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WHAT CAN WE EXPECT?
Investment Economist at Sanlam Investments
May 28, 2020
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Economic lockdowns and social distancing set in motion a destructive negative supply and negative demand feedback loop around the globe during the first half of 2020. Governments responded in unprecedented fashion, implementing numerous policies including temporary employment relief programmes, tax and loan holidays, guaranteed loans, the easing of banking regulations and central bank purchases of a wide range of public and private sector assets. The primary aim of these interventions is to ensure businesses survive the expected temporary disruption to income, so that employees have jobs to return to.
China’s recovery, which began in March 2020, appears to have gathered momentum, although activity levels haven’t yet been fully restored. Elsewhere, in developed economies, upcoming data for the second quarter is likely to show astonishingly sharp annualised falls in real GDP. However, restrictive economic measures are being eased, fuelling expectations of a strong bounce in annualised GDP in the second half of this year. Indeed, a strong increase of +5% is expected in global real GDP in 2021, following a sharp fall of, on average, -4% in 2020.
In South Africa, stringent restrictions on economic activity and personal movement have been in place through most of the second quarter. Although the country’s restrictions have been tough, Oxford University’s COVID-19 Government Response Stringency Index shows that a host of other countries have experienced similar levels of restriction on activity, including both developed and developing economies.
The hit to domestic economic activity has been extensive. Statistics South Africa’s second COVID-19 survey of 2 182 firms, covering the period from 14 April to 30 April 2020 across all industries and ranging from small to large businesses, was released in mid-May 2020. It indicates 8.6% of firms permanently ceased trading in this period, while 47.9% temporarily ceased trading and 34.7% traded partially. The survey shows 36.4% of businesses laid off staff in the short term, while 24.9% have decreased working hours.
Given these outcomes, real GDP is expected to contract by -8% in 2020. However, the shift from lockdown Level 5 to Level 4 has already initiated some improvement in activity. This can be expected to gain momentum as draft proposals announced by President Cyril Ramaphosa on 24 May 2020 indicate that all manufacturing and retail activity (with limitations on alcoholic beverage sales and excluding tobacco product sales) should be allowed under Level 3 from 1 June 2020.
It will be some time before the economy is fully operational as, for example, accommodation and food services, aspects of travel, some personal services, live entertainment and sports remain on the restricted or prohibited list. On balance, though, real GDP is expected to record a firm increase of 4% in 2021.
However, despite the expected bounce in GDP into 2021, the key problem for economies everywhere is the ‘permanent’ loss of income, despite policy interventions. It will take time for economies to recover to the same income levels that prevailed pre-COVID-19. In the interim, as debt-to-income levels have increased, businesses and households will seek to repair their balance sheets, which can be expected to weigh on demand.
In South Africa, interest rate cuts to date and the easing of bank regulations are unlikely to prompt banks to extend new loans to the private sector until the path for future income streams becomes clearer and confidence levels lift. As such, the South African Reserve Bank (SARB) is arguably pushing on a string. This underlines the importance of the government’s guaranteed loan facility of up to R200 billion for enterprises with annual turnover of up to R300 million per year (subject to certain conditions being met).
The facility formed part of the government’s comprehensive COVID-19 economic support package of R500 billion (10% of GDP), which also included R100 billion for job protection, reprioritised government spending of R130 billion, and R70 billion in tax measures. The latter comprised tax relief and incentives (R26 billion), and tax deferrals (R44 billion).
Looking ahead, South Africa’s comprehensive COVID-19 package is an important intervention and a key reason to expect an economic recovery as we head into the second half of 2020. Less clear is the strength of the recovery, and we should warn that forecasts are subject to change as more information is made available.
One key unknown is the extent to which COVID-19 infections may gain traction again once restrictions on economic activity and personal movement are lifted. It’s encouraging that the global COVID-19 infection rate (daily percentage change) has slowed from close to 30% in late February 2020 to around 2% currently. Infection rates, however, still vary significantly between different countries.
In South Africa it is unfortunately still stubbornly high, trending at around 6%, with the strongest recorded growth in the Western Cape. Communication by the government indicates we’re some way from the peak and work disruptions are inevitable as the government’s risk-adjusted strategy to opening the economy unfolds.
Moreover, it’s not clear that the transmissibility of COVID-19 will remain well contained in all countries. At the very least, we should expect intermittent disruptions to activity as firms shut down to adhere to health protocols. At the same time, we should expect disruptions to the global mobility of workers and tourists for some time.
The depressed level of economic activity in 2020 points to a negative real repo rate, leaving the nominal repo rate at, say, 3% before the end of this year. However, the yield curve is very steep and the SARB, which cut its repo rate to 3.75% in May 2020 from 4.25%, may be reticent to cut too much further if it places greater emphasis on its medium-term inflation forecast as opposed to the near-term economic activity fallout, or given South Africa’s deteriorating fiscal position.
The SARB alluded to the latter specifically in its May 2020 Monetary Policy Committee (MPC) Statement, noting that ‘credit risk associated with public borrowing needs remains very high’. Due to a decrease in GDP in current prices this year, the government’s main budget deficit is expected to widen to -12.5% of GDP in fiscal year 2020/21 with a primary budget (revenue less non-interest spending) deficit of 7.6% of GDP.
Ultimately, given high real interest rates and dismal potential economic growth, the budget balance surplus required to stabilise the debt ratio may prove too onerous to implement. In the absence of a return in global capital inflows, the South African government will increasingly rely on domestic sources for funding, implying we should expect continued crowding out of private sector credit extension and investment spending.
Like bond investors, the central bank is aware of the currency and inflation risk inherent in failed fiscal policies. Ultimately, bad things happen to economies if fiscal policy unravels. A continuously weakening government financial position also increases the risk of the pursuit of alternative policies and financial repression, which can be expected to have damaging long-term implications. This highlights the importance of mapping a credible path to fiscal and economic reform in the National Treasury’s upcoming 2020 Special Adjustment Budget, which must include a plan to stabilise ailing state-owned enterprises and limit government’s excessive level of consumption expenditure.
Against this backdrop, the SARB’s May MPC Statement also warns of ‘sustained higher levels of country financing risk’. Currently, at least, inflation expectations remain well anchored, which implies significant support for the substantially undervalued rand, especially given the nascent improvement in the trade account (against the backdrop of a material increase in South Africa’s terms of trade in recent months). However, it’s clear that South Africa needs to attract renewed interest from investors abroad, given the extent of the government’s financing need.
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