Amid capital outflows reminiscent of the 2008-09 financial crisis in early Q2 due to the outbreak of Covid-19, the South African rand hit a record low of 19.3540 against the dollar in early April. While the rand has recovered over 13% from its April low, it still remains over 5% weaker than the pre-virus levels seen in February.
USDZAR currently sits near its post-pandemic low of 16.3390, but this is predominantly due to broad USD weakness and stabilisation in global conditions. The recovery isn’t necessarily reflective of a recovery in economic fundamentals.
On a fundamental basis, South Africa’s economy suffered a substantial blow from the virus, and with officials still struggling to contain the domestic outbreak, we believe the domestic economy will be one of the laggards in the global recovery.
This is at odds with the SARBs relatively optimistic forecasts for GDP in 2021 and 2022, and more in line with the National Treasury’s. With deep structural scarring and the recovery only delayed with the continued imposition of stage 3 lockdown measures, we believe USDZAR may have established a new, weaker, medium-term range. The rand has tested the 16.33 level multiple times since June, failing to break on each occurrence. With the economic outlook bleak and investors refusing to pick up South Africa’s attractive yield in a low yielding environment, the low 16 level may provide a floor for the pair. On top of the bleak economic outlook and the continuing domestic outbreak in South Africa, constrained fiscal policy and the steepness of the SAGB curve means we maintain our marginally bearish forecast of 17.00 for Q3. However, with the recovery set to take place in 21H1 we have lowered our USDZAR forecasts to reflect the return of favourable carry conditions, allowing the rand to recover towards pre-pandemic levels of 15.6.
Figures in parentheses reflect previous forecasts
ECONOMIC OUTLOOK REMAINS BLEAK AS SOUTH AFRICA REMAINS IN LEVEL 3 LOCKDOWN
We must first address the economic impact Covid-19 has had on the South African economy to give context for the effectiveness of the fiscal measures, SARB rate cuts and why the SAGB curve remains extraordinarily steep. South Africa’s economy, as measured by the Oxford University stringency index, continues to have a relatively tight containment policy in place. After easing measures temporarily, the spike in new cases forced South African officials to tighten lockdown measures at the margin. A return to stage four or five lockdown was discussed but deemed too economically damaging. However, the recent spike in cases has led to the prohibition of alcohol sales for the second time since the pandemic struck, a national curfew between the hours of 21:00 and 04:00, restrictions on social gatherings including meeting family members, and wide scale school closures. In addition to this, domestic and international travel is also heavily restricted. With this in mind, the economic toll continues to stack up. The length of the serious stage of the outbreak, which is hampering a broader re-opening of the economy, will not only weigh on growth this year but also sentiment going forward, muting the economic rebound once the virus is effectively contained.
The explosive outbreak in South Africa has led to stringent lockdown measures remaining in place for longer, with stage 3 being re-implemented along with school closures
Source: University of Oxford, Blavatnik School of Government
The loosening of containment measures still seems like a distant prospect at the moment. South Africa currently has the fifth largest number of total cases and rises in the ranks once adjusted for population size. New cases, as shown below, remain elevated, while the high positive test rate suggests that the official new case data underreports the true level of the outbreak. The average new cases per million has risen above 200 over the last two weeks, with the peak of the domestic outbreak expected in the coming days. Additionally, mortality rates in South Africa are now the highest in the CEEMEA region, highlighting the extensive nature of the outbreak and the strain on healthcare infrastructure.
7-day rolling average of new cases per million people highlights how South Africa continues to struggle containing its domestic outbreak, while the positive test rate suggests that the number of true new cases is like underreported by the headline data
Source: Our World in Data, European CDC – Situation Update Worldwide
At the latest SARB meeting, the central bank lowered its GDP estimate for this year from -7.0% to -7.3%, reflecting the impact of prolonged level 3 lockdown measures, while also downgrading its estimates for 2021 and 2022 by 0.1 percentage point to 3.7% and 2.8% respectively. This remains optimistic relative to the National Treasury’s estimates, which as of the supplementary budget release in June projected a 7.2% contraction in 2020 and a more muted rebound of 2.6% and 1.5% in 2021 and 2022.
Given the rapid pace of the domestic outbreak and trend seen globally of targeted containment measures in response to localised outbreaks, along with the scarring inflicted on both the labour market and household finances explained below, we are inclined to agree with the National Treasuries more pessimistic growth outlook.
Additional notes on the state of South Africa’s economy:
- While the effects of the pandemic on South Africa’s labour market are still unknown, with the Q2 unemployment rate released on the 11th August, data from the NIDS-CRAM study analysed by Jain et al 2020 provides a good estimate. The study conducted by the Centre for the Study of African Economies using the NIDS-CRAM data provides the first estimates of the impact Covid-19 had on employment. It estimates a 40% decline in active employment, half of which consisted of respondents who didn’t expect to return to the same job, with a third of job loses having no access to any major source of social protection. The study finds that only 20% of those workers moving from employment to temporary unemployment or paid leave between February and April received payouts from the Temporary Employee/ Employer Relief Scheme (TERS). While the study is substantially lagged, released in May but surveying data as recent as April, it provides a good first estimate of the level of scarring inflicted on the labour market.
- A more recent survey, conducted and released by StatsSA between 29th April and 6th May, suggests 89.5% of survey respondents remained employed during lockdown, however, with an 8.1% rise in unemployment and business closures. Of the survey group, only 67.5% of the respondents reported income levels stayed the same. While this survey contained a smaller sample size with more recent sampling dates, it arguably underestimates the true economic damage inflicted by the pandemic. Although the true level of damage caused won’t be known until the official Q2 unemployment data is released in August, some general arguments can be drawn from the studies. Firstly, the government’s TERS scheme was vastly undersubscribed, leading to a loss of income for many workers place in furlough or reduced work hours. Secondly, social assistance measures introduced in May were expanded too late and also didn’t provide wide enough coverage. Taken together, the loss of income and employment is likely to be substantial and weigh on the economic recovery.
- Other government provisions such as the ZAR200bn loan guarantee scheme have had limited effects. The loan guarantee scheme previously had poor uptake, with only ZAR12bn distributed as of the last release, leading to the conditions being widened. However, businesses most in need of support are likely to have already closed. Over the weekend, the government was in talks with non-bank lenders to join its guarantee scheme, with conditions for businesses loosened. The interest and capital repayment holiday was increased from 3 to 6 months, the revenue cap was scrapped and replaced with a maximum loan amount of ZAR100m, and the credit assessment period was pushed back to December 2019 instead of February 29th to adjust for the Q1 economic strain on business finances. This further highlights the limited uptake of the programme, adding to the reasons why our growth outlook is less optimistic than the SARB’s and consensus.
- The South African current account recorded its first surplus in Q1 2020 since 2003. The balance of ZAR70bn (1.3% of GDP) was driven by a combination of suppressed import demand, improved terms of trade and less drag from the primary income balance. We expect this dynamic to continue as the extended contraction of South Africa’s economy is likely to weigh on imports more than the global contraction has on exports, while the depreciation in the rand has improved the competitiveness of South African exports. The primary income balance is likely to have improved as well as payments to foreign investor’s declines further.
- The ABSA PMI readings above 50 shouldn’t be misinterpreted. The surveying company themselves reiterated this in their June report, stating that the multi-year high in the headline PMI reading shouldn’t be interpreted as an increase in actual output YoY. It merely means that output increased strongly from the month prior, which is expected given the relaxation of lockdown measures from June 1st, allowing production and retail outlets to re-open. One positive, however, is the increase in the new-sales orders sub-index from 41.2 to 60.3. This shouldn’t be understated and highlights the release of pent up demand, whereas the theme globally has been muted new orders while PMIs have been supported by firms working through backlogs of orders and rebuilding inventories.
- South Africa retail sales halved in April reflecting the impact of lockdown measures, with retail sales growth also printing in negative territory at -12% YoY in May. Essential product services remained in negative territory in May as footfall remained lower than average, while specialized food, beverages and tobacco stores were down 29% in May, reflecting partly the shifting prohibition policies on these products. We expect retail sales to remain in negative territory for the next few months, reflecting both the extended lockdown measures and deteriorating household financial positions.
FISCAL POLICY CONSTRAINED WITH LIMITED NEW SPENDING ANNOUNCED IN THE SUPPLEMENTARY BUDGET
While the details of the Treasury’s active fiscal approach were largely left for the October budget, the stimulus measures announced in the supplementary budget highlighted the limited fiscal firepower the government had. While the ambitious debt consolidation effort hinges on more realistic growth levels, there is limited room under the current trajectories for fiscal policy to fill any shortcomings of the economic recovery. The ZAR776bn of financing that is required this year, up from the ZAR344.2bn announced in February’s medium-term budget proposal, is driven largely by a revenue shortfall of ZAR304bn.
On the stimulus side, of the ZAR145bn redirected towards Covid response efforts, only ZAR36bn is additional fiscal spending. The remaining ZAR145bn is redirected from other areas of the budget previously.
In conjunction with debt projected to peak below 90% in FY2023 under the active scenario, which is based on an effective spending freeze in the coming years along with a ZAR40bn tax increase by FY2024, this highlights how limited fiscal policy is in driving the economic recovery. With structural issues still needed to be addressed, namely in the form of State Owned Entities such as Eskom, the room for error is slim.
The recent news of the US$4.3bn loan being approved from the IMF comes as welcome news to the Ramaphosa government.
Although the loan respects South Africa’s decisions on how best to provide economic relief, the IMF’s first deputy managing Director states that “there is pressing need to strengthen economic fundamentals and ensure debt sustainability by carrying out fiscal consolidation and structural reforms”. The low interest loan should provide authorities with a bit more breathing room to help ignite growth, but given the likely structural damage to the economy, we believe this merely reinforces the Treasury’s latest projections as opposed to providing upside risks to their GDP forecasts prior to the IMF loan.
Active scenario means austerity measures are due in South Africa in the coming years, limiting the economic rebound
Source: South African National Treasury
SARB EASING CYCLE SLOWING BUT 25BPS STILL SCHEDULED FOR 2020, LIKELY IN NOVEMBER’S MEETING
The latest decision by the South African Reserve Bank to cut the repo rate by another 25bps rounds off 175bps of monetary easing since the imposition of lockdown measures on March 24th, bringing the key rate to its lowest level since its introduction in 1998. At 3.5%, real rates still sit in positive territory as inflation has fallen below the central banks 3-6% target range. Despite this, we expect the SARB to take a breather at their next meeting in September, opting to reduce rates by a further 25bps in November in response to the economic damage being more visible in the underlying data. We take this stance for two reasons:
- The SARB’s voting history has shown increasing resistance to cutting rates as aggressively as previous meetings. At the July meeting, members vote 3-2 for a 25bps reduction as opposed to holding rates, similar to the May meeting where members voted 3-2 for a 50bps reduction as opposed to a lesser 25bps cut. Given the tone of the central bank’s external communications, we expect the SARB to favour holding rates at 3.5% for now to allow the previous rate cuts to filter through to the economy. The transmission of previous cuts has been restricted somewhat by the lockdown measures. We believe the latest 25bps of easing was in response to the collapse in inflation pressures and believe the SARB may have opted to hold rates in July if inflation remained in the target range. This is due to the MPC’s latest shift towards Brainard conservatism. With the 25bps cut now implemented, however, the SARB’s repo rate sits at the central banks current modelled rate of 3.48% for 2020.
- Although we believe that the central bank is likely to hold rates at its next meeting in September, deteriorating economic fundamentals, predominantly a widening output gap, means inflationary pressures are likely to remain subdued. The SARB’s economic projections for the recovery are optimistic in our view. Given the relationship between output and inflation, the weak growth outlook suggests that the SARBs projected rebound in inflation towards the midpoint of the target range is too aggressive. Additionally, the starting point of the rand at ZAR17.93 vs the US dollar is substantially weaker than current market prices, adding further inflationary pressures to the projections. Inflation currently sits below the SARB’s 3-6% target range for the first time since 2005, falling to 2.2% in May and rising only 0.1pp to 2.3% in June. Core inflation is faring better at 3% but disinflationary forces remain in play.
CARRY CONDITIONS AREN’T QUITE RIPE FOR A SUSTAINED RALLY IN ZAR IN 2020
The rand’s rally has been predominantly driven by broad USD weakness and a stabilisation in the global backdrop, but in our view the currency’s latest appreciation isn’t suggestive of a recovery in either the economy nor investor sentiment. Additionally, the lack of uptake by foreign investors in the SAGB market despite lower yields globally remains concerning. Investors remain net sellers of South African government debt in 2020, despite the recent uptick. Additionally, the SAGB curve remains steep despite the issuance targeting the front-end. This largely reflects the deteriorating fiscal position which has only been exacerbated by the pandemic, leading to higher yields needed to adjust for the elevated risk. Debt issuance is expected to rise to ZAR462.5bn in 2020, with a focus on shorter-dated issuance. The average weighted maturity will fall from 15-years to 7-years with short-term borrowing rising from ZAR48bn, as planned in February, to ZAR146bn. The shift towards shorter dated maturities is in response to the rising concerns over South Africa’s fiscal sustainability. The steepness of the SAGB curve has even started to concern the SARB, leading to conversations with the Treasury to continue focusing on the front-end of the curve.
The SAGB curve is historically steep as investors refuse to pick up longer-dated debt at lower yields due to the fiscal risks
Given the substantial normalisation in global conditions since the record level of capital outflows in March, along with the decline in global bond yields and resumption of large scale QE programmes, the lack of external uptake in SAGBs is telling.
With South Africa’s economy still battling the domestic outbreak and the recovery likely to lag the global economic recovery, we expect foreign involvement in the SAGB market to remain subdued.
Higher yields will pave over the cracks in the South African economy, but once shorter-dated debt instruments are purchased, we believe the risks towards the belly of the curve remain too significant at present to lead to mass capital inflows. With this in mind, we don’t see the rand benefitting from improving carry conditions until the economy begins its recovery, likely in 21H1.
Foreign investors remain net sellers of SAGBs after the deteriorating fiscal position (pre-pandemic) and the virus induced capital outflows seen in EMs generally
Author: Simon Harvey, FX Market Analyst