South Africa
Optical Improvement in 4Q08 BoP
March 27, 2009

By Michael Kafe, CFA & Andrea Masia | Johannesburg

Summary

South Africa’s current account deficit came in at R137.3 billion (5.8% of GDP) in 4Q08 – considerably lower than consensus forecasts of 7.5% of GDP and our own 7.4% estimate. It appears that the downside surprise may have been driven by accounting differences between the flow of visible goods as captured by the South African Revenue Services (SARS), and final adjustments made by the SARB for balance of payments reporting. For the record, we believe that the undershoot was largely technical, and is likely to unwind going forward.

Elsewhere, the capital account of the balance of payments shows an optical improvement. However, the devil’s in the detail: A more detailed analysis exposes a clear deterioration in the structure and quality of payment flows, with potentially negative consequences for the currency. We therefore stick to our view of an intra-year breach of USDZAR12.00, and a year-end target of 10.80. Also, having reached our entry target of USDZAR 9.50 this week, we recommend initiating a long USDZAR position at current levels. Here’s why:

Export Outperformance Seen Temporary

Data published by the SARB in its 1Q09 Quarterly Bulletin (the Bulletin) show that the improvement in South Africa’s current account deficit from 7.8% of GDP in 3Q08 to 5.8% in 4Q08 was driven by a sharp improvement in the visible trade balance, as well as a narrowing deficit on the net invisible account. We believe that the improvement on the trade account was somewhat technical, and that this must have had marginal implications for the narrowing invisibles deficit too.

According to data published in the Bulletin, export revenues fell from R755.7 billion in 3Q08 to R719.4 billion in 4Q08, while imports put in a worse performance, falling from R792.4 billion to R739 billion over the same period. The Bulletin shows that the relative outperformance of total exports was driven by a 19.4% increase in the average realized price of gold, thanks to a weaker exchange rate and hedging behavior by gold exporters.  While we had accounted for currency weakness in our analysis, we admittedly did not take hedging behavior into account.

We were also surprised by the fact that the Bulletin reports higher international sales of vehicles and transport equipment in 4Q08 – a time when the automobile sector was under severe pressure both locally and globally. As such, we believe that our model may have under-estimated vehicle exports too.  But with no clarity on a sustained recovery in global demand conditions just yet, and given that domestic new vehicle production has continued to fall sharply, it is only reasonable to expect vehicle and transport equipment exports to contract sharply going forward, in our opinion.

Import Data Raise More Questions than Answers

With regards to imports, we could not help but notice that there are some glaring differences between the monthly data captured by SARS and the quarterly aggregates reported by the SARB. First, the Bulletin shows that imports were “mainly weighed down by subdued domestic demand for non-oil merchandise”, while the SARS data show that non-oil imports (accounting for close to 80% of total imports) were broadly sticky in 4Q08. Second, and more intriguing, is the fact that the Bulletin shows there was import compression in capital and consumer goods. This is very contrary to monthly SARS data showing that imports of machinery rose by R1.3 billion in 4Q08. In fact, not only does the SARS data show rising absolute overlays on machinery imports, it also shows that the share of machinery imports rose from 36% of total import spend in 3Q08 to 42.4% in 4Q08.  Third, while the Bulletin reports that “the volume of imported crude oil remained broadly unchanged over this period”, our calculations from SARS data show that oil import volumes in fact rose in 4Q08, presumably as domestic refineries took advantage of lower oil prices to build up inventories, and as the shut-down of a local refinery led to imports of refined petroleum products.

SARS-SARB Data Disparity Not Uncommon

These stark disparities between the monthly data captured by SARS and the quarterly aggregates reported by the SARB are not uncommon. This is because while the monthly SARS data are simply an aggregation of the value of imports and exports of goods as captured and processed by customs officials on an ongoing basis, the quarterly trade data published by the SARB are carefully adjusted for seasonality, valuation, cover, classification and payment timing differences. It is therefore not entirely surprising that the final product published by the SARB – once it is done with the data-mining exercise – is sometimes materially different from the original SARS data. (Please see South Africa: Oil Imports and One-Off Customs Union Transfers May Push Current Account to New Highs – Will the SARB Act Again? January 26, 2007, for a more detailed discussion.) For the 4Q08 reading, it is possible that certain imported goods (oil and non-oil) may have landed on the country’s shores in 4Q08, for which payment may have been made a few months later. If this is the case (and we are inclined to believe it is), the sharp improvement in the 4Q08 trade deficit is likely to be reversed in the 1Q09/2Q09 print.

Genuine Improvement in Net Invisibles

Against this background of much lower-than-expected imports – particularly manufactured imports – it is not too difficult to see why net service payments came in below expectations: The sharp contraction in machinery imports would have required much lower-than-expected freight and insurance payments. But that’s not all.

Dividend payments also fell by R11 billion in 4Q08, driven in large measure by a near-halving of gross payments on non-direct investments (mainly portfolio equity).  At R8 billion, dividend payments on these investments slumped to their lowest level since 4Q04. Gross dividend payments on direct investments, on the other hand, only fell marginally in 4Q08, while gross compensations rose over the quarter. Interestingly, despite huge portfolio bond outflows, interest payments on non-direct investments were flat in 4Q08.

BAT Lights Up the Capital Account

The capital account of the balance of payments showed a five-fold improvement in foreign direct investment (FDI). However, we would argue that this is optical, as the improvement here was almost entirely due to reporting issues associated with the unbundling of British American Tobacco (BAT) shares within the Richemont group (Richemont distributed 90% of its BAT holding to its shareholders as part of a longer-term strategy to create a pure luxury goods business).

We believe that this transaction featured in the top-line FDI category as an increase in assets because of international accounting rules (Richemont owned more than 10% of BAT). The net impact of the transaction was actually neutral, given that there was an offsetting asset outflow of equal magnitude on the portfolio investment line. We suspect that the offsetting entry was reported on the portfolio line (and not FDI) simply because no single South African investor owned more than 10% of BAT, post unbundling. Had this offsetting outflow been reported on the FDI line, net FDI would have come flat at some R3 billion – significantly lower than the R10.8 billion that was reported in 3Q08, and similar to 2Q08’s R3.4 billion print.

Banking Sector FX Repatriations Funding the CAD – but For How Long?

Of utmost importance in the 3Q08 capital account statement is confirmation by the SARB that South African commercial banks indeed funded the country’s 2H08 current account deficit last year as they aggressively liquidated their foreign exchange deposits offshore (see South Africa: Further Growth Downgrades, November 14, 2008; South Africa: Global Downturn Aftershocks, February 18, 2009; and South Africa: Watch Currency as Economy Contracts, March 17, 2009 for more details).  According to the Bulletin, the country recorded a “substantial inflow of R52.9 billion in the fourth quarter of 2008 as the South African banking sector withdrew part of its deposits abroad”.  While we agree that capital flows by definition are fungible, the sheer magnitude of this inflow suggests that commercial banks did not only single-handedly fund the whole of the 4Q08 current account deficit of R33.3 billion (non-seasonally adjusted and annualized); they also part-plugged the deep R108.4 billion hole on the portfolio investment line of the capital account, leaving a much smaller basic balance of -R32.89 billion. 

Thankfully, this basic deficit was fully funded by R38.6 billion of ‘unrecorded transactions’ – a de facto, glorified balancing item – allowing the SARB to build up some R5.8 billion worth of FX reserves. Without the commercial bank cross-border FX repatriations, the basic balance would have printed a deficit of unprecedented proportions, requiring a significant adjustment in the currency, in our view.

As we have highlighted in previous research, commercial banks’ foreign exchange reserve holdings are not infinite. At some point, this cushion may become too thin to matter.  In fact, data published by the SARB elsewhere show that such deposits have already halved after reaching a peak of US$26.2 billion in September 2007.  One must also remember that ‘unrecorded transactions’ are extremely fickle, and cannot be relied upon to persistently cover the deficit on the basic balance.  This, among others, informs our fundamentally bearish outlook on the rand.

Discomforting Distribution of GDP

Separately, the Bulletin also confirmed the severity of the contraction on the demand side of the economy, showing a rather discomforting distribution of GDP in 4Q08. For the first time since 1992, household consumption expenditure contracted for a second consecutive quarter, while the pace of fixed capital investment and government consumption decelerated sharply.

From the household perspective, consumption of durable goods fell sharply (-20.1%Q, SAAR) as credit extension moderated, hours worked declined and wealth effects subsided. Unsurprisingly, a cutback in transport equipment led the decline, although it appears as if furniture and appliance spend may have contributed strongly too. There were contractions of 2.3%Q in the non-durable and 0.1%Q in the service categories, while semi-durable consumption actually accelerated by 2.6%Q. With consumption in freefall, the household savings rate improved very marginally, from -0.4% to -0.2% of disposable income. Finally, as disposable income growth decelerated from 2.6%Q to an 11-year low of just 0.2%Q, the household debt to disposable income ratio edged higher, from 75.6% in 3Q08 to 76.4% in 4Q. We estimate that this was associated with a 1.3%Q increase in household debt, little changed from its 1.4%Q reading in the prior quarter.

Compared to the high-teen levels reported in recent history, gross fixed capital formation grew at a snail’s pace of some 3.0%Q, driven in the main by a 2.9%Q increase in private corporation investment. Public corporation and general government capex spend decelerated, however, from 32.4%Q to 4.1%Q and 5.3%Q to 2.3%Q, respectively. Across the sectors, electricity and transport outperformed, expanding by 38.5%Q and 10.7%Q, respectively.

Most surprising however, was a massive R21.1 billion fall in inventories (mainly manufacturing and mining). Our calculations show that, were one to adjust the inventory reading to its four-quarter moving average level, while leaving all other components unchanged from their reported readings, GDE would have actually risen some 0.9%Q. Hence, it is the decline in inventories that took GDE into negative territory of -3.9% (its lowest rate since 1Q99), and not the collapse in consumption, as may have been expected.

Time to Initiate a Long USDZAR Trade

Last week, we highlighted that although South Africa’s medium-term fundamentals point to a weaker currency, USDZAR could, on a technical basis, sell off to 9.50 in the short term, providing a good entry opportunity to initiate a long USDZAR position in anticipation of a move back to double-digits. The move has occurred – perhaps much quicker than we thought.

At the present level of 9.45, USDZAR appears fundamentally cheap to us. We therefore recommend building a long dollar position. This trade targets a move back to USDZAR10.00/20 or higher, and stops out at 9.30.

We believe that the largest risk to the trade is a move in EUR to 1.40 (or higher).  However, as the 1.40 level now appears to have become a consensus view, smart money is likely to exit the trade just before target.  This gives us further comfort to recommend a long USDZAR trade now.

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Global
QE2 – Size Matters
March 27, 2009

By Manoj Pradhan | London

Central banks that have adopted QE have used very different strategies, except for one which they have all shared – they have managed to surprise markets with almost every announcement. Since our last write-up (see “QE2”, The Global Monetary Analyst, March 4, 2009), monetary authorities in the UK, Switzerland and the US have delivered hefty surprises to the market by introducing larger-than-expected or significantly enhanced programmes. The Bank of England put £75 billion of the £150 billion tranche approved by the Treasury to use on March 5, most of it to be used to purchase gilts. The Swiss National Bank announced on March 12 that it would buy corporate bonds as well as foreign currency – specifically the euro. Finally, at its meeting on March 18, the FOMC delivered a hefty increase in its MBS purchase programmes (from US$500 billion to US$1.25 trillion) and introduced a US$300 billion programme to buy Treasury securities.

We are optimistic about the traction from QE… QE is not a panacea for economic ills, but we believe that it can work in conjunction with the many other programmes that are attacking the problem from various angles. These actions from major central banks are a continuation of their earlier aggressive easing of policy rates and their willingness to use any and all available means to pull economic growth up by its bootstraps. The size of these programmes to purchase assets outright as well as the demonstrated commitment of central banks to persevere with unconventional measures are integral parts of the policy package.

…but we also see higher risks now. The increase in the size of the active QE programme directly increases the potential policy traction in much the same sense that pushing policy rates lower increases the monetary stimulus. However, the size of these programmes also raises risks in two ways. First, it increases the potential size of losses that the central bank and its guarantor (the government) may have to bear. Second, unwinding such massive purchases of assets will act like a sizeable contractionary monetary policy shock. While the chances of QE making a significant impact on the economy have increased, so have the risks associated with managing and correctly unwinding these programmes.

In our earlier note, we defined QE as the willingness or indeed desire of the central bank to expand the monetary base rapidly. Additionally, we identified two types of QE regimes. The ‘passive’ QE regime covers the various types of liquidity enhancement programmes that allow financial institutions to borrow from the central bank against eligible collateral, leading to an increase in the size of the reserves and the monetary base. However, the regime is passive in the sense that the increase in the size of the monetary base depends on the needs of financial institutions and cannot be dictated by the central bank. ‘Active’ QE (the outright purchases of risky securities, government bonds or foreign exchange), on the other hand, gives the central bank direct and precise control of the increase in the size of the monetary base. We summarise the active QE programmes that are in progress around the world.

QE in the G10. The G10 aggregate policy rate is already close to zero. It is therefore not surprising that QE is being either considered or implemented here, depending on the need for further policy action. The Swiss National Bank announced its active QE package (purchases of corporate bonds and FX) only on March 12, but it has been using passive QE since November 2008. Both Norway and Sweden have allowed their monetary base to grow since September and October 2008, respectively, in sync with increases of the monetary bases of the G4 central banks. The Bank of Canada, having cut its policy rate to 0.5%, seems to be readying itself to use “credit and quantitative easing”. Our strategists believe that QE could be in action there sooner than markets expect.

Perhaps the most crucial decision on the adoption of QE clearly lies with the ECB. The ECB, like the other major central banks, has instituted a passive QE regime since September 2008. Our ECB watcher, Elga Bartsch, believes that the ECB is unlikely to go down the path of active QE, but would be quite willing to extend the term on repo operations. These facilities were put in place at an early stage in the crisis, have worked well and have been copied by other central banks around the world. Also, the ECB may widen the pool of eligible collateral yet again by lowering further the required minimum rating for eligible assets. There is still room to cut rates, and our forecasts project the refi rate at 0.5% in 2Q09.  However, given the downside risks to growth, the adoption of active QE can clearly not be ruled out. If the ECB does decide to purchase assets on an outright basis, it is likely to prefer corporate securities to government bonds in order to ease credit conditions (for more details, see QE or Not QE? by Laurence Mutkin, March 20, 2009).

Emerging market central banks with near-zero rates have also been turning to these unconventional measures. The Bank of Israel started monetary expansion in September 2008 and has also been buying government bonds since February 17. The Bank of Korea is set to cut rates further to 1% on our forecasts, but has already started early redemption of its own Monetary Stabilisation Bonds. The other countries under our coverage where rates are forecast to go to 1% or less are Malaysia, Thailand, Chile and the Czech Republic. In Asia, our colleague Chetan Ahya believes that QE is more likely to be adopted in Malaysia than it is in Thailand. Active QE in Malaysia would likely take place through the purchase of government securities. Luis Arcentales believes that Chilean policy rates will go to 1% and that QE is a possibility. The Chilean central bank could operate in a manner similar to the Bank of Korea, by buying back its own bonds. Pasquale Diana believes that the Czech National Bank is unlikely to adopt QE, but that such a strategy cannot be ruled out, given downside risks to growth.

What are the risks to QE? QE is certainly unconventional as a monetary policy tool, and central banks are probably more anxious than anyone else to get back to using interest rates as the instrument of choice for economic adjustments. However, between now and a time when they can, there is the question of rolling back the QE regimes – passive and active. Central bankers have been quick to point out that QE can be rolled back quickly and that they will start doing so at the earliest possible time. But is the process going to be as smooth as it sounds? We don’t think so.

Can QE be rolled back quickly? In theory, yes! Both passive and active QE could be reversed very quickly. The desire to hike rates above their currently low levels complicates matters slightly. Why? The effectiveness of passive QE depends on the willingness of banks to seek returns in the economy rather than simply parking excess reserves with the central bank. Hiking interest rates would reduce these incentives. Thus, rolling back passive QE would likely have to precede interest rate hikes. No such conflict exists for active QE, which implies that purchased assets could be sold before, alongside or after rate hikes. However, for reasons explained below, we believe that assets from active QE will be sold into the market slowly, possibly in well-specified tranches, and that government securities will likely be sold before risky assets.

Size matters… Just as rate cuts proceeded faster and lower than anyone expected, the scope and size of QE regimes has also grown significantly. While the impact of this will be welcome during the recovery, the effect of the withdrawal of such large programmes will likely be substantial. Central bank rhetoric seems to suggest urgency in rolling back QE programmes at the earliest possible juncture. Withdrawing liquidity in such large quantities would act as quite a contractionary shock, pushing up government bond yields and widening spreads of the risky assets that the central bank had purchased.

…and so does the timing. This makes us wonder if the central bank rhetoric on quickly rolling back QE is likely to be put into practice. Passive QE could be unwound with relatively little discomfort as credit markets start functioning again. However, a smooth transition for policy rates from zero to neutral and an orderly unwinding of active QE is neither likely nor salutary, in our view. If active QE is rolled back at the same time as rate cuts, the impact would be a significant upward shift of the yield curve. Policy rate hikes would push the front end up while the sale of assets (mostly long-dated bonds) would reverse the rapid decline in longer-term yields witnessed after the announcements to purchase assets. This would leave no place to hide anywhere along the yield curve, adversely affecting all types of borrowers. We therefore believe that rate hikes as well as the sale of assets (whether conducted simultaneously or at different times) would have to be orchestrated in steps (for rates) and tranches (for assets), with a willingness to hold or reverse both moves if the impact turns out to be more adverse than anticipated. Finally, given that corporate debt markets are typically smaller than government debt markets, even smaller sales of such securities could cause spreads to widen considerably. For this reason, it would be prudent for central banks to reverse purchases of any corporate bonds towards the end of the QE unwinding process.

Risk of inflation further down the road. Essentially, the trade-off described above implies that the central bank will want to wait until the economy has recovered sufficiently to withstand higher policy rates and/or unwinding QE. Given the slow nature of the recovery that our global team expects, central banks are likely to err on the side of caution and keep policy expansionary for longer, which might be enough to let inflation start creeping in. Whether central banks will risk a second downturn in order to keep the inflation genie bottled as growth returns remains to be seen. However, we believe that they are unlikely to put economic recovery at risk in its early stages, having worked so hard to engineer growth in the first place.

Global stimulus, global inflation. Even if a central bank were to successfully navigate the reversal of QE and low policy rates to curb the risk of domestic inflation, the job would still not be complete. With low policy rates and QE adopted in so many countries, the possibility of inflation rearing its head further down the road in more than one part of the world is no tail risk. Our research has shown that global inflation has played an increasingly important role in determining domestic inflation rates (see “More Global, Less Local”, The Global Monetary Analyst, April 2, 2008). Thus, central banks have to not just worry about their own monetary policy, but also attempt to re-create a coordinated monetary tightening comparable to the coordination that was shown when rates were being slashed nearly everywhere around the globe – a tough task!

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