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South African Economy Outlook Q2 2017

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Incoming data for H2.17 is evidencing that while sub -Saharan Africa continues to experience subdued growth on the commodity price effect, globally economic activity is picking up, but structural impediments in many sub-Saharan countries, South Africa included, will limit the lift gained from the (modest) global upswing.

While commodity prices have recovered to some extent, many commodity exporters are reported to be finding commodity price levels still insufficient and government debt levels have been rising, particularly in sub-Saharan countries where this has increased uncertainty and so negatively impacted investment.

S outh Africa suffered from a contraction in investment last year (2016), and government gross debt has escalated from 22% of GDP in 2008/09 to 45.7% of GDP in 2016/17. Uncertainty has risen too on the political and economic policy front with South Africa currently seeing its key credit ratings split between investment grade (IG) and sub-investment grade (SG).

Moody’s and S&P have South Africa local currency (LC) long-term sovereign debt (LSD) on investment grade, while Fitch has it on sub-investment grade. South Africa’s foreign currency (FC) long-term sovereign debt is investment grade from only Moody’s, while Fitch and S&P have it on sub-investment grade.

This three/three split will likely persist after Moody’s country review of South Africa, as the agency is expected to move its local currency and foreign currency long-term sovereign debt ratings down by only one notch (still investment grade). South Africa bonds would then not fall out of the World Government Bond Index (WGBI), with likely little further impact on the rand from this source this year.

However, with country reviews from Fitch and S&P twice a year at least, and the possibility of ratings changes between scheduled reviews, the possibility of further downgrades cannot be excluded, which has heightened uncertainty.

A 35% weighting is ascribed to this down case of further credit rating downgrades and a 35% weighting to the expected case. With the World Government Bond Index holding a large amount of South Africa’s LC (local currency) LSD (long-term sovereign debt) the rand could weaken substantially if this Citibank fund has to sell its South African bonds (local currency long-term sovereign debt), given the large size of its holdings.

The rand and bond yields were to a significant extent shielded from April’s credit rating downgrades by the strong risk on financial markets as foreign investors were heavy purchasers of Emerging Market debt globally.

Looking forward for the rand much will depend on the global cycle, with the domestic currency at high risk of volatility, and weakness in particular from further credit rating downgrades and/or a risk-off global environment.

Expansionary fiscal policy in the US is still expected to drive growth, while the European recovery continues, with manufacturing activity and trade improvements of 2016 still noted globally, and indications that this persisted into H2.17. The feed through into investment and imports is expected to persist, strengthening global economic activity.

Figure 4: Commodity and oil markets and advanced economies PMI’s

Source: IMF WEO April 2017 and Bloomberg / Economist

However the slowdown in China and moderation in commodity prices has impacted emerging market growth, with only a modest pick-up expected. In sub-Saharan Africa a lift in growth is expected as well (see figure 2), with South Africa’s pick-up in growth more modest. Commodity prices are generally expected to rise this year and next, but only modestly, and not reaching the heights of 2011 (see figure 4).

In this modest global growth environment, with only a gentle upward trend in commodity prices, commodity exporters cannot expect a substantial boost to economic growth from this source. Rising government debt levels will need to be reined in, with South Africa receiving a credit rating downgrade this year on its escalation in debt to GDP since 2009 in a declining growth environment (with substantial contingent liabilities on its balance sheet from the guarantees to its state owned entities).

The credit rating downgrade is not expected to precipitate an interest rate hike this year, with the impact on the rand and bonds proving limited in the global risk-on period. The Forward Rate Agreement curve is flat to down this year while the US is expected to hike by two to three 25bp increments in 2017.

CPI inflation is expected to moderate in South Africa this year, and next year as food prices moderate and demand pressures remain weak in the economy as economic growth remains below trend until 2022. The fall in fixed investment (Gross fixed capital formation) in South Africa in 2016 (see figure 9) was driven by state owned entities and the private sector, with growth in government investment slowing down sharply.

The IMF says “rising public sector debt is becoming a cause for concern in sub-Saharan Africa …the ratio of public debt to GDP has increased …to an average of 42 percent of GDP in 2016 (and a median of 51 percent). This is the highest value since many countries received debt relief in the 2000s under the Heavily Indebted Poor Countries/Multilateral Debt Relief Initiative.”

South Africa’s fiscal constraints have led to lower investment growth for government and State Owned Enterprises, with the bulk of state expenditure focused on social services and civil servant remuneration, while the country continues to run a primary deficit.

At 46% of GDP South Africa’s debt to GDP ratio is similar to the debt to GDP ratio inherited by the ANC tripartite alliance in 1994 with the advent of democracy, when the fiscal deficit for national government was close to 7% of GDP. At that time South Africa’s credit ratings were sub-investment grade. The IMF notes “prudent fiscal policies play a special role in sustaining growth.

spells in sub-Saharan Africa: a better fiscal balance significantly increases the chance that a growth spell will continue, while conversely, a higher debt burden can accelerate its end. …in particular …a lower debt-to-GDP ratio tend to prolong growth spells in the (sub-Saharan African) region.”

The IMF adds currently that “weakening commodity exports, the ensuing sharp slowdown in economic activity, and the build-up of government payment arrears to contractors are all restricting private firms’ capacity to service their loans to various degrees across the region.” Business confidence has essentially remained at depressed levels since 2009, with an average of 59% of business dissatisfied with business conditions.

The close link to fixed investment has shown a contraction in private sector investment over the period. Heightened uncertainty, reflected in poor confidence levels leads to lack of investor appetite, as does anaemic domestic demand. Industrial production is expected to be weak, but positive over the forecast period of 2017 to 2021.

Consumer confidence has been very weak over the period, with gross national income per capita falling in real terms in 2016, both of which have subdued real household consumption expenditure (HCE), and so GDP growth.

With Moody’s still to review South Africa’s country credit local currency and foreign currency ratings, but likely to keep them investment grade, it will be December’s country reviews which could have a ratings impact on the rand, unless further political disturbances this year promote another round of downgrades.

A more gradual trajectory than previously is likely in the return to PPP, given the recent downward trend in credit ratings. The rand could therefore reach PPP in 2020, where PPP valuation will then be closer to R11.50/USD. Loss of another investment grade local currency long-term sovereign credit rating would delay the return to PPP further, while loss of all investment grade local currency long-term sovereign credit ratings would mean the rand would be unlikely to return to PPP.

Unless otherwise stated all views in this narrative are of the baseline case. South Africa has lost growth momentum, with the economy in a downward growth trend over the past several years. Economic growth of around 1.0% y/y is insufficient to prevent further credit rating downgrades, particularly if government debt to GDP ratios does not fall and there is insufficient State Owned Enterprise reform.

The agencies also point to concerns on GDP per capita and the possibility of future government policies undermining economic or fiscal strength -the latter weakening business confidence.

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South Africa

The key economic and political risk events to haunt South Africa’s economy in 2019

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South Africa’s much anticipated economic rebound in 2018 did not occur. While substantial efforts by the authorities to strengthen governance of public resources and stabilize the fiscal situation helped the economy to not contract further, economic growth remained tepid with a technical recession (two successive quarters of negative economic growth) in the first half of 2018. GDP growth is expected at below 1% in 2018, down from an already low 1.3% in 2017.

A number of exogenous factors contributed to this poor growth performance. Domestically, climate variations such as a prolonged drought in the Western Cape where harvests were delayed exerted a huge toll on agricultural production. Externally, mounting trade tensions between the United States and China, and tightening global financial conditions contributed to slowing the pace of foreign financial inflows to South Africa while lessening the demand for its exports. Rising world oil prices also exerted strong pressure on the balance of payments and domestic prices, depressing private consumption.

These negative developments, however, do not conceal the fact that South Africa’s growth challenge is deep-seated and largely structural. To grow faster and sustainably, the economy will need to be more inclusive, requiring the participation of a greater share of the population mainly through job creation.

Furthermore, persistent inequality of income and of opportunity will continue to raise pressures for redistribution of limited resources that are drawn from a small tax base. Radical policy demands are more likely in a stagnant economy, fuel policy uncertainty and deter private investment. At the Presidential Jobs Summit and the South African Investment Conference held in October 2018 agreements were made on actions that are expected to enable job creation and to attract higher levels of investment, including inter alia, education and skills interventions, and initiatives to reduce policy uncertainty on land reform, mining and black economic empowerment.

The financing of structural reforms and projects to promote greater economic and social inclusion is nonetheless rendered difficult by South Africa’s tight fiscal and debt situation, itself mainly the consequence of slow growth and strong spending pressures.

As in most previous budget speeches, the commitment to public debt stabilization was reaffirmed in the October 2018 Medium Term Budget Policy Statement (MTBPS), but the target date for debt stabilization was shifted yet again, this time to 2023/24, and at a higher level, to 59.6% of GDP against 56.1% in the 2018 Budget Review.

Though in a significant departure from previous statements, there was clear recognition of the greater role the private sector, development finance institutions, and multilateral development banks could play in complementing scarce public finances for infrastructure. Regulatory reforms, lowering the risk of financial instruments to facilitate private sector investment, and a clearer delineation between commercially viable and socially desirable interventions were identified as instrumental to breaking a vicious cycle of low inclusiveness coupled with limited public resources to speedily address the challenge.

South Africa’s economy after experiencing a recession last year may be even bumpier in this 2019. Here’s a look at the key economic and political risk factors to watch out for in 2019:

The budget

After Finance Minister Tito Mboweni painted a bleak picture for finances in October 2018, attention will turn to his plans to boost growth and prevent debt from spiralling out of control at the budget presentation in February. The national budget is a “key pressure point,” Intellidex’s head of capital markets research, Peter Attard Montalto, said in a note. The absence of concrete plans to boost economic growth could trigger a change to negative in the outlook on South Africa’s credit ratings.

Credit rating

A downgrade to junk by Moody’s Investors Service would trigger forced selling of bonds by investors tracking investment-grade indexes, including Citigroup’s World Government Bond Index. That’s “very likely,” according to David Hauner, Bank of America Merrill Lynch’s head of cross-asset strategy for Eastern Europe, the Middle East and Africa. Moody’s didn’t publish a review as scheduled in October 2018, while S&P Global Ratings and Fitch Ratings have kept their sub-investment grade assessments. Ratings companies may be waiting for the budget data before making another call.

State companies’ debts

Troubled state-owned companies will continue to weigh on the country’s finances, with their combined debt of R1.6 trillion. Almost half that is guaranteed by the government, the Treasury said in October 2018. Power utility Eskom needs R20.1 billion to meet its obligations in 2019, national carrier South African Airways needs to repay R14.2 billion by March 2019 and the state broadcaster has warned it won’t be able to pay staff unless it gets R3 billion from the government by February 2019. George Herman, chief investment officer at Citadel Investment Services, predicts a “worst-case scenario” for the companies: “the state will have to step in to bail them out,” he says.

Expropriation

Lawmakers will report to parliament on March 31, 2019 on changes to the constitution to make it easier to expropriate land without compensation. While these steps form part of the ruling African National Congress’s plan to accelerate wealth redistribution, commercial banks that hold farm debt could be hit. Lobby groups are gearing up to fight the process in court and the possible protracted legal wrangling could lead to a period of prolonged uncertainty.

May elections

South African elections have been mostly peaceful and accepted as free and fair since the first all-race ballot in 1994, but the run-up to this year’s vote may see an increase in populist rhetoric and constrain the ANC’s room for maneuver. Polls show the ANC maintaining its majority, but the party needs 55% to 60% of the vote to put President Cyril Ramaphosa in a position to implement reforms aimed at reviving economic growth, said Old Mutual Investment Group economist Johann Els. Ramaphosa could overhaul — and shrink — his cabinet after the election.

Reserve Bank

The current terms of two of the Reserve Bank’s most senior officials run out this year. While both could be reappointed, the possibility of changes in leadership will add to uncertainty amid a drive by the ANC to make the central bank state-owned. Deputy Governor Daniel Mminele’s second term ends in June 2019 and Governor Lesetja Kganyago’s first five years at the helm ends in November 2019. The governor and his three deputies are appointed by the president: Kganyago has said he’d be available to serve another term if asked; Mminele hasn’t commented.

What an economist says …

“The increase in foreign participation in the domestic government bond market to 40% from 23% in 2011 is a key risk for South Africa. It makes the rand highly vulnerable to negative domestic events as well as changes in sentiment to emerging markets. With interest payments to foreign bondholders accounting for most of the current-account deficit, South Africa is essentially borrowing more from abroad to service its higher debt load.” – Mark Bohlund, Bloomberg Economics.

 

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