Category: SA Economy

The rand and the SA economy: All about the dollar

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

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

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

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

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

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

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

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

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

Point of View: Credit anxiety

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

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

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

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

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

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

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

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

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

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

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

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

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

How fares the SA economy? An update to December

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Monetary policy and the MPC: Recognising the facts

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

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

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

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

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

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

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

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

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

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

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

New Unit Vehicle Sales in South Africa

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

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

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

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

The Cash Cycles- annual growth in the note issue.

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

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

The cash and retail cycles. Current prices

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

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

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

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

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

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

Another own goal for SA

The SA government seems determined to press ahead with a national minimum wage (NMW). This is apparently with the agreement of organised business and labour, though the minimum levels themselves are still in dispute. It however appears likely that the NMW will be set close to the incomes that define “the working poor”, those who earned less than about R4000 per month in 2015 for a 35 hour working week.

Not much poverty relief at R4000 per month, you may think. Yet the problem is that most of those with jobs in SA earn much less than this while a large number of potential workers are unemployed and earn no wage income at all. According to a comprehensive recent study of the Labour Market in SA1 , even after adding 40% to wage incomes to compensate for “underreporting” in the Labour Force Surveys undertaken by Stas SA, 48% of all wage incomes representing 5m workers fall below R4000 per month and 40% earn less than R3000 per month, about 2.7m workers out of a total employed of about 13m. The proportion of those employed who fall below R4000 are much higher in the rural areas, higher in agriculture (nearly 90%) and domestic services (95%). At the other end of the spectrum is mining, where 22% of the work force earn less than R4000 per month. Even in the comparatively well paid and well skilled manufacturing sector, about 48% of the work force are estimated to earn less than R4000 per month.

Unless the laws of supply and demand for labour can be repealed, it seems obvious that were the NMW to be made effective, the consequences for currently low paid workers would be very serious. Many will lose their jobs, while many more young workers hoping to enter the labour market will find it even more difficult to gain entry to formal employment. Some excluded from formal employment may find work in the unregulated informal sector and many others will be required to work fewer hours, as employers seek to make their work force more efficient, to compensate for an artificially higher hourly rate. This trend is already well under way, according to the study. Other employment benefits provided by employers, such as pensions, health, housing and food, may be reduced to compensate for higher take home pay.

Why then would the government wish to push ahead with such a predictably disastrous initiative, imposed without regard to labour market fundamentals? Can the government and its advisors truly believe that wages have little to do with employment or that some miracle of economic growth or currently unrealised productivity gains will come to raise the demand for labour? Surely not, though the support of trade unions and large businesses for an NMW, expecting less competition for jobs from low paid workers or firms able to hire them, is entirely rational self-interest at work. Unions attempt to maximise the wage bill they can draw member dues from and business seeks to maximise profit, not employment. Robots can replace workers very easily especially at higher wages or rather improved employment benefits.

The case for an NMW must be a political one. It cannot be an economic one. If an NMW, proclaimed at levels well above market determined wages could cure poverty, the economic problem of poverty in SA and everywhere else would have been solved by decree a long time ago. The government must believe that fewer but better paid, so called decent jobs, will mean more support for it at the ballot box. Nobody would thank a government for employment at wages that do not provide an escape from poverty, even if the alternative more poverty for now and more dependence on government hand-outs of cash and housing.

Our labour market regulations and interventions have long been pushing employment and employment benefits strongly in this direction. Fewer well paid private sector formal jobs have been provided – relative to GDP – and many people have joined the ranks of the unemployed or the informally employed, the latter not fully captured in GDP estimates.

NMW may be a recipe for political survival but is not a cure for poverty in SA. It will retard the rate of economic growth in SA that is the only long term cure for poverty. Economic growth, sustained at a rate well above population growth, would gradually lift all incomes in SA, including those of the worst paid, as well as skilled workers. Achieving higher growth rates demands a more flexible labour market. Unfortunately SA continues to move in the other direction.

Prices and Budget Reviews – all promising austerity rather than progress

Amid the pandemonium in and around Parliament yesterday, something may have been missed. What probably escaped notice was that for a third month the CPI was unchanged. It reached a value of 116.1 in July, remained 116.1 in August and prices maintained that level of 116.1 in September. In other words, average prices in SA since July 2015 have remained unchanged and so the inflation rate in Q3 2015 remained a round zero. Headline inflation, the percentage increase in the CPI over 12 months was 4.6%, also unchanged from August 2015.

The upward pressure on the CPI from rising utility bills and house rentals, including the rentals owner occupiers are assumed to pay themselves, that added 0.9% to the CPI in September, was offset by lower petrol and transport costs that took 1.6% off the index. The prices of food and non-alcoholic beverages rose by a mere 0.1% in the month.

These outcomes in Q3 must have come as a surprise to the Reserve Bank, which believes inflation is driven largely by inflationary expectations. Hence its tendency to impose higher interest rates on the economy, regardless of where the pressure on prices may be coming from, less supplied or more demanded, for fear that inflationary expectations are self-fulfilling.

These inflationary expectations, with a much weaker rand in the quarter, might have been expected to have been elevated in Q3. Judged by the gap between the yield on conventional and inflation-protected RSA bonds, reflecting compensation for bearing inflation risk, as good a measure of inflation expectations as any, have changed little, and remained very stable about the 6% level, in line with the upper band to the inflation targets, as it has done for many years.

It is clearly not expected inflation that stabilised the CPI at 116.1 (2012=100). It was the weakness of final demands for goods and services that has so limited the pricing power of firms supplying households and firms not only in SA but almost everywhere else too. This lack of demand has put pressure on the dollar prices of goods imported into SA, including that of oil and grains. The so-called pass through effect on prices of a weaker rand is running at about a fifth of the impact predicted by the Reserve Bank’s inflation forecasting model.

The Reserve Bank needs a better theory of how prices are formed in SA than are determined (mostly) by inflationary expectations. This will help it avoid imposing unwelcome extra burdens on the economy in the form of higher interest rates when too little, rather than too much, spending is part of the problem, as it has been doing ever since early 2014 when short term rates were first increased.

Yes, higher taxes on energy or higher charges for electricity or water or roads or imports may put upward pressure on prices charged (as may the budgets of firms with pricing power) that presume prices can be increased in line with inflation expected. But as is now highly apparent, prices charged and recognised in the CPI are not crudely equivalent to costs, including employment costs, plus some profit margin. They are much better explained as profit-maximising or perhaps loss-minimising prices – what the market will bear prices, which reveal highly variable operating profit margins.

The update from Shoprite, SA’s leading food retailer released on the morning of the CPI update, told the same story of pressure on food prices and operating margins. And the declining employment numbers tell of the pressure of higher wage demands on numbers employed rather than on prices charged.

It is the weak state of final demands from both SA households and firms that is holding down the CPI as well as the GDP that is barely growing. Higher taxes imposed by the national government and the higher charges for electricity etc. levied by municipalities and yes also the fees charged by educational and medical service providers that have monopoly type pricing power and also, most avoidably, higher interest rates set by the Reserve Bank, have all taken their toll on household budgets and spending power and so the pricing power of the firms supplying them.

This lack of demand for goods and services and labour is being exacerbated by the inability of the SA government to sensibly limit and manage its own spending on employment benefits for government workers, the largest item by far in its Budget. This outcome, understandable in the circumstances, and given conservative objectives for government debt ratios, means discouraging still higher taxes on the productive economic agents of the economy and less spending by government on other items, including on useful infrastructure.

The Budget statement to Parliament was eloquent in its admission that unexpectedly large employment benefit concessions to public sector employees greatly disturbed the Treasury’s Medium term expenditure and revenue plans. This disruption to sound fiscal policy was explained in the Budget Statement as somehow beyond the control of the government itself. The bargaining arrangements with public sector unions that led to such exorbitant outcomes post the main Budget in February 2015, may well have been out of the control of the Treasury and its fiscal constraints. As such it represents just another government failure.

It is the failure of the government to recognise that the path to faster growth in SA is not only through more effective government spending, but less of it, combined with less interference in the economy that so engages the well paid but now shrinking government workforce. It is less government and so lower taxes and much more reliance on business for solutions to poverty and growth that should be the way forward for SA. Resisting this direction, as it is being resisted in Budget after Budget, leads to higher taxes and charges and less rather than more spending and slower rather than faster growth. In other words more public and private austerity of the kind we are experiencing.

Payrolls post mortem

Reading the changing market mind has become a more difficult exercise.

The report on US payrolls report on Friday, which was up 142 000 and well below the consensus estimate of 201 000, was not good news about the US economy.

The initial reaction of the equity and bond markets after the data release was to drive share prices sharply lower and bond values higher. But an hour later the share market reversed itself and ended the day 1.5% higher. Bad news about the economy had become good news for markets. These reactions, in the form of higher equity values to a weaker than expected employment number, might be a consistent response to a view that short term interest rates in the US would not now be rising any time soon.

The US dollar also weakened significantly through the day against the very hard pressed emerging market currencies, including the rand. Bad news was not only good news in New York; it was well received everywhere.

These market reactions on Friday – bad news for the economy translated into good news for markets, because interest rates would be lower than previously expected – were however in sharp contrast to the negative market reactions to the Fed decision on 23 September to delay any increase in interest rates for global rather than US economic weakness. Then, after initially welcoming the Fed decision, the equity markets turned sharply lower and emerging market currencies and equities were then particularly hard hit.

Other things being equal, lower interest or discount rates can justify higher equity (present) values. But the economic activity, or lack of it, that move interest rates are other things, especially the revenue and operating profit lines of companies. This means that other forces driving equity values cannot be assumed to remain unaffected by the state of the economy. Helpfully for shareholders, the market seems convinced for now that the lower US discount rate attached to expected operating earnings, as interest rates stay lower for longer, will more than offset any pressure on revenues and operating profits. Lower US interest rates relative to interest rates elsewhere, may well mean a weaker US dollar and also stronger emerging market currencies. Such prospects are helpful to emerging and commodity-producing economies.

Such very different reactions and market patterns revealed within a short period of time to market making news, makes for confusion about the state of the market mind. Will bad news about the US remain good news about the equity and bond markets and vice versa? Will the economic data releases confirm the strength of the US economy and send equities, currencies and bonds in the direction they mostly took in August and September 2015, for fear of higher interest rates? Ideally for shareholders around the world, the Fed will continue to worry more about slow growth and deflation than the reverse, and that such caution, reflected in consistently low short rates, will prove to be too pessimistic about both threats to the global economy, for an extended period of time.

Reflationary policies are usually helpful to share markets. The bullish argument for markets is that the Fed and the ECB (and indeed EM central banks) remain in a reflationary mood while growth prospects remain largely unchanged.

Taking stock of GDP

The SA economy in Q2 2015 was not as it appeared – after taking an inventory

According to the first readings of gross domestic output (GDP), in real terms for Q2 2015, the SA economy performed very poorly. It is estimated by Stats SA to have shrunk by 1.3% on a seasonally adjusted annual rate in the quarter.

(All figures are taken from the Quarterly Bulletin of the SA Reserve Bank, September 2015.)

 

On a second reading for the second quarter of figures provided by the SA Reserve Bank, which include estimates of the demand side of the economy, the outcomes, on the face of it things. seem even worse. Gross Domestic Expenditure (GDE) is estimated to have declined by as much as a 7.2% rate in the quarter. The outcomes were not nearly as dire as might be inferred from either the GDP or GDE estimates. Final demand, the sum of spending by households, firms and the government sector, actually grew by about 1%. That final demands continued to grow at a very modest pace is consistent with our own measures of economic activity. What turned final demands into very weak GDE growth rates was a dramatic decline in inventories. Inventories in Q1 grew by R8.8bn on a seasonally adjusted annual rate. In Q2 they declined by the equivalent rate of over R38bn. This decline in inventories was enough to reduce real GDP in the quarter by as much as 6.2%.

Much of the action is attributable to the large seasonal adjustment factor interpolated to the estimates of inventories, the consistency of which may well be questioned. It is normally the case that the second and third quarters are periods when inventories are built up and the fourth and first quarters are normally associated with a general run down in inventories. But as the Reserve Bank comments, inventory events in Q2 were anything but normal in the mining and oil sectors. To quote the Economic Review of the Reserve Bank for Q2 2015:

Following a modest build-up in inventories in the first quarter of 2015, real inventory levels declined significantly at an annualised pace of R38,9 billion (at 2010 prices) in the second quarter. The rundown of real inventories in the second quarter of 2015 was mainly due to the destocking in the mining and manufacturing sectors, partly reflecting subdued business confidence levels and a decline in import volumes.

In the mining sector, inventory levels at platinum mines in particular contracted during the period on account of a significant increase in the exports of platinum in order to fulfil offshore export obligations. The rundown of inventories in the manufacturing sector partly reflected lower crude oil import volumes due to scheduled maintenance shutdowns at major oil refineries over the period. Consistent with a slower pace of increase in retail trade sales, the level of real inventories in the commerce sector rose in the second quarter. Industrial and commercial inventories as a percentage of the non-agricultural GDP remained unchanged at 13,8 per cent in the first and second quarters of 2015.

Inventories can run down because firms lacking confidence in future sales plan for a reduction in goods held on the shelves or in warehouses. They may also run down in an unplanned way because firms are surprised by the actual sales they were able to make. The planned reduction in inventories can represent bad news for the economy as orders decline. The unplanned reduction can mean better news should firms attempt to rebuild inventories. Similarly, a planned increase in inventories can reflect a more confident outlook for sales to come. An unplanned build-up of inventories may also reflect unexpectedly poor current sales volumes, and so fewer orders to come in the quarters ahead. Making the distinction between planned and unplanned inventory accumulation will be all important for any forecast of economic growth. In the case of the SA economy in Q2, it seems clear from the Reserve Bank statement that the run down in inventories in Q2 was for largely idiosyncratic reasons, making the application of seasonal adjustments particularly subject to error.

Judged by the estimated growth in final demand, the economy did not deteriorate in Q2 as the statistics on the pure face of it may suggest. In our judgment of the National Income Accounts released for Q2, the economy continues on its unsatisfactorily slow growth path as other indicators of the economic activity, included our own Hard Number Index, have revealed. The economy is growing slowly and not shrinking, nor is it about to do so. There is moreover at least one silver lining to be found in the latest statistics. As much as inventories subtracted from the growth rate, net exports added as much, due to the growth in export volumes and the stagnation of import volumes. The trade balance went into surplus and the current account deficit declined thanks to the weaker rand and the relative absence of strike action.

Another development this year, essential to lessening the tax burden on the productive part of South Africa, and so increasing potential growth, is the further decline in public sector employment in Q1 noted by the Reserve Bank. Lower tax rates and less spent on employment benefits for a bloated public sector, also lower interest rates, will help stimulate a recovery in the all-important household spending that is essential for faster, sustained growth over the longer run.

A combination of export growth and a stronger trade balance combined with a smaller budget deficit, accompanying fewer expensive public officials, of the kind revealed in Q2 2015, is some of the right stuff necessary to recalibrate the SA economy in the collective mind of the global capital market from a fragile to a resilient economy.

Time to change the narrative

The Reserve Bank needs to change the narrative on inflation and interest rates to take full account of the economic realities

The rand exchange rate since 1995 has proven to be anything but predictable. Despite this, with the help of hindsight it is possible to explain why the rand has behaved as it has over the years. It can be shown that, since 2014, it has been more a case of US dollar strength, against almost all currencies, than rand weakness that explains the rand/dollar exchange rate. In recent weeks the rand has also weakened against the euro, again also in line with almost all other emerging market currencies.

 

Explaining dollar strength is an art form all of its own. It has much to do with the superior performance of the US economy over the past few years, allowing US interest rates at the long end of the yield curve to rise relatively to rates prevailing in Europe and Japan. The strength of the US recovery has also led the money market to believe that short monetary policy determined rates in the US are soon about to rise – adding to the demand for US dollars.

A consistently important influence on the foreign exchange value of the rand is the state of global capital markets. When global allocators of capital feel more secure about the state of the global economy, they favour riskier assets and riskier currencies. And vice versa: when caution rules, funds flow in the opposite direction to safer havens. The rand as a well traded emerging market currency (as well as rand denominated bonds and equities) falls into the category of one of the more risky, that is volatile, currencies and markets, as do most other emerging markets (EM) currencies. Currency moves associated with the Global Financial Crisis (GFC) of 2008-09, shown in the figure above, illustrate the vulnerability of the rand to such events.

It is possible to measure such risks in the bond markets. Measures in the form of a wider or narrower interest rate spread between South African or other EM debt can help identify the degree of risk aversion or appetite prevailing in the global capital markets. RSA and other EM US dollar-denominated debt trades at higher yields than US Treasury Bonds. These higher yields compensate investors for the risk that the debt issued in US dollar may not be honoured.

Foreign investors may also hold local currency denominated debt, for example rand debt, and so receive interest income in rands and other local currencies rather than dollars. Since the local central banks print their own currency and as much as they choose, there is no danger of any formal default on such debt, only that they may lose some of their US dollar value should inflation accelerate. The risk to these offshore investors holding local currency denominated securities is that the guaranteed interest income paid in a local currency will lose dollar value should the higher interest currency depreciate over time. The higher interest rates on rand-denominated debt compensate investors for expected rand weakness. The equilibrium and relationship between the difference in the interest rate for securities of the same duration and risk class and the contemporaneous percentage difference between spot and forward exchange rates is known as interest parity. Arbitrage maintains this relationship.

It can be demonstrated that the spot rand will generally weaken as these interest rate spreads widen – and vice versa when the spreads narrow. In the figure below we show two measures of SA risk: exchange rate risk and sovereign or default risk. The yield spread between RSA 10 year bonds and US Treasury bonds of the same duration is shown on the left hand scale while the cost of insuring RSA dollar debt of five years duration against default, known as the Collateralised Debt Security (CDS) spread issued by global banks, is shown on the right hand scale. Higher spreads of either kind are generally associated with rand weakness and vice versa for rand strength. It may be noticed how these spreads widened dramatically in 2008. Both spreads have moved in a narrower band since 2010 while the CDS spread fell back towards about 200bps.

It is possible to identify risks of default associated more specifically with SA rather than with EM bonds generally by comparing the CDS spread for RSA bonds with the spreads attached to all other EM debt, as estimated by JPMorgan. As may be seen in the figures below, SA risk and EM risk measures are highly correlated over time, indicating very similar forces at work. A wider difference between the EM Index spread and the RSA CDS spread, indicates a more favourable relative status for SA and vice versa. It may be noticed that this difference narrowed after August 2012 indicating a deterioration in RSA credit rating. However it may also be seen that the credit standing of SA has improved relative to other EM debt over the past year. Russia, Brazil, Turkey, Malaysia and Indonesia have all been making heavy recent weather of their connections to global finance. It may also be noticed that SA’s relative standing in the debt markets deteriorated before the GFC, as the repo rate increased and then improved in a relative sense compared to the EM average during and after the global crisis.

The rand may however also weaken or strengthen in response to perceptions of SA specific risks, independently of developments in global markets. Political and economic developments in SA may cause the market to sell or buy rand-denominated securities, leading to wider or narrower spreads or for the debt rating agencies to change their credit ratings.

The unrest and violence at the Marikana platinum mine in August 2012 was one such unfortunate SA event that weakened the rand against all currencies, including other emerging market currencies. It can be shown that the rand has traded off the weaker post-Marikana base ever since; though much of the direction of the rand exchange rate since can be explained by global rather than further SA influences.

Economic theory suggests that a primary influence on the exchange value of a currency is the difference between the rate of inflation in the home currency and inflation experienced by its trading partners. The exchange rate is expected, in theory, to move to compensate for these differences in inflation in order to maintain global competitiveness for producers and distributors in both the domestic and foreign markets. What is lost or gained by relatively fast or slow inflation of prices and costs, is expected to be offset by compensating movements in the exchange rate, thus maintaining Purchasing Power Parity (PPP). Unfortunately for the theory and the SA economy, PPP can contribute very little to any explanation of the exchange value of the rand since 1995.

It is the capital account rather than the trade account of the SA balance of payments (BOP) that has dominated the rand exchange rate ever since the capital account was integrated with the trade account of the BOP in 1995. The figure below makes the point very clearly. The difference between the theoretical PPP equivalent rand and the market rand makes for the real rand exchange. It is the deviation from PPP that makes a real difference to exporters and importers. A weak real rand makes exports more profitable and imports more expensive. According to Reserve Bank estimates, the real trade weighted rand is now about 20% weaker than its PPP equivalent and 10% weaker against the US dollar according to our own calculations, using comparative CPIs in SA and the US to infer the theoretical PPP USD/ZAR exchange rate.

The reality is that the highly unpredictable exchange rate leads changes in the SA CPI. Currency depreciation does not accompany or follow changes in the CPI as PPP theory would presume, it tends rather to lead inflation. How much inflation will actually follow a weaker rand will also depend on the underlying trends in the global commodity markets. Also important for subsequent inflation will be the impact of changes in tax rates and administered prices, also hard to predict

As we show below, there is a highly variable relationship between changes in import prices and consumer prices in SA, even as changes in import prices tending to lead changes in headline inflation, the lags are also variable. Hence to forecast inflation in SA, with any degree of accuracy or conviction, would require not only an accurate prediction of the essentially unpredictable exchange rate, but also of the almost equally difficult to predict pass through effect of a weaker rand on the CPI. Import price inflation is now running well below headline inflation, so helping to contain the inflation impact of the weaker rand.

If inflation in SA in say two years cannot be predicted with any degree of accuracy or conviction, as would appear obvious given all the unknowns that could impact on consumer prices over any 24 month period, then one can have little confidence that monetary policy and changes in the repo rate will help realise some narrowly targeted rate of inflation. The fan charts of the Reserve Bank published in its 2015 Monetary Policy Review that indicate the possible inflation outcomes, confirm the difficulty in forecasting inflation with any confidence. The chart below shows that there is a 90% chance of inflation in SA in 2017 being somewhere between 3% and 10%.

In practice in these unpredictable circumstances, all the Reserve Bank can do is react to inflation, rather than anticipate inflation and act appropriately to help stabilise inflation and the economy. In reacting to realised inflation by raising its repo rate when inflation is accelerating, the Reserve Bank has a further problem. The impact of interest rate changes on the rand is itself unpredictable. The impact of higher interest rates on the exchange value of the rand is as likely to weaken as strengthen the rand. Higher interest rates, if they are regarded as likely to slow down the economy, may well imply lower returns to capital and discourage capital inflows. If this turns out to be the case, higher interest rates may well be associated with more inflation.

However what can be predicted with conviction is that higher interest rates will suppress spending and reduce the rate of economic growth. Hence it is possible that higher interest rates will lead to no less inflation and perhaps lead to more inflation, given what might subsequently happen to the rand, and could be accompanied by slower growth.

The policy implication of the unpredictable rand and inflation is that the Reserve Bank should only react to inflation when prices are rising because domestic demand is increasing faster than domestic supplies, perhaps because money and credit supplies are growing too rapidly. It should not react to higher prices irrespective of the cause of such higher prices. For example, higher prices that follow exchange rate or other supply side shocks, following droughts or higher taxes on domestic goods or services. These shocks depress demand and higher interest rates will depress demand even further to no useful anti-inflationary effect.

The Reserve Bank might argue that if it didn’t react to higher inflation, whatever its cause, inflation would trend higher because of so-called second round effects. If it failed to react, more inflation would come to be expected and in turn lead by some self-fulfilling prophecy and producer pricing power, to more inflation itself. There is no evidence to support the view that more inflation expected leads to more inflation.

Indeed inflation expected in SA has remained remarkably stable around the 6% level, the upper range of the inflation targets. Expected inflation is a constant rather than a variable in the SA inflation story.

The problem for policy makers is that the market has been conditioned to expect higher interest rates, irrespective of the cause of higher inflation and the implications this may have for the economy. The task for the Reserve Bank is to change the narrative to take full account of the economic realities. The value of the rand and its impact on inflation is unpredictable and monetary policy should not be expected to react to it or other supply side shocks to the CPI that are of a temporary nature. The flexible exchange rate should be regarded as a shock absorber for the economy – not a threat to it. The proper task for the Reserve Bank is to manage aggregate spending in SA in a counter cyclical way. Chasing inflation targets, regardless of their provenance, can lead to pro-cyclical monetary policy.

Extraordinary volatility in all markets – causes and effects

The past week or two of exceptional market volatility was not so much a case of China sneezing and the world catching cold – but the sense that China may have little idea of how to cope with a cold. Its feverish interventions in the Shanghai stock market and perhaps also the currency market did not make a good impression. Surely the advice – starve a fever but feed a cold – holds everywhere.

Clearly there is much room for further slips before China becomes more of a fully market and service-driven economy – policy errors that will continue to complicate the calculation of market values in and outside of the Middle Kingdom. Fortunately, the US economy, despite some doubts about possible China contagion, remains well set on its recovery path. A major upward revision of US Q2 GDP growth rates released yesterday would have served as a helpful vapor rub for unnecessarily troubled breasts.

It remains for the Fed to get its long heralded first interest rate hike out of the way – to help confirm that the US economy has normalised, even when accompanied by below normal inflation rates. Our sense is that the markets will be reassured rather than troubled buy a 25bp increase in the Federal Funds rate, while giving the Fed ample time to consider its next move on the path to normality.

It is emerging market (EM) equities that have lagged far behind the progress made in developed equity markets since 2011. They have most to gain from a US recovery that can be expected to promote faster growth everywhere. EM equities and currencies, South Africa naturally included, lost relatively most in the recent turmoil. It is encouraging to observe that EM equities (priced in US dollars) have recovered as much as (or more) than the US market in recent days.

 

Also coming back with the recovery in equity markets was the volatility indicator for the S&P 500 (the VIX) and the risk premium for SA and the rand – indicated by the spread between RSA and US bond yields. There is clearly scope for further declines in these risk indicators and if they do decline to anything like normal levels, we will see further strength in the S&P 500 – and also in the rand.

 

What also may have been noticed in all the turbulence and rand weakness was that there was only one place to hide in the equity markets from rand weakness – in gold shares. In other words, there were no rand hedges, other than the gold shares. The rand value of even the most globally exposed counters, the global consumer plays and their like, declined with the cost of a US dollar.

There is an important difference between equities that can be regarded as rand hedges (rand values that rise with rand weakness\) and SA economy hedges. When the rand weakens for global reasons the dollar and the rand value of most equities and bonds will decline, as recent trends confirm. Hence there are no rand hedges outside the gold mines when the global risk outlook deteriorates. When the rand declines for South African specific reasons – those companies on the JSE with a largely global footprint – will see the US dollar value of their activities largely unaffected; hence rand weakness for SA reasons can then translate into higher rand values.

Gold is different. Its price and the value of gold mines, in US dollars, tends to rise in troubled times. Hence the extreme behaviour of JSE-listed gold mines in August. Between 17 August and 24 August, the JSE mold miners gained 27.8%. This was while the USD/ZAR exchange rate moved from R12.90 to R13.21 – down some 2.3%. Over the same few days of rand weakness the All Share Index went from 50751 to 47631, a decline of 6.3%. Over the next three days the Gold Mine Index gave up 19.25% of its rand value at the close on the 24 August as the All Share Index added 3.1% and the rand stabilised.

Clearly, SA gold shares can protect portfolios meaningfully against global risk aversion, even though they have proved to be a very expensive form of portfolio insurance over the longer run. The SA gold mines have suffered from not only higher costs of production and declining grades of ore mined, they have also proved vulnerable to SA events (strikes and the like) that limit production. Investors in SA mines should wish for a weaker rand in response to additional global risk aversion, unaccompanied by greater SA risks to their production.

South African shareholders should therefore wish for rand strength – not for rand weakness – unless they have an unhealthy weight in gold shares. But they should wish even more for rand strength that might follow a reduction in SA specific risks. If perceptions of SA risk, currently reflected in a high discount rate used to value company profits realised from SA activities, were to decline in response to better economic governance, the US dollar value of the rand would rise and the rand and the US dollar value of SA securities would rise. And most important, SA would be able to attract more foreign capital of all kinds on improved terms to help realise faster growth.

Unleashing the household sector

The state of the SA economy – reading the tea leaves and providing a recipe for a stronger reviving brew

The trend in retail sales volumes in 2015, now updated to May, help confirm that the SA economic engine is stuck in a slow growth gear of between 2% and 2.5% a year. Year on year retail inflation is also fairly stable between 4% and 5%.

Our Hard Number Index (HNI) of SA economic activity, based on new vehicle sales and cash issued by the Reserve Bank, adjusted for consumer prices, updated to the June month end, indicates a very similar pattern to that of retail, a pattern of slow growth. This is predicted to continue for the next 12 months at its current very pedestrian pace. We add the Reserve Bank Co-incident Business Cycle Indicator, based on 12 economic time series, for comparison, also smoothed and extrapolated beyond March 2015, the latest data point for this series. All of these indicators of reveal similar trends and cyclical turning points that provide very little sense of a cyclical upswing. The HNI shows up as a very reliable leading indicator of retail volumes and the more broadly measured business cycle.

It may be of some consolation that the indicators still predict some positive growth, though higher interest rates, if imposed by the Reserve Bank, may threaten even these predictions of slow growth. There is no suggestion that spending growth is about to pick up to add to inflationary pressures that are almost entirely the result of higher taxes on fuel and energy and municipal services generally.

The series for import and export prices to March 2015 suggest deflation rather than inflation emanating from the balance of payments and the exchange rate. The rand is weaker against the US dollar but stronger against the euro and only marginally weaker on a trade weighted basis compared to a year ago. Import or export prices (measured by the export or import deflator) were lower in Q1 2015 than they were a year before and so are not adding pressure to SA inflation rates: nor is domestic spending. The tax increases and the drought in the maize belt that have pushed the CPI temporarily higher, will not respond favourably to higher interest rates that the Reserve Bank seems intent on imposing on a highly fragile economy.

The case for raising short term interest rates in these circumstances is, in our judgment. a very poor one. It is certain only to further depress domestic spending without promising to have any predictably favourable influence on inflation or inflation expected over the next 12 – 18 months. As we will show SA needs lower rather than higher interest rates if it is to escape from slow growth forever.

The question the Reserve Bank should be considering – as should all those with responsibility for economic policy – is how can the economy hope to break out of this seemingly indefinite prospect of slow growth? Ideally it would be increased exports that lead the economy to faster growth. But exports from SA will be constrained by the weakness in metal and mineral prices associated with slow global growth and the fact that global supplies of metals have caught up with the extra demand that came from China in the boom years before 2008, though as we have seen recently, merely keeping the factories and mines working rather than shut down through strike action can help to add to exports and employment and incomes.

Stimulus from government spending has also run its course – it was ended by rising government debt and interest payments and threats to credit ratings accompanying these adverse trends. Increased duties on fuel and energy as well as higher income tax rates are not only adding to inflation- they are an extra burden on household budgets. And to look to the capital expenditure programmes of publicly owned corporations to lift the economy, as was the official case made a few years ago, would seem only to court further disaster. The clear reluctance of private business to invest more in their SA operations will continue until their capacity to produce more is challenged by increased demands form their customers. Private businesses in Q1 2015 reduced their capital expenditure and their payrolls.

The essential condition for any step up in SA growth rates is an increased willingness of households to spend and borrow more. Household spending accounts for about 60% of all spending and without encouragement for the rest of the economy from the household sector (encouragement now clearly lacking), the economy will not grow faster. How then could this come about? A look back at how the economy managed to grow much faster between 2003 and 2008 may be instructive.

In figure 3 below we show how spending in 2008 collapsed as retail prices rose sharply after the rand weakened in response to the Global Financial Crisis. Notice also the extraordinary growth in retail volumes between 2003 and 2007 as retail inflation subsided. Inflation subsided then as the rand strengthened and lower interest rates followed lower inflation so stimulating consumption spending further. Bank lending, as mentioned (particularly mortgage lending to households), grew even faster than consumption spending, so providing strong support for the spending intentions of households.

At the peak of the growth cycle in mid 2006, bank lending to the private sector was 26% up on a year before and mortgage lending had grown by about 30% on a year before. The value of residences owned by households increased by an average 21% a year between 2003 and 2007, adding significantly to the willingness of households to borrow and spend and banks to lend to them on the security of rising house prices. See figure 5 below that illustrates these housing and household wealth effects.

SA spending grew faster than output between 2003 and 2008 and the current account went into deficit, having remained in balance throughout the slow growth years that preceded the boom. Foreign capital more than made up the shortfall in domestic savings. The boom in spending and growth between 2003 and 2008 could not have continued without support from foreign capital that proved very forthcoming.

This helps make an essential point: growth improves returns on capital and attracts additional savings from all sources, domestic and foreign, to fund faster growth and benefit from higher returns on capital invested. Slow growth repels capital because expected returns fall away. The limits to spending and growth are set by the supply of savings from domestic and foreign sources. But to attract capital, conditions for it need to be attractive. Expected growth rather than stagnation or worse is the essential lure for capital.

If the economy were to grow faster in response to a pick-up in household spending, the lack of domestic savings might prove a constraint, should foreign capital not be fully forthcoming. If this were to happen, the rand would come under pressure and higher inflation would then call for higher interest rates – trends that would in turn inhibit any incipient recovery in household spending.

The point to be recognised is that unless the economy asks for more foreign capital the answer as to how much would be made available, only time and evidence would be able to tell. But there would be no point in inhibiting any recovery in household spending for fear that it might soon run into the sands. Entry into a virtuous circle of something like the 2003-2007 episode of faster growth will hopefully be attempted sometime in the not too distant future and would have to be led by faster growth in household spending. South Africans can only hope for the chance to test the market for capital to fund our growth.

One positive influence on spending will be the improved state of household balance sheets. The household ratios of debts to assets have declined – helped by a recent improvement in the value of houses, which are up by about 10%.

Lower, not higher short term and mortgage interest rates, would be helpful to this end. A recovery in the prospects for emerging equity and bond markets that have underperformed developed markets since 2011 would be very helpful indeed. The rand would attract a share of additional flows into emerging markets and so help add strength to its value, improve the outlook for lower inflation and lower interest rates. In other words, 2003-2007 reprised. We live in hope for more favourable tail winds from off shore.

But there is much South Africa could do to improve its economic prospects and its attractions to foreign capital, which are essential to any attempt to lift growth rates. They come under the broad rubric of reducing the risks of investing in SA business. Planning for more competitive labour and energy markets (less power to the unions and privatisation of generating capacity very much included) would go a long way to raising the bar for the SA economy and attracting capital to the all-important purpose of faster growth in incomes.

SA economy: Household help

Faster growth will have to be led by SA consumers. Adding to household indebtedness is the solution, not the problem.

The SA economy added neither jobs nor capital equipment in Q1 2015. The business sector is unlikely to come to the rescue of the economy unless households lead the way forward and prove able and willing to spend more. Growth in household spending growth, that contributes about 60% to GDP, has been trending lower ever since the post-recession recovery of 2010. Though in the latest quarter to be reported, Q1 2015, growth in household consumption spending estimated at an annual rate of 2.8% actually helped, raise rather than depressed GDP, which grew at a very pedestrian 1.3% rate in Q1, 2015. The national income statistics reveal the great reluctance of the corporate sector to spend more on equipment or workers. In Q1 2015 fixed capital expenditure by private businesses declined as did their payrolls.

The statistics on bank lending to the private sector are very consistent with the revealed reluctance of households to spend more and to borrow to the purpose. Yet the banks are lending far more freely to the SA corporate sector at a well over 10% rate of growth. However this corporate borrowing is not showing up as additional spending on fixed or working capital, that is, to employ more workers.

It would therefore appear that SA businesses are using their strong balance sheets to fund offshore rather than on shore operations. The significant increase in mortgage borrowing by SA corporations, presumably to this end, is noteworthy. By contrast household borrowing from the banks, including mortgage borrowing, has long grown more slowly, in fact declining in recent years when loans are adjusted for inflation. The price of the average house in SA has also been falling in real terms, so discouraging households to borrow or banks to lend to them in a secured way.

Much attention is usually given to the rising debt levels and ratios of households. The rising ratio of SA household indebtedness to disposable incomes is often referred to as a signal of the over indebted state of the average SA household. As may be seen below, this debt ratio increased markedly between 2003 and 2007 when the economy enjoyed something of a boom. This boom was led inevitably by a surge in household consumption spending , funded increasingly with credit, especially mortgage credit, linked to rising house prices of the period.

Also often referred to is the debt service to disposable incomes ratio, which has declined in recent years as interest rates have fallen- presumably a positive influence on spending. But this ratio ignores interest received by households that has fallen with lower interest rates- presumably to the detriment of household spending.

Much less attention unfortunately is paid to the other side of their balance sheet. As we show below the asset side of the SA balance sheet strengthened consistently before and after the meltdown in equity markets in 2008-09. A mixture of good returns in the equity and bond markets and a diminished appetite for debt has seen the household debt to asset ratio fall significantly.

The reluctance of SA households to borrow more and or the banks to provide more credit for them is being maintained despite a marked improvement in the balance sheets of SA households. Hopefully at some point soon, this balance sheet strength will translate into more household spending and borrowing. These improved balance sheets may well have helped sustain household spending in the face of deteriorating employment and profit prospects in Q1 2015.

As may be seen in the figure above the ratio of household wealth to disposable incomes fell between 1980 and 1996. These were very difficult years of political transition for the SA economy, made all the more difficult by declining metal prices. This wealth ratio has since risen significantly to the peak levels associated with the gold and gold share boom of the 1979-1981. Access by SA companies and individuals to global markets and global capital that came with the transition to democracy has clearly been wealth adding and so helpful to SA wealth owners. The value of their shares, homes and retirement plans has more than kept up with after tax incomes in recent years.

In the figures below, we show the composition of the asset side of the household balance sheet in 2014 and also how the mix of assets has been changing. The largest share of household wealth is held in the form of claims on pension funds and life insurance with ownership of residential buildings following closely in importance. The fastest growing component of household wealth is holdings of other financial assets, investments in shares and bonds mostly via unit trusts, while bank deposits lag well behind in importance.

In the figure below we compare the real, after inflation growth in household assets, in household debts, household consumption expenditure and real household per capita incomes. These growth rates move in much the same direction. More household borrowing is associated with greater wealth, more spending and most importantly, a faster rate of growth in real per capita incomes. This virtuous circle that is initiated by more household spending and more borrowing to the purpose is particularly well illustrated through the boom years of 2003-2007, the only recent period when the SA economy could be described as performing well. Over this five year period, household assets in real terms increased at an average rate of 11.9% a year, household debts by an astonishing real rate of 15.6% a year, while household consumption spending grew by 5.9% a year on average and household per capita real incomes were up at a welcome average real rate of 3.9% a year. Without the extra credit, all this good stuff could not have happened. So what is not to like about a credit accommodating boon to spending and economic growth?

One possible regret would be that such rapid growth rates cannot be sustained in the absence of an increase in domestic savings as well as of wealth. The ratio of gross savings to GDP in SA has been in more or less continuous decline since the peak rates realised in 1980 as is shown below.

This declining savings rate has meant a greater dependence on foreign capital inflows to maintain growth rates. Even the slow growth of recent years has had to be accompanied by deficits on the current account of the balance of foreign payments and equilibrating capital inflows that have funded these deficits and more – also adding to foreign exchange reserves.

Given the low rate of domestic savings, South Africans have had to sell more debt to foreign investors and shares to foreign investors. More interest and dividend payments have gone offshore in consequence. But what is not well recognised by those who concern themselves (unnecessarily) with the sustainability of faster growth is that faster economic growth attracts capital and slower growth frightens capital away (Unnecessary because the sustainability of the growth will either be supported by the capital market or will not be, in which case the potential growth will not materialise, leaving nothing to worry about, except slow growth).

In the boom years after 2003 the inflation rate in fact came down as the rand strengthened with inflows of capital. SA enjoyed faster growth and lower inflation until the boom ended with much higher interest rates, imposed by the Reserve Bank, before not after, the Global Financial Crisis frightened capital away.

If SA is to re-enter the virtuous circle of faster growth and supportive capital inflows of the kind enjoyed after 2003, it will have to be accompanied by a renewed appetite for household borrowing and lending. Strong balance sheets may help initiate a recovery in the household credit cycle. Higher short term interest rates will do the opposite. A test of the hypothesis that faster growth in SA can be self sustaining when supported by capital inflows is overdue. Hopefully conditions in global capital markets will become more risk tolerant and more inclined to fund growth in SA. A growth encouraging agenda, initiated by the SA government, would be a much needed further stimulus to raising SA growth rates and attracting foreign investment.

‘Season of outrageous demands for wage increases upon us’

As published in Business Day 10 July 2015: http://www.bdlive.co.za/opinion/2015/07/10/season-of-outrageous-demands-for-wage-increases-upon-us

THE season of outrageous demands for wage increases is upon us. And, more important, it is the season of wage agreements that appear to take little account of the hundreds of thousands of workers outside the mine and factory gates who would willingly accept employment for existing benefits.

Even more unsettling will be the loss of jobs, as managers replace unskilled workers with machines and more skilled and experienced workers productive enough to justify their higher costs of hire. The losers will be the newly unemployed with little opportunity for alternative employment on anything like the same conditions.

How, then, can one make sense of this seemingly irrational behaviour by the unions? How can they not be aware, it will be asked, as their members will continue to be retrenched in large numbers? Why do the unions do what they do? They are surely as well aware as any that higher real wages can lead to job losses in the sectors of the economy where they exercise the power to strike.

The answer must be that they are well aware of the economic circumstances and the trade-off between wage gains and job losses, which they make for their own good reasons. I would suggest that, in fact, unions are not in the business of maximising employment or employment opportunities. Rather, unions are in the business of maximising the total wages paid to their members. The objective they quite rationally and self-interestedly attempt to achieve is the highest possible wage bill, not the number of wage earners or members of the union. It is the total wage bill agreed to by employers that forms the basis for collecting dues from members. Therefore, (percentage) increases in employment benefits can more than compensate for fewer workers employed. And better paid members may be more willing and able to pay their dues.

It is theoretically and practically possible for the wage bill paid by firms to rise in both nominal and real terms even as employment drops. This is precisely what has happened in the mining and other sectors of SA’s economy. While employment has declined in recent years, total compensation paid to employees of all kinds has continued to increase, and so presumably have the dues paid to their unions (collected conveniently by the employers themselves).

To put these outcomes in terms familiar to the financial sector, the asset base of the unions and staff associations from which they collect their fee income — the wage bill — has continued to rise as the unemployment rate continues to remain damagingly high to the economy, but not necessarily to the unions. There is nothing ignorant or irrational in all this, just predictable self-interest at work. Such an explanation fits the facts of the economy and its labour market well.

The statistics help make the point. SA’s economy may well have become less labour intensive — fewer worker hours employed per unit of gross domestic product (GDP) — but the share of total remuneration in GDP or total value added has changed very little. The wage bill (not numbers employed) has risen more or less in line with output. The share of owners and funders and rentiers in SA output peaked at about 47% of GDP in 2008 (before the global financial crisis) and has been in decline since (now 44%) as the share of employees has been rising. Employment benefits now constitute 46% of GDP. That is despite or maybe because of slow growth that reduces the rewards for savings and the demands for labour — but not necessarily the rewards of the majority who hold on to their jobs.

A similar picture emerges for the mining sector. The share of mining output accrued by employees has been rising in recent years, from 35% of total output (in current prices) to about 42% in 2013. In other words, the unions appear to be successful if their objective is (as I infer) to increase the wage bill paid by the industry rather than the numbers employed at the expense of the other claimants — shareholders and creditors — on the value added by the mining sector

Thus, while mining employment was at 2008 levels in 2013, average employment benefits per worker employed have risen consistently, at an average annual rate of more than 11% in money-of-the-day terms, and equivalent to an average increase of 4.5% in real terms, using the GDP deflator to convert nominal into real growth of employment benefits or rather costs to owners. The average employee in the mining sector came with an average cost to employers of more than R220,000 per employee in 2013. Not bad work if you can keep it.

The data on compensation of employees supplied by Statistics SA goes back only to 2005. It is, however, possible to view mining output and employment over a much longer period. The mining work force declined dramatically in the 1990s, from nearly 800,000 employees to about 400,000 by 2002, whereafter the number rose to more than 500,000 in 2008. Volumes of mining output, having declined in the 1990s as metal prices came under pressure, increased significantly in the mid-naughties, only to fall away again after 2008. The producers of iron ore and coal produced significantly more during the commodity price super-cycle that accompanied the Chinese thirst for raw materials. The big losses of output were suffered by the gold mines, as they ran out of profitable grade to extract.

But a focus on mining volumes rather than mining revenues (volumes times price) misses the driving forces in the industry. SA’s mining industry had the advantage of rising prices, especially after 2000, and became significantly more profitable — enough to hire more labour as well as offer significantly higher rewards to its employees between 2000 and 2008, after the savage job losses incurred in the 1990s.

A better sense of the environment for SA’s mines, for their owners, managers and workers, can be gained if we reduce mining revenues to their real equivalents by deflating current revenues by prices in general, represented by the GDP deflator, rather than by the index of the prices of the metals and minerals themselves, which rose much faster than prices in general to the advantage of the mines. Real mining revenues measured this way show a strong growth pattern until 2008 and explain the employment and wage trends much better than mining volumes that have remained almost constant over many years.

Notwithstanding a better appreciation of SA’s mining environment, it can still be asked about employment of workers in SA that is so desperately needed. A better understanding of the self-interested behaviour of the unions (in the quantum of dues collected) and the shareholders in mines attempting to improve returns on their capital, which have led to fewer better paid and skilled workers, should lead us to expect more of the same in the years to come. This would be a trade-off of better jobs in the industry for fewer employment opportunities and more capital (robots) per unit of output.

What then can be usefully done to encourage employment in SA, especially of unskilled workers, of whom there is an abundance? The first step would be not to look to the established unions or firms as sources of employment gains. The right way to look for employment gains is to find ways to inject competition in the labour market. Competition for customers and workers and competition for work will help convert the pursuit of self-interest to better serve the broad interests of society; that is in more employment.

More competition for the established interests in mining and every other sector of SA (unions and firms) from labour-intensive firms needs to be encouraged in every way possible. This means, in practice, rules and regulations that allow willing hirers and suppliers of labour to more easily agree to terms (they may well be low-wage terms) without artificial barriers. These barriers to more competition in the labour market come particularly in the form of closed shop agreements that apply to all firms and workers, wherever located or regulated. Less regulation and more competition is the solution to the employment problem. Higher employment benefits for the fortunate few with artificially enhanced bargaining powers will not reduce the unemployment rate any more than it has to date.

 

Some good news from the motor manufacturers

The balance of SA foreign trade turned into a very welcome surplus of about R5bn in May 2015. It apparently took the market by surprise, though it should not have, since the National Association of Automobile Manufacturers (Naamsa) had previously reported over 33 000 vehicles exported that month, more than enough to turn the trade flows.

Further good news came from Naamsa yesterday that reported 31 422 vehicles exported in June, another very good month for the motor manufacturing sector, the largest component of manufacturing generally, and the balance of payments. Export volumes of over 30 000 units now compare very well, with a satisfactory 50 251 units sold in the local market. Domestic sales numbered 47 868 units in May and June sales were about 1000 units higher, on a seasonally adjusted basis. However, as we show below, the vehicle cycle is clearly pointing to lower sales to come, with annual sales precited to fall from the current rate of 612 000 units to an annual rate of 523 000 units in June 2016.

This makes sustaining exports even more important for the industry and its dependents. The limits to exports are set by the willingness of the workers and their unions to stay on the job. The ability of the local industry to sustain its role in the global vehicle supply chain will depend on offering security of supply over the long run. The role of the unions in offering predictability of supplies from SA plants is clearly crucial. It is surely possible for the owners and the unions to come to terms on exchanging better paid jobs for reliability of attendance at work. Inevitably though, fewer person hours will be employed per vehicle produced as robots are substituted for more expensive labour, as is the case in manufacturing plants everywhere.

Yet if export volumes can be enhanced it may be possible to hire more rather than fewer workers – at better wages – even if the on average more expensively hired worker is made more productive with the aid of computer-driven equipment. The motor industry and the SA economy – in the form perhaps of a stronger rand – has much to gain from an infusion of self interested economic reality into collective bargaining. The reality is that it may be possible to provide well paid employment for a larger work force in some industries, if the opportunity to increase output for foreign markets can be taken. The highly competitive current rand exchange rate should encourage these negotiations. A better trade balance may well in turn help sustain the exchange value of the rand, which in turn would be very encouraging to domestic consumers. Additional demands from the households are even more essential to lifting SA GDP growth than are exports.

Point of View: The rationale behind wage demands

Explaining the actions of trade unions in SA. Why it is not irrational to go on strike for higher wages even when employment declines. What are the policy implications?

The season of outrageous demands for wage increases is upon us. And, more important, it is the season of wage agreements that appear to take little account of the hundreds of thousands of workers outside the mine and factory gates who would willingly accept employment for current benefits.

Even more unsettling will be the loss of jobs, as managers replace unskilled workers with machines and more skilled and experienced workers productive enough to justify their higher costs of hire. The losers will be the newly unemployed with little opportunity for alternative employment on anything like the same conditions.

How then can one make sense of this seemingly irrational behaviour by the unions making the demands? How they can not be aware, it will be asked, since their members will continue to be retrenched in large numbers. Why then do the unions do what they do? They are surely as well aware as any that higher real wages can lead to job losses in the sectors of the economy where they exercise the power to strike?

The answer must be that they are well aware of the economic circumstances and the trade off between wage gains and job losses, which they make for their own good reasons. We would suggest that, in fact, unions are not in the business of maximising employment or employment opportunities. Rather, unions are in the business of maximising the total wages paid to their members. The objective they quite rationally and self-interestedly attempt to achieve is the highest possible wage bill, not the number of wage earners or members of the union. It is the total wage bill agreed to by employers that forms the basis for collecting dues from members. Therefore (percentage) increases in employment benefits can more than compensate for fewer workers employed. And better paid members may be more willing and able to pay their dues.

It is theoretically and practically possible for the wage bill paid by firms to rise in both nominal and real terms even as employment drops away. This is precisely what has happened in the mining and other sectors of the SA economy. While employment has declined in recent years, total compensation paid to employees of all kinds has continued to increase, and so presumably have the dues paid to their unions (collected conveniently by the employers themselves).

To put these outcomes in terms familiar to the financial sector, the asset base of the unions and staff associations from which they collect their fee income, the wage bill, has continued to rise as the unemployment rate continues to remain damagingly high to the economy, but not necessarily to the unions. There is nothing ignorant or irrational in all this, just predictable self-interest at work. Such an explanation fits the facts of the economy and its labour market well.

The statistics help make the point. The SA economy may well have become less labour intensive – fewer worker hours employed per unit of GDP – but the share of total remuneration in GDP or total value added has changed very little. The wage bill (not numbers employed) has risen more or less in line with output as we show below. The share of owners and funders and rentiers in SA output peaked in 2008 (before the global financial crisis) and has been in decline since, as the share of employees, has been rising. That is despite or maybe because of slow growth that reduces the rewards for savings and the demands for labour – but not necessarily the rewards of those, the majority who hold on to their jobs.

A similar picture emerges for the mining sector. In the figures below we compare mining output in money of the day (R millions) with total compensation paid by the industry to its employees. The share of mining output accrued by employees has been rising in recent years. In other words, the unions appear to be successful if their objective is (as we infer) to increase the wage bill paid by the industry rather than the numbers employed.

While mining employment was at 2008 levels in 2013, average employment benefits per worker employed have risen consistently, at an over 11% average annual rate in money of the day terms , and equivalent to an average increase of 4.5% in real terms, using the GDP deflator to convert nominal into real growth of employment benefits or rather costs to owners. The average employee in the mining sector came with an average cost to employers of over R220 000 per employee in 2013. Not bad work if (big if) you can get it.

The data on compensation of employees supplied by Stats SA only goes back to 2005. It is however possible to view mining output and employment over a much longer period. In the figure below we graph mining output in volumes (tonnes of coal and iron ore, kilograms of gold and platinum produced) and numbers employed in mining going back to 1990. The mining work force declined dramatically in the 1990s from nearly 800 000 employees to about 400 000 by 2002, where after the number rose to over 500 000 in 2008. Volumes of mining output, having declined in the 1990s as metal prices came under pressure, increased significantly in the mid-naughties, only to fall away again after 2008. The producers of iron ore and coal produced significantly more during the commodity price super cycle that accompanied the Chinese thirst for raw materials. The big losses of output were suffered by the gold mines, as they ran out of profitable grade to extract.

But a focus on mining volumes rather than mining revenues (volumes times price) misses the driving forces in the industry. The SA mining industry had the advantage of rising prices, especially after 2000 and became significantly more profitable, profitable enough to hire more labour as well as offer significantly higher rewards to their employees between 2000 and 2008, after the savage job losses incurred in the 1990s.

A better sense of the environment for SA mines, for their owners, managers and workers can be gained from the figure below. Here we reduce mining revenues to their real equivalents by deflating current revenues by prices in general, represented by the GDP deflator, rather than by the index of the prices of the metals and minerals themselves, which rose much faster than prices in general to the advantage of the mines. Real mining revenues measured this way show a strong growth pattern until 2008 and explain the employment and wage trends much better than mining volumes that have remained almost constant over many years.

Notwithstanding a better appreciation of the SA mining environment it can still be asked about employment of workers in SA that is so desperately needed. A better understanding of the self-interested behaviour of the unions (in the quantum of dues collected) and the shareholders in mines attempting to improve returns on their capital, which have led to fewer better paid and skilled workers, should lead us to expect more of the same in the years to come. This would be a trade off of better jobs in the industry for fewer employment opportunities and more capital (robots) per unit of output.

What then can be usefully done to encourage employment in SA, especially of unskilled workers, of whom there is an abundance? The first step would be not to look to the established unions or firms as sources of employment gains. The right way to look for employment gains is to find ways to inject competition in the labour market. Competition for customers and workers and competition for work will help convert the pursuit of self-interest to better serve the broad interests of society; that is in more employment.

More competition for the established interests in the mining and every other sector of the SA (unions and firms) from labour intensive firms needs to be encouraged in every way possible. This means in practice rules and regulations that allow willing hirers and suppliers of labour to more easily agree to terms (they may well be low wage terms) without artificial barriers. These barriers to more competition in the labour market come particularly in the form of closed shop agreements that apply to all firms and workers wherever located or regulated. Less regulation and more competition is the solution to the employment problem. Higher employment benefits for the fortunate few with artificially enhanced bargaining powers will not reduce the unemployment rate any more than it has to date.

Presumably these risks of default decline as growth prospects improve. And improved growth prospects (lower risk) are well associated with higher share prices. In the figure below we show the relationship between the value of the MSCI Emerging Market Index benchmark and the JSE ALSI and the CDS risk spread over recent years. We show how the CDS spread for RSA five year US dollar-denominated debt and the JSE in US dollars have moved in consistently opposite directions.

These relationships would suggest that the threat to the JSE and the rand will not be higher rates in the US and Europe, provided they are accompanied by improved global growth prospects. The threat however to the rand, the RSA bond market and the SA economy plays might still come from SA specific factors. These include strikes, load shedding and higher short rates imposed by the Reserve Bank that prevent the SA economy from participating in a faster growing global economy. The objective of the SA economic policy makers is to avoid such pitfalls.

The SA economy in May 2015: Slow but steady forward momentum, for now

The course of the SA economy at the end of May 2015 appears largely unchanged since February. This is judged by the pace of new vehicle sales and demands for cash (adjusted for inflation) in May.

These two hard numbers, which are not dependent on surveys based on selected samples – released very soon after the economic events themselves – serve to make up our Hard Number Indicator (HNI) of the immediate state of the SA economy.

The HNI may be compared to the Reserve Bank’s Coinciding business cycle indicator, updated only to February 2015. Current readings well above 100 (2010=100) indicate that the economy has moved ahead at a more or less constant modest forward speed, and is forecast to continue to maintain this pace over the next 12 months. This impression is supported by comparison with the very similar readings taken a month before. The recent inflexion of the HNI is also supported by the Reserve Bank Indicator that has continued to point higher, at least until February 2015 the latest observation.

Unit vehicle sales, after a strong start to the year, however fell back in May 2015, especially when viewed on a seasonally adjusted basis. The trend in new vehicle sales on the local market is now pointing lower towards a pace of 45 000 units per month or an annual market of about 540 000 units in 12 months’ time.

The consolation for the automobile manufacturers and their suppliers in South Africa, the largest component of domestic manufacturing activity, facing a likely decline in sales volumes, is that exports in May rose very strongly to 33 411 units, enough to maintain very high volumes of overall activity in this important sector of the economy. Hopefully the unions will also recognise the long term benefits to them of sustained production and the export contracts that will flow from the SA plants being regarded as reliable partners in global manufacture.

A lower underlying trend in the headline inflation rate has helped support the growth in the demand for and supply of cash. But this favourable trend appears likely to be reversed in the months ahead, according to our time series based forecast. The prediction of higher inflation to come in the months ahead would be well supported by other forecasts, including those made with the Reserve Bank forecasting model. This model predicts that headline inflation, off its low base of early 2015, will breach the 6% upper band of its inflation targets in early 2016 but fall back within it later in the year.

There might be some relief that the SA economy has not slowed down faster in 2015 and has been able to sustain a modest rate of growth, equivalent to GDP growth of about 2% a year. The biggest threat to sustaining a mere 2% a year growth in output would be higher inflation itself- particularly the sort of inflation that has been inflicting the SA economy in the form of higher taxes and higher electricity prices (taxes by another name), as well as poorer harvests that push maize and food prices in SA higher. Higher prices forced by the supply side of the economy, extract from the purchasing power of households and depress the real incomes of households and the volume of spending they wish to undertake, which constitutes such a large component of total spending (over 60% of the total of spending). Without a recovery in household spending growth the economy will not grow faster than it is now doing. Businesses will only wish to add significantly more to their capacity in response to stronger demands from their ultimate customers, the household spender.

A weaker rand imposes the same risk of higher prices to come and would act as a further drain on household spending power and propensities. In the 12 months to date the rand has held its trade weighted value rather well (despite the stronger dollar) and could not be regarded as contributing to higher inflation to come. Without higher excise tax rates, on what is now a lower rand price for oil compared to a year ago, the inflation rate would have been significantly lower and so would have eliminated, at least for now, any argument for higher interest rates, given the state of demand.

The further and imminent danger to the growth prospects of the economy is the pronounced intention of the Reserve Bank to raise interest rates, apparently regardless of the state of the economy or the unpredictability of the impact of higher short rates on the exchange value of the rand and inflation. The hope for the SA economy and for a firmer rand must be an improved outlook for the global economy and especially emerging market economies that encourage flows of funds to emerging market equities and bonds that will support emerging market currencies. A stronger, not weaker, rand might then accompany a gradual normalization of global growth and global interest rates.

Until then emerging market central banks, including the SA Reserve Bank, would be wise to do nothing to harm their own growth prospects with tighter monetary policies in response to a gradual normalisation of interest rates in the developed world. The tool to help their economies adjust to possible volatility in global capital markets should be exchange rate flexibility, not higher interest rates.

UIF and unintended consequences

A large post Budget surprise (though no relief for the workers in the form of UIF contributions) and other unintended consequences of it.

National Treasury was faced with a problem ahead of this year’s Budget: the Road Accident Fund was running a huge deficit while the Unemployment Insurance Fund (UIF) was running as large a surplus. And so the 2015 Budget proposed to take more than R10bn from the economy through higher taxes on petrol, diesel and paraffin while giving back to employees and employers in the form of significantly lower contributions to the UIF.

But now, most unusually, the Budget was anything but the final word on the matter as it almost always is on tax matters of this large order of magnitude. The government, in its wisdom, now intends to dispose of its taxing power otherwise. Contributions to the UIF will continue as before adding an extra R15b to government revenues.

To quote the Minister of Finance Nene, as reported in the daily media, the step was taken for fear of “unintended consequences” and to allow for further consultations. What these unintended consequences may be is not indicated and clearly escaped the Treasury when it drafted its Budget, a process that presumably takes much official effort and time and many a consultation. Another of the unintended consequences of the decision to reverse course will be to undermine the value of the Budget proposals themselves – until now regarded by businesses and households affected as a done deal rather than the opening of negotiations.

Incidentally the most important item on the expenditure side of the 2015 Budget was also left unresolved by the time the Budget was presented in February – the sum of tax payers’ contributions to the employment benefits of public sector employees (of which wages and salaries, after taxes and social security and pension contributions are only the largest but seemingly most visible part to those receiving and paying for the benefits). We can only hope that the decision to take more in the UIF contributions from the lower income average SA household with members in formal employment in the private sector is unrelated to unintended further generosity to public sector employees. These public sector employment benefits already compare more than favourably to those employed in the private sector. This is especially so when the very low risks of unemployment and defined benefit pensions related to final salaries, almost only provided by the public sector, but also guaranteed by the hard pressed taxpayers, are factored into the calculation of comparative employment benefits. Little wonder then that working for the government is much the desired objective of the majority of entrants to the labour market out of the schools and universities.

But a proper think on the role of social security contributions or the so called payroll taxes in SA is called for. They play a very small role in the overall tax structure compared to tax structures in the developed world. By comparison, SA relies much more heavily on income taxes collected from companies (or rather their shareholders), than employees in the developed world. Social Security, or what may be called National Insurance Contributions, can easily amount to 15% or more of the salary bill. This helps pay for the significant benefits received from their governments by the average household in medical benefits and pensions etc.

The scope in SA for raising additional income tax from companies or individuals is clearly limited. Higher income or expenditure tax rates may well lead to lower revenues collected, which is counterproductive both from the perspective of SARS as well as highly damaging to growth in employment, output and pre tax incomes. It is also not good tax policy to tax some expenditures, for example on energy (including electricity), at much higher rates than expenditure in general. It distorts expenditure and production patterns in unhelpful ways. Taxes are ideally general and proportional, rather than specific and unequal, if economic growth is to be encouraged.

It would only be fair to the large ranks of the unemployed or the underemployed unable (because of regulation of the labour market) to gain access to formal employment, that the comparatively well paid insiders with decent jobs should pay more for what has become the privilege of formal employment. The important point about payroll taxes, such as the UIF contributions made by workers and their employers in SA, is that they largely represent a sacrifice of their wages or salaries or other employment benefits, for example contributions to medical insurance, even when the employer pays in the cash. The workers subject to a payroll tax would have very likely taken home more not only because their contributions would have been lower, but because their employers, in time, would have seen their savings as a reason for paying higher wages or providing other benefits that help retain actual and potential employees whose sought after skills may be in short supply. Payroll taxes are largely a tax on workers (not their employers – something they would be well advised to appreciate) and so they should demand that their sacrifices of take home pay are always put to good use.