Hawkish Hold From South African Reserve Bank Likely as Political Risks Rise

The South African Reserve Bank meets Thursday.  The firmer rand should give it leeway to keep rates steady, as the economy remains sluggish.  With the government pushing ahead with controversial land reform, political risks should rise ahead of next year’s election.

POLITICAL OUTLOOK

At its December party conference, the ANC announced that it would pursue a land reform policy of expropriation without compensation.  President Ramaphosa said it was urgently needed, but stressed that any reforms must not harm the economy.  Lawmakers have already started the process for making the necessary changes to the constitution.

Why now?  Senior ANC official Zweli Mkhize said that doing it too soon after the end of apartheid would have hurt investor confidence, but warned that waiting too long now could stoke unrest as unemployment and income inequality remain high.  Whites reportedly still own almost 75% of the nation’s agricultural land.  Whilst down from 87% during apartheid, this share remains very high given that whites make up less than 10% of the total population.

Pursuing land reform is a potentially risky move ahead of elections next year.  There is no date in set yet, but they will be held in Q2 2019.  Post-apartheid elections have been held in April (1994, 2004, and 2009), May (2014), and June (1999).

The ruling ANC has seen its share of the popular vote fall in every election since 2004.  The ANC only got 54% of the vote in the 2016 municipal elections, a record low and down from 62% at the last national election in 2014.  Since seats are awarded proportionally to the popular vote, a sub-50% showing next year would be a disaster for the ANC, to state the obvious.

Recent polls suggest the ANC’s popularity has rebounded after Ramaphosa replaced Zuma as its leader.  Ipsos poll conducted this April-June shows 60% would vote for the ANC.  13% would back the Democratic Alliance and 7% would back the Economic Freedom Fighters.  Still, a lot can happen between now and next spring. 

A BRIEF HISTORY LESSON

Neighboring Zimbabwe (formerly Rhodesia) has also struggled with the issue of land reform.  Like South Africa, generations of white minority rule in Rhodesia had led to growing income inequality that black majority rule wanted to reverse upon independence in 1980.

In the late 1800s, territory north of the Transvaal River was chartered to the British South Africa Company (BSAC) led by Cecil Rhodes.  Rhodes and his private army seized control of an even greater area, which eventually evolved into the British colony of Southern Rhodesia.  BSAC‘s charter was revoked in 1923 and Southern Rhodesia was given a measure of self-government.

The colonial government in Southern Rhodesia eventually divided the country into five farming regions that corresponded roughly to rainfall patterns.  Land ownership in these regions was determined by race under the Southern Rhodesian Land Apportionment Act that was passed in 1930, which reserved Regions I, II, and III for white settlement.  As those regions generally received higher rainfall, this division was considered unfairly favorable to the whites.

Growing inequality fed into rising support for black nationalist movements Zimbabwe African National Union (ZANU) and Zimbabwe African People’s Union (ZAPU).  Both fought to overthrow white minority rule in what became known as the Rhodesian Bush War (1964-1979).  Land reform was such a huge issue that it was a critical part of the Lancaster House talks, which were held to end the war.

Both ZANU leader Robert Mugabe and ZAPU leader Joshua Nkomo insisted on land redistribution as a prerequisite to a peace.  When Southern Rhodesia became the republic of Zimbabwe in April 1980, incoming President Mugabe signed the Lancaster House Agreement, which sought to redistribute land more equitably between the black subsistence farmers and the landed white colonial elite.  This agreement required a so-called “willing seller, willing buyer” for at least ten years.  This meant any land redistribution would be done by mutual consent, not by expropriation.

Yet this initial policy was considered a failure, as only 3 mln hectares of land were acquired for black settlement vs. 8 mln targeted.  After the mandated ten years ended, President Mugabe pushed through the Zimbabwean Land Acquisition Act in 1992.  This allowed the government to acquire any land that it saw fit but with some financial compensation given.

Mugabe later doubled down, attempting to pass a new constitution that would allow the government to seize any land without compensation.  However, this was defeated 55-45%.  In the following days, pro-Mugabe veterans of the Rhodesian Bush War began to seize land violently under the so-called “Fast-Track Land Reform Program,” forcing white farm owners out as well as their black workers.  Many were killed.

Ultimately, Mugabe’s land reform had huge negative consequences.  In Rhodesia, land reform led to a collapse in tobacco production, Zimbabwe’s main agricultural export at that time.  Zimbabwe was the world’s sixth-largest producer of tobacco in 2001; by 2005, it produced less than a third of the amount produced in 2000.  Before land reform, Zimbabwe exported agricultural goods to its neighbors; after, it could no longer feed itself.

Part of the problem was scale.  White-owned commercial farms were relatively large and enjoyed economies of scale.  After these farms were seized, they generally became small-scale and/or family run operations.  Many also complained of lack of access to basic farming needs such as seeds and fertilizers.

Yet the failure of land reform in Zimbabwe was due in large part to corruption and mismanagement.  Redistribution was highly politicized, and it was reported that Mugabe had given himself 15 farms.  Others in his inner circle were also thought to have benefited from the redistribution, with reports suggesting ownership of multiple farms for those connected with Mugabe.

Zimbabwe provides a stark example of why it is so important for South Africa to do it correctly.  It would seem that South Africa feels that a voluntary, compensated solution did not work in Zimbabwe, and so is bypassing it for an expropriation-based model of reform.  As Zimbabwe clearly illustrates, this strategy is fraught with dangers.

ECONOMIC OUTLOOK

The South African economy remains sluggish.  GDP growth is forecast by the IMF at 1.5% in 2018 and 1.7% in 2019 vs. 1.3% in 2017.  GDP rose only 0.8% y/y in Q1, down from 1.5% peak in Q4 and the weakest since Q2 2016.  In annualized terms, the outlook is even worse as GDP contracted -2.2%, the worst since Q1 2009 amidst the Great Financial Crisis.  As such, we see downside risks to the growth forecasts.

Price pressures are low but rising.  CPI rose 4.6% y/y in June, the highest since December and back in the upper half of the 3-6% target range.  PPI rose 4.6% y/y in May, the highest since January, with June data out next week.  Note that state workers won a three-year wage deal with raises of 6-7% for the current fiscal year.  All the signs are pointing to higher inflation ahead.

The South African Reserve Bank (SARB) started an easing cycle last July with a 25 bp cut to 6.75%.  Heightened political risk forced the bank to remain on hold until March, when it followed up with another 25 bp cut to the current 6.5%.  Next policy meeting will be held Thursday, and we expect a hawkish hold due to rising inflation risks as well as the still-vulnerable rand.  We believe the easing cycle has ended.

The fiscal outlook bears watching.  While returning Finance Minister Nene has prioritized fiscal tightening, slow economic growth has taken a toll on revenues.  Surprisingly, expenditures have been kept largely under control despite the multiple changes at the Finance Ministry.  However, with the election looming ahead, we will be watching spending carefully.

The external accounts are worsening.  The current account deficit was -2.9% of GDP in 2017, and the IMF expects the deficit to remain steady this year and widen modestly to -3.1% in 2019.  However, export growth has been slowing noticeably this year, leading the trade surplus to narrow.  The current account gap widened to -4.8% of GDP in Q1 while data so far in Q2 suggests further deterioration.  This points to big upside risks to the forecasts.

Foreign reserves have risen to record highs but vulnerabilities remain.  At $50.6 bln (down from the all-time high of $51.1 bln in May), reserves cover over 5 months of imports but are only equal to around 90% of its the stock of short-term external debt.  Thus, the country remains vulnerable to shifts in sentiment and so-called hot money.  Indeed, FDI slumped to $1.3 bln in 2017, the lowest in eleven years.

INVESTMENT OUTLOOK

The rand is underperforming after a stellar 2017.  In 2017, ZAR rose 10% vs. USD and was behind only the best EM performers KRW (13%), MYR (11%), and THB (10%).  So far in 2018, ZAR is -7% and is ahead of only the worst performers ARS (-33%), TRY (-21%), BRL (-14%), and RUB (-9%).  Our EM FX model shows the rand to have WEAK fundamentals, and so we expect this underperformance to continue.

USD/ZAR was trading at its lowest levels since June 14 on Monday but has since moved higher.  Using the February-June rise in USD/ZAR, the major retracement objectives come in near 13.0465 (38%), 12.7525 (50%), and 12.4590 (62%).  The 200-day moving average comes in near 12.76 currently.  USD/ZAR made a stab at 14 last month and failed.  As we remain negative on EM as a whole, we think the pair will eventually test the November high near 14.5740.  That would then suggest a test of the May 2016 high near 15.9825.

South African equities continue to underperform.  In 2017, MSCI South Africa was up 19% vs. 34% for MSCI EM.  So far this year, MSCI South Africa is -8.5% YTD and compares to -7.5% YTD for MSCI EM.  Our EM Equity Allocation Model puts South Africa at VERY UNDERWEIGHT, and so we expect South African equities to continue underperforming.

South African bonds have held up well.  The yield on 10-year local currency government bonds is +10 bp YTD.  This is behind only the best performers China (-39 bp), Taiwan (-24 bp), Poland (-18 bp), Korea (+4 bp), and Mexico (+8 bp).  With inflation likely to move higher and the central bank taking a more hawkish stance as a result, we think South African bonds will start underperforming.

Moody’s recently noted that ongoing uncertainty regarding land expropriation without compensation is limiting investment near-term.  Indeed, the agency warned that this could lead to a more pronounced long-term drop if the final terms are onerous for businesses.  The IMF made a similar warning last month after completing its annual Article IV consultation.

Our own sovereign ratings model shows South Africa’s implied rating steady at BB/Ba2/BB after rising a notch last quarter.  We still believe Moody’s and Fitch’s ratings of Baa3 and BB+, respectively, are facing continued downgrade risk.  S&P’s BB rating appears to be on target.  Moody’s just affirmed its rating in March but inexplicably moved the outlook from negative to stable.

Data from the National Treasury show foreigners hold nearly 45% of South African government debt.  This is up from only 10% ten years ago, and illustrates the country’s heavy reliance on external financing.  Moody’s rating is very important, as the loss of investment grade would likely lead to forced selling of South African bonds.  Bloomberg data shows foreigners bought a net ZAR1 bln of South African bonds last week, ending an 11-week streak of outflows.