• First, how effective will the additional large-scale bond purchases that the FOMC looks likely to announce be in attaining the Fed's two stated goals: raising inflation, (which according to Chairman Bernanke at around 1% is too low) and lowering unemployment, which at close to 10% is too high?
• Second, how does a more expansionary US policy stance alter the balance of risks to growth, inflation and asset prices in emerging market economies?
• And third, will central banks in Europe follow the Fed in easing policy further, or will monetary policy paths start to diverge?
While ultimately the jury remains out on all three questions, recent events provide some interesting clues, in our view.
How Much Traction for the Fed?
A measured, flexible buying program... While the exact details of the Fed's new bond purchase program remain to be determined next week, recent press reports and signals by Fed officials confirm our US economists' expectations of a gradual, flexible approach involving purchases of Treasuries running at about US$100 billion monthly with a clear indication that the scale of these purchases over time will depend on financial conditions and on the economic outlook. This is a different approach from the ‘shock and awe' tactics applied last year, when the Fed announced a program to buy US$1,750 billion worth of Treasury and mortgage bonds over a 6-9-month period. Still, as our Fed watcher David Greenlaw notes, a pace of buying of around US$100 billion per intermeeting period, which could be scaled up or down at future meetings, "would be roughly in line with our estimated budget deficit (US$1.15 trillion) for fiscal 2011. So, the Fed would be absorbing virtually all of the net new Treasury issuance as long as it maintained this pace of purchases" (see US Economics: Restarting Asset Purchases: Some Details, October 6, 2010).
...that has already had major effects. The important point to note, of course, is that the Fed has already been hugely successful in kick-starting important elements in the transmission mechanism from additional bond purchases to the real economy and inflation before the programme has even started, namely asset prices and inflation expectations. Since Chairman Bernanke first hinted at additional stimulus in late August, US equities have rallied by more than 10%, real yields on inflation-linked 10-year government bonds have dropped by half a percentage point, the dollar has depreciated by 6% on a trade-weighted basis, and 10-year breakeven inflation rates have risen by 65bp.
But will the economy respond? Higher equity prices and lower real interest rates should support corporate investment spending, a weaker dollar should stimulate exports, and rising inflation expectations coupled with lower interest rates should induce consumers to consume today rather than tomorrow. Yet, with the various well-known headwinds - such as renewed weakness in the housing market, consumer deleveraging, the mortgage put-back situation, and corporates' inclination to hoard cash - we think there is good reason to believe that the benefits to the economy from renewed asset purchases will be limited. Against this backdrop, it seems reasonable to assume that the Fed's new purchase programme will be kept in place for a long time and may be increased in the event that growth and inflation don't respond sufficiently over time.
Also watch M1 to judge success: Apart from the usual economic indicators that everybody is watching to gauge the success of QE2, we propose to keep an eye on the development in the amount of cash and overnight deposits (the monetary aggregate M1) held by non-banks as an indication of whether QE2 will be working or not. To the extent that the Fed's additional bond purchases lower interest rates along the yield curve, households and corporates would be incentivised to hold more cash as the opportunity cost of holding non-interest bearing assets declines. Also, if banks become more willing to extend credit (or purchase assets), either because rising asset prices bolster their own and non-banks' balance sheets or because they view the higher excess reserves that are created through QE2 as excessive, this would show up in higher deposits and thus M1 (as extending a loan means creating a deposit).
US M1 has risen substantially over the past several years. The level of M1 is now almost 30% higher (or 9.4% annualised) than at the start of 2008 when the recession began. Thus, the Fed has prevented the collapse in the money stock that played a leading role in the 1930s deflation. Three factors have contributed to the strong rise in M1 over the past three years: first, higher precautionary cash holdings by corporates and households; second, lower interest rates; and third, the Fed's asset purchases which have not only bloated banks' excess reserves but, to some extent, also non-banks' cash holdings. While the growth rate of M1 has slowed from a peak rate of 18%Y in mid-2009 to 7.3%Y in September, it has reaccelerated in recent months from a trough of 4%Y in July. We will have an eye on this indicator over the next several months to gauge the impact of the Fed's new asset purchase programme, to be unveiled next week.
Rising Tail Risks Outside of the US
QExport... Importantly, the expectation of more monetary easing in the US has already had important ramifications outside the US, most notably in EM. Commodity prices have risen, many EM currencies, especially in Asia, have appreciated versus the dollar, and the EM equity rally that was already underway since the early summer gained speed since Ben Bernanke started to hint at QE2 in late August. Some central banks, such as the Bank of Korea, have already slowed or aborted rate hikes in order to offset the tightening monetary conditions that have come through exchange rate appreciation. Others, such as Brazil, raised the tax on fixed income inflows to stem the appreciation and have threatened further action to ‘punish' foreign capital. China has permitted only a very limited appreciation of its currency against the dollar and has hiked deposit and lending rates in order to lean against the easing of monetary conditions that resulted from the trade-weighted depreciation of its currency along with the US dollar. While the policy responses have been diverse, the net effect is a further loosening of the domestic monetary policy stance in many emerging market economies (except China) which should amplify the effects of the US monetary easing, and a depreciation of the US dollar that should support US exports and global rebalancing (see also A. Taylor, M. Pradhan and J. Fels' "QE20", The Global Monetary Analyst, October 13, 2010).
...raises risk of trade wars, global inflation and asset bubbles: While the Fed's additional bond purchases are welcome because they should help to minimise the tail risk of deflation for the US, the combination of Fed easing, downward pressure on the dollar and the various policy responses by other countries increase the risk of undesirable outcomes elsewhere. One such risk is rising protectionism: any trade war would have negative consequences for the global economy. Another is the risk of asset bubbles in commodities and emerging markets with potential inflationary or, once these bubbles burst, deflationary consequences.
US-Europe Policy Divergence?
While additional monetary easing in the US seems to be a done deal, the odds in Europe are against further monetary stimulus, at least for now.
UK economic backdrop different from US: In the UK, earlier expectations for QE2 following last week's MPC minutes were quashed this week by significantly stronger-than-expected 3Q GDP growth, which makes it unlikely that the MPC will embark on more asset purchases in November. With UK real GDP having grown at a higher-than-expected average annualised pace of 4% in the two middle quarters of this year (1.2% and 0.8% on the quarter in non-annualised terms in 2Q and 3Q, respectively) and inflation significantly above target and expected to remain there for an extended period, the UK economic backdrop is very different from the current one in the US. This may change as we go into 2011, when our economists expect growth to slow sharply as the fiscal tightening kicks in, but for now it looks unlikely that the Bank of England will follow the Fed anytime soon.
ECB still in phasing-out mood. Recent economic data in the euro area have also surprised on the upside, with especially Germany and France continuing to show strong momentum in the recent business surveys. Consequently, some ECB council members have indicated that the staff forecasts in December look likely to be revised up. Against this backdrop, the ECB's game plan still seems to be to gradually phase out the remaining ‘unconventional' measures - unlimited liquidity provisions to the banks at the regular tenders and selective, small-scale purchases of peripheral government bonds - over the medium term. If anything, the ECB views the fact that the overnight interbank market rate, EONIA, has risen by some 50bp to currently 85bp and thus close to the official refi rate of 1% (which has pushed bond yields higher across the yield curve) as an indication that the unsecured interbank market is normalising, which would also argue for phasing out the liquidity support. Thus, the ECB looks even less likely than the Bank of England to follow the Fed into additional monetary easing. To be sure, a tightening as in Sweden is equally unlikely in the foreseeable future, in our view.
But what if the euro surges? Yet how would the ECB respond if the euro would rise further against the dollar as the Fed embarks on additional asset purchases?
• The first thing to note is that the ECB usually looks at the euro against a broad basket of currencies. On the ECB's nominal effective exchange rate index, the euro is up 6% from its early summer low, but it stands slightly below its moving five-year average, and even almost 10% below the peak late last year. Thus, the euro would have to rise a lot further to get the ECB seriously worried.
• Second, the ECB has a deep-rooted aversion against embarking on large-scale purchases of government bonds. Even though there are no legal obstacles as long as the bonds are purchased in the secondary market, the ECB is worried about blurring the distinction between monetary and fiscal policy and the potential political pressures that could result if the ECB owned a large portfolio of government bonds. Thus, rather than purchasing large amounts of government bonds, the ECB would probably resort to other tools first. One such tool would be a cut in the refi rate. Another would be sterilised or even unsterilised currency intervention. However, both are only remote possibilities at this stage.
The euro as Ersatzgold? Moreover, it is not at all obvious that the ECB would really use these tools to resist a major appreciation of the euro, if it happened. If (a big if) this appreciation occurred because the US was seen by markets as actively trying to debase its currency in an attempt to avoid deflation and recession, the ECB might well choose to offer investors who flee from the reserve currency a new home. True, the price to pay for becoming a reserve currency is a significant loss in external competitiveness and a current account deficit reflecting the capital inflows. Yet, the benefits of offering investors a form of Ersatzgold would include higher asset prices and permanently lower interest rates, which would help especially highly indebted governments. More on this another time.
Introduction
The National Treasury of South Africa presented its Medium-Term Budget Policy Statement (MTBPS) to cabinet on Wednesday. In line with our view, the Treasury upgraded its GDP growth expectations, made downward revisions to inflation, and committed the country to responsible fiscal thrift (lower spending, a smaller-than-expected fiscal deficit, lower external funding and modest increases in domestic funding and the overall public sector borrowing requirement). News on the exchange control front was rather disappointing, as was the scanty detail on potential allocations to parastatals.
It is our opinion that South Africa's outstanding commitment to responsible fiscal management makes it a prime candidate for a sovereign rating (outlook) upgrade. Improvements in the fiscal metrics should be supportive of local fixed income, while the rather modest relaxation of exchange controls should have a smaller impact on the ZAR than we had initially anticipated. Importantly, the Treasury's fiscal prudence also gives the monetary authorities some space to relax policy further if they so wish.
Macro Data Upgrades Across the Board
With regards to GDP growth, the Treasury has now bumped up its GDP growth estimates from 2.3% in 2010, 3.2% in 2011 and 3.6% in 2012 to 3%, 3.5% and 4.1%. This was largely in line with our expectations, and appears to be the primary reason for significant upward revisions to the Treasury's revenue estimates. Consumption and fixed investment forecasts have also been tweaked to more realistic levels, as have inflation forecasts. For example, the Treasury now expects CPI inflation to average 4.4% this year (5.8% previously) before rising to 4.7% next year (6.1% previously) and 5% in 2012 (5.9% previously). These revised inflation forecasts are in line with the SARB's estimates. But while the Treasury and SARB's 2010/11 CPI estimates are in line with ours, their 2012 forecast of some 5% is much lower than our 5.7% estimate. The Treasury's current account deficit forecasts have also been reined in - although they are still well ahead of our own estimates.
Tax Revenues Well Ahead of Schedule
With regards to the fiscal metrics, the Treasury has eventually acknowledged that its tax revenues will be at least R20-30 billion per year higher than it had anticipated at the presentation of the February 2010 budget. We believe that the over-run could be even more. For the fiscal year to date, revenues are at 38.5% of budget - significantly outpacing the equivalent five-year average level of 35.5% (see South Africa Budget Preview: Expect Limited Funding Squeeze Despite Revenue Over-Run, October 18, 2010). The revenue over-run for the year to date is about R20 billion, thanks mainly to VAT and corporate income tax outperformance. We continue to see significant over-runs in the remainder of the year, resulting in a total tax take of R685 billion this year, and some R785 billion in 2011/12.
Responsible Fiscal Thrift - We Couldn't Ask for More
We found it most impressive that expenditures have actually been reined in this year (down from R907 billion to R904 billion), despite an additional R11 billion spend on employee compensation. To our surprise, the largest saving was in the goods and services line.
Last October, when the Treasury made a solemn undertaking to reduce spending on non-core functions, shift resources from administrative to front-line services, weed out poorly performing programmes, reduce wastage, prevent extravagant spending and reform its procurement systems, etc. (see South Africa: Conservative Accounting as Fiscus Deteriorates, October 28, 2009), we were agnostic at the time, and dismissed the measures as no more than a wish-list. Well, we were wrong! The 2010/11 budget for goods and services expenditure has now fallen from R169 billion in February 2009 to R149.5 billion, with similar declines expected in 2011/12. This is no mean achievement, in our view. Finally, although the debt stock is largely unchanged from the February 2010 estimates, interest outlays are now expected to come in below initial estimates, thanks in large measure to the lower level of policy rates, and the rally in domestic fixed income markets.
Borrowing Unchanged, Despite Revenue Over-Run
On the funding front, domestic bond issuance remains broadly unchanged despite the revenue over-run. Foreign funding for this year has been cancelled, presumably due to the issuance of an unbudgeted US$1.5 billion Eurobond in March 2010 (the last month of the 2009/10 fiscal year). Also remember that the Treasury is already awash with significant amounts of foreign exchange, thanks to the step-up in FX accumulation and off-market FDI transactions (for the year to date, the Treasury and SARB have deployed a combined R43 billion to FX purchases, taking the country's foreign exchange reserves to US$44.1 billion in September). For the next two years, external funding has been scaled back - again a likely derivative of the decision to step up spot FX accumulation.
Importantly, the overall public sector borrowing requirement for 2010/11 is now forecast to come in lower than was expected in February, thanks to the cancellation/reduction in offshore funding by central government, as well as an increase in FX cash holdings. It is important to note that although the revenue over-run does not result in declining domestic funding, it indirectly results in a lower foreign borrowing requirement, as such excess revenues are deployed to purchase spot FX. Modest increases in the PSBR have been priced in for the outer years, thanks largely to higher borrowing by non-financial public enterprises. Contrary to our expectation, there was no increase in government guarantees on Eskom debt in particular. This may only happen in the February 2011 Budget.
Modest Tinkering with Exchange Controls
Finally, we were somewhat disappointed on the exchange control front, where we had expected offshore limits for pension funds and insurance companies to be raised from 20% to 25% of assets under management. While the budget did indicate that exchange controls on domestic companies will be reformed to remove barriers to international expansion (this mostly impacts on foreign companies who may want to use South Africa as a launch pad to the rest of the continent), it fell short of raising the limits on institutional money.
The budget speech however mentioned that "private and public pension funds, including the Government Employees Pension Fund (GEPF), will be reviewed to support portfolio realignment and offshore diversification, especially within Africa and into other emerging markets". Further details are to be published by the SARB in the next week or so, with any potential changes only being effected in 2011.
It is important to note that there was no mention of insurance companies here. Private and public pension funds have R914 billion and R625 billion, respectively in assets under management, while long-term insurers alone have over R1.5 trillion in assets. Thus, even if the limits on pension funds are raised to 25%, the potential outflow is now likely to be in the region of R30-80 billion only, depending of course on the participation rate of the GEPF. The overall impact on the ZAR should therefore be much less than earlier anticipated.
Relaxation of Restrictions on Individuals
The Treasury also intends to amend exchange controls and offshore investment limits on individuals. The Budget speech mentions that restrictions on blocked assets of emigrants will be lifted (currently, emigrants are only entitled to a lifetime allocation of R8 million. The remainder can only be released upon the payment of a 10% exit levy).
In a separate, unpublished document that was handed to journalists well into the lock-up period, however, the Treasury proposed that such blocked assets be released free of levies. The latter document also proposed that the current R4 million lifetime offshore investment limit for individuals be increased to R4 million per annum, subject to compliance with all tax and financial integrity legislation. We do not expect significant outflows here, as most ordinary South Africans have not even exhausted the existing limits, while those who have such resources to invest offshore may have already taken significant amounts of their savings offshore. It was also proposed that investments above the R4 million threshold be allowable, subject to SARB approval.
Conclusion
On the whole, we regard this as a very positive budget that clearly positions the country for a rating (outlook) upgrade. The improvements in the fiscal metrics (lower-than-expected expenditures, revenue over-run, smaller-than-expected deficit) should be supportive of the fixed income market, while the rather modest relaxation of exchange controls points to a smaller impact on the ZAR than we had initially anticipated. Finally, the Treasury's fiscal prudence also gives the monetary authorities some space to relax policy further if they so wish.
Read Full Article »