Peru
The PENdulum
February 21, 2008

By Boris Segura | New York

Despite a strong rally in the Peruvian PEN during the first two months of the year, we are not ready to change our year-end exchange rate forecast of 2.95. Even while we are more bullish on the Peruvian currency in the coming months, a more challenging international environment during 2H08, in the shape of possible risk aversion and softer commodity prices, is likely to cause a correction.

As we argued recently (see “A PEN Dilemma”, FX Pulse, January 24, 2008), in the short term, the authorities are likely to successfully defend the 2.90 level. However, tax season is starting in Peru − when the major exporters pay (soles-denominated) taxes out of their cash flow in dollars − and the supply of dollars is bound to increase strongly in the next few weeks, which could, in turn, cause the PEN to strengthen below 2.90. We expect the central bank to attempt to resist this tide and keep buying dollars in the forex market.

Our estimates

While we are not adjusting our currency view, we are revising our estimates for Peru’s external accounts. In light of weaker terms of trade over the coming two years, we have lowered slightly our trade balance numbers to US$5.7 billion in 2008 from US$6.0 billion previously and to US$3.5 billion in 2009 from US$3.8 billion.

The most important change on the external front is that we now see a much larger current account deficit in 2008 than we had previously forecast. After recent years of current account surpluses, Peru is likely to see a current account deficit in 2008 as large as 1.7% of GDP − larger than our previous forecast of 0.4% of GDP. The deficit widens even further to 2.6% of GDP in 2009 versus our previous estimate of 0.9%. This is mostly due to higher repatriations of dividends by foreign companies investing in Peru. Against the backdrop of current account surpluses since 2004, this move to deficit over the next two years could weaken an important driver supporting the exchange rate. 

We also project Peru’s real effective exchange rate (REER) for 2008. While somewhat above its long-term average, the REER remains flattish throughout the year; so much for exporters’ anguish in 2008.

Central bank support

We suspect that the central bank is behind the curve on inflation. In its latest quarterly inflation report, the central bank attributes headline inflation breaching its target in 2007 to “imported food and fuel inflation”. In the central bank’s opinion, aggregate demand is still not generating inflationary pressures.

We beg to differ. Strong domestic demand, well above any measure of potential GDP growth in Peru, is exerting pressure on inflation. Core inflation, running at 3.3%Y, is at its highest level since 2000. Inflation expectations are also on the rise, despite well-behaved ex-food inflation. Our concern is that the central bank risks losing its hard-won credibility.

We are not confident that headline inflation is going to peak in 2Q08, at around 4.5%, as expected by the central bank. Indeed, the central bank acknowledges this as a risk in its quarterly inflation report, stating that “the weighting of several risks on inflation with respect to the base scenario results in an upward bias on the inflation projection”.

We now expect the central bank to raise rates on at least two more occasions this year, bringing the reference rate to 5.75%. We had previously forecast only one more hike to 5.5%. Together with the fed funds rate path suggested by our US colleagues (see “Playing the Double-Dip Recovery”, This Week in Latin America, February 11, 2008), we compute the differential between Peru’s reference rate and the US fed funds rate.

This interest rate differential is likely to keep the exchange rate well supported during 2H08, coincident with what we expect to be a more challenging international environment. In addition, the central bank has a war chest of international reserves to intervene in the currency market in order to avoid significant currency depreciation, as in principle it should be symmetrical in its interventions to wild swings in the exchange rate.

Bottom line

Although we expect the PEN to weaken a bit by year-end, we see room for near-term strengthening as the tax season in Peru is just beginning. However, with the more challenging international environment that we envision for 2H08, we expect the currency to reverse its course and move towards our 2.95 forecast.

We expect the softening in the currency to be orderly. A healthy interest rate differential and a central bank bent on managing the exchange rate, even at the expense of its main objective (keeping inflation low), are likely to minimize the damage of unsettled international markets on the PEN.

South Africa
Fiscal Mettle in Fine Fettle
February 21, 2008

By Michael Kafe and Andrea Masia | Johannesburg, Johannesburg

Summary
Finance Minister Trevor Manuel presented South Africa’s 2008 Budget to Parliament on February 20. While most of the macroeconomic forecasts were pretty much in line with our expectations, the announcement on further exchange control relaxation took us by surprise. Also, despite a slowdown in GDP growth forecasts, estimates of the budget surplus remained broadly unchanged relative to what was published in October 2007, thanks to better-than-anticipated tax revenues. The upward revisions to revenue have also allowed the government to maintain a surplus position on its general financing requirement line, despite some rather generous budgetary allocations to Eskom and Transnet. What’s more, the government hopes to become a net redeemer of debt over the next three years, which is extremely positive for the sovereign ratings outlook, in our view.

Foreign exchange liberalization unexpected but welcome
The major highlight of the Budget for financial markets was the surprise announcement on exchange control relaxation. Limits on foreign investment by pension funds and underwritten policies of long-term insurers have been raised from 15% to 20% of total retail assets, while the foreign exposure limit on unit trusts managers and investment-linked businesses of long-term insurers has been raised from 25% to 30%. The government hopes to move from direct controls on capital flows to a system of quarterly reporting that allows the SARB to actively monitor the flows. To help pick up early warning signals, however, the authorities require that asset managers pre-notify the SARB of any substantial changes to their foreign exposure.

Banks will also be allowed to invest as much as 40% of their liabilities offshore (40% of regulatory capital previously), while individuals are allowed to take out a further R500,000 per year in discretionary allowance (gifts, donations, etc.) in addition to the existing R2 million annual investment allowance. Finally, companies, banks, trusts and partnerships will be allowed to invest in offshore-linked instruments listed on the local exchange. On the whole, we believe that the decision to ease exchange controls was rather bold, given the current international investment backdrop and concerns about South Africa’s burgeoning current account deficit and associated external sector vulnerability. The current regime at the National Treasury may have decided that it would be politically expedient to oversee the ‘conclusion’ of the foreign exchange liberalisation process before the next regime assumes power.

Massive capital outflow unlikely
Latest data from the SARB show that assets under management by long-term insurers, pension funds and unit trusts totalled some R2.8 trillion in 2Q07. 5% of the combined assets under management amounts to some R140 billion or the equivalent of some 1.1 times daily turnover (net) in the foreign exchange market, half of the SARB’s foreign exchange reserves, 85% of the country’s current account deficit and some 1.7 times the 2007 portfolio bond and equity inflows. Clearly, if these funds were to rush for the door, we could see some currency weakness. However, given the dearth of viable investment alternatives offshore, we do not believe that a mass exodus is likely just yet. In any case, fund managers tend to go through detailed investment processes before arriving at decisions to move funds offshore. This process takes time. Hence, although the rand touched R7.90/US$ after the Budget, we do not believe that it has legs.

Fiscal mettle in fine fettle
We were pleasantly surprised by the Treasury’s assessment of the fiscal health of the country: Central government is now expected to record a budget surplus of 0.8% of GDP this fiscal year (0.5% GDP previously), and still hopes to post budget surpluses in the region of 0.6% of GDP in the coming years, despite the fact that it will be making some fairly significant allocations to Eskom (R20 billion) and Transnet during that period.

In fact, the details show that the balance on general government borrowing is expected to remain positive, although the overall public sector borrowing requirement will rise slightly (some 0.3% of GDP) in coming years, thanks to a slight jump in the borrowing requirement for non-financial public enterprises from an average of some R37 billion per annum in the October Medium-Term Budget to R44 billion. About 87% of this borrowing is required to finance the revised capital expenditure plans of Eskom and Transnet. Interestingly, the funding requirement for Eskom is some R60 billion over five years, or some R12 billion per annum ­– exactly as expected (see EM Economist, February 15, 2008). Also, it turns out that the funding will be back-loaded as we expected: Only R20 billion will be paid out in the next three years, with the remaining R40 billion to be paid over the following two years, when Eskom's baseload capacity build starts kicking in.

But then again, despite the rise in the public sector borrowing requirement (most of which will be met by a drawdown on the contingency reserve account), net domestic debt is expected to fall from R377 billion this fiscal year to R353.4 billion by 2010, making the government a net redeemer of debt in the medium term. As a percentage of GDP, total government debt is expected to fall from 22.3% this fiscal year to 15.9% by 2010, making South Africa one of the few non-OECD countries with debt-to-GDP ratios below 20%.

Tax relief for persons and business
On the tax front, the government reduced the company tax rate from 29% to 28%, while individuals were granted personal income tax relief of R7.7 billion (Morgan Stanley forecast R5 billion), mainly at the lower income levels. The Treasury also introduced a 2c/kilowatt hour tax on electricity, and promised to finalise details on the imposition of a withholding dividend tax at the shareholder level in 2009. Although the GDP growth forecast was downgraded from 4.5% to 4% in 2008/9, overall tax revenues are expected to come in higher, thanks to higher commodity prices and a positive offset from fiscal drag/bracket creep as domestic inflation has risen.

Conclusion
In conclusion, we believe that this budget was broadly neutral. While the tax relief granted to consumers and the token reduction in company tax rates are no doubt stimulatory, the overall fiscal position remains healthy. The surprise relaxation in foreign exchange controls no doubt took the market by surprise, and engendered some short-term currency weakness; but it is important to remember that economic liberalisation is a move in the right direction. The tax cuts are positive for equity markets, while the decision to remain a net payer of debt is no doubt positive for the bond market. Finally, the decision to support Eskom’s capital expenditure plans should help prevent economic growth from falling below potential in coming years, although we may still have some challenges in the very short term. On the whole, we believe that South Africa remains positioned for a sovereign ratings upgrade.