Category: SA Economy

Piece written for the Free Market Foundation: http://www.freemarketfoundation.com/publications-view/the-market-for-jobs-in-south-africa-%e2%80%93-why-it-performs-so-poorly-and-what-can-be-done-to-improve-it-

A pdf version is also available here.

The global economy remains hostage to a volatile US dollar

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

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

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

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

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

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

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

The real exchange rate is what matters for real business activity

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

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

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

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

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

Measuring real exchange rates – a focus on South Africa

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

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

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

Sensitivity to the base year

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

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

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

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

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

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

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

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

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

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

Real exchange rates considered more widely – the international evidence

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Table 1: Real exchange rates summary statistics

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

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

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

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

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

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

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

The impact of exchange rates on prices and inflation

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

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

How should monetary policy react to exchange rate shocks?

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

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

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

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

Source: Bloomberg and Investment Wealth & Investment

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

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

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

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

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

The implications of exchange rate volatility for investment portfolios

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

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

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

The alternatives to fiduciary currencies and flexible exchange rates

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

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

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

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

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

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

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

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

Below follows an update on this piece from Monday. 

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

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

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

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

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

Source; Bloomberg and Investec Wealth and Investment

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

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

Source; Bloomberg and Investec Wealth and Investment

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

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

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

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

Source; Bloomberg and Investec Wealth and Investment

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

Source; Bloomberg and Investec Wealth and Investment

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

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

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

Additional Figures

Equity performance in 2017 to November 17^th Daily Data

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

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

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

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

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

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

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

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

Source; Bloomberg and Investec Wealth and Investment

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

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

Source; Bloomberg and Investec Wealth and Investment

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

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

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

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

Source; Bloomberg and Investec Wealth and Investment 

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

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

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

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

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

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

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

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

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

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

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

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

[1]

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

I have a very radical policy proposal, which is to repeal the National Credit Act. Repeal would allow lenders and borrowers complete freedom to contract with each other for credit on any terms they found agreeable. It would help transform the economic prospects of many South Africans who do not benefit from regular incomes and so do not qualify for credit under current regulations.

Freer access to credit would be particularly helpful to informal traders and aspirant farmers and entrepreneurs. By saving the significant costs of complying with current regulations, a repeal might well lead to less expensive borrowing terms for the many who currently receive credit. Strong competition for potential credit business would convert lower compliance costs of providing credit into lower charges for all borrowers. The reputation of the lenders for fair treatment of its customers would become even more critical in attracting new and repeat credit business. A lender would not have to proclaim it is an authorised financial service provider as if this were some kind of guarantee that absolves borrowers or lenders of the need to undertake proper diligence.

The importance of maintaining reputation – brand value – in which so much is invested, including training employees to deliver their services better than their rivals, is what keeps profit-seeking businesses honest and efficient. It attracts the most valuable type of business, repeat business.

Perhaps, given their knowledge and experience, the regulators and compliance officers that would be rendered unemployed should my proposal come to pass, could be converted into useful predictors of the ability of potential borrowers to deserve the credit on offer. Identifying much more accurately and easily the credit rating of any potential borrower would allow for well-targeted, attractive offers of credit – perhaps initiated at very low cost over the internet. Credit markets are particularly well-placed to apply the new science of big data management that is revolutionising all business.

There is a long history of limiting (defined as usurious) interest rates that may be charged to borrowers, which has disturbed and complicated the contracts borrowers and lenders agree to – and in turn has encouraged regulation of these complicated terms. If lenders were free to declare all revenues they expect to receive from a borrower as simply interest or capital repayment, at whatever rate agreed to, borrowers could easily make comparisons of the costs or benefits on offer. This is the case when a motor car is leased for a monthly payment. How much of this payment pays for the car and how much for the motor plan is irrelevant to the driver. It is simply a question of how much car the monthly payment buys. The benefits of the transaction to the motor dealer, the lessee and the lessor are bundled into one convenient monthly payment. We do not pay a hotel separately for towels, linen, or air conditioning – ‘free’ breakfast may even be included in the daily rate. And no regulator (yet) tells the hotel to itemise its menu or what services they are allowed to charge for and how much they can charge

The National Credit Regulator however allows the lender only clearly defined fees and payments that include the repayment of the principal debt; an initiation fee, a service fee, interest, the cost of any credit insurance, default administration charges and collection costs. It has argued that a fee charged to retail customers to join a club of customers cannot be levied. The jury or, rather, the judges are out on this one.

Club fees, delivery, insurance or other charges are all contributions to the lender’s revenue, in addition to interest payments that are controlled. Reducing the lender’s ability to raise revenues from explicit interest charges or to protect themselves with capital repayments leads inevitably to a complicated array of fees to supplement interest received. Restricting the flow of revenues therefore means less credit supplied to well- qualified borrowers. This is an unsatisfactory outcome that an unregulated credit market would overcome. 7 July 2017

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

My book Get SA Growing (Jonathan Ball 2017) hopes to persuade South Africans that there is a clear and highly realistic way out of our poverty trap. And that is to let all our people exercise much more freedom to help themselves improve their economic circumstances. Or in other words for the economy to rely much more on highly competitive market forces, to determine output, incomes, jobs and wages. There is overwhelming support from economic history, especially from the recent immense poverty reduction achievements of many Asian economies, of how it is possible, using the power of the market place, to lift billions of people out of absolute poverty.

South Africa could be playing much more helpfully to its objective strengths – and that is the competence and competiveness of established businesses and new entrants to business to effectively deliver goods and services and employment and incomes. And are highly capable of doing much more for their stakeholders. Not only for their owners, but for their numerically much more important customers and employees.  And their owners, often pension and retirement funds who manage most of our savings, are rapidly becoming as racially representative of the work-force. Something ignored so opportunistically by the politics of empowerment.

The book tries to build trust in and respect for market forces by examining and explaining what goes on in our economy and how and why it could be better organized for the benefit of nearly all of us- and especially the many desperate poor. It is written by an economist for my fellow South Africans who share my frustration with our economic failure.

We should have more respect for the rights of individuals to make their own decisions and bear the consequences of them. And we should not allow adults who have the power to elect their government to be treated as if they were children in need of close supervision- an assumption often convenient for politicians and the officials who direct government spending on their behalf. Private providers of goods and services, now supplied by government agencies, would treat people much more as valued customers rather than as supplicants.

Privatization of the delivery of benefits – currently funded by the taxpayer – would produce much better results- especially in education – where the spending and tax burden is a heavy one and the outcomes so disappointing. The extra skills that would command employment and higher incomes are simply not emerging nearly well enough. Radical reforms are required that would make public schools and hospitals private ones. And convert public enterprises into more efficient private ones that would not convert losses and poor operating procedures into ever increasing public debts. Privatization could be used to pay off the expensive public debt.

A much greater reliance on and encouragement for the free play of market forces is called for in South Africa Much less should be expected from well-meaning national development plans or from even honestly governed state owned corporations to deliver the essential jobs and goods and services. Perhaps even more dangerous to the well- being of all South Africans would be to provide even greater opportunity for doing government business, funded by taxpayers, on highly favourable (non-competitive) terms with the politically well-connected few. The newly promulgated Mining Charter is an exercise in extreme crony-capitalism that will undermine the future of mining in SA and its ability to create incomes, jobs and tax revenues.

Faster economic growth would be truly transformational.  Building on the strengths we have- on our skilled human capital that is globally competitive – and so very vulnerable to emigration – and on the proven ability to raise financial capital from global markets when the prospects are favourable – faster growth would greatly stimulate the upward mobility of an increasingly skilled black South Africans. The upper reaches of the economy could soon become as racially transformed as have the ranks of the middle income classes. And the very poor and less skilled (now mostly not working) would benefit greatly from increased competition for their increasingly valuable and scarce services. Forcing transformation of the leaders of the SA economy would have the opposite effect. It would mean further economic stagnation and increased resentment of higher income South Africans.

The hope is that the book will make it more likely that the economic future of South Africa will be decided in a less racially charged way- with more reliance on meritocratic market forces. South Africa in fact undertakes an extraordinary degree of redistributing earned incomes, unequal because the valuable skills that command high incomes are so unequally distributed. That is unusual amounts of income is currently taken from the very well off to fund government expenditure – judged by the practices of other economies with comparable incomes per head. But economic stagnation has now severely limited the capacity to help the poor. More of the higher incomes that come with growth can then be redistributed to the least advantaged -hopefully with much more help from private suppliers of the benefits provided.  Growth and redistribution is very possible for South Africa- should we change our ways and grow faster – as the book hopes to persuade South Africans to do.

Cyberspace has revealed the modus operandi of a group of SA businesses that have excelled (if that is the right term) at doing business with the SA government. We now know just how profitable these favoured procurement exercises have been.

The large modern state, which includes state owned business enterprises with genuine monopoly powers, has significant economic powers to contract for goods and services from private suppliers. Such contracts, we would surely agree, should be determined in an objective way and be subject to genuine competition for such potentially valuable business opportunities.

If objectivity is not to be the guiding principle, the waste incurred is not only in the form of hard-earned tax revenues or borrowing powers supported by the tax base. It also means a sacrifice of the alternative benefits that might have been better provided for – including spending on the least advantaged of society. That officials of government, responsible for such negotiations, might directly benefit from such contracts, is always a possibility, to be guarded against by appropriately vigilant and transparent procedures.

Government practice, anywhere in the world, does not always conform to best practice. A case can therefore be made for not only better, and more honest government, but also for less government. This argues for a smaller, less intrusive role for government as a supplier of goods and services (as opposed to funder of benefits). This would leave space for private hospitals or private schools, for example, to compete for demanding patients or pupils, funded partly or fully by the taxpayer. It would also call for the privatisation of public enterprises, with the proceeds used to pay off government borrowing.

In some societies the degree of corruption can be such as to not only destroy the practice of good government itself, but to undermine the efficiency of the greater economy. Economic growth itself, of the inclusive kind, becomes much more difficult to realise and is replaced by exclusive growth that benefits mainly those in power and their politically-favoured hangers on.

One term that describes such a failing economic system is ‘state capture’. Another is crony capitalism. South Africa is in grave danger of more crony capitalism and of undermining the growth prospects for our economy and benefits for the poor that a competitive market led economy could deliver.

Cyberspace has also revealed that the notion of ‘white monopoly capitalism’ is a creation of a PR company employed by the same group of SA businesses that have benefited so greatly from state largesse. But the notion of white monopoly capital is a politically and racially charged canard. It is an attack on well-established enterprises that compete actively and effectively for customers and employees, and which effectively service their stakeholders – who are mostly black South Africans. If these enterprises are JSE-listed enterprises, their shareowners will be pension or retirement funds, the beneficiaries of which will increasingly be black South Africans. It is convenient for crony SA capitalists and their supporters to ignore such ownership claims in conventional measures of empowerment.

Any constraints on these established businesses to compete freely for customers, skills or capital will harm their many owners, customers and employees. It will also harm the employment and income prospects of many poor South Africans. And by reducing the growth of the economy, they limit the tax base that could be used to support them.

How Orwellian it is to find the enemy in established businesses that are the most capable and competitive element of our economic structure. Arguments are raised to increase the scope for crony capitalism, rather than diminish it. The newly released Mining Charter is unfortunately a charter for more crony capitalism. However its terms of engagement make it very unlikely that more capital will be allocated to risky exploration or mining developments. Giving up 50% or more of the upside in any venture, for no protection on the downside, is a severe impediment to risk taking. Not only will potential employment or income or taxes from mining in SA be sacrificed, the very few intended beneficiaries (the potential cronies) will find the takings hard to realise – if there is no investment. 23 June 2017

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

The author makes the full case for genuine capitalism in South Africa in his recently published book, ‘Get South Africa Going’ – Jonathan Ball Publishers, Johannesburg and Cape Town, 2017.

My book has been published. ( See below for details ). It should be available in the book stores and on-line very soon. The chapter outline included in the Foreword is shown below.

Get South Africa Growing

Jonathan Ball Publishers
Johannesburg and Cape Town

Brian Kantor

Published in South Africa in 2017 by
JONATHAN BALL PUBLISHERS
A division of Media24 (Pty) Ltd
PO Box 33977
Jeppestown
2043
ISBN 978-1-86842-763-5
ebook ISBN 978-1-86842-764-2

Chapter outline

In the first chapter, I address the current very unsatisfactory state of the South African economy seen as a whole – the macro environment – and what might be done to improve it. I accept that the global economy has made it more difficult for our economy to grow faster in recent years and I consider what more favourable cyclical forces might spark faster growth. But, I would argue that our problems are not with our stars but with ourselves, and while the challenge to government is to live within the taxpayer’s means, it is a call for not just more competent government but also less government.

In Chapter 2, I make the argument for market forces properly understood – why they are fair to the participants in markets while delivering the goods, services and incomes that people want more of. I make the case for the market meritocracy and why much greater reliance on the free play of market forces is called for in South Africa. As support for this contention, I refer to the proven ability of these market forces, of individuals given essential freedom and encouragement to pursue their economic interests and protection of their gains, to lift billions of people out of absolute poverty in recent years. The global economy bears witness to an unprecedentedly successful poverty relief programme that deserves greater recognition appreciation than it has received and emulation for other economies playing catch-up. The chapter attempts to do this.

Chapter 3 attempts to answer a burning question: given its well-demonstrated achievements, why do these market forces, and the business enterprises that are their prime instrument, not receive more approval? Why are they so often regarded with hostility rather than respect? Why are they regarded as opposed to the economic interests of the many they serve, thought capable of dishonesty unless proved otherwise, rather than the other way around – recognised as beneficent forces for economic progress, unless in exceptional cases proved otherwise? In doing so I challenge those with these attitudes to perhaps reconsider their motives and to change them – so that markets in this country can more easily get on with their important task of delivering goods, services, incomes and jobs in abundance.

Chapter 4 provides further exhortation to South Africans and arguments to back up this essential view of the world and how it works. It attempts to explain how we as a society would do much better to focus on the growth in incomes and wealth rather than their redistribution. The danger to the growth opportunity is redistribution – redistribution not necessarily to the poor that are deserving of assistance, but to the better-off with a strong sense of opportunity. Opportunities that can advance the economic welfare of a privileged minority but are taken at the expense of a better functioning economy and are often to the disadvantage of the objectively poor and disadvantaged. More redistribution – taking from the more successful to give to the economically less successful – inevitably follows economic growth. It has always done so, as the history of other economies reveals. But it is vital to get the sequence right and not to let redistribution – of which we already do significant amounts – get too much in the way of faster growth by undermining the incentives of enterprising and efficient individuals to contribute their skills and assets to the economy. Discouraging rather than encouraging such individuals means that they could easily decide to supply their services to other economies rather than ours.

Chapter 5 and 6 look more closely at the labour market and at policies for regulating the South African economy and encouraging competition. Chapter 7 examines competition policy in more detail and looks at why activist policies are not good for business and so the economy. My scepticism about the beneficence of such policies will be apparent, as will hopefully the reasons for my critique. I hope that public opinion will share such views and help inhibit the ever-flowing tide of more onerous regulation and more active competition policy, which discourages rather than encourages economic efficiency in a world of continuous innovation that effectively threatens what are temporary powers to control markets.

Chapter 8 shares insights about the all-important role played by privately owned corporations and the stock exchanges that help them raise capital and monitor their use of capital. I analyse the sources and uses of savings in South Africa and why our corporations have succeeded, on both sides of the saving–investment nexus, for their owners, who are mostly members of pension and retirement funds and collective investment schemes. I celebrate the opportunities that South Africans, the pension funds that act as their agents for acquiring wealth, and the companies that they own on their behalf have been given in recent years to diversify their wealth across other jurisdictions. I explain why being able to reduce South Africa-specific risks to the wealth of South Africans has been very helpful to the economy. This has encouraged risk-taking in South Africa rather than elsewhere. This chapter also discusses the costs and benefits of black economic empowerment (BEE).

To conclude, Chapter 9 supports the thrust of my argument by turning to measures of South African economic performance. It considers how South Africa ranks relative to our competitors in the global economy. The measures of our standing in the world are mostly very discouraging – and encouraging of reforms that would add freedom and competitiveness and enhance both incomes and standing, as well as respect for our economy as a place to do business.

The text is supplemented by shorter essays, entitled ‘Point of View’, previously published on my www.zaeconomist blog and elsewhere, that substantiate and concentrate the argument without repeating too much. If you like, they offer a short reinforcement of the message.

Brian Kantor

February 2017

I recently asked a class of senior law students what they thought the purpose was of all the laws that protect property (wealth or assets or capital by other names) against theft, fraud or seizure, including by the state, and the purpose of the many laws that facilitate the exchange of assets.

The students did have a sense of the fairness of such laws protecting owners. They did not recognise the importance of the economic incentives at work: that unless rights to property were exercised, there would be little incentive to create wealth; to save, to build and to sacrifice immediate consumption for later benefits for society at large.

Who would wish to save up to build a house or a business or improve a tract of land, providing goods, services and incomes to others, if someone more powerful could move in and take over? But I also pointed out that the value of assets owned can be severely damaged by regulations of their use (perhaps of net benefit to society at large) for which compensation is seldom allowed by the courts. I spoke of the proverbial little old lady and her children whose only meaningful asset is a house, whose value is much diminished by declaring it of historical interest – for which compensation could be offered but in practice is never offered or awarded.

I made the point that property rights or their absence (or the dangers of regulation of the use of assets) would be reflected in the market value attached to such always vulnerable assets. Threaten for example a wealth tax or a mining tax and the value of assets and the incentive to create wealth will be undermined in ways that are very likely to harm the poor.

But the state not only has the power to take wealth, it also exercises the power to take from wealth or income from some and give it to others. South Africa has supplied very large numbers of houses to essentially lucky recipients – lucky because the waiting lists for gifts of this value are very long and will never be exhausted. The numbers of such interventions in the housing or accommodation space are not known with certainty, nor is it fully known what happens to the houses once handed over.

The important question is how should the value of these gifts of housing or land or low rentals be best protected by law? Protected surely best by full rights of ownership attached to them, as is the wealth protected when created through the sacrifice of consumption or the sweat of a brow. Living in a potentially valuable home without food on the table has little logic to it. Effectively exchanging the house for more food and cheaper informal shelter may be a sensible choice to make. Leasing out and combining small parcels of farming land can provide a better standard of living for its new owners than subsistence farming on it.

Our laws that most unfortunately restrict property rights – for example that only allow the transfer of RDP homes after eight years of occupancy or prevent formal rental contracts – accordingly leads to widespread losses and waste. To houses that exchange hands at far less than their cost or potential and that can never form part of any inheritance or tax base. To potentially valuable farms that become wastelands.

We should make all transfers of government assets to private ownership immediately come with full rights of ownership. And we should be making every effort to convert currently fallow government owned and tribally managed land to private ownership with full rights, whoever are the initial beneficiaries. This will then allow the market place take over to make the best use of these assets. The impact on the economy will be as favourable for the creation and preservation of wealth and the generation of extra incomes in SA, as secure property rights always prove to be. 28 April 2017

Click here for a shorter version of this article

There will be good economic reasons for rejoicing should he go. The rand would strengthen – it would move back into line with its emerging currency market peers. Today this would have meant a USD/ZAR of approximately R12.6. Yesterday, April 12^th a day of protest and a day when the probability of Zuma going sooner rather than later improved, saw a basket of EM currencies gain seven cents vs the weaker USD while the ZAR gained 34 cents, indicating less SA specific risk priced into the rand.

If the rand maintains these better values lower inflation will follow the lower costs of imports and the lower prices for exports and would bring lower short term interest rates in its wake. Cheaper than otherwise goods and services and credit would encourage households to spend more- as would the higher house prices and equity in homes that accompany lower mortgage rates and a more hopeful outlook for South Africa. And the firms that supplied them would be much more inclined to add, rather than contract capacity and hire more rather than fewer employees, as they are now doing. The SA business cycle would turn up rather than down.

The yield on longer dated RSA debt would also tend to go back to where it was, reducing the cost of servicing our national debt –easing the burden on SA taxpayers and opening up the possibility of more help for the poor and improve the prospects of growth friendly, lower tax rates. The first Zuma attempt to control the Treasury in December 2015 took the yield on RSA 10 year bonds from 8.5% p.a in early December that year to about 9.6% by early January 2016. This move also widened the spread between RSA and US debt by about the same 100bp ( see figure below) from about 5.7% p.a to 6.7%. The latest Zuma intervention in the Treasury has seen this risk premium rise further, but not dramatically, from a still unsatisfactory 6.46% level in early 2017 to the current 6.6% p.a level.

The ZUMA factor driving SA risk

Source; I-net Investec Wealth and Investment

This spread may be regarded as the SA risk premium, the extra returns in rands, all South African investments have to be able to offer to justify their viability – in addition to their covering the additional business risks associated with a particular enterprise.  This extra return is also the rate at which the rand is expected to depreciate over the next ten years. And the weaker the rand the more inflation expected. The Zuma interventions have understandably have resulted in the rand being expected to lose dollar value at a faster rate and so also, in a consistent way, to increase the expected inflation rate. The market place understandably expects a weakened Treasury to be less able to control government spending and less conservative in how such spending is funded. That is less able to raise taxes and less willing to pay ever higher rates of interest on its debts and so more inclined to print money, an approach that would be clearly inflationary.

Another way of measuring risks would be to convert the calculation of required returns and risk into to much less inflationary USD. The yield on US dollar denominated debt issued by the SA government provides an appropriate bench mark for measuring required risk adjusted returns on South African assets. As we show below these dollar yields rose significantly from around 3.6% in early 2015 to as much as 5.12% p.a. by year end. Since then this rate has receded but increased by a significant 36bp since mid- February.  The cost of insuring SA 5 year dollar denominated debt against default, an accurate measure of real sovereign risk has followed a similar pattern rising from 1.82% p.a at its lowest in 2017 to the current 2.15% p.a. That is when converted into USD an investment in a South African asset would be required to return over 2% p.a. more in USD than an equivalent US investment to justify its value.

Zuma risk measured in USD

Source; Bloomberg, Investec Wealth and Investment

More risks demand higher returns (sometimes described as the hurdle rate capital raisers have to leap over) and the higher the required returns the fewer investment projects will qualify – to the grave disadvantage of the economy and its growth prospects. The object of economic policy should be to reduce such risks rather than to raise them- something the Zuma presidency has clearly failed at.

These required returns that add business risk to sovereign risk may also be regarded as the discount rate used to present value any flow of income from businesses or government agencies. The higher the discount rate attached to SA assets the less they are worth. Adding risk makes SA immediately poorer as well as undermining their income prospects as less is invested in SA projects that could add to incomes and demands for labour.

Yet given the reactions of the credit rating agencies that have down rated SA credit indicating a higher probability of default on our debt these market reactions as we have identified them must be regarded as surprisingly subdued.

The rand, and the market in RSA bonds, clearly benefit to a degree from the prospect that Zuma might not survive the campaign to remove him.  Were Zuma certain to stay rather than possibly go, we would be facing even more risk aversion more inflation expected, higher interest rates and a very likely recession as confidence in the prospects for the SA economy ebbed away.

Were Zuma to go the benefits could extend well beyond the promise of a revival of fiscal rectitude and less inflation and lower interest rates. It would offer the prospect of a radical economic transformation. By which I mean the cleaning of the Aegean stables that the State Owned Companies (SOC’s) have become. It would not require any Hurculean effort to do. A few investment bankers could do the job of converting the SOC’s into ordinarily valuable and well managed business. So converting them into assets from their current state of very expensive and potentially ever larger liabilities, that SA tax payers and consumers have to cover. Converting these burdens into private businesses that will compete for their custom, that will be run efficiently and deliver their goods and services at lower competitive prices – as business have to do to survive the market test would be a large plus for South Africans. And they would become taxpayers rather than incur vast contingent liabilities that damage our credit rating and raise our costs of finance.

Can any SA seriously believe that these SOC’s are essential to the purpose of developing the SA economy?  Or fail to understand that their actions are driven by the narrow interests of their managers and employees and what their suppliers can extract from them. Their monopoly powers that make this behaviour possible need to be removed by breaking them up into smaller units by selling off their assets to a variety of owners and operators. And the capital to fund these purchases will be abundantly available from domestic and foreign capital providers at market determined values.

The proceeds from their privatization could be used to pay of much of SA’s debt and dramatically reduce the interest burden of serving it and open up the prospect for genuine poverty relief. This transformation – turning great weakness into strength – would help raise the growth potential of the SA economy – and truly transform the economic prospects of all South Africans

There will be good economic reasons for rejoicing should President Jacob Zuma relinquish his post in the near future.

The rand would in all likelihood strengthen and would probably move back into line with its emerging currency market peers. Today this would have meant a USD/ZAR exchange rate of approximately R12.60.

Lower inflation will follow a stronger rand and bring lower short term interest rates in its wake. Cheaper goods and services and credit would encourage households to spend more, as would the higher house prices and equity in homes that accompany lower mortgage rates and a more hopeful outlook for South Africa. And the firms that supplied them would be much more inclined to add capacity and hire more employees. The SA business cycle would turn up.

The first Zuma attempt to control the Treasury in December 2015 took the yield on RSA 10 year bonds from 8.5% p.a in early December that year to about 9.6% by early January 2016. This move also widened the spread between RSA and US debt by about 100bps from about 5.7% p.a to 6.7%. The latest Zuma intervention in the Treasury has seen this risk premium rise further, but not dramatically, from a still unsatisfactory 6.46% level in early 2017, to the current 6.6% p.a level.

This spread may be regarded as the extra returns in rands that South African investments have to be able to offer to justify their viability – in addition to their covering the additional business risks associated with a particular enterprise. This extra return is also the rate at which the rand is expected to depreciate over the next ten years. The weaker the rand, the more inflation expected.

The cost of insuring SA five year, US dollar-denominated debt against default, an accurate measure of real sovereign risk, has followed a similar pattern, rising from 1.82% p.a at its lowest in 2017 to the current 2.15% p.a. When calculated in US dollars, an investment in a South African asset would be required to return over 2% p.a. more in US dollars than an equivalent US investment, to justify its value.

Greater risks demand higher returns and the higher the required returns, the fewer investment projects will qualify – to the grave disadvantage of the economy and its growth prospects. The object of economic policy should be to reduce such risks rather than to raise them, something the Zuma presidency has clearly failed at. Yet, given the reactions of the credit rating agencies, which have downgraded SA credit (indicating a higher probability of default on our debt), these market reactions must be regarded as surprisingly subdued.

The rand, and the market in RSA bonds, clearly benefit to a degree from the prospect that Zuma might not survive the campaign to remove him. Were Zuma to go, the benefits could extend well beyond the promise of a revival of fiscal rectitude and less inflation and lower interest rates. It would offer the prospect of a radical economic transformation. By this, I mean the cleaning of the Aegean stables that the state-owned companies (SOCs) have become. It would not require any Herculean effort to do.

A few investment bankers could do the job of converting the SOCs into a number of ordinarily valuable and well-managed businesses that compete with each other. They would be run efficiently and deliver their goods and services at competitive prices – as business have to do to survive the market test.

Can anyone seriously believe, in light of the evidence, that these SOCs with monopoly powers are essential to develop the SA economy? Or fail to understand that their actions are inevitably driven by the narrow interests of their managers and employees and what their suppliers can extract from them?

The proceeds from their privatisation could be used to pay off much of SA’s debt and dramatically reduce the interest burden of serving it, thus opening up the prospect for genuine poverty relief. This transformation – turning great weakness into strength – would help raise the growth potential of the SA economy – and truly transform the economic prospects of all South Africans. 18 April 2017