SA Economy

Hail to the SA consumer

December 8th, 2017 by Brian Kantor

The South African economy cannot be said to be performing to its potential. But in one important sense it is performing well – for consumers. Those with income or borrowing capacity will not find the economy wanting when they come to exercise their spending choices over the holiday season.

The shops will be well stocked and able to meet their every demands and desires, be it for essentials or luxuries supplied from all parts of the world. They will not lack for bread or toilet paper or for wine, beer or spirits. Or lack for wonderful world class entertainment at the theatres and movie houses. The book shops will be well stocked for those who still regard reading as entertaining and valuable. Excellent restaurants of all ethnic persuasions will be open to them, but may require an advance booking, given the competition from foreign tourists, who are showing their increased appetite for what we enjoy at the prices we pay.

This is as it should be. Successful economies gained their cornucopias by putting the demands of consumers in first place. That is preventing producers, farmers or factory owners or avaricious rulers or ecclesiastical orders or soldiers to decide what is to be produced. And when consumers largely rule the economy and producers are required to respond to them, economies flourish. Doing it the other way round – for the state to put the interest of producers, including those employed by them – whose own well-being is always threatened by competition – is a recipe for economic failure and for stagnation and corruption and the waste of the opportunity to consume more.

A consumer-led economy need ask very little of the state. The State and its officials will not be called upon to design industrial policy or determine development plans, policies that require foresight that is simply not available to even the best informed and least self-interested official. What the effective State has to provide is the protection of contracts freely entered into and the capital of those who have saved and puts their capital and skills to work, hoping to satisfy their customers and be rewarded for doing so.

The state should also ensure that the success or failure of businesses, large and small, is determined by their sales to customers and the costs of doing so. Not where financial success is dependent on an ability to negotiate a morass of regulation and relations with powerful officials. This system inevitably advantages bigger business over their smaller rivals.

A consumer-led economy is a continuous process or trial and error, of firms learning and adapting to unpredictable circumstances. The winners and losers for the consumers’ spending power emerge – they are not chosen by planners. South Africa incidentally, since 1994, has spent hundreds of billions of rands – perhaps over 400 billion rands of them – in subsidising industries of one kind or another with taxpayers’ money or tax concessions, money that could have been put to much better effect by consumers, especially poor ones.

The South African government alas appears only too willing to continue to put producers and officials first. For example competition policy is directed to serve industrial and labour policy rather than protect consumers.

More important for economic development, given that education and training precedes the ability to produce, earn and consume more, it is tragically the educators, the producers, who are first in line when the huge government budgets for such purposes are allocated. Were the taxpayer to pay the fees to enable all those desperately seeking education and training to attend private schools, universities and training establishments, of their own choosing, the valuable customer would come first. And the outcomes in the form of additional employment and incomes would be far superior.

SA Economy

The market for jobs in South Africa – why it performs so poorly and what can be done to improve it

December 8th, 2017 by Brian Kantor

Piece written for the Free Market Foundation: http://www.freemarketfoundation.com/publications-view/the-market-for-jobs-in-south-africa-%e2%80%93-why-it-performs-so-poorly-and-what-can-be-done-to-improve-it-

A pdf version is also available here.

 

SA Economy

Exchange rate risks for international businesses and investors: why South Africa is not unique

December 8th, 2017 by Brian Kantor

The global economy remains hostage to a volatile US dollar

The US dollar continues to serve as the primary international unit of account and as the pre-eminent reserve currency held by central and other banks, yet the rate at which the US dollar is exchanged for other currencies remains vulnerable to large moves in both directions, so adding risks to all financial transactions that make reference to it. In figure 1 below, we show the performance of the US dollar against its developed market peers (The US dollar index or DXY). We also show the real dollar exchange rate against the same major trading partners. The real exchange rate adjusts the nominal trade-weighted exchange rate for differences in inflation rates. We discuss the economic importance of real exchange rates further below. However, it should be noted that the real and nominal US exchange rates have followed a similar pattern.

Figure 1: The trade-weighted real and nominal exchange value of the US dollar (1975=100)

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Sources: Bloomberg, The Federal Reserve Bank of St. Louis (Fred Data Base) and Investec Wealth & Investment

In figure 2, we show the performance of the US dollar against its developed market peers, an index of emerging market exchange rates since 2010 that excludes the rand, and the rand/US dollar rate.

Figure 2: The US dollar vs. major currencies, an emerging market currency basket and the rand (higher numbers indicate exchange rate strength), monthly data (2010=100)

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Sources: Bloomberg, The Federal Reserve Bank of St. Louis (FRED database) and Investec Wealth & Investment

The extraordinary strength of the US dollar in 2014 was associated with a high degree of emerging market (and rand) exchange rate weakness. Also note that a degree of US dollar weakness that begins in mid-2016 has been associated with a recovery in the emerging market basket (and the rand). US dollar volatility poses particular challenges for monetary policy in emerging economies. We return to this important issue below.

The real exchange rate is what matters for real business activity

Inflation can make a producer or distributor of goods or services less competitive in home and foreign markets. However, a weaker exchange rate can protect operating margins against those rivals subject to less inflation. What may be gained or lost in the ability to compete on price – when expressed in any common currency – can be offset by changes in the rate of exchange.

When the offset is complete, the exchange rate will have weakened or strengthened by the percentage differences in inflation in the home country and that of its trading partners. If such circumstances, the exchange rate would be said to conform to purchasing power parity (PPP). Thus, PPP is regarded as a theoretical equilibrium to which exchange rates will converge in time.

The deviations from PPP-equivalent exchange rates are used to calculate a real exchange rate. It is this real exchange rate that defines the competitiveness of prevailing market-determined exchange rates. A real exchange rate with a value of more than 100 indicates an overvalued exchange rate and a value less than 100 indicates a competitive or undervalued exchange rate. The direction of the real exchange rate towards or away from 100 shows whether domestic producers have become more or less internationally competitive.

The calculation of a real exchange rate can include multiple exchange rates and an equivalent number of inflation rates – weighted by the share of imports and export held by different trading partners. The prices of relevance for the calculation of inflation and the real exchange rate are usually derived from prices charged for the manufactured goods that are presumed to dominate international trade.

The history of flexible exchange rates in SA shows that, the USD/ZAR exchange rate as well as the trade-weighted rand exchange rate, have consistently deviated from PPP-equivalent exchange rates and in varying degrees (see figures 3 to 5). This indicates that when SA firms engage in foreign trade and have to compete on the domestic market with imports this is a risky activity, given the variability of the real exchange rate and operating margins.

Measuring real exchange rates – a focus on South Africa

These divergences from PPP-equivalent exchange rates, i.e. fluctuations in the real rand exchange rate, are large and variable. This real rand exchange rate volatility for the rand is linked to the removal of exchange controls on foreign investors that were effectively withdrawn in 1995. There was a brief period of real exchange rate volatility, between 1983 and 1985, when foreign investors were also free to move funds into and out of South Africa. A further source of capital flows has been the progressive relief on the exchange controls applied to South African residents.

Freer capital flows rather than trade flows have dominated the demand for and supply of rands exchanged for US dollars and other currencies, and has introduced significantly more rand exchange rate volatility . It is the flow of global capital that has similarly dominated exchange rate trends in all economies that are open to this free flow of capital.

As we show below, using January 1970 as the starting point, the USD/ZAR exchange rate diverged significantly from PPP in 1985, then conformed to PPP between 1988 and 1995, whereafter the divergence has been continuous, though still highly variable. Heavy shocks to the USD/ZAR exchange rate are to be observed in 2001-02, 2008 and 2014. These sharp deviations from PPP have been followed by movement back towards PPP.

Sensitivity to the base year

Notice too that the PPP calculation is sensitive to the base year used to calculate the price indices. When 2010 is taken as the starting point for the calculation, the absolute deviations from PPP exchange rates are of a different magnitude. However, the movement away from or back towards PPP-equivalent exchange rates takes the same direction in both versions of PPP-equivalent exchange rates.

The starting point for any such calculation should be when the actual exchange rate approximates PPP, as it did in 1970. By 2010, the base year for calculating the current real exchange rate, the USD/ZAR exchange rate had moved far away from PPP, using a 1970 base year. When the base year is taken to be 2010, the rand appears as less undervalued generally and even as overvalued in 2010 – when the USD/ZAR traded at less than its PPP equivalent (2010 prices).

Figure 3: Market and Purchasing Power Parity exchange rates (USD/ZAR) (1970=100)

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Sources: Stats SA, Federal Reserve Bank of St. Louis (FRED Data Base), Investec Wealth & Investment

Figure 4: Market and Purchasing Power Parity exchange rates (USD/ZAR) (2010=100)

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Sources: Stats SA, Federal Reserve Bank of St. Louis (FRED database) and Investec Wealth & Investment

In figure 5 below we show the ratio of the PPP-equivalent USD/ZAR exchange rates to the market-determined USD/ZAR, using 1970 or 2010 as the base year. This ratio may be regarded as representing the real USD/ZAR exchange rates. Values above 100 indicate an overvalued (less competitive) nominal exchange rate and values below 100 indicate the opposite – the nominal exchange rate has changed by more than the difference in inflation in SA and the US.

Using 2010 prices and exchange rates, the rand was overvalued for much of the period from 1970 to 1995 and for some years afterwards. The strong real rand was supported in the 1970s by rising gold and metal prices in US dollars. The picture using 1970 prices as the basis of the calculation is different, revealing a consistently undervalued rand after 1985.

Figure 5: USD/ZAR – the ratio of PPP to market exchange rates; a measure of the real exchange rate using different base years

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Sources: Stats SA, Federal Reserve Bank of St. Louis (FRED database) and Investec Wealth & Investment

Real exchange rates considered more widely – the international evidence

In the figures below, we show a variety of trade-weighted real exchange rates for the period 1995-2017, as calculated by the Bank for International Settlements and the SA Reserve Bank. All these real exchange rates are highly variable, including those of the US. The real US dollar demonstrated continuous strength between 1995 and 2002, then weakness to 2008, whereafter the safe haven status of the US dollar in a time of crisis added some real strength to the trade-weighted exchange rate. A further period of pronounced real dollar strength ensued after 2014. Not coincidentally, the real trade weighted rand moved in very much the opposite direction, as seen in figure 6.

It should be recognised that the real rand, for all its volatility and the risks to which it has exposed SA business, has not in fact been more variable than the real dollar. As a relatively small economy that is very open to foreign trade, real exchange rates are, of course, more important for the South African economy. The value of exports and imports for South Africa is equivalent to about 50% of GDP. The exposure to imports and exports in the US is equivalent to about 30% of GDP.

As may be seen in the figures below, the real euro and real sterling have also been highly variable since 1995, while the Brazilian real has been more variable than most. The summary statistics for these real exchange rates are provided in Table 1.

The conclusion, therefore, is that the volatility of the real rand that so complicates the business of exporting from and importing to SA is not exceptional. The same complications and risks of doing business across frontiers, or rather exchange rate regimes, apply across the modern world of flexible exchange rates. It should be recognised that flexible exchange rates have added generally to the risks of doing international business everywhere. As such, these risks are presumed to have increased the required returns on capital invested in servicing global markets.

One can also determine whether there is a general tendency of exchange rates to revert to PPP and foreign trade-neutral real exchange rates. In other words, can one conduct a statistical test of whether real exchange rates are mean reverting?

The answer is that they don’t pass this statistical test with any degree of statistical confidence. The Chinese and Japanese real exchange rate trends since 1995 are most conspicuously not mean reverting to the theoretical 100 as may be observed in figure 9. The real yuan has a distinct and persistently stronger trend while the real yen moves persistently weaker.

Figure 6: Real exchange rates 1995-2017, South Africa and the US (2010=100)

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Source: SA Reserve Bank, Federal Reserve Bank of St. Louis (FRED database) and Investec Wealth & Investment

Figure 7: Real exchange rates 1995-2017, South Africa and Brazil (2010=100)

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Source: SA Reserve Bank, Federal Reserve Bank of St. Louis (FRED database) and Investec Wealth & Investment

Figure 8: Real exchange rates 1995-2017, UK and Eurozone (2010=100)

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Source: SA Reserve Bank, Federal Reserve Bank of St. Louis (FRED database) and Investec Wealth & Investment

Figure 9: Real exchange rates 1995-2017, China and Japan (2010=100)

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Source: SA Reserve Bank, Federal Reserve Bank of St. Louis (FRED database)and Investec Wealth & Investment

Table 1: Real exchange rates summary statistics

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The importance of capital rather than trade flows in determining nominal and real exchange rates

The notion that exchange rates will trend, over time, back towards some kind of competitive equilibrium, as imports and export volumes adjust to the real exchange rate effects on operating margins, therefore does not hold. The volatile behaviour of both nominal and real exchange rates is driven by unpredictable capital flows rather than by flows of currencies generated by the international trade in goods and services.

These capital flows that are based upon changing expectations of future returns, move the rate of exchange stronger or weaker. Inflation rates then react, but not rapidly or sufficiently enough to sustain PPP.

The exchange rate therefore leads inflation and the nominal exchange rate leads the real exchange rate – because inflation rates are much more stable than exchange rates. This stability is partly the result of the convention that measures inflation as the year-on-year change in consumer or other price indices, rather than as price moves over shorter periods of time. For example, a one or three month trend in consumer prices would indicate much more variability. The variability of real exchange rates has, in practice, almost everything to do with shocks to nominal exchange rates rather than price.

The shocks to the real exchange rate observed in the charts above therefore have very little to do with shocks to inflation rates. The openness of an economy to imports of staple commodities reduces the impact of harvests that are subject to unfavourable climatic conditions. Droughts and famines might otherwise have pushed prices temporarily much higher, providing a price shock to the economy.

As we show in figure 10 below, annual moves in the nominal ZAR/USD exchange rate dominate the moves in the real rand exchange rate that are so important for operating businesses and their operating profit margins. Similar results could be found for many other economies and their currencies as was found to be true of the US demonstrated in Figure 1

Figure 10: Annual changes in the USD/ZAR nominal and real exchange rates

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The impact of exchange rates on prices and inflation

Exchange rate shocks will have implications for the domestic price level. Other things being equal, the price of imported goods and the prices realised for exports in the local currency will rise or fall with the price of a US dollar. Other things may not remain unchanged and may also effect the prices charged domestically. For example, the US dollar price of imported oil may be rising or falling as might other imported commodities.

Dollar strength might well mean downward pressure on prices set in US dollar and dollar weakness might have the opposite effect. The state of the domestic economy will also have an influence on prices. The more or less buoyant domestic spending is, the greater or lesser the pressure on domestic prices will be. However a weaker exchange rate and the higher prices that are likely to accompany it will, in themselves, act to reduce spending power. They may also undermine the confidence of households and firms in their economic prospects, and their willingness to spend more or less of their incomes.

How should monetary policy react to exchange rate shocks?

How then should monetary policy and interest rates react to exchange rate shocks that are so difficult to anticipate? We would argue the best approach to exchange rate shocks is not to react to them at all. This is because such shocks are temporary rather than persistent. If such exchange rate shocks really are temporary – even perhaps rapidly reversible – the impact they have on inflation will be as temporary. They therefore will not be expected to permanently add to inflation and therefore will not add to expected (forecast) inflation.

It should nevertheless be recognised that dollar strength and other currency weakness can persist for an extended period of time. Persistent US dollar strength – against its developed economy peer currencies and against most emerging market currencies – explains much of the nominal and real rand weakness observed between 2014 and 2016.

The difference between rand weakness against the dollar and the weakness of other emerging market currencies vs. the US dollar represents additional SA specific risks to the returns expected from SA domiciled assets. We show these global and SA influences on the rand in the figure below. The USD/ZAR and the equally weighted Index of nine other emerging market currencies generally move in the same direction. The ratio of the USD/ZAR exchange rate to the USD/EM basket indicates South Africa-specific risks at work. These South Africa-specific risks spiked significantly in 2001, 2008 and 2015, when they added to rand weakness for global reasons. In other words, a weakness against the US dollar was shared by the other emerging market currencies.

Figure 11: The US dollar vs the rand and the EM Basket (LHS); and the Ratio rand/EM (RHS)

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Source: Bloomberg and Investment Wealth & Investment

Thus, much of the persistently high rates of inflation over the period between January 2014 and June 2016 (an average of 5.5% per annum) can be explained by dollar strength and its impact on the rand prices of imports, exports and alternatives for both in the production and price choices firms make. Inflation remained at these levels despite increases in interest rates and near recessionary conditions.

South African inflation over this period cannot be explained by the extra demands exercised by local households or businesses. Aggregate spending remained highly depressed over this period, which was also due to the inflation of prices charged to them. A drought proved to add another supply side shock to the rand prices of staple foods.

Only persistent and permanent increases in the demands for good and services, fueled by persistent increases in the supply of money and credit, will lead to continuous increases in prices and, sooner or later, increases in the price of foreign exchange. Interest rate expectations and capital flows will, in such circumstances of highly accommodating monetary policy settings, come to anticipate more inflation and help weaken the exchange rate.

A central bank charged with securing permanently low inflation would have to react to demand side pressures of this kind on prices. But they are strongly advised not to react to exchange rate shocks, especially when they occur in the absence of excess domestic demand over domestic potential supplies.

To react this way is to make monetary policy hostage to the variable and difficult to predict, nominal and real US dollar exchange rate. It is a risky exposure that businesses engaging in international trade cannot easily avoid. But monetary policy would do well to do what it can to moderate the shocks that emanate from the foreign exchange market. Unfortunately, the SA Reserve Bank added higher interest rates to exchange rate misery over the 2014-2016 period. We regard these as errors of monetary policy that reduced growth rates without any obvious reduction in inflation rates or inflation expected.

The implications of exchange rate volatility for investment portfolios

The volatile dollar can easily lead to such monetary policy errors of judgment – as in the case of South Africa. Emerging market economies, particularly those with significant exposure to foreign trade, are especially vulnerable to fighting exchange rate shocks, that is US dollar-driven shocks, with higher interest rates, which further damage the prospects for local businesses.

These are errors the US is much less likely to make, given that the dollar is likely to be the source of the exchange rate shocks. Monetary policy in the US understandably does not react to the exchange value of the dollar. Therefore, when investing abroad, a bias in favour of dollar based investing seems appropriate.

It may be concluded that the volatility of the real rand (that so complicates the business of exporting from and importing to SA) is not exceptional. The same complications and risks of doing business across frontiers and exchange rate regimes apply across the modern world of flexible exchange rates. It should be recognised that flexible exchange rates have added generally to the risks of doing international business everywhere.

The alternatives to fiduciary currencies and flexible exchange rates

The alternative to flexible exchange rates is fixing the rate at which a domestic currency may be converted into another currency. For example, the Hong Kong dollar has been fixed at 7.8 to the US dollar for many years. This fixed exchange rate link demands that inflation and interest rates in the two currencies will be very similar, to protect the sustainability of the fix. However, this also means that the real USD/HK exchange rate has been as variable as the real USD exchange rate.

An alternative form of fixing an exchange rate that was practiced widely before 1970 elsewhere including in the US, would be to fix the rate of exchange to the price of gold or silver at some predetermined local currency price of gold. For example, between 1933 and 1970 the dollar could be converted into gold at 35 US dollars per troy ounce.

This gold convertibility requirement restrained central banks from increasing the supply of cash issued to banks – held mostly in the form of deposits with the central bank – that could be converted into gold in the days of the gold standard. Constraints on the growth in the supply of central bank cash in turn helped to sustain low rates of inflation in normal times.

In abnormal times of large balance of payments outflows, this convertibility of local currency deposits into gold (that could be exercised by foreign central banks after 1945) might break down, as it did for the US in the early 1970s. This breakdown, or not enough central bank stocks of gold to meet the demands for gold by other central banks, might lead to either a new fix of the rate of exchange of gold for the local currency, or lead to inconvertible currencies. This would be a move to flexible exchange rates and the abandonment of the gold standard.

This is what the US chose to do in 1971 under pressure to convert dollar liabilities into gold that came from the French government particularly. The French strongly objected to the reserve currency role played by the US dollar that increased demands for dollars that they argued added to the economic power of the US.

It might be recalled that the IMF, established immediately after the end of the Second World War to assist a global economic recovery, effectively restored the gold standard and reaffirmed the convertibility of US dollar into gold. The IMF, however, also allowed for and supported orderly adjustments to fixed exchange rates under conditions of “fundamental disequilibrium”.

The intention was to avoid a series of competitive devaluations and ‘beggar your neighbour’ policies that were such a damaging feature of international economic relations in the depressed 1930s.

The problem that fixed exchange rates after 1945 could not resolve, was when a global shortage of dollars became a surplus of dollars. In effect, the US as the dominant economic power that supplied the reserve currency was unwilling to play the gold standard game and limit the supply of dollars to sustain convertibility at a fixed rate. And so the global economy has had to cope with flexible exchange rates that do not necessarily trend to PPP-equivalent exchange rates. The price paid for allowing flexible and market-determined exchange rates to absorb the shocks caused by highly variable capital flows, has been to add to the risks of cross border trade flows

Global Policy

US Tax reform- how to respond effectively

November 24th, 2017 by Brian Kantor

The leaked “Paradise Papers” reveal how global companies minimize their tax payments by (legally) routing revenue and taxable earnings through low tax or no tax jurisdictions. Such revelations should not be a surprise given the significant differences in company tax rates and tax systems across tax regimes that influence corporate actions.

The obvious solution to this reality is not to tax companies at all. Rather to tax all the income generated by business operations for their many dependents, where they reside at the personal income rate. Though the very highly income taxed may still decide to live in Monaco, the Bahamas or Mauritius – a freedom they should not be denied and where they may well be subject to high expenditure and property taxes.

The owners of businesses can be taxed on the dividends received and the wealth (capital) gains, realized and unrealized gains generated for them. Their lenders can all be taxed on the interest received from business borrowers. All landlords including institutional owners can be taxed on their rental income.

And those employees receiving benefits in cash or kind, including contributions the firms make on their behalf to pension plans and social security funds, can as usual have taxes withheld from them by their employers and passed on to the government. Indeed fuller use of businesses  as tax collectors. Forcing them to withhold income of all kinds, for which the individual income tax payer is only later credited. Collection rates are likely to be as good as they are with PAYE and could fully make up for any loss of taxes from companies.

The costs incurred by companies collecting taxes for the government are (understandably) allowed as a deduction from their taxable income. Usually also allowed as a deduction from taxable company income are the interest, rental and employment costs incurred by the firm – though not all interest incurred may be treated the same way. Also allowed as a deductible expense will be a rate of depreciation of the purchase price of plant and equipment, though with different rates applied to similar asset classes in different jurisdictions.  These allowances may or may not approximate the actual loss of market value incurred by the company. And if not will add to or deduct from the economic income being generated.

All companies and individuals have every incentive to manage their tax liabilities as best they can and not only where they best report revenue and income. They may well structure their balance sheets with more risky debt to take advantage of the taxes saved. Debts that may (wrongly) appear cheaper than equity, the opportunity cost of which, is not allowed as a tax expense.

With the elimination of taxes on the income of businesses, all this tax structuring and gaming will disappear. Companies and their auditors would have to determine the measure of income as well as assets and liabilities to report. And so owners and managers would more rationally incur expenses, including interest and depreciation and location costs, regardless of their tax implications.

The US Congress is currently proposing a dramatic reduction in its federal corporate tax rate to 20% to make its companies more competitive. A reduction intended to keep more of them and their taxable income and investment and employment activity at home. There are also tax reforms on the agenda. Among them is to allow firms to fully deduct all capital expenditure (whatever its life) from taxable income- a very important way to increase economic income after taxes. A further proposal is to disallow all interest incurred as a business expense.

This would take the US company tax system close to a very low company tax rate – much lower than 20% in economic effect, given how income is to be defined. It is a new competitive challenge that all other economies will have to confront. The ideal way to compete with the US and all the tax havens is to eliminate the company tax system.

SA Economy

The market and the bookmakers inform us about the ANC succession battle (Update)

November 23rd, 2017 by Brian Kantor

Below follows an update on this piece from Monday. 

The immediate outlook for the economy depends on who governs SA after December 2017. Will it be the Zuma faction or some other ANC coalition calling the shots? That is the essential question for the economic outlook and the value of the financial claims on it.  The market in SA assets has made its preferences for much less of President Zuma very clear. RSA risk premiums rise and fall as the expected Zuma influence on policy gains or loses momentum.

On Thursday and Friday last week the market suddenly came to reverse recently very unfavourable trends to register less SA risk. The rand strengthened, not only against the USD, but more meaningfully, also gained against other EM exchange rates.[1] Furthermore not only did RSA bond yields decline late last week – they declined relative to benchmark US yields. Still less SA risk has been registered this week in the foreign exchange markets. The ratio of the USD/ZAR to the USD EM basket (Jan 1st 2017=1) had moved out to 1.104 on the 13th November is 1.065 a relative SA gain of 3.6%

The behaviour of these foreign exchange indicators in 2017 is shown in figure 1 below. As may be seen, despite this recent improvement in sentiment, 2017 has not been a good year for the ZAR. The USD/ZAR weakened relative to its EM peers when Finance Minister Gordhan, in public dispute with the President over spending plans, was sacked in March 2017. It also suffered in response to the Budget statement presented by his successor, Milusi Gigaba in late October, as may also be seen.

The budget disappointment was perhaps not in the details about the revenue shortfall  – this was well telegraphed – but that no revised plan to address the widening fiscal deficit was offered. The concern was presumably that Zuma and his cohort would soon announce more government spending, on nuclear power or students, rather than less,  regardless of the fiscal constraints.

Fig.1; The USD/ZAR and the USD/EM exchange rate basket in 2017. Daily Data January 1st=100 to November , 23rd  OR ratio (LHS) =1

b1Source; Bloomberg and Investec Wealth and Investment

Though perhaps a little longer perspective on SA risk indicators is called for, as is provided in figure 2 below. There it may be seen that the ratio of USD/ZAR exchange rate to the USD/EM currency basket, weakened significantly in December 2015, when Finance Minister Nene was so surprisingly sacked. However as may be seen in the figure, the rand in a relative and absolute sense did very much better in 2016. Perhaps because the decision Zuma made under pressure from colleagues and the business community to immediately reappoint Pravin Gordhan, indicated less rather than more power to the President. A sense perhaps that the market had gained of Zuma overreach and a degree of vulnerability.   Just how vulnerable is President Zuma remains to be determined- hence market volatility.

Fig 2; The ratio of the USD.ZAR to the USD/EM currency basket (January 2017=1) Daily Data

b2Source; Bloomberg and Investec Wealth and Investment

The indicators derived from the Bond market make the same statements about SA risk. As shown in figure 3 below the spread between RSA and USA government bond yields, the so called interest rate carry that reveals the expected depreciation of the USD/ZAR exchange rate, widened sharply as the rand weakened in late 2015. They then narrowed through much of 2016, stabilized in 2017 until the Budget disappointment pushed them higher. The difference however between RSA rand bond yields however has widened gain to 7.2% p.a. and is back to levels recorded on the 14th November. The default risk premium attached to five year RSA dollar denominated bonds though has declined further from 208 b.p on the 14th November to 187 b.p on the 23rd November

In figure 4 it may also be seen how the RSA sovereign risk premium has behaved in 2017. Sovereign risks are revealed by the spread between the yield on a USD denominated RSA (Yankee)  Bond and its US equivalent. As may be seen this spread has been variable in 2017 – that it increased by 40 b.p. in October – and then declined sharply in the week ending on November 17th.  These spreads indicate that SA debt is already being accorded Junk Status by the market place, ahead of any such ruling by the rating agencies. The spread on the lowest Investment Grade debt would be of the order of 1.6%.

In figure 5 we show the interest carry- the rate at which the USD/ZAR is expected to weaken over the next ten years and inflation expectations. These are measured as the spread between a vanilla bond that carries inflation risk and an inflation linker of the same duration that avoids inflation risk. As may be seen more inflation expected is strongly connected to the rate at which the ZAR is expected to weaken. It should be recognized that the weaker the rand the more it is expected to weaken further. It will take a stronger rand to reduce inflation expected- a welcome development that is beyond the influence of interest rates themselves.

Fig.3; The USD/ZAR and the Interest Rate Spreads. Daily Data 2015 to November 23, 2017

b3Source; Bloomberg and Investec Wealth and Investment

Fig.4; The RSA sovereign risk premium and the interest carry. Daily Data 2017.

b4Source; Bloomberg and Investec Wealth and Investment

Fig.5: The interest rate carry and inflation compensation in the RSA bond market. Daily Data 2017.

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The market place, as well as the bookmakers, will continuously update the odds of one or other candidate for the Presidency of the ANC ( now very probably) being determined in December 2017.  The odds offered by Sportingbet at 13h00 on November 20, 2017 are shown in the Table below. (www.sportingbet.co.za ) They have not changed since- indicating perhaps a lack of betting activity. These odds imply a 40% chance of Dlamini-Zuma winning the nomination and a 45% chance for CR. As they say in racing circles- the favourite does not always win- but don’t bet against it.

Lower South African risks and the stronger rand and lower interest and inflation rates associated with rand strength are good for the economy and all the businesses and their stakeholders dependent on the economy. One prediction can be made with some degree of conviction. That is without less SA risk any cyclical recovery in the SA economy is unlikely.

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Additional Figures

Equity performance in 2017 to November 17th Daily Data

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Credit Default Swap Spreads over US Treasuries 5 year;  Daily Data 2015-2017

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Credit Default Swaps over US Treasuries, 5 year Daily Data to November 17th 2017.

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[1] Our construct for Emerging Market exchange rates that exclude the ZAR  is an equally weighted nine currency basket of the Turkish Lire, Russian Ruble, Hungarian Forint, Brazilian Real, Mexican, Chilian and Philippine Pesos, Indian Rupee and Malaysian Ringit

 

SA Economy

The market tells us about the ANC succession battle

November 22nd, 2017 by Brian Kantor

 The outlook for the SA economy depends on who governs after December 2017. Will it be the Zuma faction or some other ANC coalition calling the shots? That is the essential question for the economy and the value of the financial claims on it.  The market in SA assets has made its preferences for much less of President Zuma very clear. RSA risk premiums rise and fall as the expected Zuma influence on policy gains or loses momentum.

On Thursday and Friday last week the market registered less SA risk as the rand strengthened, not only against the USD, but more meaningfully the rand also gained against other EM exchange rates.[1] Furthermore not only did RSA bond yields decline late last week – they declined relative to benchmark US yields. The political developments that actually moved the market are however not that obvious.

The behaviour of these indicators in 2017 is shown in figure 1 below. As may be seen 2017, despite this recent improvement in sentiment, has not been a good year for the ZAR. It weakened relative to its EM peers when highly respected Finance Minister Gordhan was also sacked in March. It also suffered in response to the Budget statement of his successor in late October, as may also be seen.

The budget disappointment was perhaps not in the details about the revenue shortfall  – that were well telegraphed – but that no revised plan to address the widening fiscal deficit was offered. The concern was presumably that Zuma and his cohorts would soon announce more rather than less government spending regardless of the fiscal constraints.

 

Fig.1; The USD/ZAR and the USD/EM exchange rate basket in 2017. Daily Data January 1st=100 or ratio (LHS) =1

 

 

a1



Source; Bloomberg and Investec Wealth and Investment

 

Though perhaps a little longer perspective on SA risk indicators is called for, as is provided in figure 2 below. There it may be seen that the ratio of USD/ZAR exchange rate to the USD/EM currency basket, weakened significantly in December 2015, when Finance Minister Nene was so surprisingly and ignominiously sacked. However as may be seen in the figure, the rand in a relative and absolute sense did very much better in 2016. Perhaps because the decision Zuma made under pressure from colleagues and the business community to immediately reappoint Pravin Gordhan, indicated less rather than more power to the President. A sense perhaps that the market had gained of Zuma overreach and a degree of vulnerability.   Just how vulnerable remains to be determined- hence market volatility.

Fig 2; The ratio of the USD.ZAR to the USD/EM currency basket (January 2017=1) Daily Data

a2Source; Bloomberg and Investec Wealth and Investment

 

The indicators derived from the Bond market make the same statements about SA risk. As shown in figure 3 below the spread between RSA and USA government bond yields, the so called interest rate carry that reveals the expected depreciation of the USD/ZAR exchange rate widened sharply as the rand weakened in late 2015. They then narrowed through much of 2016, stabilized in 2017 until the Budget disappointment pushed them higher. In figure 4 it may also be seen how the RSA sovereign risk premium has behaved in 2017. Sovereign risks are revealed by the spread between the yield on a USD denominated RSA (Yankee)  Bond and its US equivalent. As may be seen this spread has been variable in 2017 – that it increased by 40 b.p. in October – and then declined sharply in the week ending on November 17th.  These spreads indicate that SA debt is already being accorded Junk Status by the market place, ahead of any such ruling by the rating agencies. The spread on the lowest Investment Grade debt would be of the order of 1.6%.

In figure 5 we show the interest carry- the rate at which the USD/ZAR is expected to weaken over the next ten years and inflation expectations. These are measured as the spread between a vanilla bond that carries inflation risk and an inflation linker of the same duration that avoids inflation risk. As may be seen more inflation expected is strongly connected to the rate at which the ZAR is expected to weaken. It should be recognized that the weaker the rand the more it is expected to weaken further. It will take a stronger rand to reduce inflation expected- a welcome development that is beyond the influence of interest rates themselves.

 

Fig.3; The USD/ZAR and the Interest Rate Spreads. Daily Data 2015-2017

a3Source; Bloomberg and Investec Wealth and Investment
Fig.4; The RSA sovereign risk premium and the interest carry. Daily Data 2017.

a4Source; Bloomberg and Investec Wealth and Investment 

Fig.5: The interest rate carry and inflation compensation in the RSA bond market. Daily Data 2017.

a5

The market place, as well as the bookmakers, will continuously update the odds of one or other candidate for the Presidency of the ANC ( probably) being determined in December 2017.  The odds offered by Sportingbet at 13h00 on November 20, 2017 are shown in the Table below. (www.sportingbet.co.za ) As they say in racing circles- the favourite does not always win- but don’t bet against it.

Lower South African risks and the stronger rand and lower interest and inflation rates associated with rand strength are good for the economy and all the businesses and their stakeholders dependent on the economy. One prediction can be made with some degree of conviction. That is without less SA risk any cyclical recovery in the SA economy is unlikely.

a6

 

[1] Our construct for Emerging Market exchange rates that exclude the ZAR  is an equally weighted nine currency basket of the Turkish Lire, Russian Ruble, Hungarian Forint, Brazilian Real, Mexican, Chilian and Philippine Pesos, Indian Rupee and Malaysian Ringit

Global Financial Markets

A world of exchange rate volatility – tough on trade and central banks

November 13th, 2017 by Brian Kantor

SA is very open to international trade. The aggregate value of imports and exports in any year is equal to 50% of GDP. Yet all this great volume of trade across borders is subject to highly volatile exchange rates. This volatility adds considerable risks to exporters, importers and those who compete with imports and exports in the local market.

What matters for the operating margins of businesses is exchange rates adjusted for differences in inflation between trading partners. These are known as real exchange rates. An undervalued exchange rate will add to profit margins, while an overvalued one – should the exchange rate change by less than the differences in inflation – will depress margins.

When the offset is complete, or when what is gained or lost on the exchange rate is equal to the difference in inflation rates, purchasing power parity (PPP) exchange rates are said to hold. In such a case, the prices of common goods or services delivered in any market place will be about the same when expressed in any common currency. Real exchange rates above 100 indicate overvalued exchange rates while real exchange rates below 100 indicate the opposite: an undervalued or generally competitive exchange rate.

It is however changes in nominal exchange rates that are the predominant force behind changes in the real exchange rate. In SA and elsewhere, frequent shocks to the exchange rates lead the process and inflation rates follow.

However the SA experience with real exchange rate volatility is by no means unique. The trade-weighted real US dollar exchange rate has been even more variable than the real rand exchange rate. And those of Europe and the UK are similarly variable.

In figure 1 below we show the performance of the US dollar rate of exchange against its developed market peers (DXY). We also show the real dollar exchange rate against its major trading partners. The pattern has been a highly unstable and destabilising one for the global economy, which relies on the US dollar as a reserve currency and unit of account.

 

 

We compare below in figure 2 a variety of trade weighted real exchange rates for the period 1995- 2017. As may be seen, all these real exchange rates are highly variable. Not co-incidentally, the real trade-weighted rand moved in very much the opposite direction to the real US dollar. The real euro and real sterling have also been highly variable since 1995. A consistently overvalued, less competitive real sterling between 1996 and 2007 can be identified. More recently, with Brexit in sight, sterling has become much more competitive.

 

Moreover none of the real exchange rates considered above can pass a statistical test for mean reversion. The Chinese and Japanese real exchange rates trends shown below conspicuously do not revert to the theoretical PPP 100. The real yuan has had a distinct and persistently stronger trend (off what was a very undervalued base in the mid-90s) while the real yen moves persistently weaker off what was presumably a very overvalued base in 1995.

 

How should monetary policy react to exchange rate shocks?

This global nominal and real exchange rate volatility – as well as the lack of mean reversion to trade neutral purchasing power parity exchange rates – has greatly inconvenienced global trade. It has also greatly complicated the reactions of central banks.

We would argue the best approach central banks should adopt to exchange rate shocks is to ignore them. This is because such shocks are unpredictable and largely beyond their control. They have little to do with competitiveness in international trade and almost all to do with capital flows responding to changes in expected returns across different economies. If such exchange rate shocks are temporary – even perhaps rapidly reversible – the impact they have on inflation will be as temporary. They therefore will not be expected to permanently add to inflation and therefore will not add to expected (forecast) inflation.

It should be recognised that dollar strength and other currency weakness in response to persistent capital flows can persist for an extended period of time. Persistent US dollar strength – against its developed economy peer currencies and against most emerging market currencies – explains much of the nominal and real rand weakness and also emerging market currency weakness observed between 2014 and mid-2016. Ditto the higher inflation rates that followed.

But to react to exchange rate shocks as if they threatened permanently higher inflation is to make monetary policy hostage to the unpredictable US dollar exchange rate. Monetary policy in the emerging market world would do better to moderate rather than exaggerate the shocks to spending intentions and confidence that may emanate from the market in foreign exchange.

Unfortunately the SA Reserve Bank, from early 2014, added higher interest rates to the contractionary forces emanating from a weaker exchange rate. We regard this as an error of monetary policy that unhelpfully further reduced growth rates without any obvious reduction in inflation rates or inflation expected.

The implications of exchange rate volatility for investment portfolios

Monetary policy in the US understandably does not react to the exchange value of the dollar. Thus when investing abroad (investments that always carry extra risks given exchange rate volatility) a bias in favour of US-based investing seems appropriate. Or, in other words, the risks posed by a volatile real and nominal US dollar to monetary policy and real economic activity everywhere else are best hedged by investing in the US rather than in more macro policy error prone economies. 9 November 2017

SA Financial Markets

The Bond market anticipates Reserve Bank reactions to a higher oil price- more bad news for the SA economy.

November 7th, 2017 by Brian Kantor

The bond market anticipates Reserve Bank reactions to a higher oil price – meaning more bad news for the SA economy.

The RSA bond market and the rand weakened on Friday: the yields on RSA bonds rose markedly across the yield curve. The RSA five-year yield added 22bps (0.22 percentage points) and the 10-year yield 24bps.

 

The spread between RSA yields and their equivalent US Treasury Bond yields (the carry) also widened by about the same number of basis points – indicating that not only did the rand weaken on the day but still more rand weakness was expected on the day.

The gap between RSA five-year and 10-year vanilla bonds and their inflation-linked alternatives also widened, indicating more SA inflation expected over the next five and 10 years, about two tenths of one per cent per annum more inflation expected over the next five and 10 years, with inflation now expected to average almost 7% over the next five and 10 years (see figure 3 below). The real yield on the inflation-linked five-year bond, at 2.43%, was unchanged on Friday, indicating that the higher nominal bond yields reflected a changed view of the outlook for inflation.

Further confirmation that it was inflation expected rather than real forces at work was that the sovereign risk spread was largely unchanged on the day. The extra yield offered on an RSA US dollar-denominated bond edged up only marginally, while the cost of a CDS swap that insures RSA debt against default, actually declined on the day (see below).

 

A large part of the rand weakness on Friday can be attributed to global rather than SA-specific forces at work, in the form of a degree of US dollar strength against both its peers (the euro et al) and against an Index of emerging market currencies that accords an 8.33% weight to the rand (see below).

 

Having identified more inflation expected behind the higher RSA bond yields and spreads, it remains the task to explain why inflation should have been expected to increase. Perhaps it has something to do with higher oil and metal prices. A combination of a higher oil price in US dollars and a weaker rand would be expected to add to inflationary pressures and depress domestic spending. The rand and US dollar price of a barrel of oil did spike higher on Friday. We can only hope that this supply side shock for inflation will be ignored by the Reserve Bank. Past performance alas makes it likely that the Reserve Bank would raise rather than leave interest rates alone in such circumstances. Perhaps this was also behind the spike in RSA interest rates across the yield curve. Short rates also rose on Friday, indicating an expectation that the Reserve Bank is more likely to increase the repo rate.

Our argument is not with the market but with the Reserve Bank that continues to treat supply side shocks to inflation as if they are permanent rather than temporary. Given all else that plagues the economy, such possible monetary policy reactions can make even the strongest still standing feel very weak. 7 November 2017

Fiscal Policy

An expensive Budget failure – for extra-budget reasons

October 31st, 2017 by Brian Kantor

The Budget statement and speech on Wednesday badly disappointed the market in the rand and in RSA bonds. Since the Budget statement, the rand has lost about 3.3% of its US dollar value and was nearly 4% weaker against other emerging market exchange rates. This indicates that rand weakness and additional SA specific risks are at work.

The government’s cost of raising funds for 10 years has risen by about 22 basis points (0.22 percentage points), while five year money has since become a quarter of a percent more expensive for the SA tax payer. The spread investors receive as compensation for the risk that SA may default on its US dollar-denominated debt has increased by approximately 13 basis points.

Given that SA, to the 2020/21 fiscal year, will have to raise about R1 trillion to fund the growing deficit and to roll over maturing debt, the Budget statement has been a very expensive failure for the SA taxpayer. Furthermore, by weakening the rand, widening the risks to our credit ratings and to the rand and by adding to the inflation rate, the prospects for faster economic growth have deteriorated.

Yet one has difficulty in understanding why the statement was so poorly received. The statement continues to commit the government to fiscal conservatism. That taxes collected were a very large R50bn less than estimated in the February Budget, was widely signaled, as was the breach of the spending ceilings incurred to keep SAA alive. Furthermore, the decision to increase the Budget deficit and the borrowing requirement, rather than raise tax rates, makes good sense in such dire circumstances.

The Treasury may be implicitly conceding that raising the income tax rates in February proved counterproductive. Higher tax rates have not increased revenues and have in all probability discouraged growth. Raising income tax rates in the near future may well have become less likely.

Strictly controlling government spending while selling government assets is the only way out of the debt and interest trap. But privatisation on any scale appears as unlikely after the Budget statement as it was before.

What then are the steps the SA government could immediately take that might raise confidence in the prospects for the economy, enough to encourage households to spend more of their incomes and for firms to add jobs and capacity to meet their extra demands? Confidence enough to lift growth rates closer to a highly feasible 3% rather than 1% a year?

What is essential is no less than a confidence boosting conviction that the SA government is capable of ridding the economy of those individuals who have gained destructive control of the commanding heights of the SA economy. It therefore takes more than a statement to improve the outlook for the SA economy and to escape the stagnation that makes sound budgeting so difficult. 27 October 2017

 

fig1

Monetary Policy

My Differences with the Reserve Bank – Redux

October 13th, 2017 by Brian Kantor

The Monetary Policy Committee of the Reserve Bank decided not to offer relief to our hard pressed economy.

This window of opportunity to lower interest rates was provided by declining rates of inflation and less inflation expected. The conclusion is that if cutting rates was not opportune last Thursday 21st September, when would circumstances ever allow the Bank to lower interest rates?

Indeed circumstances have since have made lower interest rates less likely. They came this week in the form of a stronger USD and a weaker ZAR, implying more inflation to come.

The MPC referred to the deteriorating assessment of the balance of risks.   However risks to the inflation rate will always be present and remain difficult to anticipate. What should be expected from a central bank is not accurate risk assessments but that it will react appropriately to the new realities. Especially to the impact of any exchange rate on prices to which the SA economy has proved particularly vulnerable.

Such events are described as supply side shocks to prices,  to be distinguished from the extra demands that might be forcing prices higher.  These supply side forces reverse as the exchange rate recovers or stabilizes or the harvest normalizes or tax rates do not increase any further. Thus these temporary supply side shocks should be left to their own devices – to work themselves out of the system without help or hindrance from higher interest rates.  The Reserve Bank however tends to react to inflation whatever its underlying causes

It often refers to so called second round effects of inflation.  The presumed danger that when inflation rises, for whatever reason, firms with pricing powers will plan for more inflation and set prices accordingly. And so inflation can become a self-fulfilling process.

That is unless corrected by higher interest rates to cause enough of a reduction in demand to prevent firms charging much more. Slack – that is an economy operating below its potential – is therefore the price that might have to be paid to achieve low rates of inflation as the economy is now paying up for.

The problem with this theory of self-fulfilling inflationary expectations in South Africa is that there is little evidence of it. Inflation and inflation expected mostly run closely together. Moreover inflation expected has been much more stable than realized inflation. This strongly suggests that inflation expected would have been a constant rather than a variable influence on actual inflation.

Inflation expected is surely not a simple extrapolation of past inflation. Inflation expectations will take account of the forces that are known to have cause inflation in the past, including the impacyt of reversible supply side shoks on prices. They will be informed by models very similar to the Bank’s own model that forecasts inflation. This Reserve Bank model currently forecasts inflation of about 5% in eighteen months, close to the inflation expected by the bond market.

The Reserve Bank and the market’s ability to forecast inflation is highly vulnerable to error given the unpredictability of the exchange rate and all the other supply side shocks that may send inflation temporarily higher or lower.

The inflationary forces that the Reserve Bank can influence consistently are only those that emerge on the demand side of the economy- not the supply side. The current problem for the economy is now one of much too little demand. A case of too much slack and too little growth.

The Reserve Bank therefore should adopt a very different approach to supply side shocks and to alter its narrative accordingly. One that will convince the market place that interest rate reactions to supply side shocks do not make economic sense. And that by not reacting to them when the economy is performing well below its potential does not mean that the Bank is soft on inflation.

Monetary Policy

Learning by doing – the next phase for monetary policy – reversing QE

October 13th, 2017 by Brian Kantor

The success of Quantitative Easing (QE) in promoting a global economic recovery calls for its reversal and the resumption of more normal in monetary affairs. The scale of QE, that is the creation of cash by central banks since 2008, has been extraordinary and unprecedented. Why this injection of cash has not led to more spending, much more inflation and a much greater expansion of the banking systems and in bank deposits than has occurred has been the big surprise. Providing an explanation for these highly muted reactions can explain why the reversal of QE may also be less eventful than might ordinarily be predicted.

The total assets of the major central banks, US, Europe and Japan grew from just over 3 trillion dollars in 2007 to their current levels of over 13 trillion USD, an amount that is still increasing The Fed balance sheet grew from less than one trillion dollars in 2008 to over 4 trillion by 2014.

The key fact to recognize is that almost all of the trillions of cash created by the Fed and other central banks buying the bonds and other securities that so bulked up their balance sheets, came back in the form of extra bank deposits. Commercial member banks before 2008 held minimal cash reserves in excess of what regulations said that were required to hold. They exploded thereafter. These excess reserves in the US peaked at 2.5 trillion dollars in 2014 remain above 2 trillion dollars worth of potential lending power.

The banks holding cash rather than making loans or buying assets has not only led to less spending than might have been predicted, it has also led to a much slower growth in bank deposits. It has shrunk the dramatically the ratio of total US bank deposits to the cash base of the system. This money multiplier has declined from nine times in 2008 to the current 3.5 times. Therefore the size of the banking system relative to the GDP has declined and made the US economy less dependent on bank credit. The US commercial banks on September 27th cash assets were equal to an extraordinary 20% of their deposit liabilities.

Extra bank lending requires that banks attract not only extra cash but also extra capital. Banks were undercapitalized before 2007 and have had to add to their capital to loan ratios. This has restrained bank lending as has a reluctance of potential clients to borrow more. Holding extra cash rather than making additional loans was an understandable choice. The extra cash held by US banks also earns interest, a further incentive to hoarding rather than lending cash. Low inflation – more so deflation – falling prices – can make holding deposits with the Fed, a good investment decision. The Fed minutes released yesterday reveal a concern that currently very low inflation may be “more than transitory”

Coming reductions in the supply of cash to the banking system are very likely to be offset by reductions in the excess cash reserves banks hold. Given the volume of excess cash reserves held by banks the danger is still of too much rather than too little bank lending to come. Were excess cash reserves to be exchanged on a significantly larger scale for bank loans the FED would have to accelerate its bond sales and raise interest rates at a faster pace.

This would all be a sign of faster growth and welcome for it. But there is possibility of a slip twixt central bank cup and lip and that markets will misinterpret the signals coming from central banks. So adding volatility and risks to markets before or as a new normal is established. Past performance will not be a guide to what will be another  unique event in monetary history- first was QE- then its reversal.

SA Economy

The inflation news has become out of date

September 20th, 2017 by Brian Kantor

Inflation in SA rose to 4.8in August- up from 4.6% in July 2017. However in August 2017 prices were largely unchanged, rising by a mere one tenth of one per cent in the month. The statistical anomaly is that a year ago Consumer Prices had actually fallen by about the same 0.1 per cent. And so a monthly increase in August this year of 0.1% was enough to raise the year in year increase in Consumer Prices by 0.2%.

Of further and greater importanc% e is that the Consumer Price Index has been largely stable since April 2017. In April prices increased by 0.1%, in May by a still minimal  0.3%, in June by 0.2% and in July by 0.3%. Helped by a consistently stronger rand compared to a year before, and stable food prices following the drought of last year, the direction of inflation has been decidedly lower. Thus as we show below the increase in prices, measured over consecutive three month periods, has declined sharply. Were such trends to continue headline inflation would fall to three per cent. A time series forecast indicates a much lower rate of inflation next year of about 3%.

 

Picture1

Figure 1: Inflation in South Africa and the underlying trends in consumer prices

 

 

 

 

 

 

 

 

 

The Reserve Bank forecasting model of inflation, upon which it will determine its interest rate settings, is not a time series extrapolation of recent trends. It will have the trade weighted rand and food prices as amongst its more inputs. Chris Holdsworth of Investec Securities runs a simulation of the Reserve Bank model that suggest that the forecast rate of inflation for Q1 2018 will have declined marginally and would imply a further reduction in interest rates .[1] He remarks as follows

  • Since the last MPC meeting CPI inflation has dropped from 5.1% in June to 4.6% in July. The MPC’s previous forecast was for CPI inflation to average 4.8% for Q3. The slightly lower than expected print should marginally lower the MPC’s estimate of the inflation trajectory.
  • PPI has dropped from 4.8% in May to 3.7% in July. The fall in PPI inflation should further lower the inflation trajectory.
  • We don’t expect the MPC to make meaningful adjustments to its ZAR and oil price assumptions.
  • Subsequent to the last MPC meeting SA GDP growth for Q2 has come out at +2.5%, up from -0.6% in Q1. Given our understanding of the MPC’s macro-economic model, that should imply a small upward revision to the MPC’s growth assumption for the year (currently 0.5%). This should see a reduction in the expected output gap and an associated increase in the inflation trajectory but we expect the effect to be minimal.
  • The net result is that we expect a minor reduction to the SARB’s inflation trajectory over the medium term. We expect that the SARB will forecast inflation to reach 4.4% in Q1 next year.

A further reduction of 25 basis points in the repo rate therefore seems likely. Especially given the continued absence of any demand side pressures on prices. And so given to the near recession state of the economy. And were the stability of the rand to be maintained and a normal harvest delivered in 2018 the current underlying trends in consumer prices in SA  would be sustained and lead to further reductions in headline inflation and forecasts of it and be accompanied by still short term interest rates. Rates that could fall further and until very welcome strength in spending by households and firms becomes manifest. The conditions for a normal cyclical recovery are falling into place. One can only hope that political developments do not reverse the direction of the rand and the SA risks spreads that have also been receding. Presumably on the belief that better government is in prospect.

It is perhaps worth making an observation about inflation – measured as a year on year increase in prices and – and the advantage in identifying underlying trends in prices within a twelve month period that may be much lower. And portend lower headline inflation to come. The problem for inflation watches and commentators on it – and drawing implications for interest rates- is that 12 months is a long time in economic life. That much of importance can happen to prices or any monthly series within a year that makes year on year comparisons out of date. This is illustrated in a hypothetical example shown below. We show a case of a sharp increase in the price index after a period of stability and low inflation and how this may lead to more and then sharply lower inflation after twelve months.

In the figure below we show a sharp 5% increase in the CPI in early 2016. An increase in the VAT rate or a collapse in the ZAR might be responsible for such a sharp increase.  Thereafter prices are assumed to stabilise for an extended period of time. Perhaps this is because he exchange rate recovers somewhat and the VAT and other tax rates do not increase further. As we show inflation – measured as a year on year increase in prices – initially increases sharply to about 6% p.a and remains at these elevated levels for a full twelve months- where after it collapses back to about zero inflation.

Thus the impact on inflation of an inflation shock will be very temporary provided the underlying trend in prices is a very stable one. Presumably also inflationary expectations as well as models of inflation are fully capable of see through a temporary price shock.  One would hope that monetary policy settings can also see beyond temporary year on year changes in prices. As we hope the SA Reserve Bank is looking ahead rather than behind and will take the opportunity to help stimulate a recovery in spending that is desperately needed.

 

Figure 2: A hypothetical example of price shocks and underlying trends in prices

Figure 2: A hypothetical example of price shocks and underlying trends in prices

 

 

 

 

 

 

 

 

[1]

Forecasting the MPC’s forecasts; Quantitative Strategy, Investec Bank September 18th 2017

 

SA Economy

What the dollar means for the SA economy

September 15th, 2017 by Brian Kantor

The most important single indicator for the future direction of the SA economy is the value of the US dollar compared to the euro and other developed market currencies. When measured this way, and helpfully for SA and the emerging market world, we see that the US dollar has lost nearly 4% of its exchange value this quarter. Dollar weakness has brought a small degree of strength to emerging market (EM) currencies, including the rand, and to metal prices that make up the bulk of SA’s exports.

Dollar strength put pressure on the rand and EM exchange rates for much of the period between 2011 and mid-2016. This was when something of a turning point in dollar strength, weakness in metal prices (in US dollars) and rand and EM exchange rate weakness, was reached. Over this period, the US dollar gained as much as 30% against its peers, while the EM currency index lost about the same against the US dollar, while industrial metal prices and the trade weighted rand fell to about half their values of early 2011 in 2016. (See below)

The dollar has weakened and industrial metal prices have improved since 2016 because the rest of the industrial and emerging market world has begun to play catch up with the revival of the US economy. A stronger Europe and Japan imply more competitive interest rates and returns outside the US and hence less demand for dollars and more for the competing currencies and for metals.

The rand and dollar-denominated RSA bonds have benefited from these trends – despite it should be emphasised – less certainty about the future direction of SA politics and economic policy and a weaker rating accorded by the credit rating agencies. The rand exchange rate since lost more than 50% of its average trade weighted exchange value between 2011 and early 2016. The cost of insuring five-year US dollar-denominated RSA debt had soared to nearly 4% more than the return offered by a five year US Treasury Bond by early 2016. (See below)

Today this risk spread has declined to less than 1.8%, while the rand since early 2016 has gained about 15% on a trade weighted basis and 17% against the US dollar. This improvement has, as indicated, come with general dollar weakness and EM exchange rate strength. But it has also been strong despite the continued uncertainty about the direction of SA politics. The markets, if not the rating agencies, appear to be betting on a better set of policies to come.

It is to be hoped that the markets are right about this. The recent strength of the rand and metal prices offers monetary policy its opportunity to do what it can to help the economy – by aggressively reducing interest rates. Inflation has come down and will stay down if the rand maintains its improved value – and the harvests are normal ones – and the dollar remains where it is. Lower interest rates will lift spending, growth rates and government revenues.

Interest rates were raised after 2014 as the rand weakened and inflation picked up, influenced also by a drought that drove food prices higher. These higher interest rates and prices further depressed spending by South African households and firms and GDP growth. Consistently, interest rates could and should now be lowered because the rand has strengthened and the outlook for inflation accordingly has improved. Does it make good sense for interest rates in SA to take their cue from an exchange rate and other supply-side shocks that drive inflation higher or lower but over which interest rates or the Reserve Bank have no predictable influence? Their only predictable influence seems to be to further depress spending and growth rates. 15 September 2017

Global Financial Markets

Reading the markets – a spring update

September 5th, 2017 by Brian Kantor

These are very good times for emerging market (EM) equities and currencies. The MSCI EM equity index continues to power ahead and has gained over 25% this year. This may be compared to a gain of about 10% for the S&P 500 and the average European equity. The JSE All Share Index has also had a good year and is up by about 16% in US dollars (see figure 1).

A degree of perspective on these recently favourable equity trends is called for. As we show in figure 2 this EM outperformance has come after years of underperformance between 2011 and 2016, as is shown in figure 2. The EM comeback is still very much a partial one that dates from the first quarter of last year. Perhaps some encouragement can be taken from this perspective.

The EM equity comeback (measured in US dollars) can be attributed partly to a weaker US dollar and stronger EM exchange rates. In figure 3 below, we compare the performance of the US dollar vs other developed market exchange rates – mostly vs the euro. The US dollar has weakened significantly since January 2017, by about 8% according to the trade weighted (DXY) index, while the index of EM currencies vs the US dollar has shown a similar degree of strength. The EM Currency Index calculated by JP Morgan (JPMEMX) includes a small weight in the rand. The rand/US dollar exchange rate has performed in line with the average EM exchange rate. Note higher numbers in these figures indicate a more favourabe rate of exchange.

This strongly negative correlation between US dollar weakness vs its peers and EM currency strength vs the US dollar is of long standing, as we show in figure 4 below. The correlation coefficient is of the order of a negative (-0.83) using daily data.

Thus much of the recent strength in EM currencies, including the rand, reflects US dollar weakness vs its peers. As we will demonstrate further below, the recent strength of the rand is much more a tale of the US economy vs its developed market peers than of political and economic developments in SA. The rand has performed very much in line with its own EM peers against the USD,

EM economies and their equity and currency markets have clearly benefitted from a recovery in metal and commodity prices that are dependent on global demands. The global economy has grown faster and in a highly synchronised way in recent months. This news about the state of the global economy has become more encouraging for metal producers. The underperformance of EM currencies and equities since 2011 and their recent recovery is closely associated with the recovery in metal prices, as we show in figure 5 below. Metal prices bottomed out in mid-2016 and have enjoyed a strong move higher since mid-2017, as we show in figure 6.

As with the recovery in EM equity markets, the recovery in metal prices should also be understood as a still partial recovery from the heights of the super-cycle and one that has come after an extended period of lower prices.

The strength in the rand and in metal prices bodes well for the SA economy. It implies more valuable exports and more importantly raises the prospects of lower interest rates – essential if the economy is to enjoy something of a cyclical recovery. The market place appears to have recognised some of the better news about the global economy. The RSA sovereign risk spreads have receded, as we show in figures 8 and 9. The yield on RSA five year dollar denominated debt has fallen sharply from the yields and spreads demanded when President Zuma first intervened in the SA Treasury in December 2015. The cost of issuing RSA dollar-denominated debt has fallen significantly, despite the downgrading of the debt rating agencies.

What has not changed much in recent months has been the spread between rand-denominated RSA bond yields and their US equivalents. For 10 year bonds, the yield spread remains well over 6% p.a. indicating that the rand, despite its recent strength, is still expected to lose its USD exchange value at an average rate of more than 6%. Consistent with this view of persistent rand weakness, is that inflation compensation in the bond market, calculated as the difference between a 10 year vanilla bond yield and its inflation protected equivalent, also remains well above 6%. Inflation expectations or the outlook for the rand have not (yet) responded to the strength of the rand. 5 September 2017

 

Corporate Finance

The Naspers logic – getting our Tencent’s worth

September 1st, 2017 by Brian Kantor

The recent Naspers annual general meeting saw shareholders at serious odds with management about the value of their contribution to the company.

Amidst all the Sturm und Drang and misconceptions about how to measure the performance of the Naspers managers, some facts of the matter deserve proper recognition. Chief among these is that is Naspers managers are expected – emphasis on expected – to destroy shareholders’ value on an heroic (or is it a tragic?) scale.

To explain, were Naspers simply a clone of Tencent, that is the company did nothing but collect and distribute to shareholders the dividends it received for its 34.33% share of Tencent, it would be currently valued as is Tencent itself. Currently it would be worth close to R1.6 trillion. The current market value of NPN is much less than this, about R1.3 trillion, or a staggering near R300bn less than the value of its stake in Tencent.

The correct logical conclusion to come to about this fact is that the market expects the Naspers managers to destroy value on their behalf. In other words, the ambitious capital investment programme of Naspers is currently worth much less (on a net present value basis) than the capital NPN management is expected to deploy over the economic life of the company. To be more precise: worth some R300bn less than it is expected to cost. Why not liquidate all those investments and return the money to shareholders, which would surely close the gap?

Unfortunately for Naspers management, the market has recently become more pessimistic about the capabilities of the Naspers managers. In January 2017, the expected destruction of value was a mere R98bn compared to the current R300bn. It may be concluded that the better Tencent performs, and so adds to the balance sheet strength of Naspers, the more ambition and so the more value destruction the market expects from Naspers. (See chart below)

Independently of the success Tencent has enjoyed in the market place, in which Naspers shareholders share to only a lesser degree, given more value destruction expected, the recent operating performance of the Naspers subsidiaries gives very little cause for believing that their fortunes are about to turn around for the better. We rely here on the Credit Suisse HOLT lens for these observations. Naspers’s cash flow return on investment (CFROI) on its operating assets dropped from -3.6% in 2016 to -10% in 2017. In other words, the operating core of Naspers is destroying value by generating a return on capital far below its opportunity cost of capital. This is nothing new. CFROI has been dropping since March 2011.

The expense missing from every income statement is a charge for the use of shareholders’ equity. Equity is not free and no rational investor wants to give it away for nothing. If we apply a capital charge on the use of Naspers operating assets, its economic profit drops from -R6.2bn in 2016 to -R11bn in 2017. Consistent with these negative returns is that the growth in the sales of these operating subsidiaries has turned negative and the operating margins (expressed as an EBITDA percentage), which were well over 20% between 2004 and 2010, are now barely positive. In 2015 and 2016, the growth in Naspers assets, which includes cash but excludes Tencent and other associate investments, has been at an ambitious rate of over 40% p.a.

Capture

Naspers managers and its shareholders clearly have a very different view of its prospects. Time will tell who has the more accurate view of the capabilities of Naspers management. One would recommend however that the Naspers management put a time limit on their ability to prove the market wrong. If the market in five years continues to value Naspers as a serial value destroyer, its managers should be willing to cut its losses, by radically reducing its investment spending and to unbundle or dispose of its loss making subsidiaries. Any expectation that Naspers is willing to adopt a much more disciplined approach to its capital allocation would add immediate value for its shareholders. 1 September 2017

SA Economy

Is the SA economy glass half full?

August 28th, 2017 by Brian Kantor

The SA economy has begun to offer a few glimmers of cyclical light. Of most importance is that industrial metal prices have continued to recover from their depressed levels of mid-2016, as we show below in figures 1 and 2. The London Metal Exchange Index, in US dollars, is up 20% on its levels of January 2017 – a helpful trend for SA exports and manufacturing and mining activity. Less helpful to the SA economy is that the oil price has also sustained a muted recovery, influenced no doubt by the same pick up in global growth.

Further encouragement for the economy has come from a stronger rand: it has more or less maintained its US dollar value when compared to its emerging market (EM) peers. The US dollar exchange value of the rand has moreover remained consistently ahead of its values of a year ago, as is shown in figure 3.

The stronger rand has helped to reverse the headline rate of inflation, which is now well down on its peak levels of mid-2016 and could easily fall further, as we show in figure 4, where currently favourable trends are extrapolated. Over the past quarter, the consumer price index has risen at less than a 3% annual rate.

The prospect of significantly lower short-term interest rates, which would be essential to any cyclical recovery, has therefore now greatly improved, given prospects of lower inflation. The demand for and supply of cash, a very useful coinciding business cycle indicator, has been growing ever more slowly in recent months and, when adjusted for inflation, has turned significantly negative. Somewhat encouraging therefore is that the cash cycle appears to have reached a cyclical trough (see figure 4). A reversal of the cash cycle is an essential requirement for any cyclical recovery.

Two other activity indicators, retail sales volumes and new vehicle sales, provide somewhat mixed signals about the state of the economy. Retail volumes, as can be seen in figure 5, have continued to increase, albeit at a slow rate, while new vehicles sold in SA have declined sharply since early 2016. However the latest vehicle sales trends as well as retail volumes suggest that the worst of these sales cycles may be behind the economy. The sales trend however remains very subdued and will need all the help it can get from lower interest rates over the next 12 months.

We combine two recent data releases, new vehicle sales and the cash in circulation in July 2017, to establish our Hard Number Index (HNI) of the immediate state of the SA economy. As we show in figure 7, the HNI of economic activity turned decidedly down in mid- 2016 but now appears to have levelled off. The HNI can be compared to the coinciding business cycle measured by the Reserve Bank as we do in Figure 7. Extrapolating this Reserve Bank business cycle indicator also indicates that the worst of the current business cycle may be behind us.

The economic news therefore is not all negative. However essential for an economic recovery is further rand stability and the lower inflation and interest rates that would accompany a stable rand. A combination of better global growth and so higher metal prices would help. So, presumably, would any confirmation of the end of the Zuma regime – a view seemingly already incorporated into the current strength of the rand as well as by the reduction in SA risk premiums. Both the strength of the rand, relative to other EM exchange rates, and the spread between RSA Yankee (US dollar) bond yields and US Treasuries indicate that the market expects the Zuma influence over economic policy to be over soon. For the sake of the rand, the economy and its prospects, one must hope the market is well informed. 25 August 2017

 

Corporate Finance

The avoidable risks Eskom assumes on behalf of all South Africans.

August 21st, 2017 by Brian Kantor

A shorter version published in Business Day is available here

The avoidable risks Eskom assumes on behalf of all South Africans.

The owners of Eskom (all South Africans) should be aware of the grave risks Eskom’s managers and directors have taken on their behalf. The risks that is to the value of the many billions of rands that have been deployed on their behalf building plant and equipment (PPE) to generate and distribute electricity.

The danger is that all this PPE may be worth much less than it cost. There is also the matter of servicing and repaying the over R300bn in debt that has been incurred funding these developments, much of it that is tax payer guaranteed. These debts are large enough to threaten the credit of the Republic itself, as has become apparent.

The essential, unsatisfactory nature of a state-owned business is only part of the problem, namely that the primary purpose of the business easily becomes that of serving the interests of its employees, from top to bottom. The interests of its customers and owners become secondary and are poorly served. However the main problem is when the operations are of such an order of scale that any mistaken investment programmes or operational failures become significant for the economy at large, as has become the case with Eskom.

The further danger is that the burden of these mistakes and servicing the debt incurred are passed on to the consumers of electricity in SA in the form of further increases in prices. But Eskom’s monopoly applies only to the electricity delivered over its grid. Thus increases in electricity prices may prove self-defeating for Eskom as well as highly damaging to the competitiveness of the SA economy. Higher prices lead to lower levels of demand – perhaps the point where sales revenues decline rather than increase as key customers become more energy-conserving and turn to alternative supplies off the grid.

Potential customers can shut down operations or not start new projects when the economic case for their operations make much less sense, given higher real electricity prices. Investing in solar panels, small wind turbines or increasingly efficient gas turbines installed onsite, can make good sense as drawing on the grid becomes ever more expensive. And who knows what opportunities innovation and invention may bring for the generation of electricity on a small scale in the near future?

A further threat to Eskom and us, its owners, is that its largest customers, energy intensive miners and refiners of metals, who account for about 50% of demand for Eskom’s output, have publicly indicated a profound loss of confidence in it as a reliable competitive supplier of energy. They refer to operations being shut down or transferred outside of SA and a much weaker case for expanding capacity to upgrade (beneficiate) the metals and minerals brought to the surface.

There is in reality no good reason for all South Africans to have to carry these risks to the supply of and demand for electricity in SA. Such risks could be readily absorbed by willing new owners of the PPE – at the right price. Owners perfectly capable of raising their own sources of debt and equity capital to the purpose. The capital market has a proven taste for the predictable income streams that electricity utilities can deliver.

The Eskom assets could be divided up sensibly and auctioned off to a number of independent, capable operators. Hopefully the prices realised for the assets would be sufficient to pay off the Eskom debts. But even if not, it would be better to realise as much as possible, as soon as possible, for these assets, than to incur more debt to keep Eskom on its present path.

One advantage of perhaps lower-than-replacement-cost prices paid for the Eskom assets would be that it might enable its new owners to offer more competitively priced electricity – while still providing an adequate return on the capital they have invested. Prices for energy that could then encourage miners and manufacturers who would then be more internationally competitive thanks to lower energy costs. Competitive electricity prices, by international standards, could prove to be a stimulus for a revival of SA manufacturing and mining and the accompanying employment.

The SA economy stands to benefit from a much more competitive market for energy; from many more generators and distributors of electricity who would compete for customers on price and reliable supplies; from contracts that would facilitate the raising of capital on favourable terms for new owners and managers; and from the alternative technologies, relying on wind, solar or gas, that would have every opportunity to compete for custom on the same competitive terms. This would be a system much more like those that apply in the US or UK, a system designed

Global Financial Markets

Go offshore – for the right reasons

August 4th, 2017 by Brian Kantor

*Published in Business Day on 4 August 2017 (Published version available here)

Offshore diversification by SA firms is not necessarily the best way for investors to diversify their risks.

South African business leaders are demonstrating a heightened taste for expansion offshore. They are borrowing more locally and abroad to fund this growth. The reasons for doing so seem obvious enough. The stagnant SA economy now offers them minimal growth opportunities, yet they are likely to be well rewarded for growing earnings. Clearly such growth would be helpful to managers – is it as likely to be helpful to their shareholders?

It all depends on how much of their capital or debt incurred on their behalf is employed to pursue earnings growth. Unless the extra cash generated by expansion abroad or domestically can be confidently expected to provide a cash return in excess of the opportunity cost of the extra cash invested (cash in for expected cash out, all properly discounted to the present with proper allowance for the maintenance and replacement of the assets acquired) the investment should not be made. One wonders how many of the offshore acquisitions by SA companies offshore can confidently offer cost-of-capital-beating returns for their SA shareholders?

Why then the near flood of such acquisition activity?  Every director acting as the custodian of the capital of shareholders should know that growing earnings or earnings per share may not be helpful to shareholders, if too much capital has been expended to realise growth in earnings.  If managers are incentivised to grow earnings regardless of the extra capital employed to do so, they should not be surprised when managers seek growth wherever it can be found, regardless of how much it costs and whether or not it destroys wealth for shareholders. The golden rule of finance is always relevant: positive net present value (NPV) strategies are worthy of consideration but negative NPV strategies should be declined, especially if they are being made for “strategic reasons” (when an investment is made for “strategic reasons” it often means that there are no “financial reasons” for pursuing it).

A further benefit to managers from expansion offshore will come in the form of a more diversified flow of earnings when these include earnings generated independently of their SA operations. Full exposure to SA risk may threaten the survival of a business and so their own employment prospects. Shareholders however may have no need for managers to diversify their risks. They diversify their portfolios by holding small stakes in a large number of companies. The more specialised and efficient the companies they are able to invest in, the better. Conglomeration in principle comes at a price – that of the cost of a head office or holding company discount. Executives who diversify earnings on behalf of their shareholders are not doing them a favour. Shareholders can do it themselves at a fraction of the cost, e.g., no expensive investment bankers are required, and they can exit when they wish by simply selling assets in their portfolio.

South African shareholders, especially private shareholders, have enjoyed much greater freedom in recent years to invest directly in companies listed offshore. The case for their SA managers investing offshore on their behalf as part of a diversification strategy is therefore a weak one.

SA institutional portfolios subject to a 25% limit to their offshore holdings may have a stronger case for JSE-listed companies investing offshore on their behalf. Indeed, the case for what are essentially offshore companies having a listing on the JSE, primary or secondary listings, is predicated on this constraint on their asset allocations. These companies, with minimal exposure to the SA economy, can raise capital on the JSE on superior terms to those available to them elsewhere. Or, to put it alternatively, they can benefit from a higher share price (in US dollars, on the JSE) by catering to the SA institutional investor. For the private SA investor able to invest abroad, essentially without limit, it makes little sense to pay any premium for access to offshore earnings, dividends or the capital appreciation provided by a JSE listing. The private investor can diversify directly, without exchange control constraints, by investing in the most promising of companies listed offshore.

All this is not to suggest that SA companies and their managers cannot succeed offshore. Some exceptional managers have created a lot of wealth for their SA shareholders by doing so. Rather it is to argue that such attempts should be made on their own strict investment merits; that is, they offer a return (cash in/cash out) that exceeds the risk-adjusted returns their shareholders could hope to achieve independently. Chasing earnings growth regardless of properly measured returns on the capital at risk, or because it offers diversification, is not nearly a good enough reason to go offshore. Without such good reason and given the lack of growth opportunities in SA onshore, it would be better to return excess cash (excess capital) to their SA shareholders by paying dividends or buying back shares or debt. Let shareholders decide for themselves how they wish to diversify their risks.

*David Holland is from Fractal Value Advisors

 

SA Economy

How to get South Africa growing

July 26th, 2017 by Brian Kantor

South Africans would benefit greatly if the country’s state-owned enterprises were to be privatised. Full story as published in FinWeek here.

SA Economy

Out with the credit regulator

July 26th, 2017 by Brian Kantor

I have a very radical policy proposal, which is to repeal the National Credit Act. Repeal would allow lenders and borrowers complete freedom to contract with each other for credit on any terms they found agreeable. It would help transform the economic prospects of many South Africans who do not benefit from regular incomes and so do not qualify for credit under current regulations.

Freer access to credit would be particularly helpful to informal traders and aspirant farmers and entrepreneurs. By saving the significant costs of complying with current regulations, a repeal might well lead to less expensive borrowing terms for the many who currently receive credit. Strong competition for potential credit business would convert lower compliance costs of providing credit into lower charges for all borrowers. The reputation of the lenders for fair treatment of its customers would become even more critical in attracting new and repeat credit business. A lender would not have to proclaim it is an authorised financial service provider as if this were some kind of guarantee that absolves borrowers or lenders of the need to undertake proper diligence.

The importance of maintaining reputation – brand value – in which so much is invested, including training employees to deliver their services better than their rivals, is what keeps profit-seeking businesses honest and efficient. It attracts the most valuable type of business, repeat business.

Perhaps, given their knowledge and experience, the regulators and compliance officers that would be rendered unemployed should my proposal come to pass, could be converted into useful predictors of the ability of potential borrowers to deserve the credit on offer. Identifying much more accurately and easily the credit rating of any potential borrower would allow for well-targeted, attractive offers of credit – perhaps initiated at very low cost over the internet. Credit markets are particularly well-placed to apply the new science of big data management that is revolutionising all business.

There is a long history of limiting (defined as usurious) interest rates that may be charged to borrowers, which has disturbed and complicated the contracts borrowers and lenders agree to – and in turn has encouraged regulation of these complicated terms. If lenders were free to declare all revenues they expect to receive from a borrower as simply interest or capital repayment, at whatever rate agreed to, borrowers could easily make comparisons of the costs or benefits on offer. This is the case when a motor car is leased for a monthly payment. How much of this payment pays for the car and how much for the motor plan is irrelevant to the driver. It is simply a question of how much car the monthly payment buys. The benefits of the transaction to the motor dealer, the lessee and the lessor are bundled into one convenient monthly payment. We do not pay a hotel separately for towels, linen, or air conditioning – ‘free’ breakfast may even be included in the daily rate. And no regulator (yet) tells the hotel to itemise its menu or what services they are allowed to charge for and how much they can charge

The National Credit Regulator however allows the lender only clearly defined fees and payments that include the repayment of the principal debt; an initiation fee, a service fee, interest, the cost of any credit insurance, default administration charges and collection costs. It has argued that a fee charged to retail customers to join a club of customers cannot be levied. The jury or, rather, the judges are out on this one.

Club fees, delivery, insurance or other charges are all contributions to the lender’s revenue, in addition to interest payments that are controlled. Reducing the lender’s ability to raise revenues from explicit interest charges or to protect themselves with capital repayments leads inevitably to a complicated array of fees to supplement interest received. Restricting the flow of revenues therefore means less credit supplied to well- qualified borrowers. This is an unsatisfactory outcome that an unregulated credit market would overcome. 7 July 2017