom dealing with the CCMA can be delegated, is one of the economies of scale available to big business. The small business owner-manager attempting to navigate the system is at a severe disadvantage that will surely discourage job offers.

The impact of Covid-19

It is not just the regulations and practices that inhibit the willingness of employers to take on more labour. Post-Covid-19 reactions reported by the latest survey of households give some important clues to the forces at work. During lockdowns, numbers employed fell from 16.3 million in Q1 to 14.15 million in Q2, and recovered slightly to 14.7 million in Q3. The numbers counted as unemployed fell sharply from 7.1 million in Q1 to 4.3 million in Q2 and then rose to 6.5 million in Q3, after the lockdown. The numbers of those who were not economically active rose dramatically in Q2 from 15.4 million in Q1 to 21 million in Q2, when it made little sense to actively seek work. The numbers of the economically inactive then fell dramatically by over 2 million in Q3, as more people sought work and were physically allowed to do so.

The numbers employed in Q3 rose, but were not as many as those additional work seekers and so the unemployment rate picked up. It was a development highlighted in the survey. It made sense for more people to look for work because it was more likely to be found, and also presumably because the declining economic circumstances of the family, perhaps the extended family on which many depend, made the search for work and additional income imperative.

South Africans understandably have a reservation wage, below which working does not make good sense. It has to pay to work. And the economically inactive in SA who are overwhelmingly low or no income earners are presumably able to survive without work by drawing on the resources of the wider family. They will not have accumulated much by way of savings to draw upon. The family resources, on which they rely, are likely to be augmented by cash grants from government and from subsistence agriculture or occasional informal employment. Covid-19 may well have damaged the ability of the extended family to provide support for those not working or intending not to work, hence the fewer inactive members of the workforce.

The failure of SA’s mix of economic policies is revealed by what is still for many a reservation wage that remains higher than the wage employers are able and willing to pay them. Hence the discouraged employment seekers who are among the economically inactive. It seems clear that South Africans choose to some extent to supply or not to supply their labour, depending on their circumstances including their skills and earning capacity as well as the state of the economy. They have a sense of when it seems sensible to work or to seek work at the wages they are likely to earn.

Practical solutions

What can be done about this essentially structural issue for our economy? Businesses surviving Covid-19 have increasingly learned to manage with fewer workers and managers. Abandoning the NMW or the CCMA or reducing the legal powers of trade unions and collective bargaining would help increase the demand for labour, but this course of action is unlikely. Meaningfully improving the quality of education and training (on the job as lower-paid interns and apprentices) to raise the potential earnings of many more over their lifetimes of work, also seems wishful thinking. Reducing the value of the cash grants paid, so reducing the reservation wage to force more of the population to seek and obtain work, would be cruel and is as unlikely. Some form of welfare payments for work seems to be on offer in the form of the internship scheme announced recently by President Cyril Ramaphosa.

The Employment Incentive Scheme allows employers to deduct up to R500 off the minimum wage paid to workers under 29 and for all workers in the special economic zones. Employers simply deduct the subsidy from their PAYE transfers. It takes very little extra administration by either the firms or the SA Revenue Service. In 2015/16, 31,000 employers claimed the subsidy for 1.1 million workers and the scheme cost R4.3bn in 2017-18. The subsidy may well have to be raised to keep pace with higher minimum wages imposed on employers.

Raising taxes to subsidise the employment of young South Africans may be the only practical and politically possible way to provide more opportunities for them, especially if the market is not allowed more freedom to address the employment issue, by offering wages and other employment benefits that workers are willing to accept. Abandoning the NMW, the CCMA and nationwide collective bargaining agreements, all so protective of the insiders, would increase the willingness to hire and raise real wages for the least well paid in time. But it would be unrealisitic to expect the unemployment rate in SA to rapidly decline to developed market norms. It will take faster economic growth, which leads to higher rewards for the lowest paid and least skilled, to make work the better option for many more. And it will take many more workers to raise our growth potential.

The Vaccine and the SA economy – Urgency demanded

The prospect of an effective vaccine for Covid19 has been particularly good news for investors in SA. The ZAR has recovered all of the ground it had lost to other EM currencies through much of 2020 and is now only about 10% weaker against the dollar this year. In March, when the uncertainty surrounding Covid19 was most pronounced, the ZAR had lost 30% of its USD value of January 2020(see below) The ZAR has gained about 4% on both the EM basket and the USD this month. (see below)

Exchange Rates; The ZAR and the EM basket Vs the US dollar and the ratio ZAR/EM; Higher values indicate dollar strength (Daily Data Jan 1st 2020=100)

 

 

Screenshot 2021-01-04 145036

 

 

Source; Bloomberg and Investec Wealth and Investment
The JSE equity and bond markets consistently also responded very well to the good global news led by the companies that are highly dependent on the SA economy. The JSE All Share Index since October has gained 14% in USD and the JSE All Bond Index has appreciated by a similar 14% in USD. The emerging market index was up by 9.1% over the same period while the US benchmark the S&P 500 gained 5.4% over the same period. The JSE has been a distinct outperformer recently (see below)

The JSE Equity and Bond Indexes Daily Data (October 1st=100)

Screenshot 2021-01-04 145053

Source; Bloomberg and Investec Wealth and Investment

The JSE, The S&P 500 and the MSCI EM Indexes USD Values (Daily Data January 1st 2020=100)

Screenshot 2021-01-04 145106

Source; Bloomberg and Investec Wealth and Investment

These developments should not have come as a complete surprise. Such favourable reactions in the SA financial markets to a reduction in global uncertainties, usually accompanied by a weaker USD are predictable. What South Africans lose in the currency and financial markets when the world economy appears less certain, we regain when risk tolerance improves. SA unfortunately is amongst the riskiest of destinations for capital and investors who always demand higher returns as compensation for the risks they estimate. As taxpayers we pay out more interest and our companies have to offer higher prospective returns than almost anywhere else where capital flows freely, as it does to and from Johannesburg.
Recent developments in the markets do provide some relief for our beleaguered economy. The yield on long dated RSA bonds has declined by more than a half a per cent this month. With an unchanged outlook for profits such a reduction in the discount rate applied to expected income could add 10% to the present value of a SA business or roughly 10% its price to earnings ratio. (market reactions confirm this) A further reduction in these very high required returns – now equivalent to about 9% p.a after expected inflation – is much needed to encourage SA businesses to invest more. Essential if our economy is to grow faster.
Yet if the economy were expected to grow sustainably faster the discount rate would come down much further and businesses would be very willing to invest more in SA. And foreign investors would willingly supply us with their savings to do so. And the SA government would be much more confidently expected to raise enough revenue to avoid the danger of a debt trap and avoid a much weaker rand- expectations that are fully reflected in our high bond yields.
We can hope for the stars to align but should not expect them to do so. We can help ourselves by making the right policy choices. Opportunity presents itself. The terms at which we engage in foreign trade have improved consistently in recent years, by 20% since 2015. Think metal prices over oil prices. These relative price trends are even more favourable than they were in the seventies when the gold price took off. These developments should spur output and investment by business government policy permitting.
There is a further related large opportunity presented by the discovery of a major energy resource off our southern coast. Bringing the gas ashore can accelerate infrastructure and export led growth, funded by foreign capital not domestic taxpayers and led by business not government. It demands the kind of urgency that has brought us a vaccine.

South Africa. Terms of Foreign Trade. Export Prices/Import Prices (2010=100 Quarterly Data 1970-20200)

Screenshot 2021-01-04 145119

Reputation at stake

Doing what is right for the depressed economy while hoping to regain a reputation for fiscal responsibility over the long run is no simple task. The adjustments made to the Budget last Wednesday (28th October) were made in these highly adverse circumstances. Tax revenues have collapsed along with incomes and output inevitably increasing the borrowing requirements of government- indeed more than doubling them as a per cent of GDP. The sacrifice of incomes in the lockdown however calls urgently for more government spending not less and lower, not higher tax rates.

Economic theory tells us that spending more on resources that will otherwise remain idle makes good sense.  Extra income or benefits in kind provided by governments for households and firms brings more spending in its wake and results in more output, incomes and employment. The normal trade-off of schools for hospitals or cleaner air for more expensive electricity or spending less today to spend more tomorrow, does not apply when an economy operates well below potential and can be expected to continue to do so. More can be spent now so that more will be produced. The extra spending has no economic cost. It is the proverbial free lunch now being consumed generously, sensibly and widely across the globe in response to lockdowns.

We learned from the Minister that the SA economy is not expected to recover to 2019 levels until 2024-25. A much slower process of recovery than is expected elsewhere, for want presumably of enough stimulus, and a reason for spending more now. It will nevertheless take strict control over government spending, especially on the employment benefits provided for its own employees to regain a much better fiscal balance over time. And limiting such highly attractive employment benefits has to start now, as the Minister emphasized . Stabilizing the debt to GDP ratio to limit spending on interest should take a good deal longer. The very limited reactions in the Bond and currency markets to the revised Budget indicate that the jury is still very much out. Unproven is the interim judgment.

While the Treasury is constrained by want of reputation, the Reserve Bank is not so.  It could be helping to hold down the costs of funding long dated government debt. And lending more freely to the banks so that they could fund much more, lower cost short term debt issued by the government. It should lower interest rates further and encourage the banks to lend more freely and make use of the loan guarantee scheme. Which is much the largest part of the Treasury’s stimulus package, regrettably still largely unused. Creating money as the cheapest form of funding government debt is as right now for SA as it is everywhere else. And the Reserve Bank has the anti-inflation credentials to be expected to reverse its monetary course when the time and the recovery calls for it.

Last Wednesday, a vital opportunity to enhance SA’s growth prospects and hence its ability to raise revenue and greatly relieve its Budget constraints was revealed outside Parliament. In the confirmation of a major energy resource in South African waters. Total and partners have speculated heavily on and in South Africa and have triumphed. Good for them and for all of us. The Intergrated Resource Plan (IRP 2019) sees very little scope for natural gas in SA as part of the energy mix. The plan predictably will have to be rewritten. And much better replaced by not another plan but a process well known to balance supply and demand. That is a market led process. One that would leave Total to develop its discovery as it sees best unencumbered by unhelpful regulation or crony capitalism or retrospective expropriation. The potentially favourable consequences of the right approach are hard to overestimate.

The construction of pipelines and urban gas grids and an infrastructure led growth beckon.  Municipalities seeking electricity are likely partners as is Eskom. The people of SA will benefit from additional royalties, income and VAT and taxable income earning opportunities of all kinds. And from cheaper energy. The financial and structural constraints on our economy can be relieved. More immediately can be expected to be relieved with the right business friendly approach.  Our fiscal and investment reputation depends upon it.

Thinking and acting long term comes with a price – the discount rate

An analysis of discount rates shows the extent to which a high risk premium encourages short-term thinking.

In making economic or social choices today, how far ahead do you look? You may blow your Friday wage packet on hedonistic pursuits without any regard to how little food will be on the family table the following week. Or you may run up the mortgage bond to fund the next holiday abroad. We might ascribe such myopic actions as reflecting high personal discount rates. In such cases, future benefits clearly command very little competition with immediate pleasures.

When a business contemplates an investment decision, how far ahead should it calculate its expected benefits? How many years of future cash flow would your business estimate as necessary to justify an acquisition or an addition to plant and equipment? The longer the estimated pay-back period, the greater will tend to be the present value of the investment decision.

Expecting to get back capital risked in 10 or 20 years, rather than in five years, encourages investment by reducing required returns. It means the application of a lower discount rate to future incomes or expected cash flows. It brings higher present values that are more likely to exceed the current costs of the plant, equipment or acquisition. Future-conscious economic and social actors, with longer time horizons, benefit themselves by saving and investing more. They also benefit their broader communities, by helping to contribute to a larger stock of capital and so more productive workers capable of earning higher incomes.

South African investors are exposed to high discount rates. They are as high as they have been in recent times and are high when compared to discount rates in the developed world. The long-term promises of interest and capital repayments by the SA government are discounted at about 9% a year. Adjusted for expected inflation of 5%, this provides savers with a real return of about 4% a year, with which every risky SA business contemplating capex has to compete for capital.

A risk premium of at least 5% for a well-established and listed SA company would have to be added to this 4% and so the discount rate applied to any prospective cash flow. A required return of more than 10% a year after inflation makes for short pay back periods and so limited capex and limited growth opportunities generally. It also means much lower present values attached to established SA business so that they can satisfy such demanding expectations. Higher discount rates destroy wealth.

For example, assume you have an investment that earns income, initially worth 100, that is expected to grow at 5% a year over the next 20 years. Assume a developed world discount rate of 6% – made up of 1%, which is all that is available from government bonds, plus an assumed 5% extra for risky equity. The present value of this expected income or cash flow stream will be 320. Moreover 81% of its current market value can be attributed to the income expected after five years.

The same business, with the same prospects in SA, and with the same risk premium, but competing with government bonds offering 9%, would have future income discounted at 14%. This is more than double the discount rate applied to an averagely risky investment in the developed world. It would have a present market value of 116, about a third lower. Of this, only 54.9% of its present market value will be attributed to income to be expected after five years. This forces such a business to adopt a much shorter focus, with fewer viable investment opportunities.

The direction of economic policy reforms in SA should be evaluated through the prism of the discount rate. The purpose of reform must be to build confidence in the future growth and stability of the economy to lower the damagingly high discount rate. Only this can make businesses more valuable, by encouraging their managers to think more about the long term than the short, and to invest more and thus improve the economic prospects for all South Africans.

The importance of lower long-term interest rates

An SA economic revival will depend on lower real long-term interest rates. Only a credible commitment to restraining government spending over the longer run can therefore relieve SA of the burden of expensive debt.

Central Banks have more to offer a distressed economy than just lower interest rates. Interest rates cannot or will not be allowed to fall much below zero, however central banks can supply their economies with more of their own money, in the form of the deposits they supply to their private banks, if necessary. They can add money by lending more of their cash to their governments, private banks and even businesses. They may choose to buy back assets from banks or buy the debt or even the equity of private businesses.

Central bankers will hope that the banks will lend out more of the extra cash they will be receiving automatically from the central bank. If the banks and their borrowers respond favourably to these monetary injections, the supply of private bank deposits and of bank credit will increase by some multiple of the additional central bank money. The extra money (deposits) supplied will then not be hoarded by the public but exchanged for goods and services and for other assets. Higher share prices, more valuable long-dated debt and real estate will translate into more private wealth, leading to less saved and more spent (asset price deflation has the opposite, depressing impact on an economy).

An economy that delivers less income and output than it is capable of, is distressed. Lockdowns have disrupted output and sacrificed the incomes of businesses, households and governments in a serious way. Getting back to an economically normal state requires a mixture of increasing freedom and willingness to supply goods, services and labour. It also needs more spending to encourage firms to produce more and hire more people.

Money creation on a large and urgent scale is helping to stimulate demand almost everywhere. M2 in the US has grown by nearly 25% over the past 12 months. It has led to a more helpful response from US banks than occurred after the Global Financial Crisis (GFC), as the monetary statistics in figure 1 show.

Figure 1: Money supply growth in the US (M2)
Money supply growth in the US (M2) graph
Source: Federal Reserve Bank of St.Louis and Investec Wealth & Investment

The SA Reserve Bank has adopted a very different strategy and rhetoric. It has decided that it has done all it can for the economy by cutting its repo rate associated lending rates by three percentage points, to 3.5%. It has rejected any quantitative easing (QE) that might have reduced pressure on interest rates at the long end of the yield curve. It argues that a structural inability to supply (over which it has limited influence), is the cause of our economic distress, not the state of demand, which it could influence if it chose to do so – with still lower repo rates and money creation. It is an argument that can be challenged.

Yet perhaps all is not lost on the SA monetary front. The deposit liabilities of the banks (M3) had grown by about 11% by August, compared to a year before, while the money base is up by 12.5%. This is a welcome acceleration, as figure 2 shows. Less helpfully, bank lending to the private sector was up by only 3.9%.

Figure 2: Growth in monetary aggregates

Growth in monetary aggregates graph

Source: SA Reserve Bank and Investec Wealth & Investment

It is possible to reconcile the faster growth in the deposit liabilities of the banks with the slower growth in the credit they have provided. The difference between the growth in bank deposit liabilities (up 11%) and assets (up by about 4%) is accounted for by a large increase in the free cash reserves of the banks. The negative difference between cash and repos narrowed by about a net R60bn in 2020. The banks have been provisioning against loan defaults on a large scale. These provisions reduce their reported earnings and therefore dividends, but it increases their cash and free reserves – represented as an increase in equity reserves. As figures 3 and 4 below show, the equity reserves and their provisions rise during times of stress, as they are doing now and did during the GFC, which led to a sharp recession in SA.

 

Figure 3: SA banks’ free reserves – cash less repurchase agreements with the Reserve Bank and others

SA banks’ free reserves – cash less repurchase agreements with the Reserve Bank and others graph

Source: SA Reserve Bank and Investec Wealth & Investment

Figure 4: SA banks’ capital and reserves (R millions)

SA banks’ capital and reserves (R millions) graph

Source: SA Reserve Bank and Investec Wealth & Investment

The banks however have an attractive alternative to providing credit for the private sector. They borrow short (raise deposits) and can lend to the government at higher rates without risks of default. The currently very steep slope of the yield curve adds to this attraction as well as to the profitability of borrowing short and lending long. If long rates are the average of expected shorter term rates over the same period, the currently steep slope of the yield curve implies that short rates are expected to increase dramatically over the next five years. A one-year RSA bill is now offering 3.2%. A three-year bond currently offers 5.06% and a five-year bond 6.72% (all annual rates). The one-year rate would have to rise to more than 8.3% in three years’ time and to 11.3% in five years, to justify the current slope of the yield curve. Unless inflation or real growth surprise significantly on the upside, these higher short rates, as implied by the yield curve, make such outcomes unlikely. Borrowing short to lend long to the SA government looks like a good profitable strategy for SA banks, for now. Similarly, for the government, it favours a strategy of issuing short-term debt and then rolling it over, rather than raising long-term debt at much higher rates.

Figure 5: The spread between RSA 10-year bond yields and money market rates

The spread between RSA 10-year bond yields and money market rates graph

Source: Bloomberg, Iress and Investec Wealth & Investment

Figure 6: The RSA yield curve and the implicit one-year forward rates

The RSA yield curve and the implicit one-year forward rates  graph

Source: Thompson-Reuters and Investec Wealth & Investment

The banks have been holding significantly more government paper over recent years in response to presumably weak demand for credit from private borrowers and the availability of relatively attractive interest rates on low-risk government paper. Government debt as a share of all bank assets is now 13%, a share that has doubled since 2010. The banks invested a further (and significant) R110bn in additional government debt between January and June 2020.

Figure 7: Bank lending to the government

Bank lending to the government graph

Source: SA Reserve Bank and Investec Wealth & Investment

Figure 8: Composition of bank lending to the SA government

 

Source: SA Reserve Bank aComposition of bank lending to the SA government graphnd Investec Wealth & Investment

Such extra investment in government bills and bonds by the banks is helpful to the government, given the ballooning deficit it has to fund one way or another. The growing deficits are the result more of a collapse in revenue than a surge in spending as the chart below shows. But for the banks to prefer government over private debt would effectively crowd out the lending to the private sector that could contribute to economic growth.

Figure 9: National government expenditure and revenue (monthly, seasonally adjusted and smoothed)

National government expenditure and revenue graph

Source: SA Reserve Bank and Investec Wealth & Investment

Figure 10: Annual growth in government revenue and expenditure (smoothd)

Annual growth in government revenue and expenditure graph

Source: SA Reserve Bank and Investec Wealth & Investment

Viewing all these forces at work leads to one important conclusion: any revival of the SA economy will depend on lower real long-term interest rates and less expensive debt for the government and taxpayers. It will also mean lower real required returns for any business. These required returns are currently extremely high, given high nominal bond yields, low inflation and the additional equity risk premium. The returns required to justify an investment in the SA economy are thus of the order of a prohibitive 10% or more after inflation. The Reserve Bank can help in the short run by managing long rates lower. However only a credible commitment to restraining government spending over the longer run can lead SA out of the burden of expensive debt.

Money matters – also in SA

Central Banks have more to offer a distressed economy than lower interest rates. They can supply their economy with much more of their money in the form of the deposits they supply to their private banks. They can add as much money to the economy as they deem necessary, by lending more to their governments, private banks and businesses.

If the banks and their borrowers respond favourably to these monetary injections, the supply of private bank deposits and of bank credit will increase by some multiple of any additional central bank money. The extra money and credit created will then be exchanged for goods and services, the labour to help produce them and exchanged for other assets.  Higher share prices, more valuable long dated debt, and real estate, translates into more private wealth, leading to less income saved and more spent. Helping to relieve distress.

Lockdowns have disrupted output and sacrificed the incomes of businesses and the households and governments on a large scale. Getting back to an economic normal requires a mixture of increasing freedom and willingness to supply goods services and labour. It also needs more spending to encourage firms to wish to produce more and hire more workers and managers. Money creation on a very large and urgent scale is helping to stimulate demand almost everywhere. M2 (that is bank deposits) in the US have grown by nearly 25% over the past twelve months. QE is working very rapidly this time round.

The SA Reserve Bank has adopted a very different strategy and rhetoric. It has decided that it has done all it can for the economy by cutting its repo rate by 3 percentage points to 3.5%. It has rejected any QE that might have reduced pressure on interest rates at the long end of the yield curve. It argues that a structural inability to supply over which it has limited influence, is the cause of our economic distress, not the weak state of demand.  Go figure as they would say in New York

Yet perhaps all is not lost on the SA monetary front. The deposit liabilities of the banks (M3) had grown by about 11% by August and the supply of Reserve Bank money is up by 12.5% p.a. in September compared to the year before. This represents a marked acceleration. Much less helpfully bank lending to the private sector was up by only 3.9% p.a. in August. The difference between the growth in bank deposit liabilities, up 11% and assets up by about 4%, is accounted for by a large increase in the free cash reserves of the banks, of about a net R60b in 2020. That is the cash on their books less all their repurchase agreements with the Reserve Bank and others have become less negative.

The banks have been provisioning against loan defaults on a large scale. These provisions reduce their reported earnings and therefore dividends. It therefore increases their cash and free reserves that are reflected as an increase in equity reserves. A process that is reversed should the bad debts materialize.

The banks invested a further and significant R110b in additional government debt between January and June 2020. Very helpful to a very hard pressed fiscus, but also crowding out lending to the private sector. The currently very steep slope of the yield curve adds to the attraction of borrowing short to lend long to the government. It also implies that short rates are expected to increase very dramatically over the next five years. Unless inflation or real growth picks up very surprisingly, the very much higher short rates implied by the yield curve seem unlikely. Borrowing short to lend long seems like a very good and profitable strategy for SA banks and others. Borrowing short and rolling over short term debt rather than borrowing long, at much higher rates seems like a good idea for the RSA.

This all leads to an undeniable conclusion. Any revival of the SA economy will depend on realizing lower real long-term interest rates and flattening the yield curve. It will bring lower real required returns for any business that might invest more in the SA economy, essential if the economy is to pick up any sustainable momentum.   Only a credible commitment to restraining government spending over the longer run can lead SA out of the stultifying burden of very expensive capital.