Japan
Integrating Fiscal and Monetary Policy: March Tankan Preview
March 20, 2009

By Takehiro Sato | Tokyo

Bad News Discounted, New Equity Story of Greater Imports from Here

We expect the March Tankan headline to plunge beyond the bottom last marked in December 1998. We foresee downward revisions to negative year on year in large manufacturers’ F3/09 capex plans, and we expect large enterprises to reveal forecasts for a 60% slide in recurring profit in F3/09. For F3/10, not all the content of capex plans has been compiled as yet, and we expect even large corporations to start out with plans for sharp capex reduction and targets of 40% falls in recurring profit, but leaving room for downward revisions later. We expect all of the numbers to shed added light on the severity of the economic downturn.

The market has already discounted a poor Tankan, and we do not expect a fresh negative impact. Instead, at about the same time as the Tankan outlines management plans for F3/10, we expect companies to embark on a quest for survival through plant restructuring and, in turn, industry realignment. We expect the possibilities of extensive capacity restructuring and industry realignment to furnish a new equity story and opportunities in the Japanese market.

Our Forecasts for Business Conditions DIs

We expect the headline (business conditions DI for large manufacturers) to show another record fall from -24 in December to -58 (-34pt). A drop of this magnitude would be the largest since records began, even steeper than the slide from +8 in June 1974 to -18 in September of the same year. In terms of level, moreover, it would be below the -38 of December 2001-March 2002 seen when the IT bubble burst, and even the -43 of December 1993-March 1994, following the collapse of Japan’s land price bubble. Instead, it would exceed the -51 of December 1998 during the Asian Financial Crisis and -57 of June 1975, at the time of the first oil crisis. We expect the outlook DI to change little quarter on quarter, at -55. The manufacturers’ outlook DI tends to come out weaker than the current DI, but this April-June fields like automobiles and electronic components face a swing-back from the past six months of steep inventory correction; as the drop in production eventually levels off, we expect the outlook DI in the Tankan to be spared the deep sense of dread that recent surveys have conveyed.

Meanwhile, rough calculations based on the Reuters Tankan DIs published on March 19 put forecasts for large corporations in the BoJ Tankan at -53 for manufacturers (-29pt from December) and -18 for non-manufacturers (-9pt). Forecasts for the Tankan must also consider factors such as production, inventory, exports, share prices and corporate earnings, so we do not automatically use these results as our actual forecasts. (At the moment, the usual practice is for the economists to publish BoJ Tankan forecasts immediately after the Reuters Tankan figures, but normally there is a gap between the two announcements of more than ten days. Meanwhile, survey responses from the companies are likely to keep coming in after the official deadline in mid-March (March 10). This means that in highly volatile times such as currently, responses about the outlook can change with the prevailing market environment.)

Moreover, though indicators of grassroots sentiment in the Economy Watchers Survey and Shoko Chukin Bank’s Business Survey Index for Small and Medium-Size Enterprises have picked up recently, they are still close to lows and, as such, we also expect the DIs for SMEs to plunge at an angle that recalls 1975 and 1998.

Forecasts for F3/09 Management Plan Revisions and F3/10 Initial Plans

1) Sales/profit targets: The December Tankan saw large companies of all industries forecast F3/09 recurring profit down around 20%Y, at -20.6%. Given the series of downward revisions to corporate guidance following Oct-Dec earnings, we expect the March survey to project profit declines of around 60%. (Company guidance is provided on a consolidated basis, whereas sales and corporate profits in the Tankan are parent-based. So Tankan-base corporate profits tend to show lower growth than the consolidated figures.) 

As indicated by the sharp fall in industrial production in recent months, we forecast an unprecedented pace of sales plunge. Therefore, our view is that the benefits of the recent dip in energy/raw materials prices in cutting COGS (i.e., better terms of trade) will surface only in F3/10 at the earliest. Until then, we foresee the impact of negative gathering. Note that we anticipate a 60% drop in profits on MoF’s corporate statistics basis (large firms, excluding financials; parent entities).

As for the initial indications of corporate targets for F3/10, we forecast a similarly gloomy picture. While we expect companies to submit initial projections for a 40% profit plunge, we also anticipate downward revisions later.

These sharp slides in corporate profits could potentially lead to large-scale elimination of facility stocks, and, eventually, industry reshuffling. For instance, many manufacturers may shed losses over two straight fiscal years starting in F3/09, due to the likely scenario (as explained below) of facility operation rates plummeting to around 50% and not recovering significantly from well below breakeven point, even in the second half of the year. However, with regard to corporate capital policies, it only seems natural for companies to make every effort to avoid going into the red two fiscal years in a row. We think many will unveil major restructuring plans with, or close to the announcement of, the new earnings guidance in an attempt to steer from presenting forecasts for profit losses. Moreover, the above could lead not only to the restructuring of facilities but also full-blown reorganization of manufacturing industries. We foresee the initiation of such moves in areas including electronics, diversified chemicals and paper/pulp from the second half of F3/10.

2) Forecasts for F3/09 capex plan revisions and F3/10 initial plans: Capex plan forecasts are generally revised in the March Tankan, regardless of economic cyclicality. Given the current environment, with restricted liquidity and unprecedented weakening of production reducing facility operation rates to around 50%, we forecast an equally unprecedented cut to capex plans. Specifically, we expect the revision rate for large companies to be -3.0% (which rivals the downturn in 1998), leaving these companies to estimate a capex decline of -3.1%Y (including land, excluding software).

As for the initial guidance of corporate capex in F3/10, the March survey is often missing data from many companies, and we expect a notably lackluster initial figure of -14.6%Y for large companies of all industries, extremely downbeat even considering the missing data. We need to see the June Tankan (due out on July 1) for a more complete picture.

Policy Implications

Going forward, we expect progress in the integration of monetary and fiscal policies. The former is running out of traditional means of tackling issues, and looks set to diverge further from the existing policy framework to (1) purchasing risk assets and (2) supporting the fiscal policy of purchasing more government bonds by the BoJ. Target assets of (1) above are, in order of priority, one-year and longer corporate bonds and other securitized products, and stocks (ETFs). (2) includes boosting the amount of Rimban operations and rolling over maturing JGBs held by the BoJ. We expect monetary policies ahead to replace more of the functions of the existing fiscal policy.

If so, the BoJ’s balance sheet (B/S) could burgeon, and overseas investors could view this as an incentive to sell Japan. However, there is still the conundrum as to how much the central bank’s B/S would swell, and whether a flight of capital would actually occur. The ultimate dilemma for the government/BoJ is that, while a half-hearted fiscal expansion may fail to overcome the downward spiral of the economy, an overblown version risks depressing market confidence in the fiscal policy. Nevertheless, because of weakened financial intermediary functions, we see little risk of an imminent inflation, meaning that, surprisingly, the central bank still has ample room for discretion. Although the BoJ has just decided to raise the Rimban value to JPY1.8 trillion per month in the March regular policy meeting, we believe that the BoJ has the capacity to expand its purchase of JGBs regardless of the banknote cap on JGB holdings, while maintaining its credibility.

Of course, for the above to be realized, we assume that the complementary deposit facility (allowing interests on excessive reserve deposits) is abolished, and that we enter ZIRP again. That said, we do not expect QE ahead to be similar to what we saw in 2001-06 where the target was set well above the reserve amount. We believe that the BoJ will be aiming to follow in the footsteps of the Fed with its version of credit easing, by focusing on the asset side of the B/S, and extending the target to include a wider range of assets.

Note that we had previously foreseen a return to ZIRP in its full form in Jan-Mar 2009, but have pushed this back by a quarter to Apr-Jun in our February 16 update to our interest rate outlook. Following this revision, we now expect ZIRP to end a quarter later than we initially forecast; our base case assumes Oct-Dec 2010. That said, if the BoJ’s price outlook (-0.4% in F3/11) turns out to be accurate, we doubt that ZIRP will be terminated before the end of 2010.

Important Disclosure Information at the end of this Forum

Japan
Integrating Fiscal and Monetary Policy: March Tankan Preview
March 20, 2009

By Takehiro Sato | Tokyo

Bad News Discounted, New Equity Story of Greater Imports from Here

We expect the March Tankan headline to plunge beyond the bottom last marked in December 1998. We foresee downward revisions to negative year on year in large manufacturers’ F3/09 capex plans, and we expect large enterprises to reveal forecasts for a 60% slide in recurring profit in F3/09. For F3/10, not all the content of capex plans has been compiled as yet, and we expect even large corporations to start out with plans for sharp capex reduction and targets of 40% falls in recurring profit, but leaving room for downward revisions later. We expect all of the numbers to shed added light on the severity of the economic downturn.

The market has already discounted a poor Tankan, and we do not expect a fresh negative impact. Instead, at about the same time as the Tankan outlines management plans for F3/10, we expect companies to embark on a quest for survival through plant restructuring and, in turn, industry realignment. We expect the possibilities of extensive capacity restructuring and industry realignment to furnish a new equity story and opportunities in the Japanese market.

Our Forecasts for Business Conditions DIs

We expect the headline (business conditions DI for large manufacturers) to show another record fall from -24 in December to -58 (-34pt). A drop of this magnitude would be the largest since records began, even steeper than the slide from +8 in June 1974 to -18 in September of the same year. In terms of level, moreover, it would be below the -38 of December 2001-March 2002 seen when the IT bubble burst, and even the -43 of December 1993-March 1994, following the collapse of Japan’s land price bubble. Instead, it would exceed the -51 of December 1998 during the Asian Financial Crisis and -57 of June 1975, at the time of the first oil crisis. We expect the outlook DI to change little quarter on quarter, at -55. The manufacturers’ outlook DI tends to come out weaker than the current DI, but this April-June fields like automobiles and electronic components face a swing-back from the past six months of steep inventory correction; as the drop in production eventually levels off, we expect the outlook DI in the Tankan to be spared the deep sense of dread that recent surveys have conveyed.

Meanwhile, rough calculations based on the Reuters Tankan DIs published on March 19 put forecasts for large corporations in the BoJ Tankan at -53 for manufacturers (-29pt from December) and -18 for non-manufacturers (-9pt). Forecasts for the Tankan must also consider factors such as production, inventory, exports, share prices and corporate earnings, so we do not automatically use these results as our actual forecasts. (At the moment, the usual practice is for the economists to publish BoJ Tankan forecasts immediately after the Reuters Tankan figures, but normally there is a gap between the two announcements of more than ten days. Meanwhile, survey responses from the companies are likely to keep coming in after the official deadline in mid-March (March 10). This means that in highly volatile times such as currently, responses about the outlook can change with the prevailing market environment.)

Moreover, though indicators of grassroots sentiment in the Economy Watchers Survey and Shoko Chukin Bank’s Business Survey Index for Small and Medium-Size Enterprises have picked up recently, they are still close to lows and, as such, we also expect the DIs for SMEs to plunge at an angle that recalls 1975 and 1998.

Forecasts for F3/09 Management Plan Revisions and F3/10 Initial Plans

1) Sales/profit targets: The December Tankan saw large companies of all industries forecast F3/09 recurring profit down around 20%Y, at -20.6%. Given the series of downward revisions to corporate guidance following Oct-Dec earnings, we expect the March survey to project profit declines of around 60%. (Company guidance is provided on a consolidated basis, whereas sales and corporate profits in the Tankan are parent-based. So Tankan-base corporate profits tend to show lower growth than the consolidated figures.) 

As indicated by the sharp fall in industrial production in recent months, we forecast an unprecedented pace of sales plunge. Therefore, our view is that the benefits of the recent dip in energy/raw materials prices in cutting COGS (i.e., better terms of trade) will surface only in F3/10 at the earliest. Until then, we foresee the impact of negative gathering. Note that we anticipate a 60% drop in profits on MoF’s corporate statistics basis (large firms, excluding financials; parent entities).

As for the initial indications of corporate targets for F3/10, we forecast a similarly gloomy picture. While we expect companies to submit initial projections for a 40% profit plunge, we also anticipate downward revisions later.

These sharp slides in corporate profits could potentially lead to large-scale elimination of facility stocks, and, eventually, industry reshuffling. For instance, many manufacturers may shed losses over two straight fiscal years starting in F3/09, due to the likely scenario (as explained below) of facility operation rates plummeting to around 50% and not recovering significantly from well below breakeven point, even in the second half of the year. However, with regard to corporate capital policies, it only seems natural for companies to make every effort to avoid going into the red two fiscal years in a row. We think many will unveil major restructuring plans with, or close to the announcement of, the new earnings guidance in an attempt to steer from presenting forecasts for profit losses. Moreover, the above could lead not only to the restructuring of facilities but also full-blown reorganization of manufacturing industries. We foresee the initiation of such moves in areas including electronics, diversified chemicals and paper/pulp from the second half of F3/10.

2) Forecasts for F3/09 capex plan revisions and F3/10 initial plans: Capex plan forecasts are generally revised in the March Tankan, regardless of economic cyclicality. Given the current environment, with restricted liquidity and unprecedented weakening of production reducing facility operation rates to around 50%, we forecast an equally unprecedented cut to capex plans. Specifically, we expect the revision rate for large companies to be -3.0% (which rivals the downturn in 1998), leaving these companies to estimate a capex decline of -3.1%Y (including land, excluding software).

As for the initial guidance of corporate capex in F3/10, the March survey is often missing data from many companies, and we expect a notably lackluster initial figure of -14.6%Y for large companies of all industries, extremely downbeat even considering the missing data. We need to see the June Tankan (due out on July 1) for a more complete picture.

Policy Implications

Going forward, we expect progress in the integration of monetary and fiscal policies. The former is running out of traditional means of tackling issues, and looks set to diverge further from the existing policy framework to (1) purchasing risk assets and (2) supporting the fiscal policy of purchasing more government bonds by the BoJ. Target assets of (1) above are, in order of priority, one-year and longer corporate bonds and other securitized products, and stocks (ETFs). (2) includes boosting the amount of Rimban operations and rolling over maturing JGBs held by the BoJ. We expect monetary policies ahead to replace more of the functions of the existing fiscal policy.

If so, the BoJ’s balance sheet (B/S) could burgeon, and overseas investors could view this as an incentive to sell Japan. However, there is still the conundrum as to how much the central bank’s B/S would swell, and whether a flight of capital would actually occur. The ultimate dilemma for the government/BoJ is that, while a half-hearted fiscal expansion may fail to overcome the downward spiral of the economy, an overblown version risks depressing market confidence in the fiscal policy. Nevertheless, because of weakened financial intermediary functions, we see little risk of an imminent inflation, meaning that, surprisingly, the central bank still has ample room for discretion. Although the BoJ has just decided to raise the Rimban value to JPY1.8 trillion per month in the March regular policy meeting, we believe that the BoJ has the capacity to expand its purchase of JGBs regardless of the banknote cap on JGB holdings, while maintaining its credibility.

Of course, for the above to be realized, we assume that the complementary deposit facility (allowing interests on excessive reserve deposits) is abolished, and that we enter ZIRP again. That said, we do not expect QE ahead to be similar to what we saw in 2001-06 where the target was set well above the reserve amount. We believe that the BoJ will be aiming to follow in the footsteps of the Fed with its version of credit easing, by focusing on the asset side of the B/S, and extending the target to include a wider range of assets.

Note that we had previously foreseen a return to ZIRP in its full form in Jan-Mar 2009, but have pushed this back by a quarter to Apr-Jun in our February 16 update to our interest rate outlook. Following this revision, we now expect ZIRP to end a quarter later than we initially forecast; our base case assumes Oct-Dec 2010. That said, if the BoJ’s price outlook (-0.4% in F3/11) turns out to be accurate, we doubt that ZIRP will be terminated before the end of 2010.

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South Africa
Watch the Currency as the Economy Contracts
March 20, 2009

By Michael Kafe, CFA & Andrea Masia | Johannesburg

Summary

Following persistently weak economic data locally, a substantial downgrade to European growth prospects by our colleagues in that region, and a revision to gold and platinum price forecasts by our commodity analysts, we feel compelled to revisit our GDP and external account estimates for South Africa. Our analysis now points to an outright contraction of a full percentage point in South Africa’s 2009 GDP, before recovering to 2.8% in 2010. This will be the first contraction since 1990-92, when GDP fell by a cumulative 3.5% over the three-year period. A key difference between that downturn and the current one, however, is the fact that, while the former was characterized by a massive decline in public sector capital formation – and a concomitant fall in capital imports – the present one is likely to be driven by a sharp fall in consumption; and this is happening at a time when the public sector is taking visible leadership in infrastructure projects, leaving capital imports somewhat sticky.

We also note that the commodity price downturn in 1990-92 was much less severe than presently, suggesting that the external payments position could be materially worse. While we stick to our year-end USD/ZAR target of 10.80 for now, we believe that an intra-year breach of 12.00 is a reasonable proposition.

Sharp Contraction in Europe to Detract from SA Growth

This week, our European economists reduced their 2009 GDP forecasts to -3.3% from -1.6% (see Euroland Economics: A Much Deeper Recession, Elga Bartsch, March 17, 2009), and they now expect 2010 GDP to come in at a mere 0.5% (1.1% previously). Not only is the contraction likely to come in at double the initial estimate, but most of the adjustment comes from a severe cutback in European investment spending, suggesting that imports of intermediate manufactures from countries like South Africa could slow sharply. 

Strong Capex Spend to Weigh on External Accounts

Capital formation should remain in positive territory this year with a 3.7%Y reading that is entirely driven by double-digit growth in public sector capital spending ahead of the 2010 FIFA World Cup. A disaggregation of capital formation in South Africa by GDP sector reveals an interesting dynamic that points to the rising risk of import compression and associated currency challenges: importantly, the country’s export-oriented sectors such as manufacturing and mining (i.e., sources of foreign exchange to fund the country’s large capital import requirements) will contract sharply as external demand shrinks, while the heavy users of imported capital outside of manufacturing (i.e., social services, transport, finance & real estate, etc.) continue to show relative outperformance as the country undergoes significant modernization ahead of the 2010 FIFA World Cup. Declining export revenues and rising import demand are likely to continue to exert downward pressure on the external account and currency.

Current Account Deficit Will Likely Remain Wide

We estimate that the current account balance is likely to print a deficit of 6.8% of GDP in 2009. This is based on a set of admittedly optimistic assumptions, including:

Gold, platinum and coal prices of US$1,000/oz, US$1,000/oz and US$75/t, respectively, in 2009, rising to US$1,200/oz, US$1,450/oz and US$90/t in 2010. We also assume that non-commodity export prices are down 10% in dollar terms. Export trade revenues are then converted at an average USD/ZAR rate of 10.30 in 2009 and 11.10 in 2010. 

For imports, we pencil in an average 2009 oil price of US$35/bl and a 10% decline in non-oil import prices.

We also price in a 10% decline in 2009 export volumes (-5% previously), thanks to the anticipated fall in offshore demand for South African mining and manufactured exports. Import volumes, on the other hand, are now expected to contract by 5% (3% previously).

We have also cut the oil-related components of net service payments by the same magnitude as the decline in the rand cost of oil (given that half of the country’s service payments are linked to transport/travel & tour); we slash all dividend payments to non-residents (80% of net income payments) in half (given our weak outlook on domestic expenditure and exports) and allow for a modest decline in net transfers. 

ZAR Fundamentally Weak in the Medium Term

Our concern about a potential funding shortfall on the capital account of the external payments balance has intensified: latest data published by the South African Reserve Bank show that close to half of the 2008 deficit was funded by commercial bank liquidations of foreign exchange deposits offshore, and that such deposits have since halved. Clearly, at this rate, such deposits may be depleted at some point this year, forcing commercial banks to source all foreign exchange requirements in the spot market, thereby exerting some pressure on the currency. As we highlighted in previous research (see South Africa: Implications of the Global Downturn, October 7, 2008), South Africa has often experienced a significant currency depreciation when the overall balance of payments position comes in at a deficit of more than 2% of GDP.  This was certainly the case in 1Q96/2Q96, 2Q98/3Q98, 3Q01 and 3Q08. For 2009, we estimate a conservative basic balance of at least -R57 billion or 2.2% of GDP. This point, among others, informs our fundamentally bearish outlook on the ZAR.

Timing Is Everything

In the short term, however, we believe that there could be some downside risk in the long USD/short ZAR trade for a number of reasons. First, the verbal agreement by G20 Finance Ministers to address global market volatility could reignite global risk-appetite, leading to a potential short-term rally in the EMEA currency space. Second, should Telkom shareholders vote in favor of its R22.5 billion Vodacom transaction (proposed sale of 15% stake in Vodacom to Vodafone Plc, which would make it one of South Africa’s largest recent foreign direct investments) at the March 26 general meeting, a cash injection could take place anytime between April 23 (transaction finalization date) and May 5 (Vodacom listing date). Investors looking to short the rand ahead of the April 2 elections should bear this in mind. Third, the government’s US$1.5 billion 9.125% May 2009 Yankee bond matures in less than two months; and while more than half of this has already been rolled, we believe that the Treasury could well brave the poor investment weather and issue its budgeted fiscal 2009/10 US$1 billion replacement bond ahead of the May 19 maturity.

Thus, while we maintain our year-end USD/ZAR target of 10.80 and, in fact, believe that an intra-year breach of 12.00 is not an unreasonable proposition, we do not necessarily recommend initiating a long USD/ZAR trade just yet, as we think that there could be better entry levels in the coming weeks. For now, we would stick to the 9.50-10.20/50 range that has held relatively well since the beginning of this year. 

Morgan Stanley South Africa (Proprietary) Limited., an affiliate of Morgan Stanley, is acting as a financial advisor to the Department of Communications of South Africa in connection with the agreement with Vodafone Group Plc to acquire a 15% stake in Vodacom Group (Proprietary) Limited.

In accordance with its general policy, Morgan Stanley currently expresses no Rating or Price Target on Telkom South Africa Limited.

This report was prepared solely upon information generally available to the public. Morgan Stanley has not verified the accuracy or completeness of such information. No representation is made that it is accurate and complete. This report is not a recommendation or an offer to buy or sell the securities mentioned. Please refer to the notes at the end of this report.

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Global
Still Sinking and Synching
March 20, 2009

By Joachim Fels | London

Salami economics? Economists are often accused of using ‘salami tactics’ in revising their forecasts: adjust them frequently and in wafer-thin slices.  Well, it’s different this time.  While forecasts of economic growth around the globe have in fact been cut frequently over the last 3-6 months, the changes have been anything but wafer-thin. The Morgan Stanley economics team is no exception – during 4Q08 and 1Q09 we have been forced to cut our growth forecasts several times, and in big chunks.  We thus remain more bearish than the consensus, seeing a record-deep recession and only tepid recovery in 2010.

Chopping the forecasts, again: For example, over the past 10 days or so, we have chopped 2009 GDP growth from -0.4% to -4.0% in Latin America, from -4% to -6% in Japan, from -1.6% to -3.3% in Europe, and from -2.7% to -3.3% in the United States. These changes take our estimate for 2009 global GDP growth down from -0.3% a month ago to -1.2% now. While it has become a stereotype, it is still worth repeating: The global economy is currently in its deepest and most synchronised post-war recession.  In fact, with the exception of China, India and another lucky few, GDP is likely to contract in almost every country around the globe we cover.

Globalisation’s revenge: The single most important factor behind the latest revisions is the transmission of shocks around the world from a vertiginous drop in global trade, which according to the available data for January and partial data for February has continued in the first quarter.  Our proxy of global exports was down by almost 25% from a year ago in January.  As a consequence, global industrial output has kept spiraling down since the start of the year and companies are busy slashing inventories and capex.  It therefore comes as no surprise that export champions such as Japan and Germany are hit especially hard and will likely see the biggest GDP contractions among the major economies this year (-6.0% and -4.5%, respectively, on our latest forecasts). 

US, Europe to bottom in the second half: It is important to note, though, that while we are now looking for an even deeper plunge of the global economy, in most countries we haven’t really changed our view on when the (lower) bottom will be hit.  Across the main industrialised economies, we continue to expect GDP to roughly stabilise (i.e., to stop falling) during 2H09 or, in the case of Japan, in early 2010.  One reason is that companies appear to be making progress in reducing excess inventories as output has recently begun falling faster than demand.  Another is that the recent and coming plunge in inflation will help support real household incomes and thus consumer spending.  But most importantly, we continue to bank on the combination of fiscal and monetary stimulus finding traction later this year.  As we explained in more detail in last week’s The Global Monetary Analyst, we are encouraged by the pick-up in money supply (M1) growth, particularly in the US and Europe; we view this as a good longer-leading indicator of spending growth.

China to re-emerge first... Among the major economies, we expect China to emerge first from the slowdown. Our China economist Qing Wang expects the sharp deceleration of growth that has been underway since the middle of last year and is still ongoing to give way to a V-shaped recovery in the second half of this year when the massive fiscal stimulus should start to be felt (see China Economics: 2009 Outlook Downgrade: Getting Much Worse Before Getting Better, January 18, 2009).  However, while we expect China to re-emerge first from recession, we do NOT think that China will pull the rest of the world out of recession, as the import content of higher fiscal spending on infrastructure is rather low.  Any meaningful recovery in the industrialised economies will have to come from monetary and fiscal policy finding traction and credit markets unfreezing further, in our view.  Moreover, as Qing points out, any continuation of the Chinese recovery in 2010 crucially depends on a recovery the industrialised economies. 

...Latam last: At the other end of the spectrum, our Latin America economics team sees virtually no recovery in the region for most of 2010 (see Latin America: Lengthening the Downturn, March 16, 2009).  The main reason why we think Latam will be a laggard in the global recovery is that the room for counter-cyclical fiscal policy is limited, that monetary easing has started later, and that the limited level of financial intermediation and the role of credit in most of the region is likely to tamper the traction of monetary policy. 

The real question: What kind of recovery? To many, our baseline view that the global economy will bottom during 2H09 and will witness a recovery in 2010 appears optimistic.  Only time will tell.  However, the more important question to us is what kind of recovery to expect over the next several years.  We have only fully fleshed out forecasts for 2010 at this stage, and we point out that the anticipated global GDP growth rate of 2.8% is only barely above the ‘global recession’ threshold of 2.5%.  Looking beyond 2010, there are strong reasons to expect significantly lower average rates of economic growth rates than in the last 5-10 years, for at least three reasons:

•           The sharp decline in global capex is likely to reduce potential output growth over the next several years.

•           More government involvement in the economy and a likely increase in protectionism should reduce economic efficiency (see “Prognosis? Protectionism!” The Global Monetary Analyst, February 18, 2009). 

•           The ability of the financial sector to provide and the willingness of the non-financial private sector to take on leverage are likely to be curtailed for years to come. Thus, while we are reasonably confident that the recession will end some time later this year, we do believe that the medium-term growth trajectory will be much lower than in the last five years.

So, the real issue may not be how thick or thin the salami slices are, but how big the next salami will be. Our guess: much smaller.

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South Africa
Watch the Currency as the Economy Contracts
March 20, 2009

By Michael Kafe, CFA & Andrea Masia | Johannesburg

Summary

Following persistently weak economic data locally, a substantial downgrade to European growth prospects by our colleagues in that region, and a revision to gold and platinum price forecasts by our commodity analysts, we feel compelled to revisit our GDP and external account estimates for South Africa. Our analysis now points to an outright contraction of a full percentage point in South Africa’s 2009 GDP, before recovering to 2.8% in 2010. This will be the first contraction since 1990-92, when GDP fell by a cumulative 3.5% over the three-year period. A key difference between that downturn and the current one, however, is the fact that, while the former was characterized by a massive decline in public sector capital formation – and a concomitant fall in capital imports – the present one is likely to be driven by a sharp fall in consumption; and this is happening at a time when the public sector is taking visible leadership in infrastructure projects, leaving capital imports somewhat sticky.

We also note that the commodity price downturn in 1990-92 was much less severe than presently, suggesting that the external payments position could be materially worse. While we stick to our year-end USD/ZAR target of 10.80 for now, we believe that an intra-year breach of 12.00 is a reasonable proposition.

Sharp Contraction in Europe to Detract from SA Growth

This week, our European economists reduced their 2009 GDP forecasts to -3.3% from -1.6% (see Euroland Economics: A Much Deeper Recession, Elga Bartsch, March 17, 2009), and they now expect 2010 GDP to come in at a mere 0.5% (1.1% previously). Not only is the contraction likely to come in at double the initial estimate, but most of the adjustment comes from a severe cutback in European investment spending, suggesting that imports of intermediate manufactures from countries like South Africa could slow sharply. 

Strong Capex Spend to Weigh on External Accounts

Capital formation should remain in positive territory this year with a 3.7%Y reading that is entirely driven by double-digit growth in public sector capital spending ahead of the 2010 FIFA World Cup. A disaggregation of capital formation in South Africa by GDP sector reveals an interesting dynamic that points to the rising risk of import compression and associated currency challenges: importantly, the country’s export-oriented sectors such as manufacturing and mining (i.e., sources of foreign exchange to fund the country’s large capital import requirements) will contract sharply as external demand shrinks, while the heavy users of imported capital outside of manufacturing (i.e., social services, transport, finance & real estate, etc.) continue to show relative outperformance as the country undergoes significant modernization ahead of the 2010 FIFA World Cup. Declining export revenues and rising import demand are likely to continue to exert downward pressure on the external account and currency.

Current Account Deficit Will Likely Remain Wide

We estimate that the current account balance is likely to print a deficit of 6.8% of GDP in 2009. This is based on a set of admittedly optimistic assumptions, including:

Gold, platinum and coal prices of US$1,000/oz, US$1,000/oz and US$75/t, respectively, in 2009, rising to US$1,200/oz, US$1,450/oz and US$90/t in 2010. We also assume that non-commodity export prices are down 10% in dollar terms. Export trade revenues are then converted at an average USD/ZAR rate of 10.30 in 2009 and 11.10 in 2010. 

For imports, we pencil in an average 2009 oil price of US$35/bl and a 10% decline in non-oil import prices.

We also price in a 10% decline in 2009 export volumes (-5% previously), thanks to the anticipated fall in offshore demand for South African mining and manufactured exports. Import volumes, on the other hand, are now expected to contract by 5% (3% previously).

We have also cut the oil-related components of net service payments by the same magnitude as the decline in the rand cost of oil (given that half of the country’s service payments are linked to transport/travel & tour); we slash all dividend payments to non-residents (80% of net income payments) in half (given our weak outlook on domestic expenditure and exports) and allow for a modest decline in net transfers. 

ZAR Fundamentally Weak in the Medium Term

Our concern about a potential funding shortfall on the capital account of the external payments balance has intensified: latest data published by the South African Reserve Bank show that close to half of the 2008 deficit was funded by commercial bank liquidations of foreign exchange deposits offshore, and that such deposits have since halved. Clearly, at this rate, such deposits may be depleted at some point this year, forcing commercial banks to source all foreign exchange requirements in the spot market, thereby exerting some pressure on the currency. As we highlighted in previous research (see South Africa: Implications of the Global Downturn, October 7, 2008), South Africa has often experienced a significant currency depreciation when the overall balance of payments position comes in at a deficit of more than 2% of GDP.  This was certainly the case in 1Q96/2Q96, 2Q98/3Q98, 3Q01 and 3Q08. For 2009, we estimate a conservative basic balance of at least -R57 billion or 2.2% of GDP. This point, among others, informs our fundamentally bearish outlook on the ZAR.

Timing Is Everything

In the short term, however, we believe that there could be some downside risk in the long USD/short ZAR trade for a number of reasons. First, the verbal agreement by G20 Finance Ministers to address global market volatility could reignite global risk-appetite, leading to a potential short-term rally in the EMEA currency space. Second, should Telkom shareholders vote in favor of its R22.5 billion Vodacom transaction (proposed sale of 15% stake in Vodacom to Vodafone Plc, which would make it one of South Africa’s largest recent foreign direct investments) at the March 26 general meeting, a cash injection could take place anytime between April 23 (transaction finalization date) and May 5 (Vodacom listing date). Investors looking to short the rand ahead of the April 2 elections should bear this in mind. Third, the government’s US$1.5 billion 9.125% May 2009 Yankee bond matures in less than two months; and while more than half of this has already been rolled, we believe that the Treasury could well brave the poor investment weather and issue its budgeted fiscal 2009/10 US$1 billion replacement bond ahead of the May 19 maturity.

Thus, while we maintain our year-end USD/ZAR target of 10.80 and, in fact, believe that an intra-year breach of 12.00 is not an unreasonable proposition, we do not necessarily recommend initiating a long USD/ZAR trade just yet, as we think that there could be better entry levels in the coming weeks. For now, we would stick to the 9.50-10.20/50 range that has held relatively well since the beginning of this year. 

Morgan Stanley South Africa (Proprietary) Limited., an affiliate of Morgan Stanley, is acting as a financial advisor to the Department of Communications of South Africa in connection with the agreement with Vodafone Group Plc to acquire a 15% stake in Vodacom Group (Proprietary) Limited.

In accordance with its general policy, Morgan Stanley currently expresses no Rating or Price Target on Telkom South Africa Limited.

This report was prepared solely upon information generally available to the public. Morgan Stanley has not verified the accuracy or completeness of such information. No representation is made that it is accurate and complete. This report is not a recommendation or an offer to buy or sell the securities mentioned. Please refer to the notes at the end of this report.

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