Fragile funding flows indicate continued rand weakness
By Michael Kafe & Andrea Masia
Data released by the SARB in its 4Q08 Quarterly Bulletin (QB) show that South Africa’s current account deficit rose from 7.3% to 7.9% of GDP in 3Q08. While this is no doubt less severe than our central forecast of 8.5%, it is nevertheless a significant deterioration in the country’s external accounts. The lower-than-expected deficit was largely due to an undershoot in imports, relative to monthly data published by the South African Revenue Services (SARS). Quite worrying is the fact that net invisible payments came in much higher than expected. In fact, if one adjusts for the undershoot in visible imports, the current account deficit would have come in at 9% of GDP. This inspires no confidence whatsoever to change our bearish call on the rand.
Weak Global Demand Caps Export Growth
Data from the SARB show that exports rose only marginally from R728 billion in 2Q08 to R755 billion in 3Q08, thanks to subdued growth in both the volume and price of exports produced as external demand for South African exports slowed. According to the bulletin, export volumes and prices rose by only 1.7% and 2%, respectively in 3Q08, with particularly sluggish performance being reported in a wide range of products including motor vehicles and transport equipment, machinery, electrical equipment and precious stones and pearls.
Oil Imports Come in Lower than Expected
Sluggish domestic demand helped to contain import growth at no more than 4.9%Q (quarterly growth rates are seasonally adjusted and annualized unless otherwise indicated), compared with 12.7%Q in 2Q08. This is despite the fact that import spend was ‘artificially’ lifted by the purchase of two military aircraft. According to the QB, manufactured import volumes were down 2.2%Q, while crude oil import volumes “increased marginally over the period” as oil prices came off. We find the rather benign oil import bill reported by the SARB to be intriguing, given that monthly data reported by the SARS show that South Africa’s mineral imports (mainly oil and coal) rose from R45 billion in 2Q08 to R55 billion in 3Q08 – a 22% increase – on a non-seasonally adjusted and annualized basis. This huge disparity between the monthly SARS and SARB oil import data accounts for most of the R22 billion undershoot in our forecast of a R66.3 billion deficit versus the actual out-turn of R44.3 billion.
Strong Dividend Outflows Lift Net Invisible Deficit
The bulletin shows that South Africa’s invisible payments on dividends and interest continue to push the current account into deficit: On a net basis, total invisible payments rose from R132 billion to R141 billion (i.e., much higher than our forecast of R134 billion). Of this amount, 52% (R73 billion) was related to dividends and interest on South African investments. On the whole, our calculations show that, had there not been a significant offset from the rather intriguing import data published by the SARB, the huge outflows on the net invisible line would have pushed the 3Q08 current account deficit to a record R208 billion, or some 9% of GDP.
Capital Account Susceptible to Fickle Flows
Net financial transactions on the capital account of the balance of payments came in slightly ahead of our expectation, thanks in part to stronger-than-expected net FDI flows of R17 billion. However, the total reliance on unrecorded transactions – an extremely volatile balancing item – to fully fund the overall deficit on the country’s basic balance is a deep concern to us. This R36.1 billion in unrecorded transactions is a historical high. And while FDI inflows were somewhat higher than expected, this was largely driven by a single deal – the acquisition of a vehicle manufacturing company by its foreign parent company (Toyota Motor Corporation lifted its share in Toyota South Africa by 25% in August).
Sharp Revisions to Portfolio Investments
The SARB made significant revisions to its estimates of bond portfolio flows. Initial estimates of -R5.6 billion in August and -R13.1 billion in September were revised to R362 million and -R1.9 billion, as it turned out that the Bond Exchange of South Africa (BESA) had reported some repo trades on the R153 government bond that were subsequently unwound. The SARB rightly excludes these numbers from its final tally, thereby avoiding a repetition of what happened in 2Q08, when BESA reported a chunky R15 billion bond portfolio inflow in one day (April 25). As we pointed out in earlier research notes (e.g., South Africa: BoP Funding Mix Woes, September 5, 2008), such an unprecedented inflow is unlikely to have taken place on a day when bond yields were in fact 2-5bp weaker across the curve.
Local Banks Draw Down FX Deposits and Credit Lines
Thanks to the significant revisions to the portfolio outflows, the funding requirement in ‘net other investments’ came in lower than expected. Even so, the data confirm our view that local commercial banks have become an important source of ‘funding’ for South Africa’s current account deficit – obviating the need for the SARB to sell its foreign exchange reserves to support the currency. According to the SARB, a R20.6 billion inflow reported in net other investments was driven by a draw-down on short-term loans by commercial banks and an increase in non-residents’ foreign currency deposits with these banks. A run-down on commercial banks’ foreign currency deposits abroad to help fund local import orders, and foreign currency surrenders to foreign investors disposing of their South African assets also contributed. We pointed out in an earlier note (see South Africa: Further Growth Downgrades, November 14, 2008) that commercial banks have already liquidated up to one-third of their foreign exchange deposits (including advances to foreign banks) over the past 12 months, leaving them with roughly US$17.5 billion in FX reserves as at the end of September.
As we highlighted in that note, commercial banks’ foreign exchange reserves are not infinite: At some point, when these reserves are exhausted, and foreign credit lines dry up, it is conceivable that the rand comes under significant pressure, as commercial banks will have to source all foreign exchange requirements in the local spot market.
Real GDE Growth Is Disappointing
Elsewhere, the QB provided valuable insights on the real economy. For example, the bulletin shows that gross domestic expenditure staged a rather disappointing rebound of 1%Q in 3Q08, after contracting sharply (-3.5%Q) in the previous quarter. Although household consumption growth was in line with our forecast, we were surprised by the strong growth reported in gross domestic fixed investment and government consumption spend. On the part of general government, consumption expenditure rebounded to 9.6%Q after a technical decline of 2%Q recorded in 2Q08. In 3Q08, further outlays on aircrafts and an increase in real compensation of employees drove the reading. Excluding the aircraft, government consumption rose 5.1%Q.
Maiden Contraction in Household Spend Since 1998
Household consumption (accounting for more than two-thirds of real GDP) turned negative for the first time since 4Q98, as disposable income growth moderated, debt burdens remained high and the high cost of fuel, food, beverages and tobacco discouraged private consumption expenditure on non-durables. Additional evidence that earlier monetary policy action is rapidly percolating was confirmed by a further decline in household debt to disposable income from 76.7% to 75.3%, while household saving as a proportion of disposable income improved moderately from -0.5% to -0.3%. This suggests that South African households are deleveraging – even if only marginally so. However, one must remember that although the household debt/GDP ratio dropped from 46.3% to 45.3%, on our estimates, the fact remains that South African households are still deficit spenders. Importantly, the fact that the current account deficit is deteriorating despite a contraction in consumption spend confirms our view that the deficit is being driven a lot more by investment spend than consumption outlays. This should help to lift the country to a higher growth path in the future.
Public Sector Infrastructure Spend Still Buoyant
According to the QB, gross domestic fixed capital formation expanded by 44.3%Q in 3Q08, as public corporations and general government continued to implement South Africa’s capital-deepening program. In 3Q08, investment by public corporations was driven by huge outlays on generation capacity in the electricity subsector, including but not limited to the construction of the coal-fired Medupi and Kusile power stations by Eskom. Upgrades to national airports, the rapid rail link and communications networks also lifted the reading. On the other hand, investment by private corporations slowed from 13.7%Q in 1Q07 to 2.6%Q in 3Q08 as monetary conditions tightened; significant investment cut-backs have been reported in the real estate and business services sectors in particular.
Looking forward, we expect 2010 FIFA-related imports of capital equipment to remain high, leaving the visible trade and overall current account in permanent deficit over the next two years. At the margin, a small recovery in private consumption as interest rates ease through 1H09 should also lift import absorption by households. With all this happening against the background of a significant dearth in global capital flows, it is only reasonable to expect the currency to continue to trade on the back-foot, in our view. For the record, we expect the rand to close the year at 10.0 versus the US dollar, before depreciating further to 10.80 at end-2009 and 11.40 at end-2010, with risks firmly skewed to the upside.
Source: Michael Kafe & Andrea Masia, Morgan Stanley, December 12, 2008.
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