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By Brian Kantor*
Moody’s Investors Service showed its softer side when confirming SA’s investment grade credit rating. The rating agency made it clear that to maintain this grade, SA would need to increase its GDP – that is, simply not fall into recession. A mere 0.5% increase in 2016 would meet Moody’s modest expectation, followed by 1.5% in 2017.
Growth, as Moody points out, not only makes government debt easier to manage. It helps the banks and the households meet their obligations and will also encourage firms to invest more in additional capacity.
To quote the preamble to the report:
“The confirmation of South Africa’s ratings reflects Moody’s view that the country is likely approaching a turning point after several years of falling growth; that the 2016/17 budget and medium term fiscal plan will likely stabilize and eventually reduce the general government debt metrics; and that recent political developments, while disruptive, testify to the underlying strength of South Africa’s institutions.
“The negative outlook speaks to the implementation risks associated with the structural and legislative reforms that the government, business and labor recently agreed in order to restore confidence and encourage private sector investment, upon which Moody’s expectations for growth and fiscal consolidation in coming years — and hence the Baa2 rating — rely.”
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Moody’s identifies three drivers that inform its decision. The first, most critical, we would suggest, is that the economy will recover from a business cycle trough:
“..The first driver for the confirmation is Moody’s expectation that South Africa’s economic growth will gradually strengthen after reaching a trough this year, as the various supply-side shocks that have suppressed economic activity since 2014 recede. Specifically, the electricity supply is now more reliable, the drought is ending and the number of work days lost to strikes has shrunk significantly (a trend that planned rule changes are likely to embed further).
In addition, the inflation outlook is more subdued, which would suggest fewer interest rate rises ahead than we expected when the South African Reserve Bank saw inflation heading towards 8% by year end. Less severe tightening of monetary policy would alleviate extra pressure on South Africa’s relatively highly-indebted household sector and support growth.
“Alongside the more competitive exchange rate, these improving trends are likely to strengthen growth in South Africa from the second half of this year and thereafter. While we expect the economy to expand by only 0.5% in 2016, we expect growth to rise to 1.5% in 2017. Moreover, ongoing structural reforms and diminished infrastructure bottlenecks offer upside potential for growth over the medium term.
The recent rapprochement between the government, business and labor holds promise from the standpoint of identifying areas of mutual concern. A number of benchmark actions related to matters such as the rationalization of state-owned enterprises (SOEs) and the enactment of labor market reforms have been identified in the process.
To the extent that implementation of such measures helps boost business confidence, investment and job creation, they would improve prospects for gradually reducing wide economic disparities and high levels of poverty, deprivation and unemployment.”
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The second driver for the unchanged rating was “The Stabilization of government debt ratios likely to occur in 2016/17” and the third was “Recent political developments testify to the strength of South Africa’s institutions”.
The rating was placed on a negative watch because such hopeful predictions have still to materialise. Or, to put it bluntly, will the economy grow by 0.5% in 2016 and 1.5% in 2017? These are not demanding outcomes even by SA’s well below average growth performance in recent years. What then could cause SA to fall into recession?
The simple short answer would be a further slowdown in household spending. Since households account for over 60% of all spending, any further reluctance in their willingness or ability to spend more will drag the economy into recession. It will neither encourage firms to invest more in people or capacity nor encourage foreign savers to fund our savings deficit.
It is striking that Moody’s could look to lower rather than higher interest rates to improve the growth outlook and the ratings prospects. To repeat the observation made above from Moody’s:
“In addition, the inflation outlook is more subdued, which would suggest fewer interest rate rises ahead than we expected when the South African Reserve Bank saw inflation heading towards 8% by year end. Less severe tightening of monetary policy would alleviate extra pressure on South Africa’s relatively highly-indebted household sector and support growth.”
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We have long questioned the Reserve Bank’s decisions to raise interest rates into higher inflation and a weaker economy. It seems to us that the higher rates can make no predictable impact on inflation or, it may be added, on inflation expected – that has also risen lately despite the weakness of the economy and despite interest rates that have been rising since early 2014.
This proves only that inflation and expected inflation is dominated by forces well beyond the influence of higher short term interest rates. That is in particular by the behaviour of the rand, the behaviour of the weather, the behaviour of the President, the behaviour of global commodity and oil prices and Eskom and its regulators, to mention some of the supply side shocks that have driven inflation in SA higher.
Interest rate increases do nothing useful to contain inflation in a world where the supply side shocks are pushing prices higher and household spending lower. What they do is to reduce household spending further than would have been the case with stable or lower interest rates. For every one percent increase in the repo rate, the Reserve Bank forecasts a 0.4% reduction in GDP growth over two years.
This should be emphasised, in the light of the Moody’s report, since rate increases prejudice rather than enhance our credit rating. An independent central bank is one of SA’s institutional strengths. But such independence could have been much better managed than it has been. Lower, not higher interest rates, would have served the economy better (and still can) and helped preserve its growth rates. Moody’s would seem to agree.
The country deserves a better narrative for its monetary policy. One that can make the distinction between supply side shocks driving prices higher and excess spending and lending that will result in higher prices – without calling its ant-inflationary intentions into question.
After all it should be possible to explain why it is not a good idea to raise interest rates when a drought stalks the land. And why not doing so would not mean the Bank has become soft on inflation. Half of the monetary policy committee would seem to agree- judged by their vote against the latest March increase in rates
Are there other forces at work that could help the economy grow a little faster? The weaker real and more competitive rand finally seems to be helping the manufacturers as well as the tourist business. The latest survey of manufacturing activity, the Barclays PMI, shows a very healthy recovery and positive growth.
If the past strong statistical relationship between the PMI and GDP growth is to be relied upon (showed below), this improvement does suggest significantly faster growth to come. The PMI is well up and the GDP growth rates in Q2 can be expected to follow. We thank Chris Holdsworth of Investec Securities for drawing this relationship to our attention:
The other helpful influence at work is a much smaller foreign trade deficit recorded over the past two months. Less imported and more exported add to GDP growth rates. A decline in inventories held, especially inventories with import content, may offset these favourable forces on recorded GDP growth.
But a combination of a more competitive rand and a more cautious Reserve Bank, more sensitive to the growth outlook, as well as the business cycle trough from which conditions improve rather than deteriorate, should deliver growth of 0.5% this year and 1.5% next; enough to satisfy Moody’s. Raising the growth rates to permanently higher rates of over 3% requires the structural reforms of the labour and other markets that Moody’s appears surprisingly optimistic about. One can only hope that their optimism is justified.
• Brian Kantor is chief economist and strategist at Investec Wealth & Investment. The views expressed in this column are those of the author and may not necessarily represent those of Investec Wealth & Investment.
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