Thawing out the South African economy

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By Cees Bruggemans, Chief Economist of FNB.

Like defrosting a fridge after too much ice accumulation has started to interfere with its working, so the economy was for long frozen over and in need of reinvigoration.

Such overly frosty condition we call recession. When accompanied by much earnings collapses, employment losses and asset price declines, it can give rise to trauma and severely intimidated mindsets, especially business-wise, inhibiting expansion and fixed investment decisions.

The manager of this particular fridge, so to speak, is the government. Its main agent is the SARB and its main defrosting tool is interest rates, also to the extent that these (and other actions) influence the Rand.

Though SARB started cutting interest rates as long ago as December 2008, in a highly uncertain global crisis environment capable of many curved balls (not all of them foreseeable or favourable), the 20/20 hindsight of subsequent history suggests policy easing could have been more aggressive.

Indeed, why we never quite took a leaf out of so many other countries’ policy books is somewhat of a mystery, because it never was as if this Great Crisis was going to pass us by but completely.

Still, the slow coach also catches the monkey. Nearly two years on and prime has been lowered from 15.5% to 9.5%.

But on a CPI inflation of 3.5% this still suggests a 6% real rate, slightly above the long-term ideal average of 5.5% of recent decades at full economic potential. And we are hardly yet back at full potential (although inflation has also yet to show where it will settle next, if ever).

Over a year ago, on the cusp of ending recession, many people already sensed to be at the bottom of the interest rate cutting cycle (at prime 11%). Indeed, the Governor at the time intimated as much. Since then we have had three more 0.5% cuts, but the goalposts (inflation, Rand, domestic output gap) haven’t stopped shifting either.

It is a fallacy that after repeated rate cuts, another one wouldn’t make much of a difference. Most economic and financial decision-making is hidden from view, with only the results in time reflected in published data.

Meanwhile every change in the incentive structure counts, with the main impact on financial portfolio composition and changes there in affecting real economy decisions.

The fact of the matter is that many households and businesses found themselves with too much debt when asset prices started to decline, income in many instances became uncertain and the credit game changed, both regarding cost and access.

As exuberance made way for new sobriety, a sense of major overcommitment prevailed, aside of the minor matter of having to pay the higher interest rates while voluntarily or involuntarily deciding or wanting to deleverage debt.

If in such an environment, no different in essence to so many overseas countries in deep trouble, the authorities had cut our interest rates much more aggressively early and faster, it might have assisted early resolution to the defensive debt workout, allowing an earlier and faster growth resumption in a deeper sense (ignoring inventory and export repair effects).

For it wasn’t only households holding back on credit purchases and curtailing debt. Businesses were even more aggressive in cutting capex budgets and reducing debt on their balance sheets, through cost-cutting also enhancing their cash flows.

But even if slow, at least SARB remained alive to changing conditions, as much locally as abroad, and following a change in leadership also proved willing to keep changing the policy stance in line with changing circumstances.

And so the falling inflation rate, lingering output gap, and changing external and internal risks to the outlook led to serial rate cuts, until prime last month fell to 9.5% (a 30 year low).

Despite the severity of the observed trauma, and despite the slowness in easing interest rates, such policy action did not remain without effect on the margin.

We can observe this in the take-off in new car sales this year, the early resurrection in consumer confidence, the belated consumer inclination to become less cautious where it concerns credit and durable goods purchases (as per the FNB/BER consumer confidence survey), and not least the reviving bond and equity markets (though the later two mainly overseas driven).

With the full transforming impact of any interest rate cut only reaped over a two-year period, the interest rate cuts of the past year still have a substantial impact to make on household and business calculations and actions.

It is akin to you throwing the switch on your freezer. Defrosting doesn’t take place instantly. Instead, there is quite a wait involved.

Similarly, what we are currently engaged in is the gradual thawing out of the South African economy.

This is true as much in its bond and equity markets as they reach for new highs (earlier and more aggressively in bonds than in equities, but don’t underestimate the latter’s recuperation potential), but also in the broader economy (and reflected in those equity price changes).

As to property, that other great asset class, the supply and demand imbalances here are at present inhibiting an early vigorous recovery, with expectations also severely hamstrung.

But every interest rate cut probably makes the biggest difference in this particular asset segment, as debt features so heavily. With income recovering at a near 10% rate at present, wealth as multiple of income happily rising anew, debt servicing steadily falling, and with income and wealth prospects generally improving, calculations in the property game are presumably also shifting, even noticeably.

Another rate cut (never mind two more) would certainly have a profound impact here.

Not so much in starting an overnight boom (for the dead have never risen quite so fast from the grave, except perhaps in a massive unexpected gold boom like 1979-1980) as that the deleveraging process can slow down, and more income and spending power allocated to household consumption and business outlays generally.

And this would greatly help in coaxing somewhat faster growth from a so far disappointing economic recovery.

Every day, new household and business decisions are made, regarding a new purchase, or repair, an investment, expansion or replacement, however humble or big, whatever its nature, across every sector of the economy.

But this is ultimately a slow recuperation, given the depth of the earlier trauma. And with goalposts still shifting, as global forces steadily pummel the Rand firmer and it in turn suppresses inflation still lower, also providing severe headwind to exporters and import-competing businesses in the economy, the scope is there to undertake yet more supportive policy action.

Thus markets and commentary continue to look for yet more interest rate easing. At some point such eagerness will obviously overplay its hand, but given the exceptional conditions raging overseas, such a moment is probably not yet (not even close?) at hand.

Though do allow that policymakers could suddenly take action of a different kind, about which there has been much speculation in the media recently, and at political leadership conferences, but so far no hint as to practical implementation.

Even so, bearing such important qualification in mind, it could still well happen that yet another 0.5% interest rate cut materializes in November (or would that be January?). And given evolving global conditions, the Rand and our inflation prognosis, could we get surprised yet again in March (or would that be May?).

To cut rates at every MPC meeting might be too eager and smack of panic (inconceivable) or political pressure (probable much more conceivable, even in an agreeable kind of way and perhaps not to be misconstrued).

In contrast, cutting only every second MPC meeting would keep up pretences, and certainly maintain policy gravitas (the equivalence of the British stiff upper lip), always to be recommended in a serious-minded central bank.

But then haven’t we already had our fair share of gravitas and isn’t it now perhaps warranted to get where we may need to go in record time? Or won’t that do as we could not conceivably know where we really need to be or want to go so early in time, given long impacts and uncertain future events?

A complex challenge indeed.

Meanwhile, to the extent that the Minister of Finance and SARB Governor and others in authority do decide on the need to lower South African interest rates yet further, it would certainly not remain without effect in the wider economy and financial markets, were it to happen.

For every additional cut still to come would in many ways change daily portfolio decisions and also feed through to the many spending, employment, production, investment and credit decisions.

It would minutely contribute to the great thaw that is now already over twelve months underway, ever so gradually assisting in undoing the great trauma of recent years and importantly assisting in putting us back on our two feet, even if still for now remaining rather groggy and uncertain.

For so much has happened to us, and could conceivably still happen, it will take much for us to regain our old singleness of purpose.

The Great Thaw, though, is a fact. You see the dripping water everywhere as people come out of their foxholes and ever so tentatively start to pick up the pieces so cruelly shattered only so very recently.

More heat, please, it remains a cold spring so far.

Source: Cees Bruggemans, First National Bank, October 11, 2010.

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