South Africa: Slow Growth and High Inflation Suggest Depreciation Ahead


Monday, November 13, 2017 3:55 PM / BMI Research

BMI View: After a sizeable multiquarter rally, challenging political dynamics and falling real yields suggest that the South African rand is poised for depreciation in the months ahead. Over a multiyear time horizon the downtrend is likely to continue given a combination of structurally high inflation and low growth.


Short-Term Outlook (three-to-six months)

We see the rand as set for a gradual sell-off in the months ahead, forecasting the currency will end 2017 at ZAR13.95/USD. This is revised from our prior forecast of ZAR13.10/USD, and reflects our view that the resumption of a gradual downtrend is likely to begin before the end of this year.


Real yields are likely past their peak at this stage. While the country had benefitted from steadily cooling price pressures following severe drought, food prices have already come in substantially on the back of a record harvest and substantial further disinflation will be somewhat limited, especially given less favourable base effects toward the end of this year. At the same time, we are factoring in further modest monetary easing in H217.


While the South African Reserve Bank kept the benchmark interest rate on hold at the September Monetary Policy Committee (MPC) meeting, we forecast an additional 25bps worth of cuts before end-2017. From a technical perspective, the currency is testing multi-year support at ZAR13.58/USD at the time of writing (October 3). A break of this level could presage the start of a more sustained downtrend.


Long-Term Outlook (six-to-24 months)

Over a multi-quarter timeframe, we expect the rand will maintain a depreciatory trajectory, with sluggish growth and higher inflation relative to the US weighing on economic competitiveness. We forecast the currency will average ZAR14.00/USD in 2018, implying a 4.6% depreciation in spot terms from our forecasted 2017 average.


Inflation has cooled noticeably in recent months, as a record harvest has helped to temper high food prices. However, over a multiyear time horizon, price growth will remain structurally elevated. Wages remain under upward pressure, even despite limited gains in productivity given strong unions and a limited number of skilled workers. Moreover, market monopolisation in certain key sectors, allowing for de facto cartels, has limited scope for downward adjustment in prices.


At the same time, economic growth will remain structurally subdued. Indeed, we forecast average real GDP growth of just 1.6% over the next five years. On top of a relatively low savings rate (16.3% of GDP in 2016), the country's limited prospects for reform will inhibit scope for a significant injection of foreign savings, weighing on multi-year growth potential.


We have long noted that the ruling African National Congress (ANC)'s December elective conference – when a new party leader will be chosen – has substantially increased uncertainty about the direction of policy and likely kept many investors on the sidelines. However, even after the conference, we believe the regulatory environment will remain challenging, tempering foreign investment.


A victory by a 'traditionalist', candidate (most likely Nkosazana Dlamini-Zuma) would likely see a continuation of the status quo, including a heavy reliance on leftist rhetoric and patronage politics. While some of the most left-leaning policies (such as land expropriation without compensation) would be unlikely to move ahead, a traditionalist candidate would likely feel pressure from the party's support base to follow through with some promises ahead of the 2019 general election.


Even a win by the more business-friendly Cyril Ramaphosa would be unlikely to augur a shift toward significant reforms with deep divisions within the ruling party stymieing any substantive attempt at change. This suggests that crucial reforms to improve access to education, cut red tape and improve the efficacy of government spending likely remain off the cards.


Risks to Outlook

The main risks to our view are skewed to the downside. While we believe political risk has been priced in to the rand's trajectory ahead of the ruling ANC's December elective conference to a certain extent, a surprise result could prompt a much sharper than expected sell off.


For example, while not our core view, we cannot rule out the risk that the losing faction of the ANC challenges the legitimacy of the elective conference results. Such an outcome would significantly prolong political uncertainty and put downward pressure on the rand.


Alternatively, greater than anticipated monetary tightening in the US would strengthen the US dollar, exerting downward pressure on emerging market exchange rates, including the rand. At this stage, we are factoring in no further monetary tightening by the US Federal Reserve this year, and only two hikes (of 25bps each) next year. However, efforts to move ahead with the US tax cuts being pushed forward, the risks to this view are skewed to the upside.


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