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it won’t be plain sailing
Investment Economist at Sanlam Investments
Jan 25, 2018
There has been a tangible improvement in the mood of local financial market participants since late last year. After maintaining a negative bias for most of 2017, the rand strengthened appreciably from mid-November in anticipation of Ramaphosa’s election as president of the ANC at the party’s 54th national conference in December.
Government bonds, which sold off sharply following the disappointing October 2017 Medium Term Budget Policy Statement, recovered too – ostensibly reflecting market participants’ optimism that risks associated with South Africa’s deteriorating public sector finances would diminish under the new ANC leadership.
In 2017, poor fiscal outcomes threatened South Africa’s macro-economic stability. But it seems National Treasury will illustrate its intent to stabilise the fiscal position by announcing additional expenditure cuts and revenue-raising measures amounting to R40 billion (over and above previously announced consolidation measures) in this year’s Budget. Also, Ramaphosa has indicated that fee-free education will be phased in with due consideration for fiscal sustainability.
These adjustments alone are unlikely to appease ratings agencies. Attention must also be paid to the deteriorating financial position of state-owned enterprises (SOEs), which remains a clear and present danger considering the sizeable government guarantees on SOE debt. Whereas the expected sale of non-core state assets to fund equity injections into SOEs may alleviate pressure in the near term, the only viable long-term solution is to improve the governance, efficiency and financial management of these enterprises. The Budget will need to show a credible commitment to this.
Ramaphosa recognises the importance of reforming the SOEs. In his ‘January 8 statement’ he noted that ‘corruption and state capture, institutional instability, policy inconsistency, poor performance of SOEs and a sense of drift within the ANC’ have ‘severely undermined’ the economy, while emphasising the need for unity and cooperation with all stakeholders, including business. In essence, a friendlier investment stance has been adopted. This should filter through into improved business sentiment, which in itself holds the promise of better economic outcomes in 2018.
At the very least, more confident economic agents are likely to take advantage of tailwinds, including firmer global economic activity (global real GDP is expected to increase by a solid 3.5% this year), buoyant terms of trade, disinflation and, possibly, lower domestic interest rates.
Indeed, inflation is expected to slow to just 4.3% in February 2018 before lifting on base effects in the second half of 2018 to average around 5% for the year, with medium-term projections well anchored within the Reserve Bank’s inflation target range. This suggests there’s scope for the Bank to cut its policy interest rate further by, say, a cumulative 50 basis points in the first half of the year. Overall, barring unforeseen external shocks, South African real GDP should grow a bit faster, by around 1.5% to 1.75% in 2018, compared to an estimated 0.9% in 2017.
However, whereas we look forward to firmer real economic activity, it’s also important to recognise why the economy has been unable to grow at a decent pace in recent years, despite an improved global economy and easy financing conditions. The usual list of culprits includes inadequate skills levels, excessive red tape, infrastructure bottlenecks, policy uncertainty, low confidence levels and excessive currency volatility.
These are merely symptoms of more deep-rooted problems, however, including eroded institutional capacity, growing income inequality (which manifests in unequal opportunity), uncompetitive product and labour markets, and aggressive rent-seeking behaviour. The latter, which makes for an unlevel playing field, is one of the key risks associated with a developmental state in which the government plays a prominent role in resource allocation.
Even under focused leadership, which Ramaphosa is likely to offer, removing these obstacles will be difficult and time-consuming. In the interim, it would be naïve to anticipate an extended period of plain sailing for the economy.
Granted, the current account deficit is small and the extent of rand ‘overvaluation’ is limited – our current purchasing power parity estimate is R/US$ 12.70. Also, loose monetary policy in developed economies is underpinning easy financial conditions and the global hunt for yield continues to favour South Africa.
Risks linger, however, not least of which are those related to fiscal policy. The current focal point is the long-term foreign currency debt rating decision by ratings agency Moody’s, which is expected shortly after the National Budget is read in February 2018. If Moody’s lowers this rating by just one notch from BBB- to BB+ (sub-investment grade) then, given the existing Standard & Poor’s sub-investment grade rating (BB), South Africa would be excluded from the Citi World Government Bond Index. This could spark substantial capital outflows and renewed rand weakness.
There is a chance the announcement of additional fiscal consolidation measures and a commitment to improved governance and financial management at SOEs – if viewed as credible – can stave off additional sovereign debt rating downgrades. However, although this could steady the ship in 2018, especially if accompanied by asset sales, South Africa’s fiscal challenge remains formidable.
Apart from walking the talk on improving the performance of SOEs, a decisive shift away from consumption spending (including wage restraint) towards net new capital expenditure is required. Despite years of investment, the increase in the total real public-sector capital stock has been limited, while debt and debt servicing cost have increased persistently. Certainly, if growth lifts, the pressure on the fiscus would ease to an extent. However, successful fiscal consolidation usually requires expenditure restraint and expenditure demands are likely to remain elevated.
Further, the tax structure should be aligned with the growth objective. Considering the focus of government’s tax research effort, this is unlikely. The emphasis has shifted decisively in the direction of taxing income and wealth or, put differently, on taxing effort and accumulated savings, which is the opposite of what is required to support economic growth.
If left unchecked, deteriorating fiscal trends still hold risk for the currency and interest rates over time.
In the interim, though, easy global financial conditions continue to paper over a lot of cracks and underpin a reasonable outlook for the economy in the year ahead. The risk is that the supportive global economic backdrop reduces the incentive to implement much-needed domestic economic reform.
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