South African Reserve Bank on Hold Ahead of Spring Elections

The South African Reserve Bank meets tomorrow and is widely expected to keep rates steady at 6.75%. The recent release of the ANC’s election manifesto suggests a modification of the central bank’s mandate, which we think would be a mistake. Longer-term, we see more downgrades and loss of investment grade from Moody’s.

 POLITICAL OUTLOOK

Elections will be held this spring. All 400 seats in parliament will be contested. In turn, parliament will elect the next president. There is no date set yet, but they will likely be held in Q2 2019. Post-apartheid elections have been held in April (1994, 2004, and 2009), May (2014), and June (1999).

Recent polls suggest the ANC’s popularity has rebounded after Ramaphosa replaced Zuma as its leader last year. The latest Ipsos poll suggests 61% would vote for the ANC. 14% would back the Democratic Alliance (DA), 9% would back the Economic Freedom Fighters (EFF), and 2% would back the Inkatha Freedom Party (IFP). Still, a lot can happen between now and the spring.

The 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 61% showing this year would be very positive for the ANC, to state the obvious.

There are two controversial points in the ANC’s election manifesto worth mentioning. One is land reform, which we shall address in another research piece. Simply put, pushing ahead with land reform will likely secure a greater share of the black vote, which has been drifting to the opposition in recent years. On the other hand, it will likely spook businesses and hurt investment.

The other is a possible change to the South African Reserve Bank’s mandate. In its manifesto, the ANC states that SARB’s monetary policy should also “take into account other objectives such as employment creation and economic growth.” While the Fed functions with a dual mandate, we think a change in the SARB’s mandate would be very unsettling for investors. Simply put, it is one of the only institutions in the nation that is impeccably clean and free of political interference.

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

The South African Reserve Bank was created in 1921 by the Currency and Banking Act of 1920. It is the oldest central bank in Africa and was only the fourth one to be established outside of the UK and Europe.

The central bank is privately owned with 2 mln shares issued. No single shareholder may own more than 10,000 shares. According to the latest shareholders report from August 2018, there were 696 total shareholders. Total dividends are limited to ZAR200,000, with any remaining profits paid to the South Africa government. Note that shareholders have no say whatsoever in SARB policies. Admittedly, this is a very unusual arrangement for a central bank, but it has worked for almost 100 years.

It appears that the ANC has backed off its push to nationalize the SARB, at least for now. Just like changing the bank’s mandate, tinkering with the SARB’s ownership structure would also likely spook foreign investors.

The SARB’s independence is enshrined in the 1996 Constitution. Section 224 holds that “the Bank, in pursuit of its primary object, must perform its functions independently and without fear, favour or prejudice, but there must be regular consultation between the Bank and the Cabinet member responsible for national financial matters.”

Beginning February 2000, South Africa formally introduced inflation targeting. Between 1960-1998, the SARB had a variety of targets, including the exchange rate and monetary aggregates at one time or another. Initially, the inflation target was set for so-called CPIX, which was a CPI basket that stripped out the interest cost of mortgages. This was later changed. Since February 2009, the target range for headline inflation has been 3-6%.

 

ECONOMIC OUTLOOK

Growth remains sluggish. GDP growth is forecast by the IMF at 1.4% in 2019 and 1.8% in 2020 vs. an estimated 0.8% in 2018. GDP rose 1.1% y/y in Q3, rebounding from the 0.4% trough in Q2. In annualized terms, GDP grew 2.2% in Q3 after two straight quarters of contraction. Given both domestic and global trends, we see downside risks to the growth forecasts. Lastly, unemployment remains near record highs at 27.5% in Q3 2018.

Price pressures are rising. CPI rose 5.2% y/y in November, the highest since May 2017 but still within the 3-6% target range. December CPI will be reported next Wednesday. PPI rose 6.8% y/y in November, just a tick lower than the cycle high of 6.9% y/y in October. As such, price pressures are likely to continue rising.

The South African Reserve Bank (SARB) started a tightening cycle in November with a 25 bp hike to 6.75%. This ended a very shallow easing cycle that took the policy rate from 7.0% in mid-2017 to 6.5% in early 2018. This is not a one and done hike, but we suspect the bank will take a very cautious approach to tightening.

Next policy meeting will be held tomorrow and the SARB is widely expected to keep rates steady at 6.75%. The economy is very weak and so we don’t think there is much appetite to hike this year if they can avoid it. However, the market may eventually force its hand by putting more pressure on the rand. The next meetings after tomorrow are March 28 and May 23.

Due to the elections, we see risks that fiscal tightening will be further delayed in the FY2019/20 budget statement on February 20. In his midterm budget review in October, Finance Minister Mboweni painted a grim fiscal outlook. The FY2018/19 budget deficit was revised to -4% of GDP and forecast to widen to -4.2% in FY2019/20 before narrowing back to -4% in FY2021/22. If this trajectory is not improved in the February 20 statement, we think downgrades become more likely.

The external accounts are likely to worsen. The current account deficit was an estimated -3.2% of GDP in 2018, and the IMF expects the deficit to widen to -3.5% this year before narrowing to -3.3% in 2020. Export growth slowed noticeably last year, leading the trade surplus to narrow sharply. The 12-month total is almost in deficit, something we haven’t seen since late 2016. The current account gap was -3.4% of GDP in Q2 and -3.5% in Q3, suggesting upside risks to the forecasts.

Foreign reserves are at record highs, but vulnerabilities remain. At $51.6 bln in December, they cover nearly 5 months of imports but are only equal to around 95% of the stock of short-term external debt. Thus, the country is vulnerable to shifts in sentiment and so-called hot money. One mitigating factor is South Africa’s Net International Investment Position (NIIP), which has risen to an all-time high near 14% GDP.

 

INVESTMENT OUTLOOK

The rand is outperforming after a poor 2018. In 2018, ZAR fell -14% vs. USD and was ahead of only the worst EM performers ARS (-51%), TRY (-28%), RYB (-17%), and BRL (-15%). So far in 2019, ZAR is up almost 5% and is behind the best performer RUB (5.1%). Our EM FX model shows the rand to have WEAK fundamentals, and so we expect this outperformance to ebb.

USD/ZAR is trading at its lowest level since early December. That month’s low near 13.5420 is approaching. Before that, the pair first must make a clean break below the 200-day moving average near 13.7655. Looking further out, charts point to a test of the July 31 low near 13.0810. Much will depend on the external backdrop.

South African equities continue to outperform. In 2018, MSCI South Africa was -15.5% vs. -17.5% for MSCI EM. So far this year, MSCI South Africa is up 5.5% YTD and compares to 6% YTD for MSCI EM. Our EM Equity Allocation Model puts South Africa at VERY UNDERWEIGHT, and so we expect South African equities to start underperforming more.

South African bonds are outperforming. The yield on 10-year local currency government bonds is -16 bp YTD. This is behind only the best EM performers Argentina (-202 bp), Turkey (-47 bp), Russia (-45 bp), Chile (-33 bp), and Hungary (-23 bp). With inflation expected to continue rising and the central bank likely forced to hike rates again this year, we think South African bonds will underperform ahead.

Our own sovereign ratings model shows South Africa’s implied rating steady at BB/Ba2/BB. 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. The agencies are giving Mboweni the benefit of the doubt until his next budget statement this February.

After the October midterm budget review, Moody’s stated that the weaker fiscal outlook was credit-negative. The agency wrote then that “The revenue assumptions underpinning the medium-term fiscal projections are achievable, but the broadly unchanged spending ceilings will be challenging to meet as the government aims to strike a balance between economic, social, and fiscal objectives.” Moody’s rating is very important, as the loss of investment grade would likely lead to forced selling of South African bonds.