South Africa Reserve Bank Can Wait — Bank of America Merrill Lynch

Johannesburg, Capital Markets in Africa — The South Africa Reserve Bank continues to be one of the most orthodox emerging market central banks in the aftermath of the global financial crisis. As inflation has been above the bank’s target band, it is one of the few EM central banks to have hiked the policy rate so far this year. Even as the global backdrop has become much more emerging market friendly compared to late last and early this year, SARB’s rhetoric remains hawkish.

Market expectations are already in tune with the hawkish tone of the SARB and are pricing in 50bp of rates hikes between now and November 2016 and another 25bp by the end of 2017. We are expecting just one rate hike of 25bp in November and see rates on hold for 2017.

Headline inflation to prove sticky above the target, but the core is promising 
We have argued in our recent note that the overshoot in headline CPI inflation is largely due to supply side shocks and core inflation trends are better. Besides, we expect El Nino will leave much less lasting damage to South Africa compared to SSA peers.

Recent commentary from Deputy Governor Daniel Mminele suggested that in the inflation/growth trade off, keeping inflation in the target range is currently the number one priority. This is consistent with the observation that movements in the policy rate are more highly correlated with deviations of actual CPI from the maximum target than with the output gap.

We expect inflation to average 6.7% in 2016, slightly above consensus expectations of 6.5%. Food inflation will stay high, peaking at 12.8% as the effects of the recent drought constrain supply. Transport CPI will also increase, as we expect international oil prices to rise in H2, which will pass through to petrol prices, which are facing unfavorable base effects given the sharp decline in petrol CPI through most of 2015. However, this is offset by a stronger ZAR.

CPI tends to follow changes in the Rand with a nine-month lag. The SARB recently commented that pass-through from the exchange rate to domestic inflation has been low in recent years compared to history. This is likely due to the inability of firms to pass on higher input costs because of weak domestic demand. However, we would argue that currency depreciation as large as in 2015 means that even small exchange rate pass-through can yield significant increases in inflation.

This also applies the other way round, with the low base for the currency in 2015 implying significant yoy ZAR appreciation in 2016. With actual GDP growth remaining persistently below potential, ZAR stabilizing, inflation falling and fiscal policy getting tighter, the SARB may adopt a relatively easier stance than what the market is pricing in, in our view.

Fiscal policy needs to come to the rescue 
South Africa’s need for fiscal discipline is usually considered in relation to its rising debt stock and credit rating. However, the expansionary fiscal policy has not only been contributing to higher inflation via spending and high wage bill, it also crowded out the private sector to some extent. In fact, along with wider budget deficit, inflation has been increasing and growth has slowed down.  

Delivery of the fiscal targets remains key to the outlook. Director General of the National Treasury Lungisa Fuzile recently had his contract extended, meaning that he will remain in his role until May 2018, having been at the Treasury since 1998. Given the negative market reaction to the abrupt changes to the finance minister last year, we think this signal of continuity is a positive and should help the government to achieve its fiscal consolidation objectives. We expect the fiscal deficit to improve to 4.0% of GDP this year compared to government estimates of 3.6% and consensus of 3.5%.

An expansionary fiscal contraction is not a myth
Poor public finances have been one of the key weaknesses of the South African macro story. Policy determination to address it in the aftermath of the summer elections may create a virtuous cycle by improving confidence, and falling risk premium, creating room for SARB to pause its hiking cycle, and eventually supporting growth.

In fact, less can be more. The South African government does not have a good track record of using more government spending to boost GDP growth. Primary expenditure climbed to 27.5% of GDP in the latest fiscal year (2015/16) after staying stable at 26% of GDP for the previous four years. Despite the increase in spending (which was mostly current spending), growth fell to a four-year low of 0.9% in the same year.

Finance Minister Pravin Gordhan has said that economic growth remains the country’s most pressing challenge and in our view, the growth outlook is a key factor in determining whether South Africa gets a credit rating downgrade to junk this year. However, we also believe that fiscal consolidation coordinated with income policy might serve to that end quite effectively vs. keeping primary spending elevated. Sticking to the new expenditure ceilings and reducing waste in the government is prudent given the risks to South Africa’s credit rating. However, the government also needs to prioritize structural reforms to the economy, which can boost growth.

The elephant in the room is the wage growth and rigid labor market 
Wage growth outpaces productivity growth by a large margin and that is one of the key problems for inflation outlook in South Africa (Chart 6). Since the end of 2011, the manufacturing sector has seen growth in employee compensation that is on average four times higher than the growth in productivity and much higher than inflation. Across the economy, high wages have prevailed at the expense of job creation. Aside from weak sectors such as mining and construction, wages growth in South Africa has been relatively stable while productivity and overall GDP growth has slowed since 2010. This is likely due to the strength of the labor unions in South Africa, which weaken the link between wages and the business cycle as well as the link between wages and productivity.

This can be a real hindrance to growth. The IMF found that between 2008 and 2010 an “excess” of real wage growth accounted for at least 25% of the losses in total employment. The stubbornly high levels of unemployment (24.5% in 4Q15) are also a liability for political stability given that so many of the unemployed are young (among 15-24 year olds, 50% were unemployed in the first 3 quarters of 2015).

No easy fix for growth – structural changes needed 
For the labor force, introducing more flexibility and reducing the impact of frequent and lengthy strike action on the economy is key, particularly for SMEs that would benefit from being exempt from the collective wage bargaining framework. South Africa’s domestic skills base is inadequate. Among the unemployed, 58% did not complete secondary school and many of the country’s educational outcomes are far below other GEM peers. Though the skills shortage could be helped by making it easier for skilled foreigners to find work, the longer term goal should be to improve educational outcomes. Though tax incentives have been introduced to encourage firms to hire young workers and to invest in labor intensive sectors, more needs to be done to improve the ease of doing business for SMEs in the formal and informal sectors.

South Africa’s regulations against anti-competitive behavior are relatively strong with 76 cartels (excluding construction projects) sanctioned in the past 10 years. However, manufacturing and export markets remain highly concentrated. Lack of competition (due to excessive regulation) in key upstream industries such as telecommunications is leading to sustained high costs of operation for South African businesses.

Eskom, South African Airways and the National Roads Agency are significant contingent liabilities for the government where financial management needs to be improved. Adequate funding for Eskom is crucial to ensure resources are available for the current investment program to improve power supply. Though power constraints are easing, they are still bad enough to warrant caution in expanding production capacity, especially with the weak economic outlook. More robust infrastructure provision would increase incentives for investment.

We accept that many of these changes have been long overdue in South Africa for some time, but highlight that options to boost GDP growth using monetary or fiscal policy are currently restrained by global economic conditions and credit downgrade risk. Therefore, current incentives are high to accelerate the pace of structural reform.