South Africa – Cautious Rate Cuts Ahead, But Risks Finely Balanced


September 4, 2017 4:00 PM / BMI

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Cooling inflation and weaker-than-expected growth will see the South African Reserve Bank begin monetary easing in H217. However, with an uncertain political environment continually threatening to prompt a sharp sell-off in the rand, policymakers will take a gradual approach, cutting by only 25bps this year and an additional 25bps in 2018.

We now believe that weak Q117 growth and cooling price pressure will likely see the South African Reserve Bank (SARB) begin monetary easing in 2017. This represents a change from our previous forecast for the bank to hold the policy rate at 7.00%. We had initially anticipated that the more hawkish bias of South African monetary policymakers and the challenging political environment – threatening a sell-off in the rand – would keep the bank on hold this year, even despite the country's tepid growth prospects.

While these are still likely to be key concerns for the SARB, with gradual disinflation likely to continue in the months ahead and Q117 real GDP having come in even weaker than we anticipated, contracting by 0.7% q-o-q, we believe this will be sufficient to prompt a shift towards monetary easing. We now forecast a 25 basis point (bps) cut in 2017, to bring the repo rate to 6.75% and an additional 25bps cut in 2018.

Weak Growth Will Encourage Repo Rate Cuts

We increasingly believe growth is likely to disappoint, having recently revised down our already tepid 1.0% real GDP forecast for 2017 to just 0.7%. In the first quarter of 2017, growth was supported by the agriculture and mining sectors. While the agriculture sector is likely to continue to see gains as normalising weather patterns boost output, faltering metals prices and a deteriorating regulatory environment suggests headwinds to mining.

Moreover, with unemployment having hit a 14-year high, the large retail sector will see limited growth. At the same time, inflation is likely to continue cooling. While there was an uptick in May 2017 inflation, with the headline reading hitting 5.4% y-o-y, up from 5.3% the month before, we do not believe this is the start of a prolonged upswing in price growth.

Indeed, food prices have already fallen sharply as new harvests have come online and we see modest further downside as this continues to filter through to processed food prices more substantially. Moreover, favourable base effects are likely to cool upward pressure on the fuel and transport subcomponents of headline consumer price index (CPI).

Indeed, while the recovery in oil prices placed significant upward pressure on headline CPI in H117, the year-on-year differential between H217 and H216 is far more muted. Demand-pull pressures will remain muted in an environment of weak consumer confidence and while we believe currency appreciation is likely nearing its end, the rand is unlikely to give up most of the gains it has seen in the past year.

As such, after averaging 5.9% y-o-y in the first five months of 2017, we now forecast average inflation of 5.6% in 2017 (a modest downward revision from our previous 5.8% forecast). This forecast implies that we expect inflation to be between 5.5% to 4.8% over the months ahead.

Political Uncertainty Will Keep Easing Slow

While the above dynamics would suggest a rapid pace of easing, we believe that cuts will occur on a gradual timeline. The SARB has shown itself to have a relatively cautious approach to adjusting the benchmark repo rate and recent statements by the governor, Lesetja Kganyago, have stressed that the bank is unlikely to act before inflation nears the mid-range of the bank's 3.0-6.0% target band.

This policy preference will only be further reinforced by current political developments in South Africa, which we see as likely to encourage a hardening of the SARB's position. A report from the public protector, Busisiwe Mkhwebane, suggested a shift away from inflation targeting towards a more growth supportive mandate.

Specifically, her report to the legislature advocated a constitutional change, which would shift the bank's mandate to supporting 'balanced and sustainable economic growth' and 'ensuring that the socio-economic well-being of citizens are protected'.

In late June 2017, this view has been reiterated by Deputy Finance Minister Sfiso Buthelezi, who stressed that the SARB's singular focus on inflation targeting should be debated.

The move, seen by many as an attack on the central bank's independence, could encourage the SARB to embark on an even more gradual rate cutting cycle than we otherwise might have expected. Namely, the central bank will likely be keen to reinforce to international investors and ratings agencies that it remains an independent body.

As such, even as inflation cools towards the middle of the target band and growth remains sluggish, the bank may delay actions until it becomes unimpeachably clear that any cut has been taken for economic reasons rather than under political pressure.

Risks Remain High

Elevated political uncertainty continues to act as a major risk to our view for a rate cut in 2017. At this stage, after a massive cabinet reshuffle in late March saw the well-respected former finance minister, Pravin Gordhan, replaced, we believe markets are at least partially pricing in a victory by the less-reform minded Nkosazana Dlamini-Zuma.

However, many of these developments occurred in the context of more favourable investor sentiment towards EM FX. Should we begin to see appetite for riskier assets fade, the detrimental impact on the rand of political machinations could be far more long-standing, increasing the potential for greater-than expected imported price pressures.

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