South Africa
Budgetary Consolidation in 2009
February 13, 2009

By Michael Kafe, CFA & Andrea Masia | Johannesburg

Summary

In what is widely expected to be Finance Minister Trevor Manuel’s final Budget Speech, South Africa’s 2009/10 National Budget was tabled in parliament on February 11. In brief, GDP growth is now projected to fall to 1.2%, resulting in lower fiscal revenues, a higher fiscal deficit of 3.9% of GDP in 2009/10 and a consequential doubling of the overall public sector borrowing requirement (PSBR) from 3.9% of GDP in 2008 to 7.5% in 2009. We find it rather surprising that, despite its stated commitment to the pursuit of counter-cyclical fiscal policy, the Treasury opted to leave 2009 non-interest expenditure unchanged at the main budget level, and in fact cut back on overall public spend at the consolidated general government level. Encouragingly, however, the National Treasury did give the consumer some modest tax relief. At the margin, the mining sector is also expected to benefit from the Budget’s proposal to defer the introduction of mining royalties until 2010.

Revenue Shortfalls Result in Significant Deterioration in Deficit and Funding Requirement

The Treasury revised its 2009 GDP estimate from 3% to 1.2%. As a result, it now expects main budget revenues to come in at R642 billion or some R40 billion lower than its October 2008 estimate of R683 billion. Main budget non-interest expenditure was therefore kept unchanged at R683 billion, although total 2009 expenditures are up by R3.6 billion, thanks entirely to a R3.6 billion increase in state debt costs.  On the whole, the main budget deficit is now forecast at R95.6 billion or some 3.9% of GDP. This is R43.5 billion higher than the October 2008 estimate of R52.1 billion, and the deterioration is almost entirely explained by the R40 billion drop in revenues.

The PSBR is also forecast to rise from earlier estimates of 3% of GDP in 2009 and 3.2% in 2010 to 7.5% and 6.5%, respectively.  While some 40% of the deterioration here is driven by the increase in central government borrowing, the remaining 60% is entirely due to a significant R61 billion increase in funding requirements of non-financial public enterprises. It appears that the Treasury significantly underestimated the revenue line/profitability of these enterprises in October. The total stock of public debt is now expected to rise from R520.7 billion (22.6% of GDP) in 2008/9 to R810 billion (27.4%) in 2011. Foreign debt remains a relatively small component of total debt.

Cosmetic Fiscal Stimulus

A stimulatory budget is often measured by the overall share of government in the economy. Typically, a stimulatory budget is attained when the growth in government expenditure is higher than that of GDP. One must remember, however, that a higher share of government could still result if the GDP denominator slows faster than a contraction in government spend.  In such a scenario, fiscal stimulus would then be entirely cosmetic – as we think was the case in South Africa’s 2009 Budget, where the share of government spend in the economy is set to rise merely as a result of slowing GDP growth. Specifically, the Treasury expects the share of government to rise from 31.3% in 2008 to 33.7% in 2009 before falling to 33.5% in 2010 and 32.3% in 2011. These readings are higher than the October 2008 estimates of 31.8%, 32.3%, 31.5% and 30.4% for 2008-11.

At the consolidated general government level (i.e., general government plus provinces, local government, etc.), the Treasury expects a deficit of 3.8% of GDP (R94 billion). Unfortunately, as the consolidated general government revenue and deficit line items were not published in the October Medium-Term Budget Policy Statement (MTBPS), it is impossible to do a like-for-like comparison.

We also noticed that, in an attempt to downsize the country’s costs to size, the National Treasury kept the overall level of expenditure flattish at this broader level of government, from earlier estimates of R839.8 billion for 2009/10, R903.0 billion for 2010/11 and R965.3 billion for 2011/12 as published in October to R834 billion, R899.7 billion and R953.1 billion, respectively.  What’s more, within this smaller resource envelope, the Treasury demonstrated a clear willingness to improve the quality of spending, by cutting back on some recurrent expenditure items including general transfers and subsidies to government departments and agencies, and applied the cost savings therein (totaling some R19 billion across all national departments and provinces in 2009) to the funding of its infrastructure projects.  We believe that this was extremely prudent, given the anticipated revenue shortfall position of government. In fact, we think that to do otherwise would risk throwing the country into a fiscally unsustainable position. Total infrastructure spend is now expected to rise by some R30 billion in each of the coming three years, relative to the October 2008 estimates.

Targeted Fiscal Relief the Way to Go

Even so, the Minister of Finance appears to have implemented some targeted relief measures elsewhere in the budget. For example, given his expectation that private consumption expenditure is likely to contract in 2009, he has offered tax relief of R13.6 billion to the consumer. This is much higher than our estimate of some R6-8 billion. However, we are perhaps not so far off the mark if one also considers that increases in the fuel levy, the electricity tax and higher ‘sin’ taxes will wipe away a combined R10 billion of the R13.6 billion income tax relief. Also, the Treasury appears to have doled a targeted relief measure to the mining sector by deferring the introduction of mining royalties from 2009 to March 2010, effectively saving the industry some R1.8 billion.  Finally, the government’s decision to raise some US$1 billion a year in the international markets suggests that it recognizes the need to help ease the foreign exchange funding pressures on the capital account of the country’s balance of payments. The amount is less than our estimate of US$2 billion, but we think that this is nevertheless a step in the right direction – particularly given the fact that the Treasury has also expressed its willingness to consider taking up a further US$6.5 billion in World Bank and African Development Bank loans.  Separately, to help provide funds for the ailing national electricity producer, Eskom, the government has offered to underwrite R175 billion of Eskom’s debt. This includes R26 billion of existing debt and R150 billion in new debt to be issued over the next five years.

Conclusion

The 2009 Budget clearly shows some deterioration in the fiscal aggregates. But such deterioration is largely due to anticipated revenue shortfalls in acknowledgement of the fact that the global downturn will have negative implications for domestic growth, rather than a conscious decision by the government to become more profligate. In fact, absolute expenditures have been trimmed at almost all levels of government, and there has been further reallocation of resources away from current transfers into infrastructure. In our opinion, however, the relief measures targeted at the consumer, business and external accounts are somewhat inadequate. On the whole, we believe that the budget was neutral to slightly positive, and see no motivation to change our interest rate and currency forecasts.

Important Disclosure Information at the end of this Forum

UK
Bank of England Inflation Report: Embarking on Unconventional Measures
February 13, 2009

By Melanie Baker; CFA, Mayank Gargh, David Miles, Laurence Mutkin & Owen Roberts | London

Further Details

GDP forecasts: The MPC has sharply revised lower its near-term GDP forecast – it suggests that evidence points to a similar contraction in 1Q09 as in 4Q08 (likely to come in around -1.6%Q on the second release from the ONS next week).  The central GDP growth forecast now looks like it bottoms at about -4%Y.  However, it does have a pretty sharp rebound in GDP growth built in (it looks like it reaches a significantly above-trend 3.5%Y or so on a central forecast).  This rebound looks at first glance like it implies significant positive quarter-on-quarter GDP growth in 2H09.  In general, the MPC notes that there are a range of factors currently in place that together should “provide a more significant and prompt stimulus to activity than at similar stages of previous episodes”.  It thinks, however, that the balance of risks to the GDP profile is “weighted heavily” to the downside.

Despite the healthy looking rebound that is shown in the central forecasts, the MPC still thinks that a significant margin of spare capacity remains in the economy at the end of the forecast period.  This weighs down on its medium-term inflation outlook.

Inflation forecasts: The MPC’s CPI inflation forecast shows CPI inflation at a bit below about 1%Y at the two-year horizon of its fan charts on a central forecast, i.e., clearly below the bank’s 2% target.  It sees the balance of risks to its inflation profile as more balanced and “slightly to the downside”.

Unconventional easing: Governor King said in the press conference that the policy rate does not have to go to zero to move to credit easing/quantitative easing (and even suggested that at this low level of interest rates it doesn’t really matter whether the base rate is lowered or not).  In the Inflation Report, the MPC explicitly recognises that the base rate’s fall to historical lows is likely already having a dampening impact on the transmission mechanism because further cuts in rates may not be passed on to borrowers or else might hurt bank profits, and therefore capital. Our central case is still that the Bank of England does not cut rates further.

Given the undershoot of the inflation target in the MPC’s central projection, and the reduced force of the transmission mechanism at very low rates, it seems plausible that the MPC will see unconventional monetary policy tools as warranted. The Inflation Report runs through how the Asset Purchase Facility (APF) can be used as a tool of monetary policy: purchases by the APF would be financed by the creation of central bank reserves (i.e., not sterilised through the issuance of T-bills) and focus on expanding the quantity of those reserves. This would involve purchasing a variety of assets – “for example government securities and the private sector assets targeted by the current APF”.  This amounts to monetary easing through two channels: 1) increasing the supply of broad money (which should stimulate private sector spending by increasing the money holdings of those selling the assets and through an expansion by banks of the supply of credit). 2) Increasing the confidence of investors that they can sell those assets, reducing illiquidity premia and making it easier for companies to issue credit instruments.  This relies upon banks not simply hoarding the increase in reserves, and the BoE also appears uncertain about the likely strength of the second channel. 

Presumably the earliest these new channels of monetary policy easing could be accessed would be soon after the next MPC meeting on March 5, where the MPC could formally decide that this is the path it wants to go down.  We assume that this will be what it decides to do.

Our forecasts: We are more comfortable than before that the UK economy will recover in 2H09 (in terms of seeing positive quarter-on-quarter growth rates).  We see the measures mentioned by Governor King today as an extension of the UK authorities’ determination to ‘do what it takes’ to see the economy recover.  We do not expect as vigorous a recovery as the BoE appears to have in its central forecasts. But then we do not forecast as deep a near-term contraction.  We also think that the near-term decline in inflation may be a bit deeper than the MPC expects on its central projection, but that the path beyond that will be higher than it currently anticipates (where it uses ‘market-implied interest rates’ − i.e., a profile for inflation which doesn’t include a deliberate effort to increase the money supply). 

Possible Shape of Quantitative Easing

The key questions to answer relate to the size of buying, the sector, timing and, of course, the method of purchase.

The immediate impact of quantitative easing is to increase measures of the money supply. This gives a way of judging possible orders of magnitude of the scale of operations.  Shifting the stock of M4 (excluding holdings by financial institutions) is the most likely path to influencing spending and growth in the economy, and hence inflation.  It is easy to calculate how big an increase in the broad money supply (M4) would be needed to bring its growth up to 5-6% (i.e., in line with an approximate longer-run trend level of nominal GDP growth).  The relevant measure of M4 is currently growing at about 3%Y (M4 ex-holdings of ‘other financial companies’) and the stock (again ex-holdings of ‘other financial companies’) is about £1.2 trillion.  If it were, all else being equal, to continue growing at that rate, then to bring expansion up to 6% means quantitative easing should boost the stock by around £36 billion (3% of the stock) over the course of a year.  To put these numbers into perspective, the total size of the gilt market outstanding (as of December 31) is around £530 billion nominals and another £170 billion index-linked.

A historical perspective on the current programme is instructive in managing expectations for the new programme. The first gilt purchase open market operation (OMO), held as a competitive tender, was in January 2008, and monthly thereafter (but announced quarterly). Since then, the BoE nominal gilt holdings have increased by almost £12 billion (as of December 2008) – i.e., an average £1 billion per tender.

In response to a consultation paper in 2006, the OMO counterparties supported the bank’s plan to purchase at least one bond from each of three segments of the curve – defined as maturity buckets of 1-7 years, 7-13 years and 13-20 years. The bank was minded to purchase only two bonds from each of the segments of the yield curve in each tender.

Also, the BoE intended to a) purchase only conventional gilts above £4 billion outstanding issue size, b) exclude gilts that were CTD in any active futures contract, and c) exclude gilts that the DMO has already announced that it intends to re-open at auction.

We believe that the decision on which gilts to buy may be simpler than it appears. We do not think that the BoE will wish to distort the yield curve, and therefore it will probably adopt the approach it has taken in the last couple of years regarding buying gilts to liability-match its notes and coins. However, we believe that the new programme is more likely to be spread across the entire curve, rather than confined to the 1-20-year buckets of the existing programme. Also, there is nothing to limit the BoE from buying index-linked issues, though we believe that conventionals present a simpler target from a size and liquidity perspective.

The existing programme has involved a series of regular competitive tenders. We believe that it makes sense to implement this format for the new programme since the gilts will need to be purchased from the market – direct purchases from the DMO would not achieve the aim of increasing money supply. It is reasonable to assume that the reverse auctions may be more frequent or of larger sizes, though, given the apparent urgency of increasing money supply.

Finally, it is worth noting that this buying of gilts is different in nature to the APF, which is a) aimed at something different, i.e., freeing up credit to non-financial borrowers, and b) sterilized, i.e., financed through the issuance of T-bills (though this could be changed).

Implications for the Market

We believe that the announcement is bullish for gilts. Given the buying from the BoE and banks to come, we think that gilt yields can re-test previous lows. The 5-year sector looks attractive from a carry/rolldown perspective, though we would favour being long the 10-year sector, which has the most room to rally if it goes back towards the 3% level seen at the start of the year (entry: 3.61%, target: 3%, stop-loss: 3.80%).

While the curve has bull-steepened since the announcement, and this has been more pronounced in the cash market than in swaps, we don’t think that this announcement has particular implications for the curve slope going forward. Indeed, part of the outperformance of 2-year yields can be attributed to the ~20bp rally in SONIA, as the market prepares for lower policy rates as well.

On the relative value front, though, we would note that if the BoE follows the previous guidelines of not buying back issues which have already been scheduled to be tapped, this may lead to localized distortions across the curve.

In terms of spreads, we believe that gilts can outperform swaps as the BoE and banks need cash, not swaps. This should be especially true for the sectors where gilts are trading over swaps, and so we favour buying 10-year spreads. We would set an initial target for a return to the previous plateau of +25bp (entry: -2bp, stop loss -15bp).

We would also expect gilt yields to catch up with their German counterparts. 10-year gilt yields traded on par with German 10-year yields in the early part of this decade, and in fact has inverted if we go back even further in time. The 2-year yield spread has inverted in the early 1990s, but this was accompanied by a deep inversion of the policy rate spread – which we do not envisage to the same scale today.

The 10Y sector offers the widest spreads against German yields; hence, we favour buying 10-year gilts versus 10-year Bunds (entry: 40bp, target: 0, stop-loss: 60bp).

Important Disclosure Information at the end of this Forum

Disclosure Statement

The information and opinions in Morgan Stanley research were prepared or are disseminated by Morgan Stanley & Co. Incorporated and/or Morgan Stanley C.T.V.M. S.A. and/or Morgan Stanley & Co. International plc and/or Morgan Stanley Japan Securities Co., Ltd. and/or Morgan Stanley Asia Limited and/or Morgan Stanley Asia (Singapore) Pte. (Registration number 199206298Z) and/or Morgan Stanley Asia (Singapore) Securities Pte Ltd (Registration number 200008434H) and/or Morgan Stanley Taiwan Limited and/or Morgan Stanley & Co International plc, Seoul Branch, and/or Morgan Stanley Australia Limited (A.B.N. 67 003 734 576, holder of Australian financial services licence No. 233742, which accepts responsibility for its contents), and/or Morgan Stanley India Company Private Limited and their affiliates (collectively, "Morgan Stanley"). As used in this disclosure section, Morgan Stanley includes RMB Morgan Stanley (Proprietary) Limited, Morgan Stanley & Co International plc and its affiliates.

Global Research Conflict Management Policy

Morgan Stanley Research observes our conflict management policy, available at www.morganstanley.com/institutional/research/conflictpolicies.

Important Disclosures

Morgan Stanley Research does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages them to seek a financial adviser's advice. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. Morgan Stanley Research is not an offer to buy or sell any security or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.

With the exception of information regarding Morgan Stanley, research prepared by Morgan Stanley Research personnel is based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we do not represent that it is accurate or complete. We have no obligation to tell you when opinions or information in Morgan Stanley Research change apart from when we intend to discontinue research coverage of a company. Facts and views in Morgan Stanley Research have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.

To our readers in Taiwan: Morgan Stanley Research is distributed by Morgan Stanley Taiwan Limited; it may not be distributed to or quoted or used by the public media without the express written consent of Morgan Stanley. To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.

Morgan Stanley Research is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of and takes responsibility for its contents in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin);in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, supervised by the Spanish Securities Markets Commission(CNMV), which states that it is written and distributed in accordance with rules of conduct for financial research under Spanish regulations; in the US by Morgan Stanley & Co. Incorporated, which accepts responsibility for its contents. Morgan Stanley & Co. International plc, authorized and regulated by Financial Services Authority, disseminates in the UK research it has prepared, and approves solely for purposes of section 21 of the Financial Services and Markets Act 2000, research prepared by any affiliates. Private UK investors should obtain the advice of their Morgan Stanley & Co. International plc representative about the investments concerned. In Australia, Morgan Stanley Research and any access to it is intended only for "wholesale clients" within the meaning of the Australian Corporations Act. RMB Morgan Stanley (Proprietary) Limited is a member of the JSE Limited and regulated by the Financial Services Board in South Africa. RMB Morgan Stanley (Proprietary) Limited is a joint venture owned equally by Morgan Stanley International Holdings Inc. and RMB Investment Advisory (Proprietary) Limited, which is wholly owned by FirstRand Limited.

Trademarks and service marks in Morgan Stanley Research are their owners' property. Third-party data providers make no warranties or representations of the accuracy, completeness, or timeliness of their data and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. Morgan Stanley Research or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities/instruments is available on request.

The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (DIFC Branch), regulated by the Dubai Financial Services Authority (the DFSA), and is directed at wholesale customers only, as defined by the DFSA. This research will only be made available to a wholesale customer who we are satisfied meets the regulatory criteria to be a client.

The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (QFC Branch), regulated by the Qatar Financial Centre Regulatory Authority (the QFCRA), and is directed at business customers and market counterparties only and is not intended for Retail Customers as defined by the QFCRA.

As required by the Capital Markets Board of Turkey, investment information, comments and recommendations stated here, are not within the scope of investment advisory activity. Investment advisory service is provided in accordance with a contract of engagement on investment advisory concluded between brokerage houses, portfolio management companies, non-deposit banks and clients. Comments and recommendations stated here rely on the individual opinions of the ones providing these comments and recommendations. These opinions may not fit to your financial status, risk and return preferences. For this reason, to make an investment decision by relying solely to this information stated here may not bring about outcomes that fit your expectations.