The Impact of a Slowdown in the US on South Africa
September 13, 2007
By Michael Kafe | Johannesburg
Financial market turmoil to dent global GDP growth.This week, our US counterparts took another close look at the growth implications of the recent financial market turmoil, and they now believe that the shock from tighter financial conditions has raised the risk that US economic growth is capped at no more than 2% over the next six quarters (see Downside Growth Risks Become Reality, Richard Berner and David Greenlaw, September 10, 2007). This is 0.6 percentage points less than they had thought a month ago. Clearly, the dimmer outlook for US growth has implications for the global economy, especially Europe and Asia, where our colleagues have shaved 0.2-0.4 percentage points off their estimates too. For South Africa, we already have a huge out-of-consensus bet on the downside risks to GDP growth, hence we feel comfortable to leave our numbers unchanged, at least for now.
South Africanot heavily exposed to the US directly. Fundamentally, South Africa is not that heavily exposed to the US, at least not directly. Monthly data from the South African Revenue Service show that, over the past four years, the US only accounted for some 12% of South Africa’s exports, compared to Europe’s 35%, Asia’s 25% and Africa’s 14%. The data also show that, while South Africa’s export trade with Asia has been rising steadily from 23% in 2004 to 30% in the first half of this year, exports to the US have remained relatively flat, ranging between 11.7% and 13.5% during this period. It is this not-so-impressive bilateral trade relation with the US that gives us comfort that South Africa is unlikely to be badly hurt by the slowdown in the US. Risk of negative echo effects from Europe and Asia.That said, we must nonetheless highlight that South African growth prospects could still take a knock from the echo effects associated with an indirect exposure to the US economy via Europe and Asia. The latter two regions account for three-fifths of South Africa’s exports, and a US-led slowdown in these regions could cap their demand for imports from South Africa as incomes fall. Thankfully, our European colleagues are only downgrading their growth prospects by 0.2 pp in 2007 and 0.4 pp in 2008, while our Japanese colleagues look for no more than a 0.3 pp adjustment to growth prospects. In China, we expect a full percentage point fall in GDP, but this still leaves us with growth rates of about 10%Y. Domestic factors to hurt GDP growth prospects. So why do we have such a huge out-of-consensus bet that economic growth in South Africa will fall from 4.7% this year to 4.2% in 2008? Well, it has to do with domestic considerations. We stuck to our strong conviction that South Afric’'s manufacturing sector was bound to take a painful knock from tighter monetary conditions, and cut our GDP growth forecast after the SARB resumed monetary tightening in June. True, the 2Q07 supply-side GDP data showed that manufacturing activity had tumbled from 8.3%Q, saar at the end of last year to no more than 0.5%Q, saar. Overall GDP growth for that quarter nevertheless came in above expectations, distorted by a huge increase in financial disintermediation as consumers stepped up their borrowing activity ahead of the introduction of the National Credit Act on June 1, 2007. With that behind us now, we look for a sharp slowdown in the finance and real estate sector in the coming quarters, as the 300bp of rate hikes bite hard, and expect manufacturing activity to remain weak in coming quarters too. We also believe that there is risk that, at the margin, mining and quarrying activity, which now account for no more than 5.4% of GDP, could come in below expectations in 2008 if global growth were to slow. A global slowdown is negative for ZAR.Apart from GDP growth and inflation, we also believe that the global slowdown could have negative implications for the South African currency, especially if the slowdown leads to a ‘flight to quality’ that staves off the portfolio equity flows that have become the main source of funding for South Africa’s current account gap. So far this year, cumulative portfolio bond inflows are flat. After the SARB resumed tightening in June, investors net sold virtually all the bonds that they had bought in the first six months of the year and have remained on the sidelines since. Equity investors on the other hand are still net buyers of South African stocks, as commodity prices have remained firm and expectations for domestic growth have remained high. The risk here is that, were commodity prices to come off the boil as global growth slows, we could well see a squeeze in investor interest that imposes a funding constraint on the country’s burgeoning current account gap. This would exert pressure on the ZAR, which we expect to close the year at 7.50, before depreciating further to 7.90 and 8.40 respectively in the next two years. Such a trajectory should force the SARB to maintain a tight monetary stance until the second half of 2009. Policy rates could still go up 50bp in October.With regard to interest rates and inflation, our US counterparts now expect their monetary authorities to cut policy rates by 50bp by the end of this year, and a further 50bp in the first half of 2008, taking the fed funds rate from 5.25% to 4.25%. Our European colleagues also expect the ECB to stay on hold until well into 2008, when they expect a resumption of tighter money. But we do not believe that the South African Reserve Bank (SARB) will necessarily hold fire in October because of the possible slowdown in global growth: In fact, our base case is that there could well be another hike in interest rates at the October meeting, given the recent upside surprises in core inflation and a likely deterioration in inflation expectations (see South Africa: Possibility of Further Tightening Rises Above 50%, September 3, 2007). Our key concern here is that, although we have on numerous occasions pointed out that South Africa’s inflation overshoot is largely driven by exogenous factors over which monetary policy has little influence, and that it is now too late for monetary policy to do anything about the much-publicized 1Q08 peak in CPIX inflation, a rising trajectory in core CPIX could force the SARB to act again in October. Also, we expect inflation expectations to have deteriorated by some 0.3-0.4 pp since June. And given that the SARB has hiked rates four out of the six times since 2001 that inflation expectations have deteriorated by more than 0.2 pp for the year ahead, we believe that the probability is more than 50% that rates are hiked again in October. This is not to say that MPC decisions are mechanistically based on inflation expectations. We would be the first to point out that a vigorous assessment of the dynamic relationships among a wide range of macroeconomic variables is carried out at each MPC meeting, following which a judgment call is made on what the most appropriate policy response should be. For example, we note that, despite a record 1% deterioration in inflation expectations in December 2002, the MPC cited decelerating producer inflation, an appreciating domestic currency, lower oil prices, slower credit extension, decelerating money supply, excess production capacity, etc, and voted to keep rates on hold. The October MPC will be tricky, given that retail trade, new vehicle sales, household credit growth, consumer confidence, house prices and manufacturing production have all come off their respective peaks, while producer inflation, tighter capacity constraints and a high current account deficit remain a concern. We believe that the key swing factor in October could be the SARB’s view on oil prices. For some time now, it has been very conservative with its oil price assumptions. But now that global growth is looking to slow down, one cannot rule out the possibility that the SARB downgrades its oil price assumptions in October. This is a key risk to our call.
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The Circle of Growth and Petrodollar Flows
September 13, 2007
By Serhan Cevik | Istanbul
Slower global growth in the next 18 months will lower the oil price. The turmoil in credit markets has been far deeper than initially thought, spreading across the world and worsening financial conditions. The problem is no longer limited to the sub-prime mortgage market in the US and has introduced significant downside risk to the global economy. That is why we decided to revise down our global growth estimates. At this stage, we see a more pronounced correction in the US, but no outright recession. Our US economists estimate real GDP growth slowing to an annual rate of 2% over the next 18 months, mainly due to the impact of declining home prices on consumer spending and related investment expenditures. However, our new global projections come with a twist. Instead of an across-the-board cut in growth estimates, we expect the rest of the world to show a ‘soft decoupling’ from the US economy and grow at a robust pace. According to our projections, global output growth will slow from 5% in 2007 to 4.5% next year, compared to our previous growth profile of 4.9% and 4.8%, respectively. But this is still a temporary, mid-cycle slowdown and we expect to see global GDP growth at 4.9% in 2009. With such an outlook for the global economy, oil prices will likely decline from an average of US$67.1 a barrel this year to US$58.8 in 2008 and then increase to US$61.6 in 2009. Lower oil prices will lead to slower output growth in oil-producing countries. The Middle East has become more integrated with the global economy and especially the US business cycle. For example, growth correlation coefficients of Saudi Arabia and the UAE vis-à-vis the US economy increased from -0.66 and-0.01, respectively, in the 1990s to 0.68 and 0.76 in the last six years. Although greater openness and integration with the rest of the world has played a role, the most important factor is oil dependency, in our view. With oil prices increasing from US$20 to US$78 over the past five years, oil-producing countries enjoyed a surge in export revenues from an average of US$228 billion a year between 1998 and 2002 to US$786 billion in 2006 and, on our estimates, around US$835 billion this year. But now slower growth in the global economy will lower oil prices and thereby output growth in the Middle East. Our projections indicate that average real GDP growth will decline from 6% in 2006 to 5.7% this year and 5.2% in 2008, before accelerating to 6% in 2009 with the global rebound. But we have to admit that there are still significant downside risks to our growth profile. A deeper, more extensive growth correction in the US would not allow the rest of the world to decouple from America’s troubles. In that case, we would expect a marked slowdown in Europe and Asia, lowering oil demand and consequently oil prices. Indeed, over the last decade, emerging economies like China have become the major determinant of oil demand in the world. Therefore, a widespread slowdown in the global economy could push income growth lower throughout the Middle East (see Dragon’s Appetite, March 21, 2007). The accumulated petrodollar liquidity could support economic activity in the near future. Thanks to the oil windfall, oil-exporting countries’ cumulative current account surplus increased from 5.4% of GDP in 2002 to 20% last year. In turn, abundant liquidity pushed domestic growth higher and also led to the accumulation of foreign assets. In the near future, we expect petrodollar liquidity and diversification efforts to keep domestic investment spending on track and accordingly raise import demand. Nevertheless, we estimate that the decline in oil prices and higher domestic spending would lead to a narrowing of current account surpluses in the Middle East. That would of course lower ‘excess’ liquidity and thereby the recycling of petrodollars through the financial channel. In other words, we would expect a decline in the accumulation of foreign assets, which was running at an average of 2.1% of global GDP a year in the last six years and, on our estimates, 3.6% this year (see Pumping Money, May 22, 2007). Although a sudden withdrawal of petrodollar liquidity remains unlikely for the time being, the shift from the financial channel to trade channel would have significant implications for the rest of the world, as higher import demand in the Middle East is good news for Europe and Asia.
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