Message for the Reserve Bank- act now on interest rates

May 15th, 2017 by Brian Kantor

When President Zuma intervenes in the Treasury alarm bells were set off in the market place and by the credit rating agencies. The danger is that fiscal conservatism in SA – the willingness to fund government spending without printing money – will be sacrificed to other interests. So making the government more prone to raising loans from the central bank rather than raising additional revenue or issuing more debt. And when a government borrows heavily from its central bank and spends the proceeds credited to it adds to the money supply. This usually brings more spending, more inflation and a weaker exchange rate in its wake.

Zuma interfered initially in December 2015. The negative impact on the SA bond and currency markets was immediate. The spread between RSA bond yields and their US Treasury equivalents widened dramatically by close to an extra 2% p.a. to 8.14% p.a. This 8% p.a became the faster rate at which the ZAR was expected to depreciate against the US dollar over the next ten years thus still more inflation expected.

The difference between an inflation protected real yield offered by the RSA and a vanilla bond of the same duration is another good measure of inflation expected. This other spread also widened on the Zuma intervention from around the 5.5% level in mid- 2015 to well over a 7% p.a (See figure 1 below).

Fig.1: Measures of expected rand weakness and inflation in SA. (Daily Data 2013-2017)

Fig 1 - Measures of expected rand weakness and inflation in SA - Daily Data 2013-2017

Source: Bloomberg and Investec Wealth and Investment

A further direct measure of the Zuma effect on SA risk is to examine the spread between a RSA obligation to pay interest and principle in US dollars (a so called Yankee bond) and a US Treasury obligation with the same duration. This spread indicates the compensation for carrying the risk that SA would default on its debt- also the concern of the credit rating agencies. This risk spread widened from less than two per cent p.a. on offer through much of 2014-2015, to as much as 3.6% extra demanded in early 2016 for a five year obligation. (See figure 2 below)

Fig.2: The default risk spread for a 5 year RSA dollar denominated bond. (Daily Data – 2014-2017)

Fig 2 - The default risk spread for a 5 year RSA dollar denominated bond - Daily Data - 2014-2017

Source: Bloomberg and Investec Wealth and Investment

All these measures of SA risk and inflation expected declined consistently through 2016 as the rand strengthened. That is until president Zuma replaced highly respected Finance Minister Gordhan and his deputy on March 23rd 2017. Whereafter the rating agencies downgraded SA debt and the risk spreads widened and inflation expected increased. But these reaction to the second Zuma intervention have proved much more muted. The spread on the RSA Yankee bond is now no higher than it was in 2014.

The exchange value of the ZAR – a major force acting on actual if not expected inflation – has been much enhanced – from the weakest levels of more than R16 for a US dollar in early 2016 to the approximately USD/ZAR today- a gain of approximately 20%. In figure 3 below we show the exchange value of the rand compared to the USD value of eleven other Emerging Market (EM) currencies. Not only has the ZAR strenghtened – it has gained ground against the other EM currencies similarly influenced by global events. This ratio (ZAR/EM) declined from 1.25 in early 2016 to close to 1 in early 2017 aslo indicating less risk attached to the SA economy. This ratio then was bumped up by the second Zuma interevention but again only modestly so as may be seen.

Fig.3: Zuma and the exchange value of the rand

Fig 3 - Zuma and the exchange value of the rand

Source: Bloomberg and Investec Wealth and Investment

Why the market place, if not the credit rating agencies, have become more sanguine about the credit worthiness of SA is a matter of conjecture. Perhaps it is because the chances of President Zuma being removed from his high office has improved?

But the current state of the markets have an important reality. The outlook for lower inflation in SA has improved significantly with a stronger rand and a much improved harvest. The case for lowering interest rates to stimulate a now prostate SA economy is all the stronger. Uncertainty about the exchange rate, over which short term interest rates have no influence whatsover, is no reason at all for the Reserve Bank to delay much needed relief for the depressed local economy. Faster growth without any more inflation or inflation expected, is surely the right option to exercise.