South Africa
Slate Levy Scrapping to Benefit Inflation
January 09, 2009

By Michael Kafe, CFA | South Africa

Summary

South Africa abolished its fixed-rate slate levy on January 7, replacing it with a Self-Adjusting Slate Levy Mechanism (SSLM). The abolition of the slate levy shaves some 45c/l off the regulated price of petrol immediately. This, together with benign oil prices and a relatively stable exchange rate, has raised the likelihood that inflation falls back within the target range earlier than expected. We also believe that inflation is now likely to fall to the mid-point of the target range in 3Q09. This should give the SARB enough comfort to accelerate the pace of rate cuts in 1H09.

Details

The slate levy is a 44.85c/l fuel tax levied by the government to fund payments to the oil industry when there is an under-recovery in the regulated price of fuel. Generally, an under-recovery arises when the regulated price of fuel paid by consumers is lower than the actual price.  This week, the DME announced that it would abolish the existing slate levy on the regulated price of petrol and diesel, in favour of a self-adjusting levy that reprices monthly. According to the DME, by August 2008, the government had accumulated a significant R7 billion contingent liability on the slate account. We believe that this huge cumulative deficit likely arose as a result of legal and administrative bottlenecks that prevented the slate levy from being adjusted timeously to keep pace with soaring oil prices. (Although oil prices rose by more than 100% between March 2007 and August 2008, the slate levy was maintained at 4.8c/l from March 2007 to March 2008 and raised to 24.85c/l in April. It was only in September that there was a major adjustment to 44.85c/l.)

Fortunately, thanks to the subsequent sharp fall in oil prices (at a time where the levy had eventually been adjusted upwards), the huge negative balance that the government had built up on the slate account was completely wiped out in November. In fact, by the end of that month, the balance on the slate account had swung into positive territory. This allowed the government to wind down the old system, and replace it with a more flexible self-adjusting mechanism that allows for quicker adjustments of domestic fuel prices to the landed cost of fuel imports.

The Self-Adjusting Slate Levy Mechanism (SSLM)

Under the newly introduced SSLM, the cumulative slate balance will be calculated on a monthly basis, and the basic fuel price adjusted to reflect the corresponding changes in the slate balance, with a two-month lag. Although the Central Energy Fund will net off its position with the oil industry on a monthly basis, the DME was at pains to stress that it does not necessarily aim to maintain a zero balance on the slate account.  For example, where there is a positive balance on the slate account (as is presently the case), such proceeds will not be paid out to the oil sector immediately. Instead, they will be preserved and used to fund future reimbursements. Reimbursements on the slate account may be phased in over a period of up to six months. In times of an under-recovery in fuel prices, the requisite payments will be made to the oil industry. However, adjustments will be made to the regulated fuel price only when the deficit on the slate account is in excess of R250 million. The annual consumption volumes on which the slate calculations are based will be adjusted twice a year, beginning January 1, 2009. 

At the moment, the slate calculations are based on the assumption that South Africa consumes some 19 billion litres of oil annually. It is important to remember that a final levy of 44.85c/l was paid by fuel consumers in December, despite the fact that the account was already in the black. This alone would have brought in some R0.7 billion, suggesting that fuel consumers will start the SSLM with an initial buffer of some R1 billion that needs to be run down before they are required to make new contributions.  We estimate that, were USDZAR to be capped below 10.50 in the coming months, oil prices may need to rise above the US$60/bbl level to wipe out the surplus on the slate account and evoke new contributions from oil consumers. This has important implications for inflation and interest rates.

Implications for Inflation and Policy Rates

The abolition of the existing slate levy immediately shaves a hefty 45c/l off the petrol price. For example, the January 2009 petrol price falls by as much as 134c/l, and not the 90c/l implied in the daily mark-to-market. Importantly, if this significant undershoot is sustained over the coming half-year or so, it would shave at least a third of a percentage point off the 2009 CPI profile. In fact, our calculations show that the abolition of the slate levy could now combine with a relatively benign oil price profile to push targeted inflation below the upper end of the target band by April 2009 (previously June 2009). What’s more, barring a sustained depreciation in the rand, inflation could in fact dip below the mid-point of the target band in 3Q09, if oil prices remain below US$60/bbl in the coming 3-6 months – as suggested by the Brent crude oil futures curve.  Such a dramatic improvement in the inflation profile is likely to prompt the SARB to accelerate the pace of policy easing in 1H09.

A Repeat of the 2003 Easing Cycle?

We note with interest that, although inflation had clearly peaked and was decelerating somewhat sharply in the first five months of 2003, the SARB refused to cut interest rates at the time because of its view that “CPIX may only be slightly below the upper band of the inflation target in 2004”.  Come June 2003, however, when its central inflation forecast showed a dramatic improvement in the inflation trajectory (with CPIX clearly falling towards the mid-point of the target range, thanks largely to a sharp fall in oil prices), the SARB quickly reversed tack and cut the policy repo rate by a record 150bp at its June MPC meeting.  Looking forward into 1H09, we believe that the SARB may be willing to accelerate the pace of policy accommodation at the upcoming February and April MPC meetings, for similar reasons. Of course, what is different this time around is the fact that our forecasts (and hopefully the SARB’s own projections) show that the sharp fall in 3Q09 inflation is largely due to technical base effects from the 2008 oil price spike, and that targeted inflation will still rise to the upper end of the 3-6% target range in 1Q10. It is only in 2Q10 (previously 3Q10) that projected inflation falls sustainably below the target band, closing 2010 just above 5%Y.

With such a profile, it is difficult to expect the central authorities to cut rates as aggressively as they did in 2003, when the inflation trajectory allowed for a good 650bp of easing. However, we acknowledge that the inflation profile has improved significantly since the December MPC meeting, and believe that the SARB is likely to cut rates by 100bp at its February and April MPC meetings. Policy easing should be restricted to 50bp at the June meeting, however. So, for the whole of 2009, we expect 250bp of rate cuts, bringing to 300bp the total easing in this cycle. Although this is 100bp more than previously thought, it is important to note that it is still less than the 400-450bp priced in by the fixed income market.

Risks

Although our inflation trajectory has ratcheted downwards significantly over the past few weeks/months as oil prices came off the boil, we still believe that inflation risks are skewed to the upside.  Over the past month or so, oil prices have remained weak, while gold and platinum prices have held their ground. The immediate impact of this decoupling of commodity prices has thus far been positive for South Africa: The lower oil price has helped to improve the outlook for domestic inflation, while stronger gold and platinum prices have raised expectations of a moderation in the country’s current account deficit.

But while we concede that the inflation outlook has improved significantly in the short term, we remain agnostic about the sustainability of the recent decoupling between oil prices and gold and platinum prices. In our opinion, one of two things may happen going forward: Either oil prices follow gold and platinum higher, or gold and platinum prices retrace sharply – in line with weaker oil prices. The former will have direct inflation implications, while the latter also raises inflation risks considerably, via the currency channel. Consequently, we maintain a less aggressive stance on the extent of possible policy accommodation than implied by the market.

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Euroland
ECB to Enter ZIRP?
January 09, 2009

By Elga Bartsch | London

A zero refi rate is not the most likely scenario … Several major central banks, including the Federal Reserve, the Bank of Japan and the Swiss National Bank, have already embarked on a (near) zero interest rates policy (ZIRP) (see “The Fed Lady Sings”, The Global Monetary Analyst, December 17, 2008). While we would not categorically rule out that the ECB could also be forced to resort to such extreme measures, we don’t believe that ZIRP is the most likely scenario for the official refi rate. It is, however, possible for the overnight rate (EONIA – the Euro OverNight Index Average, which is the weighted average of overnight Euro Interbank Offer Rates for interbank loans), depending on market conditions.  We forecast further rates cuts of 150bp in the next few months, which would bring the refi rate down to a new historical low of 1% by the spring. This marks a downward revision of half a percentage point compared to our previous profile (see Testing Times, December 3, 2008), reflecting another downgrade to our near-term growth and inflation forecasts. We now expect euro area GDP to contract by 1.6% and HICP inflation to fall to just 1.1% this year (for more details, see European Economic Chartbook: Lowering Growth, Inflation and Interest Rates Forecasts, January 7, 2009). Given that the ECB announced in late December that the corridor around the refi rate will be widened back to 100bp from January 21, a 1% refi rate implies that the floor for the overnight rate would hit the zero threshold.

Another cut in the refi rate could come as early as January.  After the 75bp cut in the official refi rate at the early December meeting, a further 50bp stealth-easing brought about by a cut in the deposit rate announced in late December, and a range of diverging comments from various ECB Council members, it is far from clear whether the ECB is ready to ease again this month. However, the recent data flow, which showed further sharp falls in business sentiment and a marked decline in inflation, underpin the case for another 50bp rate cut, we think.

ECB reluctant to ‘go all the way’ for several reasons.  A number of ECB Council members have expressed concerns about complications that can be created by very low interest rates. Hence, we sense some resistance with respect to ZIRP on the part of the Governing Council. Historically, the ECB has drawn a line at 2%. In many respects, we are in uncharted territory though. Hence, we believe that the ECB will cut the refi rate to a new low of 1% in the current cycle. But, in our view, the ECB’s enthusiasm for further rate cuts will likely peter out before the refi rate, which is key for term funding, gets to zero. That said, with the broader corridor around the main refinancing rate and generous provision of liquidity to the banking system by the ECB, the EONIA overnight rate hitting zero – a ‘secret’ ZIRP strategy, if you will – cannot be ruled out.

For several reasons, the ECB is less enthusiastic about ZIRP and ‘targeted’ quantitative easing than the Fed. We discuss these reasons below, and highlight some potential policy alternatives:

•           The first reason lies in Europe’s history. Monetary policy in continental Europe is still shaped by the experience of the German hyperinflation of the late 1920s and probably less so than in the US by the Great Depression. The malfunctioning of fiat money during the Second World War, a post-war currency reform in Germany and empty-shelf experiences in many communist countries still make policymakers and the general public aware of the situations where money doesn’t buy much anymore.

•           The second reason is the state of the economy. While the euro zone cannot escape the global recession, the risk profile around the base case is different to that in other major economies. This is because the euro zone remains considerably less levered than the US or the UK, especially in the household sector.  On aggregate, the region has not seen a build-up of major imbalances, a sharp fall in the household saving rate or the emergence of a large current account deficit. As a result, a multi-year slump to work off some the past excesses is a more remote scenario for the euro area than it might be elsewhere. The lower level of private sector debt, the relatively high and stable saving rate and a diverse financial system suggest that the dangers of a debt-deflation spiral might be more limited in the euro area. True, HICP inflation could easily dip into negative territory next summer – depending on oil price developments. But, on our projections, this fall is likely to be reversed relatively quickly in the latter part of this year.

•           The third reason concerns the practicalities of ZIRP. A very low level of interest rates poses some operational challenges. These challenges include lower incentives to lend securities in the repo market, increasing difficulties for money market funds to pay positive returns and rising margin pressure for lenders. All of these factors can cause lending to dry up even further, exacerbating rather than alleviating the problem. Some of these undesirable side effects can be avoided if ZIRP were supplemented by ‘targeted’ quantitative easing, fiscal stimulus and financial sector reform.

•           A fourth reason for the ECB’s reluctance to embrace ‘targeted’ quantitative easing is institutional. Outright purchases of financial assets, which lie at the heart of ‘targeted’ quantitative easing, allow circumventing of the banking system and extending credit directly to the government or the private sector. While the ECB has been pursuing a two-pronged strategy of cutting interest rates and expanding its balance sheet, it hasn’t bought securities on an outright basis yet. One factor holding the ECB back, even though it can, in principle, buy securities outright, is that financial losses from such outright purchases could undermine ECB (financial) independence. This obstacle could potentially be overcome if finance ministers provided an ex-ante guarantee to cover potential losses.

But if purchases of financial assets cause market distortions – and this after all is the intention – this could become tricky in a multi-country currency union, if, say, country spreads are affected. Hence, it seems more likely (and more sensible) for individual governments to purchase financial assets directly, as some of them are doing under their bank rescue packages.

Further, for ZIRP to work, private sector balance sheets need to be cleaned up and non-performing loans need to be dealt with. If very low interest rates aren’t complemented with bold balance sheet clean-up, insolvent companies will be kept alive, excess capacity will not be cut and the deflation risk won’t be reduced. On a long-term perspective, resources (capital, workers) remain tied up in unprofitable activities, so the basis of any potential recovery is undermined before it has even started.

Where ZIRP leads to a very flat yield curve, this can stand in the way of financial sector consolidation because it prevents even strong banks from becoming more profitable again. Add some government debt guarantees and you get a blueprint of how Landesbanks and Sparkassen contributed to the low profitability of the German banking sector.

Neither banking supervision nor insolvency legislation falls into the ECB’s remit. The ECB would thus need to rely on other policy areas to provide adequate measures to make quantitative easing work. If these other measures are not in place, quantitative easing could do more harm than good. As the recent political quarrels about the fiscal policy packages showed, an agreement on a pan-regional policy effort might be difficult to achieve.

•           Last but not least, generous liquidity supply by the central bank in a quantitative-easing regime can contribute to the interbank market remaining frozen as banks become overly reliant on the liquidity drip-feed from the central bank instead. Eventually, this could force the creation of a clearing house for interbank lending. Again, for institutional reasons, this might be much more difficult in the euro area than it was in Japan, and it is something that the ECB Executive Board has expressed its opposition to in the past due to the distortions that it could create.

ECB has already taken unconventional policy measures. Unlike the Bank of Japan in the early part of this decade, the ECB did not wait until interest rates hit the zero threshold before starting to expand its balance sheet. Instead, the ECB chose a two-pronged approach, which combined interest rate cuts and expanding its balance sheet (i.e., quantitative easing). Compared to a year ago, the ECB expanded its bank balance sheet by 55%, most of it in recent months. This rate of growth had been “unthinkable” before the crisis, according to ECB President Trichet. Since October, the ECB has guaranteed unlimited liquidity provision at maturities up to six months and extended the pool of eligible collateral.

But as the heavy use of the ECB’s deposit facility shows, the liquidity seems to be going round in circles and a large part of it finds itself back in the ECB overnight. It remains to be seen whether the cut in the deposit rate by 50bp that the ECB announced just before Christmas, which comes into effect on January 21 and will increase the gap with the refi rate to 100bp, will discourage the use of the deposit facility.

An alternative measure of last resort … At the heart of the fight against deflation are inflation expectations. As nominal interest rates are normally bound at zero, it is the inflation expectations that determine the level of real interest rates. Inflation expectations are influenced by a range of policy measures, including monetary and fiscal policy, as well as a variety of other variables, such as oil prices and the business cycle. The challenge for policymakers trying to get an economy out of a deflation trap is to commit to recreating lasting inflation. Once broad-based deflation expectations have taken hold in an economy, it becomes rational for consumers and companies to postpone discretionary spending. This is when inflation’s brief dip into negative territory turns into a protracted deflation spiral.

… would be to raise the inflation objective. An alternative measure of last resort to fight a deflation spiral would be to simply raise the inflation objective. While the ECB is not an inflation-targeting central bank, it has a price stability objective. It has committed to keep HICP inflation below, but close to, 2% over the medium term. In principle, this objective could be adjusted upwards, if needed. As we have argued before, the obstacles to changing the inflation objective are high and any potential change in the objective would need to pass a series of rigorous tests (see EuroTower Insights: On the ECB’s Inflation Objective, August 6, 2008). But bear in mind that the ECB’s inflation objective might become a topic of discussion anyway, once Eurostat presents its final version of an extended HICP, which includes owner-occupied housing costs.  And some would even argue that the ECB’s last strategy review in 2003, which clarified that the ECB does not want inflation to fall too far below 2%, amounted to an upward revision in the ECB’s inflation objective.

A finely balanced outlook for the January meeting. On balance, we expect further easing of 150bp in 1Q09. What is less clear at this stage is whether further easing will take place as early as at the January meeting. Divergent views emerged from the Council, some calling for a pause and return to 25bp clips, others highlighting the scope for further easing. True, the ECB administered 175bp of easing in official rates in merely two months. And it has taken a range of additional measures, which we discussed above. A large part of this monetary policy stimulus will not have been transmitted yet. Equally, the current juncture is not a time for ‘wait and see’. Activity indicators – notably business sentiment, manufacturing orders and industrial production – are in freefall. HICP inflation is tracking below most estimates courtesy of lower energy prices. And money and credit growth seems to be slowing more noticeably. Hence, there is a case for taking out further insurance and cutting interest rates by another 50bp next week.

ECB could take back emergency easing before year-end. Provided that the economy recovers and the deflation danger abates, the ECB could consider reversing gears even before year-end, we think. This would be even more the case if EONIA indeed hits the zero line through a combination of a low ECB refi rate and further ‘collateralised’ quantitative easing. Against this backdrop, we expect 10-year German Bund yields to rise back towards 4%. However, they might do so from a lower level than the current 3.20%, if the ECB turns out to be as proactive as we predict. In this case, the near-term bull steepening in the yield curve would give way to a bear steepening.

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Japan
Revisiting the World According to ZIRP
January 09, 2009

By Takehiro Sato | Tokyo

Rate Cuts Have Not Come to an End

BoJ Governor Masaaki Shirakawa has given signals that rate cuts have come to an end. At the December 19 press conference following the announcement of a number of easing measures, which included the lowering of the unsecured call rate target to 0.10%, he observed that there is no scope for further easing, citing the need to maintain the function of the money markets. But whether there are rate cuts or not depends ultimately on the state of the economy and markets. We are forecasting that the BoJ will reinstate ZIRP (zero interest rate policy) officially during the January-March quarter.

Economic, Political and Market Conditions Make Further Actions Likely

The bleak state of the economy and markets in the current January-March quarter explains why we expect the BoJ, which is stressing the importance of maintaining money market functions, to revert reluctantly to ZIRP. The economy is tracking close to the downside case outlined in our updated outlook on December 10 (see Lowering Base-Case Outlook to the 1998 Post-War Nadir, December 10, 2008). Manufacturing is poised to drop by more than 10%Q again in January-March for a second successive quarter of double-digit decline, and the depth and speed of the correction is outpacing that of the first oil shock and heading for the worst stretch in the post-war period. We expect the job market to become increasingly grim in response to the deterioration in manufacturing, especially for temporary workers in that industry.

Meanwhile, we are concerned about a political risk. In the ordinary Diet session convened on January 5, budget approval hold-ups could derail the approval process of a number of budget-related sunset bills, quite similarly to the process last year, at a time of economic woe. Such uncertainty would also damage market sentiment.

The BoJ Could Even Pull the Trigger Itself

The BoJ could even pull the trigger itself due to a small policy backlash. In light of recent funding operations, many money market and bond market participants perceive a decline of predictability of the money market operations.

To explain, interest rates tend to rise for lending corresponding to the increased demand for 3-month and 1-month term funding at the start of the October-December and January-March periods, and at the end of November and February, due to hedging needs when funding demand increases at the end of the calendar and fiscal year. To hold down term interest rates, it had been expected that the BoJ would take steps to beef up longer-term funding provision toward the end of last year. Notably, the bank indicated in a statement after the December 19 MPM that it will continue to do its utmost as a central bank. Also the bank decided to reduce the overnight unsecured call rate to the same level as the complementary deposit facility rate. These measures, if taken at face value, would imply conducting more aggressive term operations. 

However, actual operations at year-end do not suggest concerted efforts by the bank to suppress such a spurt in interest rates. The unsecured overnight call rate has also been marginally higher than the policy directive of 0.10% for a while after the rate cut. The Lombard lending balance has risen sharply after the rate cuts due to reduced fund provision. Also, a fund-draining operation was conducted even under the complementary deposit facility system. Market participants are worried that the BoJ’s stance on funding provision lacks clarity.

There are various views among market participants as to why the BoJ has apparently been grudging in the supply of funding in the year-end period despite its official acknowledgement that monetary conditions are no longer loose. The most plausible is that the administrative staffs at the bank have been excessively preoccupied by the governor’s stated emphasis on preserving market functions and have therefore been reluctant to supply funds aggressively.

The danger is that with economic activity (production, exports) plunging and the weapons of fiscal policy undermined by political disarray, if the BoJ is not so aggressive in controlling the term rates,  then the stock and currency markets will ultimately pay the price. It is true also that, to date, monetary policy has been sensitive to stock and currency market pressures. Given these circumstances, we are calling for ZIRP to be reinstated in name as well as in deed during the January-March quarter, as the BoJ responds to market pressures.

Currently, markets have barely discounted the possibility of an additional rate cut at all, due to the BoJ governor’s negative stance on bringing back ZIRP. The lesson from last year, however, is that eventually the economic fundamentals decide everything, and override questions of the governor’s personal disposition and whether he is hawkish or dovish. This lesson is now as important as ever.

Market Implications

The global economy, and with it Japan, is facing a spiral of asset price and general price deflation. A deflationary spiral occurs when deflation trips a decrease in demand, which in turn stokes further deflation in a vicious circle of price decline and demand decline. The current situation does look increasingly like such a spiral rather than simple deflation, given the outlook for nominal as well as real GDP to contract and for corporate earnings to plummet. The consistently favorable performance of JGBs since the 1990s (except 1998 and 2003) suggests that the optimal strategy under deflation is to lengthen bond duration to the maximum extent possible.

Bearing in mind the lessons of 2003 (see later), however, we would not force this approach at a time when the economy is showing signs of a tentative pick-up, for example with manufacturing moving out of its extreme downsizing mode, hopefully in the latter half of this fiscal year. We expect 10-year yields of F3/2010 to dip below 1% towards the July-September quarter, but thereafter to rally to the mid-1% range. For yields to settle for a sustained period below 1% would, in our view, signal that the global economy is forming another dip within the current global recession.

Although manufacturing has been undergoing a brutal correction since October-December globally as well as in Japan, aggressive fiscal stimulus is being pursued in many countries. It may therefore be too pessimistic to expect that manufacturing will continue to decline at the same rate in April-June and beyond as it has in October-December and January-March. We cannot tell at this point whether the trigger would be signs of a rebound after production has finished correcting, or whether merely an easing in the rate of decline would be enough, but once a trough for manufacturing becomes visible, we would expect the markets – for stocks and bonds alike – to turn.

From a long-term perspective, there is always a double-dip during recessions, however. The economy would be particularly vulnerable to renewed slowing under the current conditions of global debt deflation at the point when fiscal stimulus is turned off. This was certainly true for Japan in the 1990s. Thus, even if signs of a production trough appear, stock prices and long-term yields may not rise sustainably. Eventually, we expect long-term interest rates to be capped around the 1.5% level throughout 2009-10.

Risks

We outlined the risks of global deflation and ZIRP dragging on in The World According to ZIRP, November 8, 2002. The policy arguments made there are still valid today. The world of a zero policy rate turned out to diverge from the reflation scenario that economists and policymakers at home and abroad originally envisaged.

Monetary policy can effectively restrict overall demand as necessary through tightening, but lacks potency for demand creation. Indeed, Japan’s experience indicates that when an economy is in a bad enough shape that the policy interest rate has come down to the 1% range or below, it is already game over for monetary policy.

Under zero rates, even if a central bank supplies reams of liquidity, this tends to be soaked up by the money market like water in the desert, since the elasticity of demand for real money increases sharply when nominal interest rates change, and so less of this liquidity feeds through to the real economy than envisioned. This is readily understandable when considering that the opportunity cost of reserve deposits becomes zero, thus creating an opportunity benefit from holding excess reserve deposits. When rates are zero, the penalty for holding reserve deposits is also zero (i.e., no pain, no gain).

As a way to supply liquidity, the BoJ has also been stepping up rimban (coupon pass) operations in stages. At the recent December 19 meeting, the bank decided to increase the scope of the rimban operations for the first time in six years. However, we suspect that the staggered increase in such operations in 2001-02 strengthened the flattening bias of the yield curve, and ultimately contributed to stronger deflationary expectations via the market’s mechanism for forming expectations.

In sum, ZIRP carries the inherent threat of a policy trap that cannot easily be escaped. As we feared at the outset, the previous ZIRP lasted for more than six years − much longer than most predictions − until July 2007.

Idleness is the devil’s workshop, however. Roughly half a year after The World According to ZIRP, long-term yields fell to 0.43% in June 2003 as the domestic bond market overheated, and then from the summer shot up rapidly to the upper 1% range. While the bond market at that time was clearly overheated to begin with, a 30% surge in stock prices in a 10-week period triggered by the government’s bailout of a major bank led to a level correction in the JGB market.

Comparing then and now, to the extent that the current recession is more far-reaching, buying JGBs now offers greater reassurance, in our view. We expect investment in bonds to continue by a process of elimination, for as long as investors remain risk-averse. With 2008 still fresh in everyone’s mind, we see little need to fear the emergence of a risk premium in the JGB markets. What should be perceived as a risk is a sudden improvement in economic sentiment, a possibility that we cannot predict and which needs careful monitoring.

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