Standard Bank Research*

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1 Standard Bank Research*

2 South Africa Positive momentum, amid some risks A gradual economic recovery and the first steps of policy reform should characterise the South African economy in 2018, although there are global and domestic risks that need to be monitored closely A gradual economic recovery and the first steps of policy reform should characterise the South African economy in 2018, although there are global and domestic risks that need to be monitored closely. The global backdrop is expected to remain benign, with reasonably strong economic growth and generally robust capital flows into emerging markets. However, we will monitor the risk of a sharper China slowdown; downside risk to the near-record terms of trade; and the risk of higher inflation and, in turn, faster monetary policy normalisation in advanced economies (the US in particular). Domestically, despite the divisions within the ANC s National Executive Committee (NEC) and also its top six leadership, we expect some traction with policy reform and implementation under newly elected ANC President Cyril Ramaphosa. This should improve business and consumer confidence and, in turn, economic growth, and most economic indicators are expected to move favourably in However, many structural impediments, deep-seated ideological divisions across society, and extreme levels of inequality and poverty will continue to make decisive progress challenging. This will be most evident in respect of fiscal policy, with growing social needs and backlogs amid an already strained fiscal position. The existing policies require economic growth above 2.5-3% to ensure fiscal sustainability. But demographic trends suggest that significantly more pro-poor spending, on top of the potential budgetary step-change from free tertiary education, will be required in the medium term, which would further lift the required economic growth rate. In short, the SA economy is expected to move in the right direction in 2018, but hard work still lies ahead. Growth We expect economic growth to accelerate in 2018 to around 1.5% from an estimated 0.9% in 2017 We expect economic growth to accelerate in 2018 to around 1.5% from an estimated 0.9% in 2017 (of which around half stemmed from the agricultural rebound), mostly driven by accelerating consumer spending growth. This, in turn, is expected to be underpinned by real wage growth and gradually improving support from employment and credit extension. While there is ultimately potential upside to fixed investment growth, this recovery may take some time to materialise. We expect very weak public sector infrastructure spending growth in the short- to medium term, and the expected private sector GFCF recovery is likely to be uneven across sectors and possibly slightly delayed. Despite our expectation that the current account deficit should remain relatively narrow, we do not expect any material contribution from net exports to real economic growth. A recovery in (business and consumer) confidence holds the key to the near-term growth trajectory. We expect that the appointment of then-deputy President Cyril Ramaphosa as ANC leader should improve business confidence, and that there will be renewed private-public sector efforts to boost economic growth and employment. Unfortunately, the positive impact of Ramaphosa s election will be counteracted to some extent by the remaining policy uncertainty, including the ANC s conference resolution to change the Constitution to legitimise expropriation without compensation, but also including lingering uncertainty about policies such as the Mining Charter and Mining and Petroleum Resource Development Act (MPRDA) as well as general lack of traction with implementation of other growth-enhancing policies. While Ramaphosa s election as party leader should improve the prospects for more decisive implementation of the National Development Plan (NDP), fundamental ideological disparities among key stakeholders, challenging compromises between different policy objectives and inadequate state capacity means that this will not be without challenges. 1

3 Figure 1: Growth composition % Figure 2: Sectoral GDP trends Index Q07 4Q08 4Q09 4Q10 4Q11 4Q12 4Q13 4Q14 4Q15 4Q E 2018E Households Government GFCF Inventories Residual Net exports GDP Agric Mining Manuf Utilities Construction Trade Transport Fin, bus. service Personal service Govt Source: Stats SA Source: SARB, Standard Bank Research Figure 3: Cyril Ramaphosa s New Deal Similar to the NDP, the New Deal is essentially based on a social pact between business, government, labour and civil society. Radical economic transformation is state-led. A combination of policy instruments, including special economic zones, tax and other reforms, incentives for the development of small and medium enterprises (SME), import substitution policies and lowering the cost of doing business (including by improving Eskom s operational performance, ensuring effective price regulation, reviewing port tariffs and increasing investment in rail and road infrastructure), is envisaged to support mainly manufacturing-led job creation. Accelerated land reform and growth of the SME sector are seen as key to support inclusivity in the economy. Policy certainty, improved institutional stability, restored credibility of the criminal justice system, and demonstrated political will to turn the economy around are regarded as key to restore (investor) confidence. Fiscal discipline is important to ensure economic sovereignty and to ensure that resources are directed to where they have the greatest developmental impact. It stresses the importance of improving the quality of education, and supports the provision of free higher education to the poor (although this requires a growing economy and stronger fiscus). SOEs should facilitate economic development, which requires that they should be properly governed and operated, with the appointment of skilled, experienced and incorruptible boards at strategically important SOEs as an immediate priority. Corruption and state capture should be addressed by taking criminal action against perpetrators, and all recovered proceeds of corruption should be put in a special anticorruption appropriation fund to be used for youth training and employment initiatives. Source: BizNews, Standard Bank Research from the expenditure side The main driver of consumer spending momentum is expected to be real wage growth, which is in turn supported by our expectation for relatively low inflation. Assuming 6.5% wage growth, Figure 5 shows that real income growth should remain positive across the 2

4 income spectrum, even once the impact of bracket creep (with tax brackets not adjusted for inflation) and the usual sin tax increases, which are incorporated into our inflation forecasts, is taken into account. However, if total hikes of R30bn are implemented, as intimated by the Finance Minister, and these hikes are broad-based, middle income households will only have around 0.5% real after-tax income growth at 6.5% nominal income growth (and thus effectively no real after-tax income growth if nominal income grows at say 6%). The chart shows that the possible monetary easing could provide modest further relief to consumers. Apart from the underpin from real wage growth, there could be modestly stronger support to consumer spending growth from credit extension in 2018 following a decade of deleveraging that reduced the household debt-income ratio from 87.8% in 1Q08 to 72.5% in 3Q17. Data from one of the credit bureaus suggests that credit growth, albeit still weak, has become somewhat more broad-based, after previously been mostly concentrated among the higher income groups. However, debt in arrears does not appear to have receded, which curbs the likely near-term upside. Figure 4: Compensation of employees % YoY (3Q avg) Mar-11 Jul-11 Nov-11 Mar-12 Jul-12 Nov-12 Mar-13 Jul-13 Nov-13 Mar-14 Jul-14 Nov-14 Mar-15 Jul-15 Nov-15 Mar-16 Jul-16 Nov-16 Mar-17 Jul-17 Total Ex-govt General government services Source: Stats SA Figure 5: Real spending power growth across expenditure deciles % YoY 3,0% 2,5% 2,0% 1,5% 1,0% 0,5% 0,0% -0,5% -1,0% Real, after fiscal drag Real, after fiscal drag and broad-based tax Real, after fiscal drag and high-end tax Real, after fiscal drag and broad-based tax, 50bps rate cut Source: SARB, Treasury, XDS, Eighty20, Standard Bank Research The immediate prospects for fixed investment growth remains weak, despite the boost to the mediumterm outlook from the political economy improvements underway The immediate prospects for fixed investment growth remains weak, despite the boost to the medium-term outlook from the political economy improvements underway. While there should be some general improvement in confidence, many firms will likely require more concrete policy signals or improvements to expand capacity, and it is normally a protracted process. In many sectors, sector-specific issues would first have to be convincingly resolved with credible and certain long-term policy programmes. Despite these factors that curb the upside in the foreseeable future, we do expect some improvement in private sector fixed investment following two years of contracting real private sector GFCF (see Figure 6). This is supported by the recovery in aggregate profitability as well as our estimate that private sector GFCF has declined significantly relative to domestic or domestic and export demand (see Figure 7) to justify some expansion against the current economic backdrop. 3

5 Figure 6: Real GFCF (seasonally adjusted) Index Q08 1Q10 1Q12 1Q14 1Q16 Govt SOE Private Figure 7: Private sector fixed investment relative to demand % Q00 1Q02 1Q04 1Q06 1Q08 1Q10 1Q12 1Q14 1Q16 Private GFCF vs HCE & exports Private GFCF vs HCE (RHS) Source: SARB, Standard Bank Research Source: SARB, Standard Bank Research Government s latest forecasts for public sector infrastructure spending implied very low nominal growth and effectively negative real growth in This is before the possible downward revisions that we expect there might be as part of the efforts to improve the fiscal metrics, so this GDP component is unlikely to provide growth impetus. from the supply side Growth is thus likely to be driven by the tertiary sectors in 2018 In 2017, the recovery in the agricultural sector was responsible for around half the aggregate economic growth of 0.9%. We suspect that the agricultural recovery has largely run its course, and the sector may turn into a negative growth impulse given the impact of the Western Cape drought. In general, we expect very low growth across the primary and secondary sectors in Growth is thus likely to be driven by the tertiary sectors in The agricultural sector s real GDP has recovered to around 5% above its peak prior to the drought. We expect only modest further expansion in the near term, but there might be slight upside risk to our current assumptions. - The medium-term outlook for mining sector volumes remains relatively bleak, although relatively high prices could have a positive bearing on supply and profits. The single biggest risk to the general SA economic outlook is at this stage the potential downside to the terms of trade, although to date there is no indication that this is imminent. - We pencil in modest growth for the manufacturing sector in 2018, and expect a slight acceleration in the sector in It is supported by the expected recovery in domestic demand growth and reasonable growth in the demand for SA s exports, although we are slightly concerned that the stronger rand (even if the recent strength is ultimately not entirely sustained) may encourage an increase in the import intensity of demand. - We do not expect any contribution from the utility sector to GDP growth, given relatively weak growth in the most electricity-intensive sectors and the general decline in the electricity intensity of GDP. 4

6 - We expect there to be some improvement in select pockets of the construction sector. However, with the weak government forecasts for public sector infrastructure spending and weakness in the structural longer-term mining volume prognosis, our base case expectations for the sector remain relatively weak. - We expect some recovery in the wholesale and retail sector in 2018 and 2019, supported mainly by our expectation for a recovery in consumer demand. - We pencil in an improvement in the transport and communication sector, owing to the recovery expected in the general economy and particularly the goods-producing part of the economy that should support the transport component of the sector. - We are cautiously optimistic about the outlook for the financial and business services and real estate sector. There has been a tentative improvement in the credit demand growth of households, which we expect to accelerate somewhat over the course of Growth in the government services sector should remain under pressure given the fiscal consolidation that is underway. At this stage we are not pencilling in an ongoing contraction, but there is some downside risk to our forecasts. - We expect some improvement in the personal services sector s GDP growth in 2018, consistent with our view that general consumer demand growth should pick up on the back of reasonable real wage growth. Fiscal policy, and credit ratings We expect the fiscal slippage in the MTBPS from higher spending and lower revenues to be counteracted in the 2018 Budget The Medium-Term Budget Policy Statement (MTBPS) has violated two key pillars that had anchored the fiscal consolidation attempts in recent years namely, the expenditure ceiling and deficit-neutral SOE support. We expect the fiscal slippage in the MTBPS from higher spending and lower revenues to be counteracted in the 2018 Budget by a combination of non-core asset sales and material revenue and expenditure adjustments in the current and subsequent years. However, whether these corrective steps will be sufficient to ensure debt stabilisation and fiscal sustainability will, to a large extent, depend on the exact cost of government s free tertiary education proposal and whether trend growth can sustainably reach at least 2.5%. The fiscal forecast risk is higher than usual given the (Treasury and ANC) leadership changes, the recent introduction of a Presidential Fiscal Committee, and the difficult trade-off between requirements to stave off a credit rating downgrade and stabilise government debt while not unduly constraining a fragile economic recovery or unnecessarily weighing on voters ahead of the 2019 national elections. It is also difficult to know what the exact cost of the free tertiary education proposal is given its dependence on the unknown income distribution of prospective students families, uncertainty regarding whether the policy will be implemented unchanged from government s plan announced in December 2017, and the impact of increased subsidisation on enrolment. The general fiscal consolidation intent (including free tertiary education) and its credibility, along with steps to reduce growth constraints and the fiscal risk from the SOEs, will therefore be crucial in determining whether Moody s will downgrade SA s credit rating when resolving the rating review in 1Q18. Our base case view is that it is possible to avoid a downgrade for now, but it is a very close call and will require decisive government action. Demographic trends amid elevated poverty and inequality mean 5

7 that this is merely delaying the inevitable downgrade and fiscal cliff unless trend growth is significantly and sustainably lifted. The public sector wage increase, and the extent to which the SOEs will require further fiscal support, pose additional fiscal risks, although we expect these two factors to influence the fiscal metrics only after the 2018 Budget. Figure 8: Tax hike options and considerations for 2018 Tax Revenue boost Probability Fiscal drag At least R12.5bn Very high probability Sugar tax (health promotion levy) R1-1.5bn Very high probability Fuel levies R7bn Very high probability Duty on alcoholic beverages R1.5bn Very high probability Tobacco duty R1bn Very high probability Carbon tax Revenue neutral initially High probability in the medium term Estate duties and donations tax R1.2bn Moderate probability Wealth tax R5-8bn initially Moderate probability Medical tax credits R2bn if scrapped above R income R20bn if scrapped entirely Low probability of getting scrapped, but high probability of some adjustment VAT rate Around R11.6bn for every 0.5% increase. Moderate probability of some adjustment Graduate tax R200m R3bn Moderate probability Dividend tax rate Modest probability Capital gains tax rate Modest probability Company tax rate Very low probability Source: Treasury, Standard Bank Research If, in contrast to our base case view, Moody s downgrades SA, it will fall out of the World Government Bond Index (WGBI). There are not many other countries that reach the coveted A-grade credit ratings required to enter the WGBI and subsequently lost its investment grade ratings to get expelled from the index, but the few global precedents suggest that the WGBI expulsion should in itself only have a temporary (though significant) impact on the currency and bond markets. Ultimately, the subsequent sustained levels depend on the fiscal and growth trajectories, and global market conditions. Figure 9: SA local currency rating A+ A A- BBB+ BBB BBB- BB+ Figure 10: SA government debt % of GDP Moody's S&P Fitch Average E Source: Bloomberg Source: Treasury 6

8 Figure 11: Countries with Moody s rating just below or above investment grade threshold 1 Country Local currency Foreign 2018 net debt 2020 net debt 2018 gross debt 2020 gross debt Primary deficit currency (% of GDP) (% of GDP) (% of GDP) (% of GDP) Hungary Baa3 Baa SA Baa3 Baa Kazakhstan Baa3 Baa Bahrain Baa3 Baa3 Romania Baa3 Baa Indonesia Baa3 Baa Trinidad and Tobago Ba1 Ba1 Portugal Ba1 Ba Turkey Ba1 Ba Russia Ba1 Ba Morocco Ba1 Ba Paraguay Ba1 Ba1 Namibia Ba1 Ba1 Guatemala Ba1 Ba1 Source: Bloomberg, IMF Rand Our rand forecasts are constructive We pencil in modest depreciation in the real trade-weighted rand in the medium term Our rand forecasts are constructive, supported by benign global economic expectations, including reasonably strong economic growth and the expectation that capital flows into emerging markets will remain robust. Domestically, improved sentiment after the election of then-deputy President Cyril Ramaphosa as ANC president (and subsequently state president) should provide support to the rand, although lingering policy debates such as land expropriation without compensation, and radical economic transformation are keeping political and policy risks elevated. This is particularly true given the factional divide within the ANC and its leadership, although our political analyst Simon Freemantle is cautiously optimistic that President Ramaphosa has enough senior support in the NEC, which could grow further, to advance his policy agenda. We also expect the rand to benefit from a relatively small foreign funding requirement given our forecast that the current account deficit should widen only modestly in However, we will monitor closely several potentially rand-negative risks, particularly towards 2H18, including a slowdown in China sharper than expected and higher inflation in advanced economies (notably the US) that could compel faster monetary policy normalisation than currently expected, as well as downside risk to the near-record domestic terms of trade (our key concern), the aforementioned general policy risks and, specifically, material fiscal risks. Capital inflows on improved sentiment towards SA could provide further support to the rand in the near term but we pencil in modest depreciation in the real trade-weighted rand in the medium term, premised on a marginal decline in the terms of trade and a modest widening of the current account deficit. At current levels, the real tradeweighted rand is still around 8-10% weaker than the and overvalued levels which had caused significant current account widening subsequently. This should be consistent with a narrow (albeit slightly widening) current account deficit, as long as the terms of trade remain very elevated. We thus expect some real depreciation when the terms of trade weaken. Our econometric ZAR-AUD model suggests that the risk premium since the end-2015 finance minister reshuffle has now been negated. However, we are slightly concerned about the model s signal that the rand is currently not reflecting any risk premium. In our view, this might be overly complacent despite some policy-implementation improvement expected under the new ANC leadership. 1 Only data available in the IMF Fiscal Monitor is used here to ensure consistency. 7

9 Figure 12: Trade-weighted rand Index SA real effective exchange rate SA nominal effective exchange rate (RHS) Index Figure 13: PPP estimates Rand R/$ PPP 2003 base year R/ PPP 2003 base year R/ PPP 2003 base year Source: Bloomberg Source: Bloomberg, Standard Bank Research Figure 14: Econometric ZAR model R/$ Figure 15: Terms of trade Index 2010= Q90 1Q93 1Q96 1Q99 1Q02 1Q05 1Q08 1Q11 1Q14 1Q17 Actual Model Q80 2Q83 2Q86 2Q89 2Q92 2Q95 2Q98 2Q01 2Q04 2Q07 2Q10 2Q13 2Q16 Source: Bloomberg, Standard Bank Research Source: SARB Several domestic currency fundamentals have improved in recent years Several domestic currency fundamentals have improved in recent years. Most importantly, the current account narrowed from 6.7% of GDP (R242bn on a seasonally adjusted and annualised basis) in 3Q13 to 2.3% of GDP in 3Q17 (R109bn). The sustainability of this improvement plays an important role in the medium- to longerterm outlook for the rand. Our current account forecast of 2.9% of GDP on average in 2018 implies a relatively low foreign funding requirement, especially once net transfer payments (which are dominated by SACU payments) are excluded (then at around 2.2% of GDP); this is an important support pillar to our relatively constructive rand forecasts 2. 2 Other improvements include the narrowing of the (main) budget deficit from 6.3% of GDP in FY09/10 to 3.5% of GDP in FY16/17, the forecast acceleration in economic growth to around 1.5% YoY in 2018 (the strongest since 2014) from 0.9% in 2017 and a recent annual trough of 0.3% in 2016 (and an expected further acceleration in 2019), and a moderation in inflation to a forecast 4.4% YoY in 2018 from 5.4% in 2017 and a recent annual high of 7.2% in These improvements should make the rand somewhat less vulnerable than it was in prior years. 8

10 However, despite these absolute improvements, some of the economic fundamentals are still weak in a global context However, despite these absolute improvements, some of the economic fundamentals are still weak in a global context. Figure 17 shows that the current account deficit is still somewhat large in a global context, although it compares less unfavourably once the transfers to the other SACU members are excluded. The budget deficit, however, should remain relatively wide in a global context, and this is subject to the adverse risks discussed in our report Some thoughts on fiscal policy and credit ratings of 9 January Figure 16 demonstrates that SA continues to offer an attractive interest rate differential but economic growth remains low in a global context. If investors were to increase their focus on economic growth, especially as the global cost of funding gradually rises, SA might be penalised for being a growth laggard, which would likely be rand-negative. That said, the chart shows that an increase in economic growth to 2.5%, which we believe is plausible in the medium term alongside the current global tailwinds if there is sufficient political will to address domestic growth impediments, would already compare noticeably better in a global context. Figure 16: SA growth and interest rates in context Figure 17: SA twin deficits in context Source: Bloomberg, Standard Bank Research Source: Bloomberg, Standard Bank Research Inflation and interest rates The rand exchange rate is the key inflation risk The inflation outlook is benign, mainly on the back of a stronger rand but also assisted by an agricultural outlook supportive of moderate food inflation. We forecast a helpful retreat in oil prices, although current levels are higher than generally anticipated and pose some upside risk to our estimates. The rand exchange rate is the key inflation risk. The SARB s rhetoric has in recent months been somewhat hawkish, but we suspect that there might ultimately still be scope for monetary easing if inflation is sufficiently benign. The Monetary Policy Committee (MPC) seems intent to strongly signal that it is targeting the 4.5% inflation target midpoint rather than the 6% target ceiling, and the Committee seems focussed on the normalisation of real rates domestically and globally towards higher neutral rates in the medium-term. Its Quarterly Projection Model (QPM) forecasts 75bps of rate hikes by end-2019, mainly owing to its assumptions that the bank will pursue 4.5% inflation and a neutral real rate of 2.2% then. We are not convinced that either of these two assumptions will be, or has to be, met within this time period, and are thus disinclined to follow these forecasts. We pencil in two 25 bps rate cuts in 2018 Whether the SARB cuts interest rates this year depends essentially on whether its medium-term inflation forecasts are lowered sufficiently to lift forward-looking real rates at least above 1.5%. We pencil in two 25 bps rate cuts in

11 Figure 18: CPI forecasts % YoY Jan-09 Jan-11 Jan-13 Jan-15 Jan-17 Jan-19 Figure 19: Global interest rate changes (consensus forecast) US Philippines Chile Malaysia Australia UK Hungary Thailand Brazil Switzerland Eurozone China Turkey SA India Mexico Russia Indonesia CPI ex-electricity CPI CPI ex-energy, food, NAB -2,5-2 -1,5-1 -0,5 0 0,5 1 % Source: Stats SA, Standard Bank Research Source: Bloomberg, Standard Bank Research Figure 20: Macroeconomics forecasts Growth data (% y/y, seasonally adjusted & annualised) Q1:18 Q2:18 Q3:18 Q4:18 Q1:19 Q2:19 Q3:19 Q4: F 2019F Expenditure on GDP Household consumption expenditure Durable consumption Semi-durable consumption Non-durable consumption Services consumption Government consumption Gross fixed capital formation Gross domestic expenditure Exports Imports Current Account Balance % of GDP Prices Inflation (average) Interest rates (%) Prime lending rate (end period) Source: SARB, Standard Bank Research 10

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