Although the initial market reaction to higher-than-expected deficit figures was a rise in gilt yields, this move then faded. Anthony O'Brien, our UK interest rate strategist, notes that gilts outperformed Bunds on the publication of the DMO Remit. He thinks some of this outperformance can be explained by the fact that the UKT 10y sector outperformed the rest of the gilt curve with the revelation of lower-than-expected medium issuance.
Still ‘on Track', but Slower Pace of Reduction in Deficit
Larger deficits and so slower pace of fiscal consolidation: The deficit forecasts published in the Budget were both worse than we had expected and worse than the OBR's previous forecasts in November. That implies more gilt issuance than expected in coming years and a higher debt burden.
There is some ‘fiscal slippage' in these forecasts in the sense that the deficit now declines at a somewhat slower rate than previously forecast. The 2011-12 deficit is £4 billion higher than the OBR previously forecast, now 7.9% of GDP versus 7.6% previously. By the end of the parliament (2014-15) the deficit is £11 billion higher than previously forecast (now 2.5% of GDP rather than 1.9%).
Still ‘on track' to meet fiscal targets: Despite the revisions, the government still looks on track to meet both fiscal targets based on the OBR's forecasts. The two targets are: i) achieve a cyclically adjusted current budget balance by 2015/16; and ii) ensure debt (as a percentage of GDP) is falling by 2015/16. The OBR judges that the government still has a greater than 50% probability of meeting both targets. In addition, on the OBR's projections, both targets are still met one year early. The cyclically adjusted current budget balance is one-tenth lower (at 0.4% of GDP) by the end of parliament than on the OBR's previous forecast, while net debt is 1.7pp higher (at 70.5% of GDP).
Why the fiscal targets aren't more ‘off track': First, on the structural deficit, the profile has been flattered by the OBR projecting that there will be more spare capacity in the economy over the projection horizon. That is, the increase in borrowing has been deemed primarily cyclical rather than structural. The projected increase in capacity comes from the OBR revising down its profile for growth in the near term while leaving its assumptions on trend growth unchanged.
Second, on the net debt figures the profile has been somewhat flattered by technical changes from the ONS and also benefits from the fact that some of the debt being raised will be used to buy highly liquid assets (currency reserves), thus netting out in the headline public sector net debt measure. The cumulative increase in the deficit (PSNB) by 2015-16 is £43 billion, compared to an increase in net debt of £38 billion.
Willingness to allow ‘slippage': That the government ‘allowed' the deficit figures to worsen is interesting in itself. It confirms to us that, were the economy to plunge into recession, the government would likely let the automatic stabilisers work. Although not back-tracking on its spending cut and tax rise commitments, we assume that it would allow some further ‘fiscal slippage' (assuming that the OBR's judgement was again that the resultant increase in borrowing was mostly ‘cyclical').
Stronger Inflation Largely Responsible for the Increases in OBR's Deficit Forecasts
1) Stronger inflation outlook: The OBR attributes the bulk of the increase in its deficit forecast to changes in its inflation outlook. The OBR has revised up its government expenditure figures, which "primarily reflects the impact of our higher inflation forecast on social security and debt interest payments". It has made only small revisions to its spending forecasts, with lots of different impacts broadly offsetting.
One reason why inflation has such a negative impact on the public finances is that the OBR assumes relatively little feed-through into wages. In 2011, for example, it assumes that average earnings growth is only 2.0% in 2011 and 2.2% in 2012. We assume higher wage growth than this. We expect wage growth to pick up further in 2011: 1) the key period for wage settlements is January to April, when inflation will likely remain well above target; and 2) Consumers will likely have taken a cut in real incomes in 2010 and employees may feel that, after helping their companies work through tough times (e.g., taking unpaid leave), higher wages are justifiable.
2) Weaker growth outlook: The OBR has revised down its outlook for growth in the near term. This is driven primary by a weaker outlook for household consumption, reflecting higher living costs. The weaker outlook for growth, by itself, has a dampening impact on tax revenues.
3) Policy announcements judged fiscally neutral: The net effect on the finances of all the actual policy changes was relatively small (costed at £-115 billion by 2014/15). Only five of the announced measures had a costing of more than £-/+1 billion by the end of the parliament. The largest easing measure was a cut and delay in fuel duty. The largest tightening measure was changes to tax relief and charges for North Sea companies.
The Budget Has Little Impact on Our Economic Outlook
Inflation: The Budget contained a number of changes in rates of duty on fuel, alcohol and tobacco. Together, we estimate that these have a fairly neutral impact on our inflation projections. We had already assumed that the planned increase in fuel duty in April 2011 would not go ahead.
GDP growth: Overall we do not make major changes: 1) A growth accounting approach would suggest some upside risk to our GDP forecasts. However, we now see downside risks to other parts of our GDP forecast. 2) There are likely some medium-term positives for GDP growth in all the announcements today. 3) But, to us, the planned deficit reduction in 2011-12 alone still seems likely to subtract about 1pp from GDP growth.
1) Growth accounting approach: The OBR now anticipates stronger growth in both nominal and real government consumption and government investment components of GDP in 2011. If we mechanically adopt these forecasts (after applying our own GDP deflator), they would point to upside risk around our current growth outlook for 2011.
However, we are reluctant to incorporate this into our forecasts. First, the past real government consumer spending numbers are subject to revision and we think it is particularly worth waiting until the release of the 4Q national accounts next week. Second, it seems somewhat counter-intuitive, given the large real cuts in departmental spending planned for 2011-12 (after today's data and using the OBR's estimate of the deflator, we still calculate that this will amount to a real terms cut of about 4% in 2011-12).
Further, after yesterday's inflation figures and the upward revisions we made to our inflation forecasts, we now see substantial potentially offsetting downside risks to our consumer spending forecast (see Inflation: Upward Revisions = More Pain for Households, March 22, 2011).
2) Potential medium-term positives: There were a raft of policy measures announced in this Budget. As expected there were lots of positive-sounding pro-business measures. Most eye-catching was perhaps a speeding up of and additional reductions in corporation tax. Corporation tax will now be cut by 2pp this year. We assume that these measures will be broadly positive for GDP growth in the medium-to-longer term.
3) Near-term impact of deficit reduction still negative: But the impact of most of the ‘pro business' measures, by their nature, is hard to quantify. Meanwhile, in the nearer term, 2011-12's combination of real spending cuts, welfare and personal tax changes as well as the VAT rise, will still subtract about 1pp from GDP growth, in our view.
Monetary policy: So far, there doesn't seem to have been a major effect on bond yields from this Budget. Further, we would expect that the Bank of England to be inclined, at this stage, to leave its growth forecasts unchanged based on the policy changes made in today's Budget. What about inflation? Compared to its existing forecasts (rather than ours) we assume that the BoE's assessment of the net effect of the policy announcements (specifically on duty rates) on inflation will be similar to the OBR's - a reduction of around 0.1pp in 2011-12 netting out all the changes. That would be welcome news to the MPC, but not enough to materially alter the risks to its monetary policy outlook, we think, or enough to alter our forecast that the first rate rise will likely come in August.
Further Fiscal Slippage Ahead
The OBR still looks too optimistic to us on GDP growth. That will ultimately require either additional fiscal action further down the line or accepting some further ‘fiscal slippage' in terms of the pace of deficit reduction. On the evidence of this Budget, we think that the government will take the ‘fiscal slippage' route.
Summary
South Africa's current account deficit narrowed from 3.1% of GDP in 3Q10 to a paltry 0.6% of GDP in 4Q10 (on a seasonally adjusted and annualised basis). This was much smaller than our and consensus expectations of 3.2% and 2.7% of GDP, respectively. A rather curious jump in the visible trade balance accounts for most of the improvement, and while the reading is certainly better than we had hoped for, we believe that the near-tripling of the visible trade surplus is largely statistical and unlikely to be sustained going forward. In fact, our analysis suggests that the much smaller-than-expected CAD print masks a noteworthy deterioration in the financial account of the balance of payments.
Elsewhere, details on demand-side GDP show that the recovery in consumer spend through 2010 was more than a short-lived, World Cup-related binge, and that early signs of a recovery in GDFI are beginning to emerge.
Huge Jump in Trade Surplus Appears Unsustainable
According to the SARB's 1Q11 Quarterly Bulletin (QB), total exports were buoyed from R648.6 billion in 3Q10 to R683.1 billon in 4Q10, thanks largely to a strong commodity export performance. The international price of gold, platinum, coal and nickel advanced significantly in 4Q10, fully offsetting a 5.4% appreciation in the nominal effective exchange rate of the rand. In addition to the price impact, commodity export volumes were boosted by a strong recovery in external demand. Further, exports of vehicles and transport equipment also staged a strong recovery in 4Q10, following a strike-related slowdown in 3Q10.
Imports, on the other hand, slowed from R618.2 billion in 3Q10 to R597.1 billion in 4Q, thanks largely to tepid growth in private sector capital spend. According to the SARB, real import volumes contracted by 2.2%Q, thanks largely to a slowdown in intermediate capital imports (mostly machinery, electrical equipment, vehicles and transport equipment), as well as a decline in crude oil imports. On the whole, the surplus on the visible trade account soared from R30.4 billion in 3Q10 to a record R86 billion.
The latter reading appears unsustainable to us, however: While non-seasonally adjusted monthly data published by the South African Revenue Services did suggest that strong commodity and manufacturing exports were likely to buoy the 4Q10 trade balance, the actual outcome published by the SARB does appear somewhat exaggerated, and may have more to do with the timing of payment flows. Seasonal patterns in vehicle exports in particular may also have been distorted by the impact of strike action in that sector, and could reverse sharply in the near future. The sharp decline reported in intermediate capital imports (especially vehicle and transport equipment) also appears somewhat inconsistent with the exceptionally strong increase in capital exports. Although we acknowledge that the latter anomaly could well be the result of exceptional inventory management, and leads and lags in the manufacturing process, the wide disparity here appears unsustainable to us.
Net Invisibles: Right on the Headline, Wrong on the Detail
With regards to net invisible payments, the actual out-turn of R103 billion was in line with our forecast of R102 billion, but the details show that we were right on the headline for the wrong reasons: Net service payments of some R42.8 billion were much higher than our R28 billion estimate, thanks to an unanticipated increase in payments from travel-related activities by South African residents travelling abroad. The significant undershoot here was offset by much smaller-than-anticipated transfers to the Southern African Customs Union (SACU) countries: National Treasury statistics show that, while two transfers were made to the SACU states in 3Q10, only one transfer was made in 4Q10. That the second transfer only took place in January 2011 again highlights another technicality with the exceptionally small 4Q10 CAD, and suggests that a correction is likely in the coming quarter(s).
Significant Deterioration in Financial Account Flows
Our analysis also suggests that the significantly positive current account surprise that made the headlines masks a continued deterioration in the capital and financial accounts: For example, we find it particularly disconcerting that South Africa reported an inward capital shortfall in a quarter where the current account gap had in fact narrowed sharply. Net direct inward capital (FDI) posted an R11.2 billion reading that was largely driven by inflows associated with the sale of Didata to NTT Japan for some £2.4 billion. This positive inflow was however more than offset by R21 billion of portfolio investment outflows as foreigners liquidated their ZAR bond holdings, and as local banks, institutional investors and individuals took advantage of the rand's exceptional strength, and further relaxation in exchange controls in 4Q10 to acquire foreign investments in a bid to diversify their portfolios (for more details, see South Africa: Local Investors Already Limit Long Offshore Holdings? March 4, 2011).
Also, net ‘other' flows (mostly movements in banking sector assets and liabilities) posted R4.7 billion of outflows as local commercial banks took advantage of the currency's strength to increase their foreign currency-denominated deposits with, and short term loans to, non-resident banks. Further, the offshore rand-denominated deposits of the banking sector contracted in 4Q10, suggesting that commercial bank clients may have switched out of offshore ZAR deposits into FX, in view of what must have been perceptions that the currency's strength was unsustainable. Such outflows were partly offset by an increase in long-term foreign loans to domestic parastatals.
Net Short Financial Position Calls for FX Reserve Liquidation
On the whole, the balance on financial transactions deteriorated significantly, swinging from positive territory in 3Q10 to a net short position of R14.6 billion (a record low) in 4Q10. This took the basic balance on the country's BoP from an average surplus of R8.5 billion in the first three quarters of the year to an overall deficit of R18.5 billion in 4Q10. In fact, were it not for a fortuitous R16.4 billion inflow in unrecorded transactions (a de facto balancing item), South Africa would have reported an exceptionally weak overall BoP position in 4Q10. As things stand, even after the R16.4 billion inflow of unrecorded transactions, the country still reported a net short BoP position of R2.2 billion - forcing the authorities to liquidate the equivalent in FX reserves to help plug the hole. We find it particularly worrisome that, all said and done, the net inflow of capital in 4Q10 amounted to only R2 billion - i.e., half the size of the unadjusted current account deficit of R3.9 billion.
Demand Side GDP - A Positive Mix
The QB also published data on the composition of demand-side GDP. Household consumption contributed a full 3.3pp to the 4.4%Q GDP growth rate (seasonally adjusted and annualised), confirming our optimism on the durability of the consumer recovery. Fixed investment accelerated marginally, while a boost to the government wage bill gave impetus to government consumption spend - after a weak strike-related 3Q10 print. Thankfully, inventory accumulation finally occurred in 4Q10 - predominantly in the mining and construction sectors - after some two years of inventory draw-downs sent stock levels to record lows. Finally, net exports provided an encouraging 0.7pp contribution to overall GDP as some easing in export growth combined with an outright contraction in real import growth.
Consumer Spend - More than a World Cup Binge
Data for 4Q10 suggest that the mid-year consumption binge was more than just a World Cup-driven event: After averaging some 5.2%Q in the first three quarters of the year, household consumption registered a further 5.1%Q in 4Q10, underpinned predominantly by services spend (8.9%Q), as well as a more sustainable pace of durable goods consumption (6.9%Q). As one would expect, appetite for big ticket items such as personal transport equipment and furniture slowed somewhat after the World Cup. However, consumers appeared willing to switch to other durable goods such as televisions, computers and other entertainment equipment. With regards to semi-durables, although households reined in clothing and footwear expenses, other sub categories such as household textiles and furnishings performed rather well, lifting the overall growth in semi-durable goods from -4.8%Q in 3Q10 to 4.6%Q in 4Q10.
Underpinning the positive consumption spend were continued gains in real disposable income (5.3%Q), lower debt service costs (from 7.8% of disposable income in 3Q10 to 7.2% in 4Q10), and further employment gains: For 2010 as a whole, average wage settlements came in at a respectable 8.2% - although this represents a modest decline from 9.3% in 2009. Statistics South Africa also confirmed that a further 101,000 people were employed in the formal sector during in 4Q10. (Earlier reports published by Statistics South Africa suggested that the number rises to 157,000 when one expands the sample to include the informal and agricultural sectors.)
Modest Recovery in Capital Formation Is Welcome
Gross domestic fixed capital formation (GDFI) registered marginal gains in 4Q, accelerating modestly to 1.5%Q from 1.0%Q previously. As expected, the public sector provided solid underpin, registering annualised growth of 1.3%Q. Projects that received particular mention in the QB were the Intelligent Transport and Electronic Toll Collection Systems, the new fuel pipeline between Durban and Johannesburg, and Eskom's Medupi, Kusile and Ingula power stations. Mining sector investment spend also rose in 4Q10, thanks to the development and exploration of coal mines and the extension of opencast pits. Continued capex roll-out in the telecommunications subsector also featured prominently.
With household consumption on the front-foot and most importantly business confidence recovering, we believe that it is only a matter of time before private GDFI regains traction for real. With an average historical lag of some 2-3 quarters between overall business confidence and confidence in the civil construction and building industry, we expect the ongoing recovery in business confidence to translate into meaningful capex spend in the coming quarters.
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