February 2017 – ZA Economist

Interest rates, exchange rates and the JSE (in US dollars) before and after the Trump Shock: all have been good for the SA economy. Now it’s over to the Reserve Bank

US 10 year yields, nominal and real, after declining to very low levels by mid-year 2016, then began to rise. The Trump election added further momentum but, as may be seen, long term interest rate levels in the US have largely stabilised at higher levels in 2017.

US Yields

Nominal rates are now about 100bp higher than they were in mid-2016 while real rates have gained about 50bp from approximately zero rates in mid-year. Accordingly the spread between the nominal and real yields that offer compensation for the inflation risks that holders of nominal fixed interest bonds assume, has widened. This indicated more inflation expected over the next 10 years, of the order of 2% p.a. The higher real rates indicate increased real costs of capital – a sign of faster growth expected and the increased demands for capital that come with faster growth. Thus the US bond market indicates that both more inflation and faster growth are now expected in the US. The rising US equity markets have regarded improved earnings growth prospects as more than adequate to off-set higher discount rates.

Long term interest rates in SA have taken a somewhat different course to those in the US. As may be seen below, RSA 10 year yields have edged lower while real yields have edged higher. The spread, indicating inflation expected over the following 10 years in the RSA bond market, has generally moved lower, from a very high near 8% in early 2016, to current levels of about 6.5% indicating still elevated inflationary expectations.

That longer term rates in the US have moved higher and equivalent rates in SA lower means that the spread between RSA and US rates have declined. This spread may be regarded as a SA risk premium, the extra yield required to compensate for the expected weakness of the rand, and equivalent to a forward exchange rate.

The difference in real yields may be regarded as the extra, after inflation yield required by foreign investors to compensate them for all the risks associated with investing in SA assets. As may be seen in the figures below, SA risk, that is the rate at which the rand is expected to depreciate against the US dollar, has declined as the rand strengthened, while the real risk premium offered to investors in SA has remained largely unchanged.

The faster the US and global economies are expected to grow the higher the expected rates in the US. But faster growth is helpful for commodity prices and emerging market currencies and equities and their profitability and reduces the risks associated with investing in emerging market economies.

Evidence of these helpful trends is clear enough, as may be seen in the figure above that graphs the similar responses of commodity prices, emerging market and JSE equities over the past year as interest rates have risen in the US.

What remains for the SA economy to benefit from improved outlook for the global economy is for the Reserve Bank to reduce its anxiety about the prospect of higher interest rates in the US and focus its attention on the downside risks to the real SA economy, rather than the upside risks to the rand and inflation, and to lower short term interest rates accordingly (President Zuma naturally permitting – and what he permits by way of his cabinet choices will be known this week).

*The views expressed in this column are those of the author and may not necessarily represent those of Investec Wealth & Investment

South Africans will soon learn how much more of their disposable incomes and wealth will be extracted to sustain the nation’s credit rating. They have been forewarned, though they do not appear forearmed, to resist the incoming tide of still more tax and less income to dispose of.

They will be told, correctly, why limiting the borrowing requirements of government (the fiscal deficit) is essential for holding down interest rates and the cost to taxpayers of servicing the debt (old and new) incurred on their behalf.

What will not receive much attention from the Minister of Finance is a recognition of the influence of taxes and tax rates on the ability of economically active South Africans to pay these taxes – so that tax rates have to rise even as the economy continues to flirt with recession.

Evidence of policy failure, in the form of persistently dismal growth in SA incomes, is there for all to recognise. The rating agencies have identified the lack of economic growth in SA and so of its tax base, as the long term threat to the solvency of SA government debt.

It is not good economic policy to tax some goods and services at a much higher rate than others. Nor does it help to subsidise more favoured (by politicians and officials) sources of income. The economy needs less of both taxation and subsidisation that can significantly alter the patterns of consumption and production; interventions that prevent prices and output from revealing the economic value of the resources used in production and distribution. Transport and energy costs, including the particularly adverse taxes on fuel and energy, have a large influence on the prices of everything consumed and produced in SA.

It is a mystery why South Africans appear so complacent about the ever higher specific taxes levied on their demands for transport and energy, yet are so defensive of the inviolate 14% VAT rate with all its significant, hard to justify exemptions that in reality help the better off more than the poor.

The Treasury is now looking to a tax on sugar added to soft drinks. It’s looking to add as much as 20% to the price of a litre of the offending liquid and also, not co-incidentally, hopes to produce significant additional revenue. This focus on extra revenue will deflect attention from the full, perhaps unintended, consequences of such penal taxes: that is not only less sugar consumed but added incentives for producers to avoid taxation, not just the sugar tax but also all the other taxes, VAT and income taxes that accompany the legal production of soft drinks. This has been the case with cigarettes, where highly penal tax rates have driven much of their production and distribution underground. When the price of a cigarette is cheaper on the street than in the supermarket, the practical limits of the ability to tax and also to influence the prices charged, have been exceeded.

The way forward is for the government to spend less, especially on the benefits provided to the nannies employed by an increasingly nanny state, who thrive on an ever-growing but largely dispensable tide of regulation that inhibits production and employment. The full costs, as well as the often marginal benefits of a regulation, need to be better recognised.

The government also needs to recognise the cost savings, were the private sector allowed to deliver more of the services that taxpayers fund, including education and hospital services as well as electricity and transport. And it should look to sell off the assets of these superfluous state-owned enterprises (SOEs) in order to reduce government debt and interest payments that the SOEs have been so assiduously adding to, given their poor operating results.

South Africans should fully recognise that ever-higher tax rates are not helpful to their economic prospects. They should be calling loudly for less government, less spending and interventions by government. This would lead to lower tax rates, faster growth and indeed more revenue collected. 3 February 2017

Month: February 2017

Some helpful financial market trends for SA to respond to

Budget time is approaching – higher tax rates are part of the problem not the solution