Brian Kantor – Page 8

The age of money creation; what will be the consequences of rapid growth in the money supply?

Dealing with a financial and economic crisis – by creating money

This is the age of money creation. Money creation à outrance– to the limit – unsparingly[1] that began on a monumental scale in response to the Global Financial Crisis of 2008-9. (GFC) A new phase in money creation on an even greater scale has begun in response to the Corona Virus crisis. Or more precisely in response to the shutdowns of normal economic activity ordered by almost all governments. In the week ending April 10^th the US Federal Reserve Banks, as an outstanding example, expanded its assets and liabilities sheet by an extraordinary 2 trillion dollars. It increased its assets and liabilities from approximately 4 to 6 trillion dollars or by 50% in one week. With more money likely to follow in the weeks ahead.

The recipe for curing a banking crisis has long been known- create more and enough money until the panic rush for money abates. It has been done this way many times before in response to one or other financial crisis. But it had never been practiced on the scale adopted after the GFC and now.

Analysing the balance sheets of central banks to find the sources of extra money

On the asset side of the Federal System you will find mostly securities issued by the US government. Its liabilities are mostly incurred in the form of deposits placed by member banks of the Federal Reserve System. The size of the Fed balance sheet has increased more than six times since 2008 – and it is set to rise much further.

These deposits with any central bank are money – central bank money – cash, if you like. Money that can be exchanged without limit for goods and services, other currencies and financial and tangible assets of all kinds. The cash so acquired by banks or others may also be used to make additional loans – bank overdrafts for example- or used to subscribe for new issues of securities offered by governments and businesses of all kinds, including other banks. They are money, because as with notes and coins of the realm, they would not be refused when offered in exchange for goods, services or other assets.

Whenever a central bank on its own initiative buys a security (a US Treasury Bill or Bond for example) or makes a loan to a bank or business, it settles the obligation to pay by crediting (digitally) its very own deposit accounts. In other words a central bank pays for whatever it wishes to buy, by creating its own money, at no extra cost to itself or the government of which the central bank is an agent. It may be described as a wholly owned subsidiary of the government.

A few additional observations are in order. When the central bank buys an asset directly from a bank, that bank will in the first instance deposit the receipts of the sale in its account at the central bank. The money supply increases accordingly. When the asset is sold to the central bank by another financial institution, other than a bank, the proceeds will first be deposited in its account at some private bank. The bank receiving an extra deposit from a client will in turn present the digital equivalent of a cheque to the central bank for settlement and will receive a credit to its deposit account with the central bank. Again the money supply increases in proportion to the value of the transaction.

When however the central bank lends directly to the government in exchange for a newly issued security or against an increased overdraft, as the UK government is now doing, the government deposit account with the central bank will be credited accordingly. This larger government deposit account is not immediately part of the money supply. It is only when the government account is drawn upon to pay for goods and services, and the transactions are banked by suppliers to the government does the money supply increase in the form of extra deposits of private banks banked with the central bank.

Modern money is only convertible into the self-same money

Modern so-called fiat currencies are however not convertible at any fixed rate of exchange into gold or other reserve currencies. Yet they are easily converted into goods, services, assets of all kinds including gold and other currencies at variable exchange values that are continuously determined in the various markets. The purchasing power of its money is therefore not at all certain. It may lose buying power if there is too much of it issued – that is when more is supplied than is willingly held as money. Money may gain value in exchange for other currencies if extra demands to hold the money press upon existing supplies.

Money is held very willingly for its convenience as a transactions balance or as part of some optimal portfolio of assets. It is the most liquid, most easily exchanged of assets, with a certain monetary value. Other assets are less certain in their future value, expressed in money of the day. Though fiat money does have not a certain real or purchasing power value when exchanged for goods or other currencies.

Money as an asset is especially desirable when the prices of other assets are expected to fall in value. That is when the risks of business failure or the prospect of higher interest rates, that may reduce the value of income earning assets, appear more likely. But the owners of money may at any time decide that they have too much money in their portfolios and too little of other assets that they might use their surplus money or cash to acquire. That switch in the composition of any portfolio of assets may be more likely when the supply of money is seen to be increasing rapidly. Money holders may well they fear that their money will lose value over time and accordingly reduce their holdings of it. And by so doing put more upward pressure on the prices of goods, services and assets.

Central bank money is mostly demanded and supplied to banks. Will they hold the extra money or use it to make loans?

The principle owners of central money are the banks. And while they hold notes and coins to meet the demands of their customers in their tills and ATM’s, their major holdings of central bank money will be in the form of deposits with the central bank. Deposits of banks with the central bank may exceed the supply of notes and coin that make up the money issued by a central bank. (see figure below on the composition of the Federal Reserve Balance Sheet)

The decisions the banks take with their holdings of additional central bank money supplied to and received automatically by them will be crucial to the outcomes for total lending and spending in the economy. Essentially the more of the extra cash received the banks prefer to hold as extra cash reserves, the less will be the repercussions for the wider economy. An increase in the supply of money accompanied by an increase in the demand to hold that money cannot lead to extra bank lending. That is to additional supplies of bank credit that can be used to fund additional expenditure. The buck stops there – literally.

But banks are in business to make money – that is profits – by keeping as little cash on their books – as is prudent – and putting their cash to work by making loans. They earn profits on the spread between the interest they pay on deposit and the interest they earn on their loan portfolio- their assets. These deposits, especially those used to make payments are a convenient substitute for the notes and coins issued by the central bank into which they can be converted on demand. They are also described as part of the wider money supply.

The banks therefore not only borrow and lend, they maintain the payments system the reliability of which is crucial for economic stability. They incur costs including wages and rents costs attracting deposits or other sources of funds and transferring them on instruction of their deposit holders. They incur losses should their loans go sour. But without taking some risk with their cash and capital in search of profits they could not hope to succeed in the banking business.

They are in the risky business of lending and borrowing. They are typically highly leveraged businesses in two important senses. The amount of cash they hold in reserve against their deposit liabilities that may be withdrawn without notice is a minimal one – the legal requirement may be as low as a 2.5% reserve of cash against deposits. Banks will also hold equity capital as a reserve to cover losses on their loan book. This reserve ratio is also regulated to be as much as a 15% capital to asset ratio.

After the GFC most of the banks of the world behaved very untypically. They held onto much of the cash and did relatively little extra lending. They held cash reserves far in excess of the regulated reserve requirements as may be seen of the US banks in the figure below. The supply of cash was increasing at enormous rate after the GFC. But so was the demand to hold those reserves. Perhaps because the banks had become very risk averse in the aftermath of the GFC and held much larger cash reserves to feel safer. They did moreover receive interest on these deposits from the Fed. Competitive with the low money market rates available. No doubt this was further encouragement to hold on to cash

Bank credit grew relatively slowly in the US after the GFC and despite the surge in central bank money. as did the deposit liabilities of the US banks which are registered on the other side of their balance sheets. Thus the increase in the supply of central bank money, sometimes known as the money base (MB) or M0, did not lead to any dramatic increase in bank lending and spending associated with such extra lending. It was not inflationary as it turned out.

Recent money supply trends

In the figure below it should be noted how the money base (M0) in the US peaked in 2014 and then declined rapidly in 2018 – as QE was reversed. In late 2019 it rose sharply again to support the banking system that was found unexpectedly short of cash that put unwanted pressure on inter-bank lending rates. The most recent Corona virus-inspired surge in the money base can also be seen. The supply of currency by contrast has increased at a very steady rate- in response to the demands for dollar bills- in and outside of the US.

Fig. 1; Liabilities of the US Federal Reserve System.

Source; Federal Reserve Bank of St Louis (Fred) Investec wealth and Investment

We show the asset side of the US Fed Balance sheet in the chart below. (figure 2) As may be seen most of the growth in assets – and liabilities – was the result of the Fed purchase of US Treasury Bonds in the capital market. The other assets of the Fed include loans made to banks and mortgage backed securities issued by government agencies.

Fig.2; Total Assets of the Federal Reserve Bank System and Holdings of Treasury Bills and Bonds

Source; Federal Reserve Bank of St.Louis. Investec Wealth and Investment

These Fed holdings of securities issued by the US Treasury have gained an important share of all the debt incurred by the Federal Government – currently the Fed share is around 12% of all US government debt – as we show in figure 3 below.

Fig.3; Federal Debt and US Government Debt held by Federal Reserve System

Source; Federal Reserve Bank of St.Louis. Investec Wealth and Investment

Increased Treasury Bond holdings of this magnitude have surely helped to reduce the interest rates paid on US Treasury Bonds. Since the Federal Reserve Bank of the US, while it keeps a separate set of accounts and balance sheet, is a wholly owned agency of the Federal Government. If we consolidated their balance sheets and set off the Reserve Bank’s holdings of Treasuries against the total Fed debt, we would reveal a reduction in outstanding Federal debt, replaced by the increased deposit liabilities of the Federal Reserve Banks. In other words cash – irredeemable non-interest bearing government debt – that is issued by the government or rather its central banks without interest – replacing interest bearing debt. Though, when the interest paid on government debt, short and long dated, is very low- close to zero- as it is now in the US – the distinction between debt and money is largely irrelevant from the perspective of the issuer incurring the liability and not paying (much) interest

Explaining why bank deposits are a multiple of central bank money- but limited by it.

Central bank money, currency and cash reserves in the form of deposits with the central bank can be described more evocatively as “high powered money”. This is because the bulk of the money held and used to pay for goods and services is supplied by the private banking system in the form of transaction balances (deposits) held with them and exchanged on the instruction of depositors. The loans and advances banks make may flow from one bank to another. But the money loaned mostly stays with the banking system. They arrive as deposits with other banks or even as another deposit of another customer of the bank making the loan. The funds lent, borrowed and spent do not drain away from the domestic banking system, except when withdrawn as notes or deposited in a foreign banking account.

It is the cash reserves held by banks that sets the theoretical limit to the sum of the loans in one form or another that the banks may make. It therefore sets the limits to the so -called money multiplier – the multiple ratio of broadly defined money – known as M1 M2 or M3 made up of bank deposits of various kinds from transactions balances to longer term deposits- to central bank money.

That ratio or multiplier as we show below was of the order of 14 times in SA M3/M0 or 8 times in the US M2/M0 before the GFC. It collapsed in the US to about 3 times as the demand of the banks to hold a much greater reserve of central bank money was exercised by the US banking system. It has increased recently to about four times the money base or M0. See figures 3 and 4 below.

South African banks by contrast with their US hold very little by way of excess cash reserves – cash reserves in excess of the regulated ratio- some 2.5% of deposit liabilities. Rather than holding excess reserves SA banks consistently borrow significant sums from the Reserve Bank to meet their demands for cash as we will demonstrate below. SA banks were not caught up short of cash in the GFC. They are now very much caught up in the crisis caused by the responses to the Corona virus. The loans they have made will not be easily serviced when their borrowers are not able to realise any revenue. Solvency and a lack of liquidity will threaten them as much in SA as it will do anywhere else.

Fig 4; South Africa Narrow and Broader definitions of the Money Supply and the money multiplier

Source; SA Reserve Bank and Investec Wealth and Investment

Fig.5; US Money Supply and the money multiplier

Source; Federal Reserve Bank of St.Louis. Investec Wealth and Investment

Private banks do not create money- they supply deposits that act as money at a cost – and not necessarily profitably

While these bank deposits can be measured as a multiple of the cash supplied to the system this does not mean that the banking system can “create deposits” in some magical, costless way. Supplying deposits to the system and maintaining the payments system to which a deposit account gives access, is a costly exercise. It takes computer systems and ATM machines and premises and people to manage the system and also equity capital that might be better employed in other businesses. And loans may not always be repaid. Banks may go broke if their bad loans exceed the value of their equity which may only be equivalent to 10-15 per cent of their loans and advances. And they may also go under if they cannot meet a run on the bank- a demand for cash in exchange for their deposits – which is their contractual obligation. Only the central bank can create money at will and without cost. The difference between private banks who supply deposits at a cost – and the central bank who can create money without cost is a fundamental one.

The limits to the size of a banking system- the aggregate value of its assets and liabilities -will be determined in any full analysis of the determinants of its size, by its profitability. Profitable banks grow their assets and their deposit liabilities – unprofitable banks shrink away. The profitability of a bank is enhanced by leverage – minimising as far as responsible its cash reserves and equity capital. Banks are typically highly leveraged businesses. But risk of failure in all enterprises comes with leverage and prudence may limit lending activity, and may have to mean larger cash and capital reserves, fewer loans and so reduced profitability and so a smaller money multiplier -as has been the case in the US since the GFC.

The habits of the customers of the banks, how much they prefer to use notes to make payments rather than accept bank deposits as payment, will also influence the cash reserve ratios of the banks and so the volume of their lending. The money habits of the community – a preference for money in the bank rather than in the pockets or purses or in offshore banks – may change only gradually over time- so limiting the growth over time in the banking system. The relative importance of a banking system might be measured as the ratio of bank assets and liabilities to GDP in money of the day prices. As may be seen in the figure below the real role of banking in the US and SA economies is not dissimilar- with M2 running at about 50 to 60 per cent of GDP. The SA ratio however increase markedly between 1980 and 2010. The US money to GDP ratio was stable even declining between 1990 and 2008, suggesting a relatively less important role for banks in the US economy, but has increased in since the GFC as may be seen in figure 6 below.

Fig.6; The Money (M2) to GDP ratios in SA and the US. Measuring the real importance of private banks.

Source; Reserve Bank of SA, the Federal Reserve Bank of St.Louis and Investec Wealth and Investment.

An economy depends on a thriving profitable banking system – able to support growing businesses with convenient credit and a payments system. Zombie banks – undercapitalised banks -that survive only on government and central bank life support – are not helpful for economic growth. They are poorly capitalised because they have not earned enough income to retain cash with which to augment their reserves of equity capital.

Furthermore it should be appreciated that every deposit made with a private bank represents a real saving – of consumption spending – however temporary. Banks pool these savings to make them available to borrowers. Money in the bank is as much a saving- a reduction in potential spending out of income or wealth – as a contribution to a pension fund. It is a more liquid form of saving, they are savings more easily cashed in for goods, services or other assets at a certain money value. Cash is an important component of any wealth portfolio and part of the working capital of any business.

However what is true of the deposits of a private bank that act as money in competition with the notes issued by the central bank – that they are costly to produce- is not true of the cash issued by a central bank. Such cash is almost costless to produce and can be supplied in unlimited quantities. It is convertible only into the same government sanctioned cash.

Why not fund government spending with cheap money? Responses to QE as the exception not the monetary rule.

Why then should any government restrain the amount of money it creates that costs so little to produce? Why do governments fund their deficits from the market place rather than via their own central banks? The value of a currency that can be issued without limit is based on a trust that it will retain to a least some degree, or at least temporarily retain its purchasing power, that is its value in exchange. Otherwise it is not very useful.

The limits to issuing money, is that issuing too much of it – more than would be willingly held as a reserve of purchasing power – is that the money created would consistently and even rapidly lose its value in exchange. That is it would cause inflation – defined as a continuous increase in the price level – and a persistent decline in the foreign exchange value of the currency and its purchasing power. This is usually not a politically popular outcome and so it is to be avoided. Hyper inflation is moreover highly destructive of the real economy.

Economies may adapt to moderate inflation- say inflation that runs between five and fifteen per cent per annum- especially if the rate of inflation though high becomes predictable. But inflation trends may easily slip higher should government come to rely more permanently and heavily on printing money rather than raising taxes or borrowing in a genuine way in the capital market. Inflation and currency depreciation would follow should the supply of central bank money consistently exceeded the demand of the public and the banks to hold that central bank money as a reserve.

QE after 2008—09 representing an extraordinary increase in the global supply of central bank money did not cause inflation because much of the extra cash issued was willingly held by the banks. Had the banks used the extra cash to make additional loans the supply of deposits (money broadly defined) and the supply of bank credit would have grown proportionately – say at the eight times multiple normal before the GFC. And spending would have grown much faster than it did with the aid of much more bank credit and prices would have risen much faster than they did. Thus it is not the supply of money that automatically leads to more spending and higher prices. It is the excess supply of money- central bank money- over the demand to hold that money that causes bank credit to increase and prices to rise.

Time will tell what use is made of the extra cash created to fight Corona Virus. Will it be held mostly as additional cash reserves by the banks? Or will it stimulate a burst of extra bank lending and a multiple creation of deposits and a rapid expansion of bank credit and the extra spending associated with freely available bank credit? That is prove more inflationary than QE was last time round- post the GFC? The reactions to QE in SA – the scale of it and the trends in money supply and bank credit will be of particular interest.

The case of SA – how much QE will and should be undertaken?

There is no doubt that a large gap will open up in South Africa between the output and incomes that might have been produced without the lockdowns and what will be produced. The output gap will be a very large one. Perhaps the equivalent of 25% of one years GDP will be sacrificed to the cause of defeating the Corona virus. It will be a very large loss to bear. And much like the losses to be incurred in all the economies subject to lock down.

How much income will actually be sacrificed will depend in part on how much the SA government spends on relief measures and how much the Reserve Bank supports the government and private sector with extra cash. The more support provided to the economy in one way and another by the government and the Reserve Bank, the more demand for goods and services can be exercised and the smaller will be the eventual loss of output as supply responds as best it can. Any reduction in economic damage of the large likely order expected is a clear gain to the economy. Given the size of the output gap and a general lack of demand for goods and services, inflation in SA is very likely to remain subdued. This surely a time to be concerned about the lack of output and incomes, not that prices may be rising faster at some time in the future.

Any additional utilization of what would otherwise be wasted capacity- human and material- comes without real economic cost. That extra demand can bring forth extra supplies would be pure gain to the economy, especially if funded with central bank money. The Keynesian argument for extra spending by government, funded as cheaply as possible, holds very strongly when supply and demand in the economy can be confidently predicted to decline significantly- as it will in SA during the lock down.

It is not clear that the Reserve Bank sees the SA predicament in this same urgent way. In the way central banks in the developed world are recognizing the role they can play and acting accordingly. The SA Reserve Bank has every opportunity to create more of its own money without any cost. In order to help borrowers, and to assist the banks and the government, but also to support hard pressed private businesses through its lending programmes. Unlike its peers in the developed world it also has scope to significantly lower short-term interest rates. All the way close to zero would make sense to help make up some of the output sacrificed with the lock down.

The Reserve Bank should not be hesitating to act boldly. Any inflation that may come along later with a recovery in the economy will have to be dealt with in its own good time. Money created can be as easily removed from circulation when the economy has closed its output gap. And a wider fiscal deficit can be temporary rather than permanent when economic normality is regained. The case for the SA government to limit its spending and fiscal deficits over the long run remains as strong as ever. But not for now. It calls for calm wisdom and good judgment. Unusual times call for unusual responses. Let us hope the SA Reserve Bank is up to the challenge.

[1] As described by Keynes. John Maynard Keynes was the originator of depression economics. He provided the justification for governments to spend more to overcome a lack of spending that caused the great depression in the nineteen thirties. And for which there appeared no self-correction. He inspired a highly influential school of economics known as Keynesians. His argument for stimulation through government spending rather than monetary policy was that interest rates could not fall far enough to encourage enough capital expenditure. But he never, as far as I am aware, advocated printing money to fund extra government spending. While logical enough to use money to fund government spending if the depression was a deep one, he knew such a proposal would be politically unacceptable. For fear of inflation of the Weimar republic that was not far from memories in the nineteen thirties when Keynes developed his ideas..

Has the US market crash fully discounted the permanent loss of earnings?

Does the reduced value of the S&P 500 reflect the earnings permanently lost after the coronavirus? We give a provisional answer.

The tribe of company analysts is hard at work revising the target prices (almost all lower) of the companies they follow. They will be adjusting the numerators of their present value calculations for the permanent losses of operating profits or free cash flow caused by the lockdowns. They will attempt to estimate the more long-lasting impact on the future performance of the companies they cover, after they get back to something like pre-coronavirus opportunities.
What discount rate will they apply to the expected post-coronavirus flow of benefits to shareholders? Will it be higher for the pandemic risk or lower because long bond yields are expected to remain low for the foreseeable future? When they have revised their target prices for the companies they cover, we could theoretically add up how much less all the companies covered by the analysts are now estimated to be worth. We would count the total damage to shareholders in trillions of US dollars since 1 January.

The analysts are taking much longer than usual to revise their estimates of forward earnings and target prices. But investors in shares are an impatient lot. They are making up their own collective minds, also with difficulty, as the turbulent markets and the high cost of insuring against market moves shows.

The companies listed in the S&P 500 Index were worth a collective US$28.1 trillion on 1 January 2020. By 23 February, when the market peaked, they had a still higher combined market value of US$29.4 trillion. By 23 March, the market had deducted nearly US$10 trillion off the value of these listed companies. Yet by 17 April, the market had recovered strongly from its recent lows, and was worth US$24.6 trillion, or US$3.5 trillion less than the companies were worth on 1 January. Is this too low or too high an estimate of permanent losses?

Figure 1: The market value of companies listed in the S&P 500, to 23 April 23 2020

Source: Bloomberg and Investec Wealth & Investment

We will try to answer these questions. First, we attempt to estimate the damage to S&P reported earnings. These lost earnings can be compared with the losses registered in the market place, the US$3.5 trillion of value destruction. To do so, we first extrapolate S&P earnings beyond 2019, using a time series forecasting method. This forecast is used to establish the S&P earnings that might have been, had the economy not been so cruelly interrupted. We then estimate the earnings that are now likely to be reported, by assuming a loss ratio. That is the ratio between the earnings that we predict will be reported as a ratio to the earnings that might have been, had the US not been disrupted by the coronavirus.

As we show in the figure below, the reduction in reported earnings is assumed to be very severe in Q2 2020, when earnings to be reported in Q2 are assumed to be equivalent of only 25% of what might have been had the earnings path continued at pre-crisis levels. Then the loss ratio is assumed to decline to 30% in Q3, 50% in Q4 2020, and 75% in Q1 2021, where after it is estimated to improve by 5% a quarter until the earnings path is regained in Q2 2022.

The calculations are indicated in the charts below. The total accumulated loss in earnings under these assumptions would be a large US$3.4 trillion. It will be seen that the growth in estimated S&P 500 earnings turns positive, off a very low base, as early as Q2 2021. The key assumption for this calculation is the loss ratio, as well as the time assumed to take until back to the previous path. The more elongated the shape of recovery and the greater the loss ratios, the more earnings will be sacrificed.

If this assumed permanent loss of over US$3.4 trillion were subtracted from the pre-coronavirus crisis value of the S&P 500 of US$28 trillion, it would bring the S&P roughly to the value of about US$24 trillion recorded on 17 April.

Figure 2: The quarterly flow of S&P earnings in billions of US dollars

Source: Bloomberg and Investec Wealth & Investment

Figure 3: Estimated quarterly loss of earnings per quarter (billions of US dollar) and growth in estimated earnings (year-on-year) 2019-2022

Source: Bloomberg and Investec Wealth & Investment

How much S&P 500 gross earnings will be lost permanently is still to be determined with any degree of confidence. The US$3.4 trillion loss we estimate is consistent with the losses recorded to date in the market value of the S&P 500 companies. The environment after the coronavirus and the impact of the new political economy will have to be considered carefully when assessing the long-term prospects for businesses. As always, the discount rate applied to future economic profits will have a decisive role to play in determining the present values of companies.

Monetary policy in South Africa – Carpe Diem

Published in Business Day 17. April 2020.

The SA government will double its fiscal deficit in response to the Coronavirus crisis and its impact on output and incomes. The losses in output and incomes from the lock downs may be of the order of one trillion rand of sacrificed output and incomes. They will certainly be large, perhaps as much as one trillion rand of lost output, or the equivalent of 25% of GDP in 2019. We can only hope the extra government spending is highly effective and well directed to minimize the damage caused. It will help close the output gap, the difference between much lower realized GDP, and what might have been GDP, without the lock downs. Encouraging more demand for goods and service will helpfully also increase the supply of them and increase incomes accordingly.

A spirit of generosity rather than any niggardliness is the right way for the government to approach its responsibilities for the economic damage it has inflicted. It should however be made very clear that whatever relief it offers and how offered is temporary in its nature. It is an urgent response to a grave emergency. Policies for the long term remain to be determined in the usual considered way, subject to all the usual due process. We are hostage to a crisis – not to the future.

The government should therefore hope to raise the emergency funds it intends to spend as cheaply as possible. This means borrowing at the short end of the bond market at very low rates of interest- as close to zero as we can get them. And we can get these short-term interest rates as low as we choose to set them. The shortest and cheapest way to fund the surge in spending would be to create money to the purpose. This is what every central bank in the developed world is doing enthusiastically and without shame. We should be doing the same as unapologetically.

The developed world faces much lower long-term interest rates than we do. They can issue long term date without paying much interest at all. And their borrowing costs are as low as they are because of the willingness of their central banks to buy vast amounts of government bonds in the market. This process now known as Quantitative Easing (QE) is money creation by another name. Their central banks are doing vastly more bond buying and additional lending to banks and businesses in response to the economic threat posed by Coronavirus. And they are creating much more money and holding down the interest their governments must pay for funds.

Addditional central bank money comes mostly in the form of bank deposits held with a central bank. The supply of money in SA increases every time the Reserve Bank makes a loan to a bank or buys foreign exchange or government securities in the market. Money in the form of additional bank deposits(cash) held with the Reserve Bank would also increase should the Treasury draw on its own considerable deposits with the Reserve Bank to make payments. It has over R160b in its deposit account with the Resbank and presumably does not need Reserve Bank permission to draw upon. If so it can do its own money creation.

The high cost of the RSA borrowing on a long term basis – 10% p.a. to borrow rands for ten years – is even more reason for us now to rely on the central bank to assist in a sensible funding plan for Corona virus relief. It means bringing down short rates further and sharply. And making enough extra cash available to the banks and other eligible borrowers on favourable terms, so that the banks can fully support the market in issues of short dated, low interest paying, Treasury Bills and Bonds. Supporting issues of short term debt that will and should be growing rapidly to fund the extra spending. We should fully eschew long term borrowing for now and replace maturing long term debt with short.

All the world including SA will be set for a post-Coronavirus battle over the future scope of government spending. On how much the government should intervene. The left will want more intervention – more spending – more regulation – more taxation of the wealthy – and will fudge the dangers of relying on central banks to cover larger fiscal deficits. Monetising government is very likely to be inflationary if done permanently on a large scale. But it will not be inflationary in SA for now- not until after the crisis. When we can get back to a new normal- that will include sensible monetary and fiscal policy.

Time for the Reserve Bank to seize the moment

How are governments and their central banks responding to the damage from the lock downs forced upon their economies and their citizens? They are doing all they can to minimize the damage to incomes sacrificed during the lock downs. There is no reluctance to spend- the issue is not about how much but rather how best to spend. Restraints on fiscal deficits and money creation have been abandoned – and rightly so in the circumstances.

When so much central bank lending is to the government, even via the secondary market replacing other lenders, the distinction between monetary and fiscal policy falls away. The British government made this clear when it exercised its right to a large overdraft on the Bank of England. The Bank could not and would not say no to such a demand for funding, giving the state of the Kingdom. The US Fed has added over 2 trillion dollars of cash to the US banking system over the week to April 10^th. That is increased its balance sheet by 50% over a very busy week. The federal government has budgeted for trillions of dollars of extra spending- including spending to cover possible losses on the Fed’s loan book.

Issuing money is usually the cheapest way for any government and its taxpayers to fund such emergency spending. Though when interest rates on long term government debt is close to zero – more so if interest rates are negative – as in the developed world- issuing debt is almost as cheap as issuing money. Though where would interest rates settle without the huge loans provided to governments and banks by their central banks?

This is not the case in South Africa and many other emerging economies. Issuing long term debt at around 10% p.a. is an expensive exercise. Issuing three-month Treasury Bills at 5% p.a is also expensive. For central banks to create money for their governments and tax-payers is a much cheaper option. Is there not the same good reason for them to support government credit in the same exceptional circumstances as vigorously as is being done in the developed world to universal investor approval?

There is every reason for the SA government to rely heavily on its central bank at a time like this. With the same proviso as applies in the developed world. That is when the economy is again running close to its potential the stimulus should be withdrawn to avoid inflation. That test however will come later. There is an immediate challenge to be met now. And spending and lending without usual restraint is rising to the challenge.

How much economic output and income will be sacrificed over the period of the lock-down and the gradual recovery after that? A broad- brush comparison between what might have been without Corona and what may yet happen to the SA economy can be made. The loss in output as a result of the shut downs – the difference in what might have been produced and earned had GDP performed as normal in 2020 and 2021, and what now – post Corona- is likely to be produced has been estimated as follows.

We first estimate economic output and incomes (GDP at current prices measured quarterly) had the economy continued on its recent path unaffected by Corona. To do this we use standard time series forecasting method. That is to extrapolate what might have transpired had GDP in money of the day continued to grow at its very pedestrian recent pace of about 4- 5 per cent per annum. GDP inflation in recent years has been of the order of four per cent per annum meaning indicating very little real growth was being realized as is well known. We then make a judgment about how much of this potential output will be lost due to the shutdowns. We estimate a GDP loss ratio for the quarters between Q1 2020 and Q4 2021 to calculate this difference between pre and post Corona GDP.

The cumulative difference – the lost output and incomes over the next two years we estimate as of the order of R1,071,486 millions – that is approximately R1 trillion of lost output will be sacrificed to contain the spread of the virus. This one trillion is equivalent to approximately 24% of what might have been the GDP in 2020. (See figures below)

GDP and GDP after Corona (Quarterly Data Current Prices)

Source; SA Reserve Bank and Investec Wealth and Investment

The loss ratio – the percentage of the economy that remains after the shutdown is the crucial judgment to be made. We have assumed that the economy operated at 95% of its pre-Corona potential in Q1 2020. Then as the impact of the lock down intensifies through much of Q2, the economy it is estimated will utilize only 75% of capacity in Q2. This, it is assumed, will be followed by somewhat less damage in Q3 when the economy is assumed to be operating at 80% of potential capacity as the lockdown is gradually relieved. Conditions are then expected to continue to improve by the equivalent of 5% each quarter. That is until the economy gets back to where it might have been without the lock downs assumed to be in the second quarter of 2021.

This almost V shaped recovery might well be too optimistic an estimate. The losses in 2020 may well be greater and the recovery slower than estimated. But the output gap – the difference between what could have been produced and what will be produced, for want of demand as well as ability to supply, will be a very large one.

Loss of Output Ratio – GDP Adjusted/GDP Estimate (pre-Corona)

Source; SA Reserve Bank and Investec Wealth and Investment

Estimated Loss in GDP per Quarter (R millions) Sum of losses 2020-2021 = R107146m

Source; SA Reserve Bank and Investec Wealth and Investment

The pace of recovery will depend in part on how much the government spends and how much the Reserve Bank supports the government and private sector with extra cash. The more support provided to the economy in one way and another by the government and the Reserve Bank, the more demand will be exercised and the smaller will be the eventual loss of output. Any reduction in economic damage of the large likely order estimated is a clear gain to the economy. Any additional utilization of what would otherwise be wasted capacity- human and material- comes without real economic cost. That extra demand can bring forth extra supplies would be pure gain to the economy, especially if funded with central bank money.

It is not clear that the Reserve Bank sees the SA predicament in this same urgent way. In the way central banks in the developed world are seeing and acting. It has the opportunity to create more of its own money without any cost – to help borrowers –not only the banks and the government but also private businesses directly through its lending. Unlike its peers in the developed world it also has scope to significantly lower short-term interest rates. All the way close to zero would make sense. It should not be hesitating to act boldly. Any inflation that may come along later with a recovery in the economy will have to be dealt with in its own good time.

Post-Script on Growth Rates They will not mean what they usually do post the crisis.

GDP growth rates are most often presented as annual percentage growth from quarter to quarter when the GDP has been adjusted for seasonal influences and converted to an annual equivalent That is growth from one quarter in seasonally adjusted GDP to the next quarter raised to the power of 4. This is the growth rate that attracts headlines. (Q1 is always a below average GDP quarter)

Two consecutive negative growth rates measured this way are regarded as indicating a ‘technical recession’. The implication of this measure is that quarterly growth will continue at that pace for the next year. Clearly under the influence of lock downs growth measured this way is likely to become much more variable than it usually is.

This will be especially true in Q2 2020 when the impact of the lock down will be at its most severe- maybe reducing annual growth to an annual equivalent negative rate of growth of 50% or so. Estimating growth on this quarter to quarter basis over the next few years will be a very poor guide to the underlying growth trends. It may show a very sharp contraction in Q2 2020 to be followed by positive growth of 40% p.a. in Q3 and Q4, 10% in Q4 and then as much as 50% again in Q2 2021. The recession will seemingly have been avoided and the economy will soon be recording boom time growth rates. A likely and highly misleading account of what will be going on with the economy it must be agreed.

If GDP is compared to the same quarter a year before we will get a much smoother series of growth rates. It is likely to show negative growth throughout 2020, (down by as much as -20% p.a in Q2) with strongly positive growth of 30% only resuming in Q2 2021, off a highly depressed base of Q2 2020 when the lock down was at its most severe.

The better way to calculate the impact of the lock down in terms of growth rates would be to calculate the simple percentage change in GDP from quarter to quarter as the impact of the lock down unfolds and gradually, we hope, dissipates. The worst quarters measured this way will be Q2 and Q3 2020 after which quarter to quarter growth in percentage terms will become positive.

Estimated Quarterly Growth rates between 2020 and 2022 under alternative conventions.

Source; SA Reserve Bank and Investec Wealth and Investment

The upshot of this is that growth rates will not be able to tell what has happened to an economy subject to a severe supply side shock – that is temporary in nature. Measuring in absolute terms , in money of the day GDP sacrificed each quarter, as we have attempted to do will tell the full tale of economic destruction.

GDP Normal GDP Adjusted for Corona. R million Aggregate Losses R835b GDP at Current Prices= 5888b in 2019 -Approximately 14% of one year’s GDP

Quantitative Easing and the money supply process- will it lead to inflation this time round?

Central Banks around the world are launching a new phase of accelerated money creation now known as Quantitative Easing or QE. They are doing so in response to the economic contraction caused by the Corona Virus and the lock downs of economic activity intended to limit the spread of the virus. The scale of this QE and its consequences for economic activity asset prices and inflation are still to be revealed.

Click to read the full paper here.

What a difference a week makes – to all of us and the Reserve Bank

An extraordinary week has passed. When the government ordered and prepared for a shut-down of much (how much??) economic activity to deal with the health crisis. All, including the participants in capital markets, have tried to come to terms with the evolving realities at home and abroad. And it was a week when the SA Reserve Bank moved from conventional to unconventional monetary policy.

The Bank at its monetary policy proceedings on the 17^th March reported in an explicitly conventional way. It cut its key repo rate by an unusually large 100bp- on an improved inflation outlook. By the 25^th March it was practicing Quantitative Easing (QE) buying RSA bonds in the market to reduce “…excessive volatility in the prices of government bonds…” and freely providing loans to the banks of up to 12 months.

The Bank is therefore creating money of its own volition. Cash reserves, that is deposits of the private banks with the Reserve Bank, are created automatically when the Reserve Bank buys government bonds and shorter-term from the banks or its customers. These deposits serve as money – and are created without any cost to the issuer- the central bank- acting as the agent of the government. These additional cash reserves support the balance sheets of the banks. And could lead to extra lending by them, as is the intention

Had the Reserve Bank not acted as it did, the bond market would surely have remained volatile. But more importantly it might not have been able to absorb a deluge of bonds and bills that the government would be issuing to fund its emergency spending. Including coping with a draw-down of R30b of bonds sold by the Unemployment Insurance Fund to generate cash for the government to spend on income relief.

The yield on the 10 year RSA was about 9% p.a. in early March. By March 24^th it was over 12% p.a. and declined marginally in response to the Reserve Bank intervention. The derating of SA credit by Moody’s on the Friday evening, after the market had closed, seemed inevitable in the circumstances. On the Monday morning the yields on long dated RSA bonds jumped higher on the opening of the market and then receded and ended as they were at the close on Friday (see figures below)

RSA Five and Ten-Year Bond Yields Daily Data 2020 to March 27th

Source; Bloomberg and Investec Wealth and Investment

RSA 10 year Bond yield 26 -30 March Intra day movements

Central banks all over the world are also doing money creation – in very great quantities. Doing so as a predictable response to their own lock downs and collapse of economic activity and its threats to financial stability. But in the developed world they deal for bonds and other securities at much lower interest rates. Though no doubt the scale of their bond and other asset buying programmes (QE) is part of the explanation for very low yields – both short and long. Yet despite money creation on a vast scale more inflation is not expected in the developed world.

Not so in SA as we have indicated and in many other emerging markets. Issuing longer dated government bonds in their own currencies is a very expensive exercise. And has become more expensive post Corona.

Lenders to emerging market governments, in their own currencies, demand compensation for high rates of inflation expected, and receive compensation for the inflation risks There is always the chance that the purchasing power of interest income contracted for, and the real value of the debt when repaid, will be eroded by inflation of the local currency.

The danger is that fiscally strained governments will, sometime in the future, yield to the temptation to inflate their way out of the constraints imposed by bond investors. By turning to their central banks, to fund their spending to a lesser or greater degree, rather than to an ever more demanding bond market. Issuing money (creating deposits) at the central bank to finance spending carries no interest cost. It can be highly inflationary depending on how much money is created and how quickly the banks use the extra cash to extend loans to their customers.

The growing risk that SA would get itself into a debt trap and create money to get out of it has been the major force driving long-term RSA yields on RSA debt higher in recent years. Higher both absolutely and relative to interest rates in the developed world. Bond yields have risen for fear that SA would create money for the government to spend in response to ever growing budget deficits and borrowing requirements and a fast-growing interest bill. As the SA government has now done with the co-operation of the Reserve Bank- though in truly exceptional circumstances and justifiably so.

Avoiding the debt trap, controlling budget deficits and convincing investors and credit rating agencies that the country can fund its spending over the long term without resort to money creation, is the task of fiscal policy. For SA to regain a reputation for fiscal conservatism and an investment grade credit rating is now more unlikely than it was when a promising realistic Budget was presented in February.

The Reserve Bank may hope to control domestic spending and so inflation through its interest rate settings. It does not however control inflation expected and so the interest rates established in the bond market. The more inflation expected the higher will be interest rates. Expected inflation over the long run is dependent in part on the expected fiscal trends and the likelihood of a resort to money creation. And these fiscal trends, thanks to Corona virus, have deteriorated as they have almost everywhere else.

How therefore should the government and the Reserve Bank react to current conditions in the bond market? Long term yields are unlikely to recede significantly; and the yield curve is likely to get steeper should the Reserve Bank reduce its repo rate further – as it is likely to do.

The government should therefore fund as much as it can at the cheapest, very short end of the capital market. To issue more short dated Treasury Bills to fund current spending and to replace long dated Bonds as they mature with shorter term obligations. It will save much interest this way. The actions of the Reserve Bank by adding liquidity (cash) to the money market through QE will have made it much easier to borrow short from the banks and others.

And when the economic crisis is behind us it will remain essential to strictly control government spending to regain access to the long end of the bond market on more favourable terms. Only the consistent practice of fiscal discipline will deserve and receive lower longer-term borrowing costs.

The Corona virus is much more than a health crisis

Nobody knows with any degree of confidence how long the economic disruption caused by the responses to the Corona virus will last. And just how much output and income and wealth (savings) will have been sacrificed.

The survival of any business that services crowds of people is gravely threatened as the Chinese lock-down approach to limit infections is widely adopted. Collateral damage to those enterprises and the large number of self-employed who depend upon opportunities to earn income generated by airlines and airports, cruise ships, hotels, shops, restaurants, theatres, conference, sporting events and their like, even retailers, will be considerable. Including damage to the banks and others who provide them with credit. The margin of safety for many businesses and the self-employed is always very narrow. They will need financial reserves as well as assistance from governments to survive the turmoil.

Perhaps as much of 10% of one year’s global incomes and output will be sacrificed to contain the virus. This is an enormous sacrifice that is being made to overcome a virus that we are informed is not that morbid and comes with limited mortality risk. Currently 180,000 people around the world have been infected. Many have now recovered. The number of victims will surely rise – perhaps treble – before the tide turns if the Chinese evidence is relevant.

What we will never know with any certainty is how many infections and deaths will have been avoided as a result of the shutdowns. Some heartless economist will no doubt attempt to calculate the cost in GDP sacrificed for each death avoided- as well as the present value of the lives saved in the form of future earnings -the narrow economic benefit of saving – mostly old lives. It will be a very large number.

It is obvious that any such cost-benefit analysis has not informed policy in any way. Admirably only potential benefits, numbers of lives saved, have driven the responses made. And taking the pressure off health systems that would otherwise have been overwhelmed by the number of supplicants has been the means to the end of saving more lives. Perhaps when the dust is settled the issue of how to develop a health system capable of responding to an emergency of this kind will be addressed – as a more effective solution than putting people off work.

It is a however a generous response that only a relatively well-endowed society with a large reserve of spending power could possibly make. Without such a reserve to provide relief to those unable to earn any income would suffer terribly for want of life’s essentials. And using the reserve to keep businesses and banks afloat so that they can fight another day also makes good economic sense.

The government spending and financial taps are therefore being opened wide- wider than ever. Central banks are not only creating money to buy government bonds they are also buying shares in businesses and securities issued by them. And are offering loans on generous terms not only to banks but directly to businesses. Taxes are being relieved and postponed and access to unemployment benefits widened. Aid to businesses, for example airlines, will be provided on a large scale. The extra spending so facilitated will reduce the loss of output. It will help pay for itself.

South Africa and too many South Africans have little by way of reserves against economic disasters. Our fiscal space is highly constrained as our Budget proposals have made clear. And raising debt to fund extra spending has become even more expensive for SA after the crisis. Yet monetary policy in SA has lots of room to help our economy. There is room for the Reserve Bank to cut interest rates significantly and to offer financial support for banks and businesses. Our frail economy will need all the help it can get. Let us hope that the Reserve Bank can think – must think and act- beyond the narrow inflation fighting box it has hitherto confined itself.

Appraising the Budget- will the economic future be much better than the past?

The 2020 Budget tax and expenditure proposals are steps in the right direction for the SA economy. Holding the line on real government spending and avoiding a growth defeating increase in tax rates, is part of the right mix of policies.

The SA economy is hostage to fortune as well as to its economic policy proposals. Market reaction to the Corona virus overtook the Budget proposals that were initially well received in the market place. RSA 10 year bond yields were 8.76% p.a the day before the Budget on the 26^th February and 60bp lower immediately on the Budget news. They were up to 9.1% on the 2^nd March. They then declined to 8.76% on March 4^th after the Fed in a Corona pre-empt, cut its benchmark rate by 50bp and US 10y Treasury Bond yields went below 1%

RSA bonds are not a safe-haven asset for investors inside and outside the country as are US Treasuries and the dollar itself. Yet were SA to be convincingly judged to be avoiding the debt trap and its money creation and inflationary dangers, taxpayers will gradually be rewarded with lower interest rates and interest expenses on their RSA debts. Global events that are now adversely affecting all EM borrowers and their currencies notwithstanding

The continued failures of the SA economy are elaborated upon in full grim even pious detail in the Budget Review. Some Treasury mea-culpa would however be entirely appropriate for what has gone so badly wrong on the Treasury watch. Most egregious was the failure to recognize and contain operating costs at Eskom. And earlier to have permitted the explosion of public sector employment benefits in the boom years after 2005. We could have done with a Sovereign Wealth Fund then, reinforced by successful BEE partnerships with it.

The Budget Review contains a broad reform agenda. Including most helpfully bringing the employment benefits of government employees back in line with “ .. the rest of the economy….” and promises legislation to “…eliminate excessive salaries and bonuses being awarded to executives and managers…” in the public sector that are indefensible. Eliminating the state’s “… complex and often ineffective procurement system. ….” is a reform long overdue. And the intended reform of the exchange control system to best OECD practice is especially welcome for the wealth friendly signals it emits. Undertaking the “…urgent regulatory reforms of the Ports …” would be a good step. But not only corporatizing the ports and cutting them loose from Transnet but allowing them to compete with each other for custom would be much better for the economy.

Staying well out, as intended, of the “….exports of intellectual property..” will greatly encourage the creation of IP. To “ Reduce the corporate tax rate” in line with the competition and eliminating many of the complex tax allowances is essential. It is these complications that are responsible for “…South Africa’s tax incentive system…” that “…favours incumbents and those able to afford specialist tax advice…”

Eliminating the extraordinarily large R600b liability for Third Party accidents of the Road Accident Fund (RAF) as was alluded to in the Budget Speech, would improve the State balance sheet. R2 per liter paid at the pump for the RAF could then be saved by households and businesses. Private insurance companies are more than capable of offering compulsory third-party cover at competitively determined rates. And capable of effectively contesting damage claims in court.

A debt for equity swap with Eskom debt holders is essential to the purpose of making it financially viable- otherwise a further R112b will be coming its way, on top of the R62b provided to date. And with no guarantees that operating results will improve.

Debt swaps on agreed terms that introduced influential private shareholders to help govern the company will make Eskom economically viable. It would reward its managers conditional on improvements in return on capital. And pay them well enough – which is the usual private sector method for adding economic value.

Wallowing in despair at the highly unsatisfactory economic condition of SA is not helpful. Past failures can be seen as providing much scope for improvement. Hopefully the Budget proposals can provide an upside surprise for the SA economy.

Are the global markets right- about permanently low returns?

If we are to take seriously the signals from global bond markets- as we should- savers should expect a decade or more of very low returns. The decline in bond yields due to mature in 10 years or more accelerated dramatically during and after the Global Financial Crisis (GFC) (see below)

Less inflation expected is part of the explanation for these lower yields. But it is more than lower expected inflation at work. Yields on inflation protected securities – those that add realized inflation to a semi-annual payment – have declined to rates below zero. Before the GFC the US offered savers up to a risk free 3% p.a. return for 10 years, after inflation. The equivalent real yield today is a negative one of (-0.11% p.a). (see below)

Real Yields in the US 10 year Inflation Linked Bonds ( TIPS)

Source; Bloomberg and Investec Wealth and Investment

These low risk-free rates also mean that firms investing the capital of their shareholders have very low investment hurdles to clear to justify their investment decisions. A 6% internal rate of return would be enough to satisfy the average shareholder given the competition from fixed interest. Equity returns might also be expected to gravitate to these lower levels.

Another way to describe these capital market realities is that the rate at which the value of pension and retirement plans can be expected to compound is expected to be at a much slower one than they have been in the recent past. Savers will need to save significantly more of their incomes to realise the same post-retirement benefits.

The past decade has in fact been particularly good for global pension funds. In the ten years after 2010 the global equity index returned 10.5% p.a. on average while a 60-40 blend of global equities and global bonds returned an average 6.4% p.a. with less risk. US equities would have served investors even better, realizing average returns of 13.4% p.a, well ahead of US inflation of 1.8% p.a. over the period.

Total portfolio returns 2010-2019 (January 2010 =100)

Source; Bloomberg and Investec Wealth and Investment

Why then has global capital become so abundant and cheap over recent years? Many would think that Quantitative Easing (QE) the creation of money on a vast scale by the global central bankers, has driven up asset prices and depressed expected returns. An additional three and more trillion US dollars-worth has been added to the stock of cash since the GFC.

Global Money Creation

Source; Bloomberg and Investec Wealth and Investment

But almost all of this cash has been added to the cash reserves of banks- and not exchanged for financial securities or used to supply credit to businesses that could have stimulated extra spending. Bank credit growth has remained muted in the US and even more muted in Europe and Japan.

The supply of global savings has in fact held up rather better than the demand for them, helped by an extraordinary increase in the gross savings to GDP ratio in Germany. These savings have increased from about 22% of GDP in 2000 to 30% of GDP in 2018- while the investment ratio has remained at around 22% of GDP. Government budget surpluses have contributed to this surplus of savings in Germany. For advanced economies the share of government expenditure in GDP has fallen from 42% in 2010 to 38% in 2018 while the share of revenue has remained stable at about a lower 35% of GDP. This could be described as global fiscal austerity -post the confidence sapping GFC.

Germany – Gross Savings and Investment to GDP ratios

Source; IMF World Economic Outlook Data Base and Investec Wealth and Investment

IMF – All Advanced Economies – Ratio of Government Expenditure and Revenue to GDP

Source; IMF World Economic Outlook Data Base and Investec Wealth and Investment

Perhaps depressing the demand for capital may be the changing nature of business investment. Production of goods and more so of the services that command a growing share of GDP, may well have become capital light. Investment in R&D may not be counted as capital at all. Nor is intangible capital as easily leveraged.

Lower interest rates have their causes -they also have their effects. They are very likely to encourage more spending – by governments and firms and households. Mr.Trump does not practice fiscal austerity. Boris Johnson also appears eager to spend and borrow more. It would be surprising if firms and many more governments did not respond to the incentive to borrow and spend more and compete more actively for capital. Permanently low interest rates and returns and low inflation may be expected – but they are not inevitable. The cure for low interest rates (high asset prices) might well be low interest rates.

To grow or not to grow? – that is the question for the RSA and investors in it.

The RSA is currently offering its bond holders a real 3.8% a year for 10 year money. It is the lowest risk investment that can be made in rands over the next 10 years. One made without the risk of inflation reducing the purchasing power of your interest income and without risk of default. If you wished to invest in a US Treasury inflation protected security (a ten year TIPS) you would have to (pay) Uncle Sam 13.3 cents per $100 invested for the opportunity.

Thus investors willing to accept RSA risk are currently being compensated with an extra 4% real rand income each year for the next ten years. This real risk spread was a mere 2.3 % p.a. a year ago. Other possible measures of RSA risk are as unflattering. The RSA borrowing dollars for five years has to pay an extra 2.2% p.a more than the US Treasury for five year money making RSA debt already well into junk status where it has languished for some time not withstanding its fragile investment grade status with Moody’s. Our rating compared to other EM borrowers has deteriorated and the ZAR is expected to weaken at a faster rate (See figures below)

The real risk spread for SA assets

Source; Bloomberg and Investec Wealth and Investment

Measures of SA risk

Source; Bloomberg and Investec Wealth and Investment

It all makes for very expensive national debt that taxpayers have to fund and higher costs of capital for SA business. These higher real rates also raise the returns that SA businesses have to hurdle to justify capital expenditure. Ever fewer such opportunities are seen to be on offer. And so the best many SA economy facing businesses can now do for their share owners is to opt out of the race in ways that are not good for growth. That is to use the cash they generate to buy back shares or pay dividends rather than attempt to grow their businesses.

The cause of this deteriorating credit rating and the higher discount rates applied to SA earnings is obvious enough. The RSA appears increasingly unlikely to manage its public finances with any degree of competence. The 2020-21 Budget has to cover an extra R50b to hold the fiscal line drawn as recently as last October. It is the result of less revenue than expected as growth has slowed and rapidly growing government expenditure on failed state-owned enterprises. A growing interest rate bill on ever more government debt is a further growing strain on the Budget .

There are however alternatives to raising taxes or borrowing more. That is to raid the SA pension and retirement funds. That is to compel them to hold more RSA debt of one kind or another on less favourable terms than have currently to be provided. Such forms of EWC have one major advantage for the politicians imposing them. Their full consequences will not become obvious for many years. That is in the form of lower than otherwise returns for pension funds and depleted pension payments. Including the bill ultimately to be presented to taxpayers for underfunded defined benefits owed to public sector employees- and largely incalculable today.

Swapping most of the debts and interest payments of SOE’s for equity without guaranteed returns has however one major potential upside. It could mean the effective transfer of ownership and rights of ownership from government to the private sector. This would bring greater efficiency and the avoidance of further losses for SA taxpayers and consumers of essential services. Such a step would bring down real interest rates and encourage private sector investment.

It would moreover indicate something much more fundamental to investors in SA. That is when accompanied by credible controls on the size of the government payroll it would clearly signal something all important for investors. And that is the primary purpose of the SA government is not to provide a growing flow of real benefits for those employed by government. This is the essential question that the Budget, we must just hope, will answer in the affirmative.

The narrow corridor of success

A new book by Harvard economists Daron Acemoglu and James A Robinson sheds light on what success looks like for nations. An empowered and critical civil society is crucial.

The achievements of a few highly successful economies are admirable and conspicuous. Consistent growth in incomes and output over many decades has eliminated poverty. The growth has been accompanied by rising tax revenues that are easily collected, without much disturbing the engines of growth.

These are then redistributed in cash and kind to provide a measure of security for all its citizens against the accidents to which individuals and their families are always vulnerable. Growth provides the means to fight crime, protect borders, provide roads, sewers and vaccinations, of equal value to all. The caveat is that this historically unprecedented abundance is not as appreciated or as popular as it should be. Continued success can never be taken for granted.

Open access to markets for all goods and services and for the resources – labour, capital and natural resources – with which to compete for custom, is a critical ingredient for success. Innovation threatens established interests and must be recognised as a force for good. Rights that protect wealth and persons against fraud, theft or violent assault, supported by predictable laws and transparent regulations, are essential for success.

Competent and responsive government agencies are essential. A society that is critical of government action, aware and unafraid of what a powerful government might arbitrarily do to them, makes for good government.

Harvard economists Daron Acemoglu and James A Robinson have followed up on their influential book “Why Nations Fail” with the excellent “The Narrow Corridor: States, Societies and the Fate of Liberty” (Penguin-Viking, 2019). It explains in fascinating detail why it has been so difficult for nations to do what it takes to enter and stay in the narrow corridor that leads to economic success.

They explain the advantages of the so-called “shackled Leviathan”. This is when the potential abuse of state power is effectively constrained by an empowered and critical civil society. This is unlike the “despotic Leviathan” that maintains essential order but does so at huge cost to a cowed and vulnerable people. China, old and new, is cited as one such example.

Another alternative may well be the “paper Leviathan”. This describes an expensive and incompetent government. South America provides more than a few hapless cases of governments that serve only the people on their payrolls.

In all the many cases of national failure there is an elite who have a powerful interest in the stagnant status quo – and who resist the obvious reforms that would stimulate and sustain faster growth. Zimbabwe comes to mind as an example.

The authors also examine the potentially suffocating role of the “cage of norms” – well-entrenched customs that stultify access to markets and inhibit competitive forces. The caste system in India is still such an inhibitor of economic progress. Traditional land rights are a serious obstruction to producing more in South Africa.

Acemoglu and Robinson regard BEE as helpful to economic success because it broadened the political interest in established enterprises and business practice, enough to help protect them and the economy against destructive expropriation. Cultivating a new elite into business success was necessary for stability and growth.

One wonders how Acemoglu and Robinson might now react to the revelations about state capture and corruption; and to the failures of the South African state to deliver satisfactory outcomes for the resources made available to it.

The next question is: will the highly transformed South African elite act in the general interest and encourage the invigorating forces of meritocratic competition for resources and customers? Or will they act to protect their gains and privileges?

The new elite should be aware that a failing economy will not be politically acceptable and any elite dependent on it will be highly vulnerable. They should be encouraged by our open and critical society to take the steps to get South Africa back into the narrow corridor that leads to economic success.

SA -in or out of the narrow corridor that leads to economic success?

The achievements of a few highly successful economies are highly admirable and conspicuous. Consistent growth in incomes and output over many decades has eliminated poverty. The growth has been accompanied by growing tax revenues that are easily collected, without much disturbing the engines of growth. And are then redistributed in cash and kind to provide a high measure of security for all its citizens against the accidents to which individuals and their families are always vulnerable. Growth provides the means to fight crime, protect borders, provide roads, sewers and vaccinations, of equal value to all. The caveat is that this historically unprecedented abundance is not better appreciated and more popular than it appears to be. Continued success can never be taken for granted.

Open access to the markets for all goods and services and for the resources, labour capital and natural resources with which to compete for custom, is a critical ingredient for success. Innovation threatens established interests and must be well recognised as a force for better. Rights that protect wealth and persons against fraudulent or violent assault and rule by predictable laws and transparent regulations are essential for success.

Competent and responsive government agencies are essential to the economic purpose. And a society, critical of government action, aware and unafraid of what a powerful government might arbitrarily do to them, makes for good government.

Harvard economists Acemoglu and Robison (A&R) have followed their influential “Why Nations Fail” with “The Narrow Corridor” [1]It explains in fascinating detail why it has been so difficult for nations to do what it so obviously takes to enter and stay in the narrow corridor that leads to economic success.

They explain the advantages of the “Shackled Leviathan” when the potential abuse of state power is effectively constrained by an empowered and critical civil society. A state very unlike the “Despotic Leviathan” that maintains essential order but does so at huge disadvantage for a cowered and vulnerable people. China, old and new, is cited as one such example. Another alternative may well be the “Paper Leviathan” an expensive and incompetent government, but only in name not in action. South America provides more than a few hapless cases of governments that serve only the people on their payrolls.

A&R also examine the potentially suffocating role of the “Cage of Norms” – well entrenched customs- that stultify access to markets and inhibit competitive forces. The caste system in India is still such an inhibitor of economic progress. Traditional land rights are a serious obstruction to producing more in SA.

South Africa, (A&R) argue, entered the narrow corridor that leads to success with the help of Nelson Mandela. They regard BEE as very helpful to economic success because it broadened the political interest in established enterprises and business practice enough to help protect them and the economy against destructive expropriation. That cutting a new elite into business success was necessary for stability and growth.

One wonders how A&R might now react to the revelations about state capture and corruption? And to the failures of the SA state to deliver satisfactory outcomes for the resources made available to it.

This raises an essential question. Will the highly transformed SA elite act in the general interest and encourage the invigorating forces of meritocratic competition for resources and customers? Or will they act to protect their gains and privileges against them?

The new elite should be aware that a failing economy will not be politically acceptable and any elite dependent on it will be highly vulnerable. They should be encouraged by our open and critical society to take the steps to get SA back into the narrow corridor that leads to economic success

[1] Daron Acemoglu and James A. Robinson, THE NARROW CORRIDOR, States, Societies and the Fate of Liberty, Penguin-Viking, 2019.

An economist’s wish list for 2020

Examining the state of the SA economy at the end of 2019 – and some suggestions for what the authorities can do to turn things around in 2020

South Africa is near the top of the global league – when it comes to the rewards for holding money, that is. You can earn about 3% after inflation on your cash, with only Mexico having higher real short-term interest rates.

However South Africa is close to the bottom of the global growth league (see below). This is no co-incidence, but the result of destructive fiscal and monetary policies.

Q3 GDP relative to the rest of the world

Source: Thompson-Reuters and Investec Wealth and Investment

Such an unnatural state of economic affairs, namely still very expensive money combined with highly depressed economic activity, has clearly not been at all good for SA business. The average real return on invested capital (cash in/cash out) has declined sharply, by about a quarter since 2012. Companies have responded by producing less, investing less, employing fewer workers and paying out more of the cash they generate in dividends.

GDP at current prices is now growing at its slowest rate since the pre-inflationary 1960s, at about 4% a year. This combination of low GDP and inflation below 4% (yet with high interest rates) automatically raises the ratio of national debt to GDP. And it makes it much harder to collect taxes (the collection rates are well explained by these nominal growth rates). Of further interest is that the actual growth in GDP is falling well below the forecasts provided in the Budget Survey (see figures below).

This leads to an economically lethal combination of low inflation and high borrowing costs (for the government and others).

Only actions by the government that clearly indicate it is heading away from a debt trap (ie printing money and so much more inflation in due course) can permanently reduce expectations of higher inflation and thus bring down long-term interest rates. Debt management is a task for the government, not the Reserve Bank.

The investors in those companies that depend on the health of the domestic economy have not been spared the economic damage. The value of these South African economy-facing interest rate plays (banks, retailers and investment trusts for example) have declined significantly and have lagged well behind the JSE All Share Index. The JSE small cap index has lost 40% of its value of late 2016. Since January 2017, the JSE All Share Index is down by 7%. However an equally weighted index of SA economy plays is down by 22%.

Top 40 and Small Cap Indexes 2014=100

Source; Bloomberg, Investec Wealth and Investment

JSE All Share Index, Precious Metal Index and SA Plays (equally weighted) 2017=100

Source; Bloomberg, Investec Wealth and Investment

It’s against this worrying backdrop that I offer my New Year wish list for South African business to be able to transform its prospects and with it the prospects of all who depend on the domestic economy. It is after business which is the most important contributor to the economic prospects of all South Africans.

My first wish is that those in government and its agencies should recognise that without a thriving business sector the economy is doomed to permanent stagnation. They should therefore show more respect for the opinions of business and the policy recommendations they make. Most important, they should interfere less in the freedoms of business to act as business sees fit.

Economic growth is transformational and inclusive. Stagnation is just that: nothing much happens, especially for the poor who are stuck in a state of deprivation from which it is difficult to escape. The opportunities that economic growth provides are a powerful spur to upward mobility – of which poor South Africans are so sorely lacking.

My second wish is that government turns over all wastefully managed SOEs to private control (there are no crown jewels) and in this way improve performance and generate cash and additional taxes with which to reduce national debt. Any sense from government that this might happen would bring long-term interest rates sharply lower and immediately reduce the returns required of SA business and in turn lead to more investment.

A third wish (linked to the second) for business success in 2020 is that government cuts its spending and raises revenues from privatisation, rather than raises tax rates next year. There is no scope for raising tax revenues unless there is faster growth. Higher tax rates will depress economic growth and growth in revenues from taxation still further. The wish is therefore that Treasury knows that only cutting government spending can avert the debt trap and has the authority to act accordingly.

Finally, a wish for monetary policy. South African business would benefit from lower short-term interest rates (notably mortgage rates) under Reserve Bank control. Lower interest expenses would help stimulate the spending of households, which could help get business going. It is my wish for business that the Reserve Bank will do what is most obvious and natural for it to do: to act decisively and urgently when both inflation and growth are pointing sharply lower.

Poverty causes inequality in SA – not the reverse. As the Income Inequality Study reveals – but has great difficulty in acknowledging (StatsSA 2019)

Brian Kantor and Loane Sharp

Kantor is Professor Emeritus in Economics UCT and Head of Research Institute Investec Wealth and Investment. Sharp is Director at Prophet Analytics

The most important question in economics – why some countries remain poor while others grow rich – has been definitively answered. According to the United Nations, between 1990 and 2015 the poverty rate in the developing world dropped from 47% to 14%. More than a billion people escaped poverty over the period.

The unequivocal cause of declining poverty has been strong and sustained economic growth. According to the International Monetary Fund, economic growth in developing countries has averaged 4.9% per annum since 1990. At this rate, with population growth in developing countries now 1.2% per annum and steadily falling, real income per person will more than double over the next 20 years. Poverty, in other words, will be substantially eliminated within a generation.

The primary question having been answered, economists have increasingly directed their attention to a secondary question – why some people within a country remain (relatively, sometimes absolutely) poor while others do much better earning and spending their incomes. It is right and good to prefer that the benefits of economic growth be distributed widely rather than narrowly. But in highly competitive markets, this may not be possible – especially in labour markets, where incomes are driven up by competition between employers, held down by competition between workers for work and ultimately settle at a mutually agreed value for the expected productivity of the employee that differs widely according to skill experience and ability. Yet growth, even when unevenly distributed, generates revenues for government that can be used to provide the most vulnerable with extra spending power and valuable benefits in kind (education housing and medical care) that will add to their income generating capacity and mobility.

In contrast to the global experience, SA’s poverty rate has been stubbornly high and recently rising. According to Statistics SA, 55% of the population is defined as poor, living on less than R11,904 per annum. (current rands) Over the period that real per capita income growth in developing countries averaged 3.7% per annum, SA per capita income growth averaged a mere 0.7% per annum.

While poverty remains high, Statistics SA’s latest inequality report, authored by the Southern African Labour and Development Research Unit (SALDRU) at the University of Cape Town, despite its summary view that income distribution in SA is largely and unhappily as unequal as it has been since 1993, shows in fact, that inequality has declined. In 2006, the top 10% of income earners enjoyed 12.5 times the income of the bottom 40%. By 2015, this Palma inequality ratio had declined to 10.2 – significant progress over a short period of time. In 2006, the top 10% incurred 8.6 times the spending of the bottom 40%. By 2015, the ratio had fallen to 7.9 times – also significant progress over a short period of time.

This seems counterintuitive: how can poverty increase and inequality decline? As we explain below, the middle class, not the poor, have been the primary beneficiaries of government policies. We pretend to care for the poor but often act otherwise, no doubt because it makes political sense. Many of the economic policy interventions of the SA authorities would not pass the Rawlsian test. That is would the intended policy be helpful to the economic interests of the least well off 20% of the population?

The distribution of spending is significantly more equal than the distribution of income, thanks to taxes, welfare spending, government services and saving (i.e. spending foregone) largely undertaken by the top 10% of income earners. They who are responsible for almost all the wealth accumulated in SA, and without whom the economy would perform even less well and be even more dependent on foreign capital.

The inequality report rightly concludes that lack of economic growth and lack of job creation are the main causes of poverty and inequality. Unfortunately, the report contains much psychosocial nonsense. An example: “High levels of inequality mean that large segments of a society may be excluded from economic opportunities [since] people who receive the best opportunities are the ones who are the richest, and these are not necessarily the same as the ones who are the most talented or who would make the best use of such opportunities.” In other words, rich people cause poverty. Surely it is poverty not inequality that denies opportunity.

To give another example: “Adding a couple of thousand rand to the monthly pocketbooks of the poor could elevate them above the poverty line and set them on a better life trajectory […] but it doesn’t immediately result in greater equality between the outcomes of certain groups” (emphasis added). In other words, eliminating poverty is unacceptable because, in doing so, white people might get better off.

The global economic experience indicates that the self-interest and creative drive of a tiny group of people – a small number of extremely successful business owners and their high-skilled employees – have sharply reduced poverty and will soon eliminate it altogether. They are the crucial agents of economic growth. Respecting their achievements, tolerating their high incomes and protecting their gains becomes the essential social contract. Redistributing these exceptional gains through progressive income tax and well-directed government spending is a further part of the social contract. Successful economies manage to grow and redistribute – in that order.

It hardly seems worth the effort to conduct a comprehensive survey of inequality in SA every few years when the results are so self-evident as to be nearly worthless. The economy hasn’t grown, unemployment has risen and therefore poverty and inequality remain significant problems. No surprise in that. We should like to know, instead, how economic growth and job creation might be achieved or, indeed, is being frustrated.

We know, of course, what causes economic growth and the attendant benefits of investment, employment, innovation, competition and taxes: business profitability. We know what causes job creation and the attendant benefits of economic mobility, childcare, healthcare, retirement savings and workplace safety: economic growth and the profitable employment of labour.

On the economic growth front, it is therefore alarming that SA companies’ return on assets (gross operating surplus / gross fixed capital stock), having peaked at 17.9% in 2004, will this year likely drop below 10% for the first time in 30 years. If business profitability does not recover, economic growth cannot. Analysis of the financial statements of listed companies reveals a similar decline in the return on capital.

On the employment front, it is alarming that, whereas in the 25 years prior to 1994 an additional 1% of economic growth was associated with a 1.3% increase in employment, since 1994 an additional 1% of economic growth was associated with a 0.2% increase in employment. Even if economic growth occurs, job creation cannot occur if the link between economic growth and employment has been severed.

The causes of economic growth and job creation, and therefore the solutions to poverty and inequality, are well understood. Growth will follow business liberalisation, and jobs will follow labour market liberalisation. Yet the report unfathomably frames these as complex and intractable problems. It surely does help to promote an endless agenda for the favoured consultariat and their flow of proposals to tinker further with the economy.

The report usefully observes that inequality in SA is overwhelmingly related to labour market inequalities: inequality between those who have jobs and those who don’t; inequality between public sector and private sector employees; and, within the private sector, inequality between skilled and unskilled employees.

The labour market is clearly central: incomes from work account for three-quarters of all incomes earned and about two-thirds of overall inequality comes from inequality in earnings. Inequality and poverty and the inability of the economy to grow faster are largely attributable to the failure of the economy to provide more employment.

There are serious problems with the survey methodology that is the basis for the report. Some of the problems are true of all surveys. For instance, people are notoriously cagey about their true income and spending patterns, especially when an individual, completing the survey on behalf of others in the household, may fail to disclose the true picture to other individuals in the household, let alone government enumerators. Other problems are specific to this survey. For example, households are asked to report the spending they actually incurred rather than the value of the goods and services received. Heavily subsidised government school fees are a small fraction of the total cost of education, yet only the minimal out-of-pocket fee is reported as expenditure with no adjustment for the full value of the benefit. Likewise subsidies related to healthcare, housing, electricity, water, sanitation and many other government services are not reflected as de facto benefits at their costs of supply, and the costs of administering government programmes are nowhere accounted for in the estimates of expenditure.

As seen in Figure 4.1.4, income from the labour market is the main source of income, increasing from 73.5% in 2006 to 81.3% in 2009 ( after a brief period of strong GDP growth) before declining to 71.0% in 2011 and then remaining constant between 2011 and 2015. The proportion of social grants to overall household income has slightly fluctuated over the years: the proportion decreased from 6.0% in 2006 to 5.4% in 2015. The share of in-kind income gradually rose from 1.2% in 2006 to 2.4% in 2011 before dropping to 1.7% in 2015. Meanwhile, the share of remittances to overall income fluctuated over the years and reached its highest proportion in 2009 contributing 1.2% to overall income. Figures 4.1.5 and 4.1.6 show the distribution of labour market income and social grants, respectively, by income-decile. From these figures, we observe growing dependence on social grants and declining reliance on labour market income in the bottom deciles. By contrast, in the top deciles there was a much greater reliance on labour market income and less reliance on social grants. Therefore, social grants to some extent contributed to the improvement in income inequality.

Unfortunately, the report does not attempt to explain why these differences exist and persist. Except by extensive reference to race. Do richer SA whites (and the rich of other races) harm or serve the economic interest of SA? Should the objective of economic policy be to retain their valuable services- or to do better without them in the interest of equality? One suspects that many of those who interest themselves in issues of inequality in SA and many others with influence over economic policy find it very difficult to give an unequivocal response to this question. In other words the economic growth that could lift the 33 million poor South Africans out of poverty would be unacceptable because a few white South African might benefit disproportionately from the process.

The truth is that the government has aggravated rather than alleviated inequality. Incomes of high-skilled people have been boosted by immigration restrictions and emigration. Incomes of low-skilled people have been diminished by uncontrolled immigration of low-skilled people from neighbouring countries. Social grants have raised the reservation wage of low-skilled people discouraging their participation in the labour force, particularly in the rural areas. Government education is so poor that a staggering proportion of enrolees drop out of school, eliminating what chances they might have had of finding work. Extensive protections against especially performance-related dismissals have reduced productivity and raised the risk of employing people who prove not worth their hire.

Given all the obstructions to hiring and firing labour – and all the unintended consequences of poverty relief in influencing the willingness to supply labour – it should be no surprise that the distribution of income in SA is what it is. It is well explained by the political interest in “good jobs” rather than in total employment – especially in the highly indulged public sector – and the support for unions and labour regulations that protect those with jobs at the expense of those seeking work. Slow growth in the number of people employed and the inability of the poor to find work should not be regarded as unintended. It is the predictable outcome of policy choices made by the SA government.

Two other important forces on the income distribution should be recognised. Firstly, the expenditure of households headed by men is significantly higher than spending by households headed by women. In 2015 the average expenditure of the households headed by men was twice as high as of those headed by women. (38180/18406) A very similar ratio (2.1) prevailed in 2006 (27058/12965) (2015 prices). This suggests that female-headed households have only one person working whereas male-headed households have two people working with very similar average incomes per worker. It appears that the important gender gap is related to the presence or absence of a working male in the household.

Secondly, average urban incomes are much higher than rural incomes. The urban/rural divide is even more dramatic. In 2015, on average, urban households spent R40,290 in 2015 and rural households R11,658 – a ratio of 3.5 times. In 2006, this ratio was very similar, 3.7. These expenditure gaps are attributable more to employment opportunities than wage differences. Of the total population, 65.3% are urban and 34.7% rural.

The policy implications of these facts of SA economic life seem obvious: more households headed by men, and more of them established in the urban areas. Social assistance and free housing and utilities that do not distinguish between urban and rural areas makes overcoming poverty through employment ever more difficult, because it encourages rural settlement and unemployment especially now that a national minimum wage is the rule.

In 2006, the top 10% spent 57.2% of all expenditure or 8.6 times that of the bottom 40% with a mere 6.6% share. By 2015, this ratio had declined from 8.6 to 7.9 – less inequality. Yet the share of the bottom 40% remained at 6.6%. In 2006, the middle 50% had a 36.2% share of all expenditure. By 2015, the expenditure share of the top 10% was down to 52.6%, and that of the middle 50% up to 40.8%, of all spending. Thus, a decline in the ratio (top 10%/middle 50%) from 1.81 to 1.32 times, while the ratio of the spending of the middle 50% to that of the poorest 40% rose from 5.5 times to a less equal 6.2 times. The large gains in the share of expenditure have been realised by the 7^th, 8^th and 9^th deciles whose combined share improved by a full four percentage points.

The redistribution of spending power in SA has been to middle-income earners – not the poor. Perhaps especially to the new members of the upper middle class who are employed by government and its enterprises and institutions. If the economy is to grow faster and incomes and spending power are to be more equally spread, the interests of the poor and the rich will have to predominate in policy settings, much more than they have done to date.

Sources:

All charts and statistics are sourced from this study: Statistics South Africa (2019), Inequality Trends in South Africa A multidimensional diagnostic of inequality, Risenga Maluleke, Statistician-General, Report No. 03-10-19

Some lessons from share market history

Shorter version published in Business Day, Friday 15^th November

The market value of any business will surely be determined by its economic performance. The most commonly applied and highly accessible proxy for performance are the earnings reported by its accountants and auditors. Cash dividends paid might be a superior indicator given how the definition of bottom line earnings has changed over time. Cash flows may be better still but are less readily available.

Robert Shiller provides 148 years and 1776 months of US stock market data. US S&P Index values, index earnings and dividends per share have followed a very similar path. The correlation between monthly prices, earnings and dividends, all up nearly 20,000 times since 1871, is close to one. [1]

Share Prices, Earnings and Dividends per Share (1871=100) Log Scale

Source; Shiller Data, Investec Wealth and Investment

The P/E ratio for the S&P has averaged 15.76 over the long period with a low of 5 in 1917 and a high of 124 after earnings had collapsed in May 2009 while the Index held up to a degree. And dividends held up much better than earnings.

Source; Shiller Data, Investec Wealth and Investment

If we run a regression equation relating the Index to earnings or dividends per share the residual of these equations (that what is not explained by the model) has a strong tendency to trend to zero- given enough time. Or in other words the price-earnings ratios have tended to revert to their long-term average of 15.8 over time but with variable lags.

The higher the P/E multiple the faster earnings must be expected to grow when they to make up for the low initial yield E/P and vice versa. Expected earnings drive current market prices. Surprisingly higher or lower revealed earnings will tend to move prices in the opposite direction. Earnings may catch up with prices or prices follow earnings. The move to any long-term equilibrium can come from either direction, with advantage or disadvantage to shareholders.

Therefore be warned. Knowing that a PE ratio is above or below a long term average is not going to make you rich or poor speculating in the share market. The correlation of starting PE and returns realized over the next twelve months is close to zero.

The starting PE appears to become more helpful as a guide to investors when returns realized over an extended period are compared to it. High starting PE’s are associated with generally lower returns and vice versa over three or five year subsequent windows. When we relate starting PE’s 36 or 60 periods before with returns realized three or five years afterwards over the entire period we do get a statistically supportive result. Choosing the right entry point to the market and waiting patiently for the outcomes would have been generally helpful to investors.

Examining the relationship between prices and earnings in the US does reveal some extreme cases. In the late forties and late seventies the market would have appeared as very cheap. But these were not good times for the US. The US was fighting and possibly losing a war in Korea. In the mid and late seventies the US was subject to stagflation- rapidly rising prices and slow growth. Also very un-promising times for shareholders.

However normality returned to the great advantage of those who did not share the prevailing pessimism and stayed in the market. Between 1950 and 1953 the S&P PE crept up from seven to eleven times helping the total returns on the Index to average 22% p.a. In early 1978 the P/E was 8 times. Over the next three years the S&P delivered over 11% p.a on average as the US got its inflation under control.

By contrast in early 2000 at the height of IT optimism the S&P was trading at an extreme 33 times. Over the subsequent three years the S&P delivered negative twelve returns of -8.7% p.a. The IT bubble was only apparent after the event when expected earnings proved highly elusive.

S&P earnings collapsed during the GFC of 2008-09. From about $80 per index share in 2006 to less than $7 in early 2009. This sent the P/E multiple to 124 even as the Index fell sharply to a value of 757 by March 2009. According to earnings the S&P was greatly overvalued. According to dividends that held up much better through the crisis, the market appeared as deeply undervalued. The dividend buy signal proved the right one as the economy recovered (unexpectedly) with lots of (unexpected) help from the Fed and the Treasury. The S&P Index since those dark days has that provided returns that have compounded on average at of over 13% p.a.

What is very different about the share market today in the US are the extraordinarily low interest rates- both long and short rates – that have surely helped drive the market higher as competition for shares from the money and bond markets fell away. What may appear as a demanding PE of about 22 times becomes much more understandable given abnormally low interest rates. Is this the permanently new normal for interest rates. Or will interest rates mean revert? And what is normal? Only time will tell.

[1] http://www.econ.yale.edu/~shiller/data.htm

The US and the JSE since the Global Financial Crisis – a tale of success and relative failure.

A shorter version was published in Business Day on 1. november.

It is ten years since the Global Financial Crisis (GFC). R100 invested on October 2009 in the 500 companies that make up the most important equity index, the New York S&P 500 Index, would now be worth as R680, with dividends reinvested in the index. This is the result of extraordinarily good 12 month returns over the ten years that averaged over 18% p.a. in ZAR and 13.4% p.a in USD.

Most other equity markets have not performed anything like as well. R100 invested in the JSE All Share Index or in the MSCI EM, again with dividends reinvested, would now be worth about R276. This is equivalent to an average annual return of about 12% from the JSE over the ten years.

Ten years ago the SA bond market could have guaranteed the rand investor 9% p.a for ten years. Realized equity returns of 12% p.a therefore did not fully reward investors running equity market risks – assuming a required equity risk premium of 4% per annum.

The strong outperformance of the S&P 500 began in 2013 and has continued strongly since. It reflects very different fundamentals. The S&P 500 delivered growth in index earnings per share in USD of 11.7% p.a. over the ten years. By contrast the JSE delivered growth in index dollar earnings per share of only 1.46% p.a and 5.5% p.a in rands, over the ten years. Barely ahead of inflation.

Source; Bloomberg Investec Wealth and Investec Wealth and Investment

Back in September 2009, US Treasury Bonds offered a guaranteed 3.4% p.a for ten years. A good yield by the standards of today. This meant, at that especially fraught time, investors would have required an average return of about 7.5% p.a. to justify a full weight in equities, assuming the same required extra equity risk premium of 4% p.a. Actual realized returns on the S&P therefore exceeded required returns by about a very substantial 6% p.a.

Time has proved that the risks of financial failure in the US were greatly exaggerated. The lower entry price for bearing equity risk ten years ago, reflected by Index values of the time, proved unusually attractive.

Dividends per JSE Index share by contrast with earnings have grown from the equivalent of R100 in 2009 to R324 in September 2019 while earnings per share have no more than doubled. The ratio of the JSE index to its dividends was 41 times in 2009- it is now only 27 times. The ratio of the Index to its trailing earnings per share was 16 times in 2009 – and is the same 16 times today. There has been no derating or rerating for the JSE. See figure below

The JSE over the past ten years. Values, earnings and dividends (2009=100) Price to earnings and dividend ratios.

Source; Bloomberg Investec Wealth and Investec Wealth and Investment

The equivalent required risk adjusted return of the highly diversified S&P 500 Index today is a mere 5.8% p.a. on average. With long RSA bond yields now offering close to 9% p.a. the required risk adjusted return from the average company listed on the JSE is now at least 13% p.a.

It has become increasingly difficult given slow growth and low inflation for a SA based company to add value for shareholders by earning returns on its capital expenditure of over 14% p.a. . And SA business has responded accordingly by saving and investing less and paying out dividends at a much faster rate. This is not good news for business or the economy. JSE listed companies would be much more valuable if they could justify investing more and paying out less- as US companies have done.

They need encouragement from faster growth in their revenues and earnings and lower interest rates. Lower short-term interest rates are in the power of the Reserve Bank and if reduced could help stimulate extra spending by households. SA business and its share market also need the encouragement of lower required long-term returns. That is from the lower long-term interest rates that would come with less inflation expected. Less inflation expected (and consequently lower interest rates) means a growing belief that SA will not fall into a debt trap and print money to escape it- that could be highly inflationary. So far and after the MTBPS last week not obviously so good. The jury remains very much out on the ability of the SA government to manage its debts successfully and the cost of capital for SA business has become even still more elevated.

Understanding the past and future of the rand

A shorter version of this essay was published in the Financial Mail (Special Edition 1959-2019) October 24^th– October 30^th 2019

A full version is available here: Understanding the past and future of the rand

The dangers of a divided world of inflation expectations

Developed and emerging markets have very different expectations of inflation. The monetary authorities should think carefully about the consequences of austerity

The developed world is much agitated by very low interest rates. Rates are so low that it is hard to imagine them declining further, so emasculating monetary policy.

Interest rates reflect a relative abundance of global savings. Hence inflation (prices rise when demands exceed available supplies) is confidently expected to remain at these very low rates. Interest rates accordingly offer compensation for expected inflation. The US bond market only offers an extra 1.56% annually for bearing inflation risks over the next 10 years (see figure below).

The US Treasury bond market (10 year yields)

Deflation or generally falling prices, have rather become a threat to economic stability. When prices are expected to fall and interest rates offer no reward to lenders, cash (literally hoarding notes and coin) may be a desirable option. If prices are to be lower in six months than they are today, it may make sense for firms and households to postpone spending, including on hiring labour. Hence even less spent and more saved, compounding the slow growth issue.

An economy-wide unwillingness to demand more stuff is not a normal state of economic affairs. If demand is lacking, resources – land, labour and capital – become idle. In these unwelcome circumstances a government and its central bank can always stimulate more spending, including its own, without any real cost to taxpayers or economic trade-offs. More demand means no less supplied – therefore no output or income will be lost and more will be forthcoming, should demand catch up with potential supply.

Most simply, spending can be encouraged without limit by handing out money or jettisoning cash from the proverbial helicopter. For a government to be able to borrow for 30 years at very low interest rates is as inexpensive a funding method as printing money.

One can confidently expect unorthodox experiments in stimulating demand – should the developed economies continue to grow very slowly – and interest rates and inflation to remain at very low levels until growth and inflation picks up. Cutting taxes and funding a temporarily enlarged fiscal deficit with money or loans is another (better) option.

Quantitative easing (QE), the process whereby central banks create money to buy government bonds on a very large scale, mostly from banks, was highly unorthodox when first introduced to overcome the Global Financial Crisis of 2009. QE prevented the banks from running out of cash and defaulting on their deposit liabilities, thus preventing the destruction of the payments system that banks provide. But the banks, when selling bonds to their central banks, mostly substituted deposits at the central bank for previously held Treasury Bills and bonds. Bond holdings went down while deposits held by banks with the central bank went up by similar amounts.

The banks did not (much) turn their extra cash into loans. It would have been more of a stimulus to spending had the central banks purchased assets from the customers of banks (retirement funds and their like) rather than the banks. Had they done more of this, the deposits of the banks as well as the cash of the banks would have increased immediately. The growth in bank credit and bank deposit liabilities has remained very modest, especially in Europe, though the recent pick-up in growth in bank loans is noteworthy. Hence the persistently slow growth in spending in Europe.

Growth in bank loans in the US and Europe

Source: Thomson-Reuters, Federal Reserve Bank of St Louis and Investec Wealth & Investment

While the developed world struggles with low interest rates and subdued inflation and expectations of inflation, the world of emerging markets present very differently. Interest rates remain persistently high, with elevated expectations of inflation (and exchange rate weakness) to come. Accordingly, interest rates, after adjusting for realised inflation, remain at high levels as do inflation protected interest rates.

South African financial markets have continued to perform very much in line with other emerging financial markets. The JSE All Share Index gained about 2.6% in US dollar terms in 2019 (to 11 October) while the MSCI Emerging Market Index was up by 4.7% – both distinct underperformers when compared to the S&P 500, which was up by over 18% over the same period. The rand and emerging market currency basket had both lost about the same 2% against the US dollar over the same period (see figures below).

The USD/ZAR and the USD/emerging market currency exchange rates in 2019

Source: Bloomberg and Investec Wealth & Investment

The JSE and the emerging market equity benchmark in US dollars

Source: Bloomberg and Investec Wealth & Investment

On the interest rate front, emerging market local currency bond yields remain elevated – above 6% per annum on average for 10 year bonds. While the average emerging market bond yield has edged lower in 2019, SA bond yields have moved higher this year (see figure below). The market in SA bonds is factoring in more rather inflation and a still weaker USD/ZAR exchange rate. Unlike in the developed world, the cost of capital, that is the required rates of real return to justify expenditure on additional plant and equipment, remains elevated in SA. This means a continued discouragement to such expenditure and is negative for the growth outlook.

SA and emerging market bond yields (10 year)

Source: Thomson-Reuters, Federal Reserve Bank of St Louis and Investec Wealth & Investment

Capital remains very expensive for SA borrowers and growth rates remain subdued.

Interest rates and spreads in the SA bond market

Source: Bloomberg and Investec Wealth & Investment

A combination of more inflation expected with less inflation realised, because demand has been so subdued, has been toxic medicine for the SA economy. As in the developed world, the slack in the SA economy calls for stimulation from lower interest rates. And, unlike the developed there is ample scope for traditional monetary policy – in the form of rate cuts.

The inflation expected of the SA economy reflects the well-understood dangers of a debt trap and that the SA economy will print sometime in the future print money to escape its consequences. Yet fighting these expectations, which have nothing to do with monetary policy, with austere monetary policy makes no sense at all. Rather it means more economic slack, less growth, a larger fiscal deficit and enhanced inflationary expectations. Eliminating slack with lower short-term interest rates would do the opposite.

Earning profits, not acting like governments, remains the central task of business

One of my pleasures is to listen in conference to the accounts of great business enterprises, as told by their CEO’s and CFO’s. They seldom fail to impress with their grasp of the essentials of business success in a complex world. One that always contains the threat of competition from close rivals and even more dangerous the disruption of their business models and their relationship with customers from quarters previously unknown. They are in it for the long run – not the approval of the stock market over the next few months. Short termism does not make for business success.

They sense the growing opportunity data collection and analysis offers to produce distribute and market their goods and services more efficiently. To scale the advantages of their intellectual property and culture, they must have global reach that inevitably includes managing successfully in China, with all its opportunities challenges and trade-offs. They are well aware of meeting the demands society and its governments may make on them for them to be able operate legitimately. They know they have to play by rules over which may have little influence.

And one senses from them a new urgency about a more disciplined approach to the management of shareholders capital. Business success and the performance of managers is increasingly measured by (internal) returns on capital employed, properly calibrated, that adds value for investors by exceeding the returns they could expect from the capital market with similar risks.

The business corporation is the key agency of a modern economy. The success of the developed world in raising output and incomes – improving consistently the standard of living is surely attributable in large part to the design that accords so much responsibility to businesses large and small. The improvement in the average standard of living, and of those of the least advantaged of the bottom quartile of the income distribution (helped by tax payer provided welfare benefits) in what we define as the developed world has been at a historically unprecedented rate over the last 70 years or so. While the rate of economic improvement may have slowed down in the past twenty or ten years it sustains an impressive clip. Over the past 20 years GDP per capita in constant purchasing power parity terms in the largest seven economies (G7) as calculated by the IMF has grown by a compound average 2.8% p.a. Over the past 10 years this growth rate has slowed only marginally to an average of 2.7% p.a. A rate rapid enough to double average per capita incomes every 26 years or so.

One might have thought that the proven capabilities and potential of the modern business enterprise would enjoy wide appreciation and respect. That is for its ability to deliver a growing abundance of goods and services that their customers choose, many of which thanks to innovations and inventions sponsored and nurtured by business that were unavailable or inconceivable to earlier generations. In so doing to provide well rewarded employment opportunities to so many and to provide a good return to their providers of capital – both debt and share capital. A large majority of whom, directly and indirectly, are not rich plutocrats but are the many millions of beneficiaries of savings plans, upon which they rely for a dignified retirement.

But this is not the case at all. Even for the commentators in the leading business publications who present a view of the modern economy and its dependence on the corporation as in deep crisis. A sense of grave economic crisis that given the much improved state of the global economy and of the role corporations play in it that is very hard to share for the reasons advanced.

For example Martin Wolf in an op-ed in the Financial Times (September 18 2019) Why rigged capitalism is damaging liberal democracy Economies are not delivering for most citizens because of weak competition, feeble productivity growth and tax loopholes

To quote Wolf’s conclusion on the reformed role of the corporation

“……They must, not least, consider their activities in the public arena. What are they doing to ensure better laws governing the structure of the corporation, a fair and effective tax system, a safety net for those afflicted by economic forces beyond their control, a healthy local and global environment and a democracy responsive to the wishes of a broad majority? We need a dynamic capitalist economy that gives everybody a justified belief that they can share in the benefits. What we increasingly seem to have instead is an unstable rentier capitalism, weakened competition, feeble productivity growth, high inequality and, not coincidentally, an increasingly degraded democracy. Fixing this is a challenge for us all, but especially for those who run the world’s most important businesses. The way our economic and political systems work must change, or they will perish.”

However much you might or might not share this view of the corporation, a state of being that is not at all apparent in the accounts of the threats and opportunities provided by business leaders- or in their actions as suggested earlier. Particularly when they are seen as rentiers given some guaranteed source of income provided by a conspiracy of protection against competitive threats. You might agree that he would have the leaders of the large modern corporation accept much greater responsibilities for the (apparently) failing human condition – responsibilities that are surely the essential purview of government. It is to ask corporations to achieve much more than they are at all capable of achieving to the satisfaction of society at large. It is to set them up for failure and to threaten the essential role given to them by society

The bad news- it takes a weak rand to keep South Africans at home. There is a better way to attract capital- human and financial

What inflation adds by way of higher prices, revenues or incomes, weaker exchange rates can be expected to reduce their value abroad. If the move in exchange rates was equal to the difference in inflation rates between SA and its foreign trading partners, the different fields on which we work or play across the globe would be a level one.

Clearly economic life does not work that way. Our rands almost always have bought us more at home than they do abroad – when exchanged at the prevailing exchange rates. The difference between what our rands can buy at home or abroad can be calculated as the difference between the market rate of exchange and its purchasing power equivalent, as determined by the differences in inflation rates.

Since December 2010, when a US dollar cost R6.61, consumer prices in SA have increased on average by 58%. In the US average prices were up by a mere 16% over the same period. If the USD/ZAR had moved strictly in line with the changing ratio of consumer prices in the two economies (168/116 or 1.36) the dollar would have moved from 6.61 rands to 9 rands for a dollar in August 2019. (9/6.61 =136) A weaker exchange rate of 9 rands to the US dollar would have levelled the playing field. (see chart below)

2010 is a good starting point for such a calculation. The rand then was very close to its PPP equivalent were you to use 1995 as a starting point for the calculation. It was in 1995 that the rand became subject to largely unrestrained capital flows. Until then the (commercial) rand traded consistently close to its purchasing power value

The reality is that exchange rates are determined by forces that may have very little to do with actual price changes in the markets for goods and services. They move in response to global capital flows between economies that can dominate the flows of currency rather than to the flows of exports and imports that are price sensitive to a degree.

As a particular economy becomes more risky capital tends to flow away and exchange rates weaken and interest rates rise to balance supply and demand for the local currency. And if the shocks to the exchange rates are sustained, the inflation rate will respond as the prices paid for imported and exported goods in the local currency, increase or decrease- but with a time lag. This time lag determines the degree to which exchange rates diverge from PPP. The exchange rate leads and inflation follows – not the other way round – as theory might have had it. And convergence to purchasing power equivalent may take a long time.

Converting your SA wealth or incomes from rands into the equivalent purchasing power in the US at August month end would therefore have required the following adjustment. That is to reduce the 6.6 dollars received for R100 at market exchange rates by about 60%. This being the ratio 9/15.2 Having to pay only nine rand for a dollar would have been enough to net out the inflation impact. Rather than the R15.2 you actually had to give up for an extra dollar to spend in New York. (9/15.2*6.6 =3.9)

Thus any R100 of spending power in SA would have provided the equivalent of less than 4 dollars of roughly equivalent spending power in the US. Or in other words what would be regarded as a substantial fortune of R100m in SA would have provided a mere 4 million dollars of buying power in the US. Perhaps not enough to live well – or not nearly as well – as you could live in SA off your capital.

Consumer prices in SA and the USA and exchange rates (2010-2019)

Source; IMF World Economic Outlook Data Base. StatsSA, Federal Reserve Bank of St.Louis and Investec Wealth and Investment

This purchasing power discount (((6.6-3.9))/6.6)*100= 40% at August month end) is a significant deterrent to the relocation of wealthy and skilled South Africans with only rands to support a life style in the developed world. Mobile younger South Africans, with a life of income earning and saving opportunities ahead of them, could undertake a similar calculation. That is multiply the prospective hard currency salaries they might be offered abroad, when measured in current exchange rates, by approximately 6/10’ths to account for their lesser purchasing power. Earning and saving rands at home (and perhaps investing abroad) might yield improved life-time consumption.

We should be relying more on better economic fundamentals than on an undervalued exchange rate to keep capital at home- especially our most valuable human capital. If South Africa would play the economic growth cards more effectively and reduce its risk premium it would retain and attract more capital on better terms. The nominal rand could then again approach its PPP value and the cost of borrowing rands (and dollars) would come down with less inflation expected. SA Incomes after inflation could grow at a much faster rate – encouraging immigration rather than emigration of capital and skills.