South Africa
Trade Surplus Reigns in 2Q09 CAD
September 08, 2009

By Michael Kafe, CFA & Andrea Masia | Johannesburg

According to the South African Reserve Bank's (SARB) September 2009 Quarterly Bulletin, the country's current account deficit shrank to 3.2% of GDP in 2Q09 from 7% of GDP in 1Q09, versus our forecast of 4.1% and consensus estimates of 4.4%. This is good news. However, while the current account deficit is shrinking, it is also plainly clear that the economy remains weak, and that the fiscal deficit is fast deteriorating. The combination of a weak economy and a deteriorating fiscus points to some currency weakness further down the road.

Trade Balance Registers Unfamiliar Surplus

Merchandise exports fell for the third consecutive quarter, declining 10% from R589.3 billion to R531.7 billion in 2Q09, thanks to a modest 2.8% volume contraction and a 15% currency appreciation that fully offset the positive impact of higher commodity prices. According to the SARB, strong commodity export demand from Asia (South Africa's most important trading block) was unable to fully offset a slump in export orders for domestic manufactures from Europe and the US.

Import revenues on their part showed a much sharper 21% contraction in 2Q09, as they fell to R505.1 billion from R642.8 billion, thanks largely to a 15.5% decline in volumes as domestic demand conditions weakened, forcing a number of private sector companies to pare back capital expenditures. Imports of manufactured equipment, electrical gadgets, vehicles and transport equipment receded strongly, while crude oil imports and intermediate and consumer goods also slowed.

Slump in Dividend Receipts Limits Current Account Improvement

While the visible trade balance came in much stronger than expected, net invisible payments turned out worse than forecast. The details show that there was a significant decline in net services (thanks to lower-than-expected transport and freight services rendered by non-residents); but this was more than offset by upside surprises in income and transfer payments. For instance, net income payments (mainly dividends and interest payments) registered R55.1 billion (much higher than our R42 billion forecast, thanks in large measure to an 80% fall in dividend receipts on non-direct investments as global corporate profitability slumped). Net transfer payments also came in at R26.5 billion versus our forecast of R23 billion, and broadly unchanged from R27 billion in 1Q09.

Capital Inflows Push Basic Balance into Surplus

On the financial accounts, inflows related to the purchase of Vodacom by Vodafone boosted the net foreign direct investment line to R20.2 billion, while inward portfolio investment was also buoyed by the issuance of a US$1.5 billion international bond by the government. Other investment flows, however, reported a R9.7 billion deficit, thanks to a decline in non-resident deposits with South African banks (carry trade transactions), as well as a reduction in loans and advances from local banks to their foreign counterparts. We found the latter surprising, given that data published elsewhere by the SARB (the BA900 report) show that deposits with and advances to foreign banks actually rose to US$15.5 billion in 2Q09 from US$14.2 billion in 1Q09.

Importantly, the resulting R39.3 billion surplus on the financial account was enough to drive the basic balance on the BoP into positive territory. We believe that this must have accounted for some degree of USD/ZAR strength over 2Q09. Also, we found it particularly encouraging that unrecorded transactions have now fallen to just -R12.6 billion (2.2% of GDP), from a very large R38.6 billion (6.6% of GDP) in 4Q08.

On the whole, it is clear that the sharp improvement in the current account balance was mostly driven by the visible trade surplus. Interestingly, monthly trade data published by the South African Revenue Service pointed to a much smaller 2Q09 trade surplus than was published by the SARB. This suggests that the massive improvement in the visible trade account may have been technical (e.g., due to seasonal adjustments made by the SARB, timing differences between goods flow and payments, etc.), and is unlikely to be sustained going forward - particularly if our thesis that imports recover quicker than exports pans out. Also, the net invisible payment gap remains uncomfortably wide, and is unlikely to disappear any time soon. For 2H09, we look for a current account deficit of some 5% of GDP, leaving the annual average at 5.1% of GDP.

Demand-Side GDP

Elsewhere, the Quarterly Bulletin also shed a fair amount of detail on the expenditure composition of GDP. As expected (see "South Africa: Inflation Details; Data Preview", EM Economist, August 28, 2009), severe weakness on the part of consumers and a lackluster performance of net exports delivered a GDP contraction of 3%Q (seasonally adjusted and annualized) in 2Q09.

Historic Inventory Drawdown

Most startling in the demand-side breakdown was a record-setting R52.9 billion drawdown in inventories, concentrated mainly in manufacturing and agricultural activity (contractions in the level of vehicle production and a drawdown in maize stockpiles, in particular, drove the reading). This inventory liquidation subtracted as much as 11% from the 2Q09 GDP print, and will have significant implications for upcoming GDP prints, as a mere normalization here could lead to a significant technical rebound in GDP. It is important to note that anecdotal evidence from PMI surveys confirm that inventory depletion has stabilized, with a rising proportion of industrialists beginning to restock in 3Q09. We believe therefore that the contribution of inventories to GDP should turn positive in 3Q09, and have thus scaled up our 3Q09 GDP tracking estimate from 0.3%Q to a brisk 2.8%Q, leaving our full-year estimate unchanged at -1.8%Y.

Household Consumption Deteriorates Further

Household consumption expenditure growth of -5.8%Q printed in line with our -5.9%Q forecast, and represents a further contraction from the -4.8%Q registered in 1Q. Consumption of services (the largest of the expenditure categories) returned to negative territory with a -2.7% reading, while durables and semi-durables deteriorated further by -18.8%Q and -9.7%Q, respectively. Transport equipment and associated products, medical equipment, residential buildings and household appliances were the most noteworthy items to have declined. Non-durable goods contracted at a slower pace, however, as a 20%Y decrease in fuel prices gave some impetus to household expenditures on fuel products.

Looking forward, the macro environment remains challenging: employment levels are falling, real personal disposable incomes are contracting (-5.7%Q in 2Q), and debt uptake by households is uninspiring. Not surprising, the ratio of household debt to disposable income slipped further to 76.3% in 2Q09 from 76.8% in 1Q09. In our opinion, consumer aversion to debt could combine with weak confidence to hold back economic recovery.

Large Revisions to Fixed Capital Formation

We could not help but notice that very large revisions were made to the 1Q09 fixed investment readings: for example, gross domestic fixed investment by the private sector was revised to -10.6%Q from 2.2%Q, while investment spend by public corporations was revised to a massive 187.5%Q from 6.4%Q, without any explanation. In 2Q09, public sector investment decelerated to a still-high 42.7%Q pace, thanks to expenses related to the refurbishment of a number of power stations, including the de-mothballing of three coal-fired plants by Eskom. An addition of diesel locomotives to Transnet's fleet also lifted investment spend in the transport sector.

Private sector investment, on the other hand, is shown to have finally swung into negative territory in 1Q09 (-0.16%Q) and 2Q09 (-11.6%Q), thanks to low levels of business and consumer confidence, as well as the more conservative lending practices of financial institutions. This swing occurred one quarter later than we had expected (see South Africa Chartbook: Global Downturn Aftershocks, February 18, 2009).

Fiscal Deterioration as Capex Spend Continues

Finally, the Quarterly Bulletin shows that South Africa's public finances are deteriorating. On a non-seasonally adjusted cash basis, the country's fiscal deficit rose to 10% of GDP in 2Q09, while the borrowing needs of the non-financial public sector alone amounted to 14.4% of GDP. These readings compare with a near-zero balance and a mere 0.6% of GDP deficit, respectively in 2Q08, and point to a much wider public sector deficit this year. However, the cash deficit widened on account of higher capital overlays in road and rail infrastructure, as well as power generation, distribution and transmission. Thus, although these investments are presently a strain on the fiscus, they should help to lift the country onto a higher growth path going forward.

Final Thoughts

On the whole, the Bulletin details a weak economy with declining global dependence. Not only has the current account deficit narrowed significantly, but the capital account also reflects a healthy surplus of international capital flows, allowing the SARB to accumulate some R7 billion worth of forex reserves. However, the fact that the deficit on net invisible payments is still wide is a concern, and suggests that there remains a reasonably high level of dependence on foreign capital. We believe that this remains a key risk for the rand.

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United States
Five Lessons from the Financial Crisis
September 08, 2009

By Richard Berner | New York

Five key lessons stand out from the current financial crisis for both developed and emerging economies.  Looking ahead, each carries with it a key challenge.  (1) A strong and well-regulated financial system should be the first line of defense against financial shocks.  The challenge is to ensure stability without stifling innovation and growth.  (2) Aggressive and persistent policy responses are the second line of defense for financial crises.  The challenge is to time exit strategies to accommodate recovery.  (3) Macroprudential supervision and asset prices should both play bigger roles in monetary policy.  The challenges are to define systemic risk regulation carefully, to define boundaries between monetary and fiscal policy, and to balance financial stability with traditional goals.  (4) Flexible exchange rates enhance the ability of monetary policy to respond to shocks.  The challenge is to embrace structural reforms and to build up financial strength and credibility to weather storms.  (5) Global imbalances contributed to the crisis by allowing internal imbalances to grow.  The challenge is to resolve them in a way that will promote a vigorous and durable recovery.

A strong and well-regulated financial system.  It is a paradox that the more free market-oriented we want our economies to be, the more we need official supervision and oversight of our financial institutions and markets.  That's because truly free market economies involve a high risk of business failure, and corresponding high risks to the financial institutions and investors that lend to and invest in those businesses.  A key lesson from this crisis is that competition among lenders breeds innovation, but also instability.  In my view, the quality and sustainability of the coming expansion will be greatly enhanced by appropriate limits to and oversight of leverage and risk-taking.  Such boundaries will improve the soundness of individual institutions and the financial system, and the stability of the economy.

That view seems to conflict with the business model for global financial services firms, but in fact it is 100% consistent: To earn high risk-adjusted returns, financial firms want an industry and competitors that are well capitalized, well managed, and a set of rules that is well understood in advance.  Although limiting leverage seems to conflict with the desire for a strong recovery, I think appropriate regulation will limit only the booming, unsustainable kind of growth that typically leads to busts.  By reducing financial volatility, appropriate regulation could actually enhance the economy's ability to reach its potential over the cycle. 

In the US, as elsewhere, we must address three major shortcomings in our regulatory system: First, we supervise institutions rather than financial activities.  That allowed some firms to take on risky activities with inadequate or no oversight.  In the US, we should designate the Fed as lead systemic regulator, which will limit the extent to which risky activities and important market information slip through the cracks and promote accountability to the Congress and the taxpayer.  Collaboration within and across borders will also be essential. 

Second, concentration in the financial services industry has created institutions that are ‘too big to fail'.  Remedies include more extensive oversight and an explicit regulatory charge on these key firms.  A well-understood resolution process for bank holding companies and non-bank financial institutions is also needed.  An ad hoc approach creates uncertainty and reduces the credibility of policy.

Third, procyclicality permeates the US and global financial system.  Our system of capital requirements, collateral and haircuts, credit ratings, and compensation are - or were - tied to short-term performance.  Two remedies are often overlooked: We must resolve the tension between accountants who want to limit reserves and regulators who want to build them - in favor of the regulators.  In addition, a through-the-cycle approach to margins and credit ratings is needed.

Aggressive and persistent policy responses are the second line of defense.  Aggressive and creative monetary and fiscal policy responses to the crisis have helped markets to heal and the global economy to recover.  But from past crises like Japan's lost decade, we learned that the persistence of policy support is also critical to facilitate balance sheet clean-up, offset the drag on the economy, and prevent deflation.  For market participants, understanding just how persistent policy support will be is important; they want central bankers to make a clear distinction between the end of easing, which is now underway, and exit strategies or the beginning of tightening, which lie ahead.  Central bankers from Ben Bernanke at the Fed to Jean-Claude Trichet at the ECB are using the Op-Ed pages of the financial press to make that distinction crystal clear. 

Macroprudential supervision and asset prices should and will play key, interrelated roles in the strategy and conduct of monetary policy.  There is broad agreement that a global focus on systemic risk is needed.  There is less agreement on exactly how to define and implement it.  I think such supervision is an essential and natural extension of central banks' role in the conduct of monetary policy and of their responsibilities as lender of last resort.  All central banks are rethinking the role of asset prices in conducting monetary policy.  An expanded set of tools is needed - the very same tools that are appropriate for systemic risk regulation.  Thus, there is substantial overlap between the goals and tools for monetary policy and those for systemic regulation and oversight.

Flexible exchange rates enhance the ability of monetary policy to respond to shocks.  For both advanced and emerging market economies, the context in which exchange rates adjust is critical.  For emerging economies, investors will give the benefit of the doubt to those with credibility earned through a robust overall macro policy mix.  Sequencing matters for acquiring that credibility.  Opening up the capital account too fast is a recipe for disaster (as in Russia in 1997), particularly where the banking system is not well regulated.  Although we escaped ‘Asian contagion' this time, investors feared contagion at the height of the crisis, facilitated by shorting FX indiscriminately.  But as correlations receded from one, the strength of Brazil's currency, by allowing retention of policy autonomy, proved to be an important FX bellwether moment in the crisis. 

A robust and credible policy mix, backstopped by adequate FX reserves, is needed to effectively use monetary policy to combat a crisis.  Brazil, Chile, and Colombia in this crisis were able to slash interest rates instead of having to defend their currencies, as has happened in the past when currencies were fixed/crawling pegs.  In contrast, countries lacking such a policy mix or with heavy external foreign currency debt are more constrained.  Russia and Eastern European countries - except the Czech Republic - are examples of each.

How we resolve global imbalances - internal and external - will partly determine the vigor and durability of the coming recovery.  The crisis exposed the vulnerability of unbalanced US and global growth.  Globalization ironically permitted internal imbalances to grow.  Now recession is helping to rebalance the US and global economies and markets.  The question now: Will this rebalancing process be benign and sustainable for economies and markets, or will it be disruptive? I worry about the latter because current US policies are expanding rather than reducing imbalances, and officials elsewhere are limiting exchange rate adjustment.  That leaves the heavy lifting of adjustment to other market forces, which increases the chances for disorderly outcomes. 

US fiscal stimulus and policy initiatives have widened our internal saving imbalances.  And unlike the past, concern about the sustainability of US fiscal policy is making global investors and central banks more hesitant to buy US debt without a concession.  Moreover, two factors likely will block a significant weakening of the dollar, especially vis-à-vis Asian currencies.  First, China (and others) will resist significant appreciation, given the need to maintain share in global markets and concerns about the value of its holdings of dollar-denominated assets.  In addition, the dollar no longer appears to be overvalued. 

If policies oppose rebalancing, and the currency channel is blocked, other asset prices will adjust.  The obvious candidate is higher US real interest rates; by moving higher, they will limit growth in demand and force a reduction in both internal and external imbalances.  Unfortunately, the economic recovery will be weaker if rates bear the burden of adjustment instead of currencies.  Two factors will reinforce that upward bias in US rates.  First, stronger Chinese and overseas growth ironically may lift US rates.  Second, expansionary US fiscal policy adds a risk premium to our debt, and increases US dissaving. 

Of course, central banks have committed to keeping rates low to prevent inflation from falling below target.  And weak private credit demands will contain pressures on rates for now.  But as growth continues to pick up, and market participants begin to anticipate a shift in monetary policies, interest rate volatility and term premiums will rise, resulting in higher long-term yields. 

Won't China and other currency interveners buy US debt as they seek to prevent appreciation?  Yes, but there are several worrying signs.  First, private capital inflows peaked in 2006 and remain weak.  Second, Chinese and other officials are becoming vocal about the perils of relying on the dollar as the sole reserve currency, so support from official inflows is also waning.  Third, Chinese and Russian officials have maintained a near-record (26%) share of their holdings of US Treasuries in short maturities, exposing the US to considerable rollover risk.  Moreover, it's hard to imagine China buying more Treasury debt when China's rebounding economy is absorbing domestic saving.  Nor will an adjustment scenario involving slower US demand and Chinese export growth necessarily be benign.  Authorities in that case will probably tolerate abundant liquidity and rising asset prices.  The resulting decline in risk-aversion probably won't be good either for the dollar or for US Treasuries.

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