Let's get Heinz's take on this article
morganstanley.com
South Africa: Stronger Growth, Rand Permitting
Riccardo Barbieri (London)
2003 will likely be remembered as a year of considerable achievements for South Africa in terms of macroeconomic stability, particularly in terms of declining inflation and interest rates. A year ago, the inflation rate measured by the CPIX, the index of consumer prices excluding mortgages, stood at 10.8% year-on-year, and the CPI inflation rate was 12.5%. We estimate that 2003 will end with a 4.1% CPIX inflation rate (unchanged from November) and a zero CPI inflation rate. In line with this improvement, interest rates have fallen sharply, with the repo rate of the South African Reserve Bank (SARB) falling by a total of 550 basis points. This was all made possible by a strong recovery in the rand exchange rate, which, similarly to 2002, exceeded even the most optimistic expectations.
The other side of the coin is that South Africa’s economic and employment growth performance has been rather disappointing this year. We estimate that 2003 will close with a 1.9% average real GDP growth rate and a meagre 4Q/4Q growth of 1.3%. Even assuming that the official figures are later revised up, we do not think that the estimated growth rate will significantly exceed 2%. Meanwhile, according to official statistics, non-agricultural private-sector employment contracted by 0.6% in the first quarter, and the overall unemployment rate rose to 31.2% in March, from an average of 30.0% in 2002. Given that the economy slowed down further in the second quarter before slowly recovering in the second half of the year, the annual unemployment rate will be probably higher than in the first quarter.
Against this backdrop, the official projections of the South African National Treasury are for a significant acceleration in economy growth in 2004–06, and a return to jobs creation. The Treasury’s latest projections call for a real GDP growth rate of 3.3% in 2004, 3.7% in 2005, and 4.0% in 2006. With fiscal policy much more stimulative than in recent years and easier monetary policy, we believe the policy mix is the right one to deliver stronger growth. The improvement in the global economy adds credence to the Treasury’s projections. Our own prognosis for 2004 is less positive than the Treasury’s, although this week we raised our real GDP growth forecast to 2.8%. On the other hand, we concur with the Treasury’s view on 2005 growth.
The key issue, though, is whether the rand exchange rate will weaken enough to allow the traded sector of the economy to return to a healthy growth rate. While this will depend in part on domestic developments, the most critical factor will be the trend in world commodity prices (notably metals), not only because of their importance in South Africa’s output and exports, but perhaps more importantly because such prices represent the key factor determining how international model-driven investors trade this currency. Our macroeconomic projections are heavily influenced by our expectation that the Bull Run in metals prices will run out of steam over the course of next year, and this will allow the South African policy authorities to engineer a soft landing of the rand exchange rate. If that failed to happen, though, we would expect a significantly worse economic performance in the next two years than suggested even by our own forecasts, particularly in 2005.
As mentioned above, this week we raised our 2004 real GDP forecast from 2.5% to 2.8%, and announced a new 2005 forecast of 3.7%. The main reasons for the upward revision to the 2004 estimates are that the latest demand-side national accounts data showed stronger domestic final demand than we anticipated, and there were upward revisions to the back data. We feel that this strength is sustainable, given the sharp decline in bank lending rates and continuing fiscal stimulus. (Government spending should rise further as a share of GDP in the 2004/05 fiscal year, before levelling off in 2005/06.) In addition, there has been an encouraging improvement in business confidence in 4Q03. This leads us to believe that gross fixed investment will continue to grow in coming quarters, albeit at a slower rate than in the days of the weak rand.
The worsening in South Africa’s net foreign trade should also diminish, as the world economy recovers, thus creating better export opportunities for South African firms. Going into 2H04, we expect these factors to be compounded by a weaker rand (see below). Our 2004 real GDP forecast would be even more optimistic if we assumed a larger contribution from stock building and, on the supply side, a very strong rebound in agricultural production after this year’s drop. For 2005, our positive view on South African growth stems from our expectation that, in addition to continuing strength in domestic demand, the economy will also benefit in full from a more competitive exchange rate while interest rates rise only moderately.
We have also upped our rand forecast. The weakening of the rand against the US dollar over the past few days could signal a turning point for this currency (similar to what happened in the opposite direction at the end of 2001). However, we expect that the rand’s correlation with metals prices (see Exhibit 1, which is based on computations by our colleague V.R. Chandramouli) will reassert itself in 1Q04. We expect the rand/dollar exchange rate to test the 6.0 level once again in 1Q04. In the absence of unforeseen domestic problems or policy mistakes (which have become rather unlikely, in our view), the rand will probably stay strong until the current rally (or, should we say, bubble?) in metals prices comes to an end.
We believe that the key factors that could bring about such turn-around are the slowdown in Chinese growth expected by our Asian colleagues and the beginning of a policy tightening by the US Federal Reserve, which our US economists believe will occur in 3Q04. We also continue to think that the South African authorities will be more inclined to accommodate or promote a gentle weakening of the rand after the general elections (in April) and key wage negotiations (in May and June) are out of the way. Changes to our forecasts are particularly significant with respect to the next two quarters, as we expect the rand (currently at 6.60 against the dollar) to strengthen to 6.5 at the end of March and weaken to 7.0 at the end of June. Our previous March and June forecasts were 7.0 and 7.5, respectively.
South African interest rates are close to the cyclical bottom, in our view. The South African Reserve Bank (SARB) surprised us on the downside, by cutting its policy rate by only 50 basis points on December 11 (although we agree completely with the move from a normative point of view). Given our bullish near-term rand scenario and positive expectations for inflation in the coming months, it makes sense to us to expect one last 50 basis-point cut at the February meeting. After that, we believe the SARB will be on hold until the 4Q04. At that stage, with the rand moving to 7.8 by end-September and both current and projected CPIX inflation rising above 5% (and perhaps even closer to the upper limit of the 3–6% inflation target range), on our forecasts, we would expect the SARB to hike its policy rate by 100 basis points. This would be followed, in our view, by a further 50 basis points of tightening in 1Q05. Alternative rand scenarios from the one we have outlined would obviously lead to significantly different interest-rate decisions by the SARB. South Africa will no doubt remain a very interesting economy to watch. |
