Risk update: material risk of SA losing its investment grade ratings persists; additional scenarios include US/allies & North Korea (brief) missile exchange

07 Sep 2017

Annabel Bishop

Chief Economist

Figure 1: Economic Scenarios – base case or scenario 3
The results of the additional scenarios, the first defined by the removal of the Reserve Bank’s central mandate of inflation targeting, the second US/allies & North Korea (brief) missile exchange are published at the end of this document. The five scenarios (extreme up, up, base case, down and extreme down) are published as usual. The heavy weight that politics has in South Africa, and in particular the perceived frequent, conflicting political and economic policy proposals, especially populist ones, is seen to have heavily (negatively) impacted sentiment levels. With the country now in a run up to the national election in 2019, and the leading party’s presidential election at the end of this year, little is expected to change to meaningfully accelerate GDP growth over this period, and so weak outcomes are forecast. With business confidence depressed since 2009 secular
Figure 2: Baseline expected case exchange rate forecasts
Figure 3: Economic Scenarios – down case or scenario 4
stagnation has occurred. Secular stagnation occurs where low confidence levels translate into low fixed investment growth and employment, dampening incomes and personal expenditure and inflation, leading to stagnant growth outcomes. Last year saw GDP growth of 0.3% y/y, essentially a stagnation of SA’s economy, and this year is likely to record similar. Business confidence has been depressed since 2009 and with little to turn sentiment around, economic growth has been on a downward trend over this period. While Q2.17 recorded 2.5% qqsaa, the outcome was 1.6% qqsaa excluding agriculture (which has seen a bumper harvest). Indeed, without the low base of the recession the economy only grew by 1.6% qqssa in Q2.17, and excluding the agriculture sector as well the economy essentially stagnated by 0.1% qqsaa in Q2.17). To date data indicates Q3.17
Figure 4: Down case exchange rate forecasts
Figure 5: Economic Scenarios – extreme down case or scenario 5
will see a markedly slower outcome, closer to 1.0% qqsaa than the 5-7% accelerated growth needed to eradicate poverty and bring unemployment down to single digits. The MPC has taken the opportunity lately of pushing through a small interest rate cut, and SA has likely entered a shallow interest rate cutting cycle. However, interest rate cuts will not lift SA out of its weak growth path. September is expected to see a further easing in interest rates, as CPI inflation, and hence inflation expectations, moderate further. With a systemic global economic recovery under way since
Figure 6: Extreme down case exchange rate forecasts
Figure 7: Economic Scenarios – up case or scenario 2
the second half of 2016, South Africa’s economy has been out of kilter with the global cycle, weakening, and then entering recession recently. Typically, when the global cycle has strengthened systemically, South Africa’s economy has followed suit on a rise in demand for its exports, and so a lift in its mining and manufacturing industries. However, structural rigidities in the industrial sector (mining, manufacturing and electricity) and decades of deindustrialisation has meant, along with secular stagnation more recently, that this relationship has broken down.
South Africa needs substantially faster economic growth of 5-7%, but this acceleration requires
Figure 8: Up case exchange rate forecasts
Figure 9: Economic Scenarios – extreme up case or scenario 1
effective, efficient and timely institution of business friendly policies and plans (ones that sustainably raise business and consumer confidence, and so economic growth) in a cost effective manner. The longer SA experiences very weak economic growth, the longer confidence levels will be suppressed. In particular South Africa requires economic reforms in line with global norms that structurally lift private sector investor confidence and so fixed investment.
Figure 10: Extreme up case exchange rate forecasts
Figure 11: First additional scenario – removal of inflation targeting from SARB mandate
The additional scenario is one where the Reserve Bank’s central mandate of inflation targeting is removed, and replaced with one of ensuring “balanced and sustainable economic growth” to protect the “socio-economic well-being” of South Africans. Models show the removal of inflation targeting results in interest rate cuts of the magnitude of 2.5% by the end of 2019, but these interest rate cuts occur in the earlier part of the period. SA needs to maintain a risk premium above that of developed markets’ interest rates, particularly the US. (SA is an emerging market and so is seen as a risker place to invest, and so investors demand a premium, both for country and currency risk.) Historically the lowest the differential between the Fed Fund rate and SA repo has been 2.0% (in June 2006), during a risk on period, in a global environment of strong growth, easy lending conditions and overly ebullient financial market conditions in the run up to the financial crisis. Replicating this low differential of 2.0% (i.e. a repo cut of 2.5%) will result in rand weakness this time around as SA was at its highest credit ratings in 2006 and has since been substantially downgraded. The rand weakens sharply on the loss of the inflation targeting mandate. The rand then sees greater depreciation in the longer term due to the loss of SA’s investment grade credit rating, and the
Figure 12: Interest rate differential
Figure 13: PPP value of the Rand vs USD
erosion of one of South Africa’s core institutional strengths, i.e. the loss of inflation targeting. Inflation rises above the inflation target and remains there, with little effort from the Reserve Bank to gain its return into target. The government bond simultaneously sees some downward pressure from the lower short-term interest rate environment, but at the same time experiences upward pressure from investor loss of confidence and increased likelihood of credit rating downgrades. GDP growth does not benefit significantly from the interest rate cuts as the substantial loss of business confidence from the credit rating downgrades to sub-investment grade, loss of SARB independence and increase in economic repression negate the gains to GDP from interest rate cuts. Interest rate cuts typically inspire increased borrowings, investment and expenditure, but when longer-term borrowing costs rise substantially, along with a sharp fall in business confidence (expected to fall to record lows), then firms look to disinvest and capital flight is likely instead.
A second additional scenario to look at could be an escalation in conflict between the United States of America, or US, (and its allies) with North Korea. In this (second additional) scenario the escalation occurs to the extent where one of North Korea’s missiles strike US or US allied territory, resulting in US (and/or its allied nations’) missiles striking North Korea. The missile exchange is expected to be brief, given the US’s superior military capability, but the impact on global sentiment, and market sentiment in particular, severe. Risk-off and marked retreat into safe havens (swiss franc, gold and US treasury bills) is expected to occur, with marked emerging market (EM) currencies’ weakness and portfolio outflows from EM’s, particularly from emerging Asia. A ‘mini World War Three’ scenario if allied nations become involved (modelled for end of 2017/2018), would see global recession in 2018, followed by a rebound into 2019. SA follows suit into recession
Figure 14: Second additional scenario – US/allies & North Korea (brief) missile exchange
Figure 15: Scenarios
in 2018 but, while the global economy is expected to rebound in 2019, SA’s growth in 2019 is likely to be tepid on a downgrade in its credit ratings to sub-investment grade and structural issues. SA’s remaining key investment grade ratings are on a negative outlook on the last rung of investment grade, meaning the next move will be a downgrade into sub-investment grade (unless the outlook returns to neutral or becomes positive). Global risk off and global, then domestic, recession would likely exacerbate the credit rating agencies concern over SA, resulting in the downgrades. In this second additional scenario the negative impact to financial markets (severe risk off) means the US is likely to cut interest rates back to zero (SA could cut by up to 1.50% from the date of the event), and the possibility of QE4 exists. With extreme global risk-off initially, and SA credit ratings falling to sub-investment grade, SA’s long bond yield rises significantly and the rand weakens substantially, then subsides as QE4 reduces the degree of global risk off. This means the severe rand weakness on the risk-off in 2018 and the credit rating downgrade, could then be followed by some rand appreciation in later years. CPI inflation will likely rise above 6.0% y/y on the rand’s depreciation, and then subside later in the period.
Figure 16: Scenarios