South Africa Mid-Term Budget Preview

New Finance Minister Tito Mboweni will present his mid-term budget review this Wednesday. We think he will do just enough for the agencies to give him the benefit of the doubt until his next budget statement in early 2019. Longer-term, we see more downgrades and loss of investment grade from Moody’s.

POLITICAL OUTLOOK

Tito Mboweni inherits an impossible task. With sluggish growth hurting revenues, he must somehow prevent the deficit from blowing out without tightening too much and hurting the ANC’s chances in next year’s elections. Oh, and he also must tighten enough to convince the ratings agencies not to downgrade South Africa again. Unemployment remains stubbornly high at 27.2% in Q2 even as unions have won some significant wage concessions.

We expect Mboweni to cut growth forecasts, reversing the more upbeat forecasts delivered in the February budget statement. We believe enough fiscal tightening will be announced to keep the current FY2018/19 budget deficit target of -3.6% of GDP within reach, but the government will likely have to acknowledge a higher deficit path for FY2019/20 and FY2020/21. That means the debt/GDP ratios will also have to be adjusted upwards.

The government announced last month that it will redirect ZAR50 bln of spending as part of a plan to boost growth and create jobs. The plan will focus on developing new infrastructure, with ZAR400 bln to be spent over the next three fiscal years. However, the measures are meant to be neutral for the deficit. Details of which areas will see spending cuts will be announced in this mid-term budget.

Meanwhile, the ongoing corruption probe inches along. This judicial commission was set up two years ago to probe so-called “state capture” during the Zuma administration. The so-called Zondo commission (led by Deputy Chief Justice Raymond Zondo) was initially given six months to complete its findings. However, public hearings only begin in August after the commission was able to secure an extension.

Corruption will remain one of the country’s biggest challenges. South Africa scores low in the World Bank’s Ease of Doing Business rankings (82 out of 190 and down from 74 in 2017 and 72 in 2016). The worst components are starting a business and trading across borders, while the best are protecting minority investors and paying taxes. It does only slightly better in Transparency International’s Corruption Perceptions Index (71 out of 176 and tied with Bulgaria and Vanuatu).

 

A BRIEF HISTORY LESSON

New Finance Minister Tito Mboweni is no stranger to public service. Mboweni served as Governor of the South African Reserve bank for two terms from August 1999 to November 2009. He was the first black South African to hold the post, taking over from Chris Stals. Stals was already tipped to become Governor in November 1989 but took over in August 1989 after his predecessor Gerhard de Kock died in office. Stals oversaw the transition from apartheid to democracy, serving as SARB Governor until 1999.

During Mboweni’s tenure at SARB, inflation averaged 5.4% while GDP growth averaged 3.6%. Since he stepped down, inflation has averaged 5.4% while GDP growth has averaged 1.9%. He was tested earlier in his tenure, when the rand came under immense pressure in late 2001. Back then, concerns about a global recession after the 9/11 attacks drove many EM currencies down, especially those linked to commodity prices. Over the course of 2001, ZAR weakened by nearly 50%.

As a result, inflation spiked to 13% y/y over the course of 2002. Mboweni hiked rates from 9.5% in late 2001 to 13.5% in 2002. Rates were eventually cut in H2 2003, and the economy did not fall into recession during this turbulent period.

Mboweni is the fifth Finance Minister in less than three years. Recall the fiasco back in December 2015, when Nhlanhla Nene was replaced by the little-known David van Rooyen. Former Finance Minister Pravin Gordhan was brought back after four days as markets revolted. Gordhan was previously Finance Minister from 2009-2014.

Gordhan served from December 2015 until March 2017. He was replaced by Malusi Gigaba, who served until the return of Nene in February 2018 after Zuma resigned and Ramaphosa took over. Nene was well-respected by the markets. However, his position became untenable after revelations that he misled investigators about his private meetings with the Gupta family.

 

ECONOMIC OUTLOOK

Growth forecasts have been marked down recently. GDP growth is forecast by the IMF at 0.8% in 2018 vs. 1.5% previously and at 1.4% in 2019 vs. 1.7% previously. GDP grew 1.3% in 2017. GDP rose only 0.4% y/y in Q2, down from the 1.6% peak in Q3 and the weakest since Q1 2016. In annualized terms, the outlook is even worse as GDP contracted -0.7% in Q1 after -2.2% in Q1, which was the worst since Q1 2009 amidst the Great Financial Crisis.

Note that the government tweaked its growth forecasts upwards in the February budget statement. GDP growth was seen at 1.5% this year, 1.8% next year, and 2.1% in 2020. We see downside risks to the growth forecasts, and the government will most likely have to downgrade its growth forecasts in the mid-term statement to basically mirror the IMF’s assessment.

Price pressures are rising. CPI rose 4.9% y/y in August, down slightly from 5.1% in July, the highest since September 2017. September CPI will be reported Wednesday and is seen steady at 4.9%. PPI rose 6.3% y/y in August, the highest since December 2016. As such, price pressures are likely to continue rising.

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 this March, when it followed up with another 25 bp cut to the current 6.5%. It has been on hold since. SARB delivered a hawkish hold last month, with three MPC members voting for a 25 bp hike.

Next policy meeting will be held November 22. A lot can still happen between now and then. The economy is very weak and so we don’t think there is much appetite to hike if they can avoid it. However, the market may force its hand by keeping the rand under pressure. It won’t take much to swing the MPC towards a hike, in our view.

Fiscal tightening was announced in the first budget under President Ramaphosa back in February. Key takeaways from that budget statement: 1) VAT was raised one percentage point to 15%, 2) other measures taken to raise income and estate taxes, 3) spending was cut ZAR85 bln over next three years, 4) growth forecasts were raised modestly, and 5) the deficit forecast for FY2018/19 was cut to -3.6% of GDP from -3.9% previously.

The IMF is less optimistic. In its Article IV report back in July, the agency forecast the FY2018/19 deficit at -4.0% of GDP and -3.9% in FY2019/20. This was based on growth forecasts of 1.5% and 1.7% in 2018 and 2019, respectively. The IMF has since cut its growth forecasts to 0.8% and 1.4%, respectively, which should lead to wider budget deficits.

Mboweni has already been bemoaning the high state wage bill. Note that state workers just won a three-year wage deal with raises of 6-7% for the current fiscal year.  Wages would also rise one percentage point more than inflation for the following two fiscal years.

The external accounts are likely to worsen. The current account deficit was -2.9% of GDP in 2017, and the IMF expects the deficit to widen to -3.2% this year and -3.5% in 2019. Export growth has been slowing noticeably this year, leading the trade surplus to narrow. The current account gap widened to -4.6% of GDP in Q1 and -3.3% in Q2, suggesting upside risks to the forecasts.

Foreign reserves remain near the record high, but vulnerabilities remain. At $50.4 bln in September, they 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 is vulnerable to shifts in sentiment and so-called hot money. Indeed, FDI slumped to $1.3 bln in 2017, the lowest in eleven years. One mitigating factor is South Africa’s Net International Investment Position (NIIP), which remains positive at around 8% of GDP.

 

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 -13% and is ahead of only the worst performers ARS (-49%) and TRY (-33%). Our EM FX model shows the rand to have WEAK fundamentals, and so we expect this underperformance to continue.

Back in September, USD/ZAR traded at a cycle high near 15.70. That was the highest level since June 2016, but the pair has since fallen back a bit. Using the big 2016-2018 drop in USD/ZAR, the major retracement objectives come in near 14.7125 (50%) and 15.4685 (62%). Break above that September high is needed to set up a test of the January 2016 high near 17.9170.

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 -16.5% YTD and compares to -15% 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 are around the middle of the EM pack. The yield on 10-year local currency government bonds is +58 bp YTD. This compares to the worst EM performers Turkey (+693 bp) and Argentina (+530 bp), as well as the best performers China (-30 bp) and Korea (-13 bp). With the weak rand likely to feed into higher inflation and the central bank likely forced to hike rates, we think South African bonds will underperform more near-term.

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 seeing continued downgrade risk. S&P’s BB rating appears to be on target. However, the agencies are likely to give Mboweni the benefit of the doubt until his next budget statement in early 2019. Moody’s just affirmed its rating in March but inexplicably moved the outlook from negative to stable. Moody’s rating is very important, as the loss of investment grade would likely lead to forced selling of South African bonds.