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Monday, January 17, 2011

South African Blues

Many ordinary South African citizens trying to figure out what is happening to their economy, and what is behind all those ups and downs which seems to characterise it, must have been scratching their heads in wonder on Saturday when they read in their morning papers that the country's currency, the rand, dropped sharply in value - by something like 2.3% against the dollar - last Friday as a result the decision by the Chinese central bank to raise reserve requirements for banks. What the hell, they must have thought, is the connection between these two phenomenon.

In fact the fall turned the South African currency into the worst performer globally among Emerging Market Currencies so far this year, and all because of something happening in China!

For the more discerning economic eye the reasons for the move in the currency are not that hard to identify, since the South African economy (and with it the rand) is generally seen as being more exposed to any eventual economic slowdown in China than it is to potential contractions in either the U.S. or European Union. Thus has the world changed during the last decade and a half!

The reason for this is the reliance of South Africa’s export reliance export sector on Chinese demand. Asia has replaced Europe as South Africa’s biggest export market, and China now accounts for almost 30 percent of the country’s exports to the continent.

And in another of example of how in the modern globalised world virtually everything is connected with everything else global coal prices hit a 28 month high during the week, largely driven by news of the Gauteng flooding tragedy, which following closely on the heels of the far more publicised problems in Australia, has started to catch investors eyses. The common thread which links the two events in the investors mind is unfortunately not the loss of human life involved (in fact at least 32 people are reported dead between Gauteng and Kwa-Zulu Natal provinces) but rather the coal shortages that could be produced in their wake. Both Xstrata, South Africa's biggest thermal coal exporter, and BHP Billiton reported delays to deliveries to the Richards Bay Coal Terminal as rain halted the goods trains. All of this of course, has Hedge Fund commodity traders all across the globe busily examining maps of road and rail networks, and photos of damage to mine installations (in the Australian case) in a bid to estimate how long it will take for output to get back to normal, and thus what the likely short run consquences for coal futures are likely to be. Such are the smoothly-oiled and tightly meshed set of gears which drive the inner complexity of the modern global economic system.

A further example of how global sentiment is influencing trends in the South African economy can be seen in the fact that government bond yields have been falling in value due to an expectation that the central bank won’t lower its main interest rate when it meets next week. The bank is worried about the additional growth slowdown that any monetary tightening might produce. South Africa's economy has emerged from the crisis, and is expected to have expanded by around 3 percent in 2010 after contracting by 1.75 percent in 2009. But these levels are a far cry from the growth rates many Emerging Market economies are currently experiencing.

Thus while South Africa's inflation remains relatively benign (prices rose by an annual 3.6% in November), the central bank is likely to keep loosening monetary policy. But there is another reason for this loose monetary policy, apart from the obvious growth-stimulus one, and that is the biggest problem facing South African manufacturing industry isn't the recent fall in the rand (which is probably welcome), but rather the sharp rise the currency has experienced vis-a-vis the dollar over the last two years (it has risen by roughly 35% since the start of 2009).

Inflows Present A Major Challenge To The Global Recovery

The key driver of the upward surge in the rand are capital inflows, these flows have been behind the vigour of the recovery in many emerging economies, although they are now increasingly starting to pose risks to a sustainable global recovery as they can trigger abrupt currency fluctuations that may do “lasting damage” to some vountries, according to the World Bank's Global Economic Prospects 2011 report, published last week.

In the words of Hans Timmer, the World Bank’s director of development prospects, “The pickup in international capital flows reinforced the recovery in most developing countries. However, heavy inflows to certain middle-income economies may carry risks and threaten medium-term recovery, especially if currency values rise suddenly or if asset bubbles emerge.”

And this of course is what has been happening in the South African case, since the currency value is sharply up, while stocks have risen much more sharply than would be justified by the rate of growth in the real economy, and while the rand was busy weakening, last Friday Johannesburg's blue-chip Top-40 put in its highest close since June 2008, finishing at 9,226.96

Countries across the globe, from Indonesia to Turkey, and from India to Brazil, are struggling to limit their currency volatility as near-zero borrowing costs in advanced economies fuel demand for higher-yielding assets in emerging markets. Net private capital flows to developing countries were up by 44% in 2010 to about $753 billion, according to the World Bank report. And the countries that attracted the main part of the fund flows were the middle-income ones “with well developed debt and equity markets". In these cases large inflows “either have caused their currencies to appreciate by more than warranted by their fundamentals, or have forced them to take extraordinary measures to prevent a disruptive appreciation.”

The nine countries that attracted the bulk of capital flows were Brazil, China, India, Indonesia, Malaysia, Mexico, South Africa, Thailand and Turkey. Brazil, for example, has seen the its currency (the real) appreciate by 39 percent against the dollar since the start of 2009, making it the third biggest increase among the 16 most traded currencies as tracked by Bloomberg, behind only the Australian dollar and the South African rand.

In an effort to try and stem the rise, the South African Reserve Bank has now lowered its benchmark repurchase rate nine times since December 2008 to its current level of 5.5 percent, the lowest level since the interest rate was first introduced in 1999.

South African domestic demand is still struggling to find growth after the years of rapid credit expansion between 2005 and 2008. Cement sales fell for a third consecutive year in 2010 as growth in the construction industry slowed and the housing market remained weak. Sales were down 7.8 percent compared with 2009, when they declined 13 percent. The recovery in housing and construction demand in Africa’s biggest economy has been slow, with house prices expected to increase by 5 percent in 2011, following an estimated 7 percent rise in 2010. Construction growth slowed to an annualized 0.8 percent in the third quarter compared with 1 percent in the previous three months, according to statistics office data.

And retail sales are also not strong for an emerging market, growing by only an annual 6.2% in November. This is a long, long way from China type growth levels.

Competitivness Pressures Crimp Manufacturing Industry Growth

South African manufacturing production, which accounts for around 15 percent of the total economy, increased an annual 4.6 percent in November following a 2.3 percent increase in October. The recovery in manufacturing output has been slow as growth eased in Europe, which buys about a third of South African manufactured exports. The rand’s 11 percent surge against the dollar in the past six months has also crimped shipments. As a result South African manufacturing still has a long way to go to recover from the 2009 slump.

There is another tool available to the South African administration in their effort to take some of the wind from the sales of the rising rand, and that is good old straightforward currency intervention. In October the Finance Minister announced that the government intended to transfer part of the last year's tax revenue windfall to the Reserve Bank to help it buy dollars. As a result the National Treasury increased its foreign currency deposits with the central bank by $614 million in December and the country's reserves rose 1.1 percent over the month, increasing them to a total of $43.8 billion.

For its part the bank said it bought $404 million of foreign currency through swap transactions during December, in order to “drain liquidity from the domestic money market.” However the banks ability to influence the value of the currency should not be overestimated, since South African reserves are still comparatively small compared to those of other emerging markets. Turkey, for example, has reserves of $80.7 billion, while Brazil has around $289 billion.

Job Creation The Key

At the emd of the day, the most pressing problem facing the country is not the rising currency, it is the continuing high level of unemployment. The country faces a quite favourable demographic outlook, and the key to growth and improved living stardards lies in finding productive work for the hundreds of thousands of young people who are desperately in search of it.

The recession worsened the country’s unemployment picture considerably, with close to one million jobs being lost in 2009 and 2010, and the unemployment rate stood at some 25.3% in the third quarter. This excessively high unemployment meant rate is - as the IMF note - an important contributor to the high level of income inequality which exists in the country. Raising potential economic growth. Current trend growth rates ( estimated by the IMF to be between 4% and 4.5% over the medium term) are unlikely to be enough to quickly reverse even the recent sharp cyclical increase in unemployment, and even less make inroads into reducing the high level of structural unemployment. The Fund suggest that really tackling this problem would require growth rates in the 6% range.

South Africa’s growth potential cannot be unleashed without tapping into the large reservoir of unemployed. The severity of the unemployment problem calls for bolder action to enhance the efficiency of both the labour and the product markets, and a very strong case can be made for undertaking these reforms now during the business cycle upswing, at a time when profitability is improving and more jobs can be created.

Towards An Unorthodox Orthodoxy?

At the same time, South Africa cannot build a sustainable economy without attracting far more inward investment to build up its manufacturing base. At the present time the country's current account deficit (which definitely needs reducing) is being financed by short term fund inflows into the debt and equity markets (and not the much desired longer term FDI). This again makes funding the deficit vulnerable to shifts in global risk sentiment, and even to that dreaded European Sovereign Debt Crisis (yet another example of global linkages).

At the end of the day the two parts of the problem go hand in hand, and in order to get sustainable employment growth solutions must be found in South Africa, as in many Emerging Markets, to the problem of unsustainable currency increases resulting from the excess liquidity being exported from the heavily endebted developed economies. In this battle, new and previously unthinkable policy measures will be deployed (see the Turkish case here). Indeed, only last week Caroline Atkinson, Director of the External Relations Department at the IMF, indicated that the Fund didn't even exclude capital controls from the armoury of possible macro-prudential measures. Ten years ago such views would have been the next best thing to heresy.

What I’m trying to suggest is that the range of measures that countries may take, some of which are particularly focused on the way that capital comes into the countries, on whether it should be taxed if it comes in on a short-term basis, and some are particularly focused on well, if a bank gets capital, an inflow of foreign exchange, should it have higher reserve requirements so that it’s in a better position to pay that capital back if it needs to go. So these are all a part of the toolbox of measures, and some people always said capital controls, macro-prudential controls, there’s kind of a fine line between them. I don’t think that really matters. I think the point is to see what the purposes of the measures are. Are they going to strengthen the economies? Are they going to lead to good use of the capital and stronger and sustainable growth going forward? That’s more important than the nomenclature.
Monetary policy in a globalised world is no longer a single country matter, and a more creative and demanding toolkit is needed to swim in the ocean of global liquidity which surrounds us all today. As Caroline Atkinson says, the question we should be asking ourselves is not whether such measures are "unorthodox" or not. The question we need to ask is rather, are they going to strengthen the economy concerned, are they going to lead to sustainable employment creation, are they going to minimise the level of structual distortion an Emerging Economy suffers as a result of near zero interest rate policies in the developed world, and above all, are they going to work?

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