JOHANNESBURG - July inflation surprised to the downside at 4 percent year on year – compared with the market at 4.3 percent. Given the global backdrop and event risks, we see nominal rand depreciation continuing.
However, the upside risks from rand depreciation are offset by weak growth (weighing on core inflation) and muted imported inflation (supported by weak growth driving global decline in commodity prices). We see average 2019 inflation at 4.2 percent and average 2020 inflation at 4.7 percent (end-2020 at 4.6 percent). We also see downside risks to our growth forecast for 2020 that suggest further downside to our 2020 inflation forecast.
Our neutral rate model suggest about 65bp easing in rates with further downside if the global easing cycle is more aggressive. This provides room for the the SA Reserve Bank (Sarb) to ease rates. The calendar, fiscal risks and rand complicates any rate decision in upcoming meetings.
Sarb feels that fiscal dominance is increasingly hampering monetary policy. Rising debt levels lead to higher real interest rates that induce capital inflows. Tighter policy by lowering inflation expectations provides a comfortable return for both local and international investors. In the former, crowding out of investment in the real sector is more pronounced while in the latter real rates induce flight into South African assets.
The bottom line
The September decision will be a close call between a hold and a cut of 25bp. We are of the view that Sarb can introduce 25bp cut to insure against staying behind the global easing cycle. A hold would postpone easing into 2020 as November will be volatile due to local (Budget statement, Moody's decision) and global (tariff wars) noise.
Fiscal deficit to reach 6% while expenditure cuts can limit deterioration
Growth and inflation have surprised to the downside since the February Budget. This weighs on fiscal revenues. Together with the Eskom cash support, we expect the budget deficit to reach 6 percent this fiscal year.
To limit the widening in fiscal, the government is contemplating a 5 percent cut in the non-interest expenditure envelope (R1.45tn) excluding spending for social development (R280bn). We estimate that if the full 5 percent expenditure cuts are implemented, this should equal 1.1 percent of gross domestic product (GDP) adjustment annually.
However, we think there will be push-back from departments and provinces that could lead to a less-than-projected adjustment. The medium-term budget policy statement (MTBPS) would provide the framework for consolidation and could be a positive surprise.
The increased issuance of R1.5bn per week was partly to compensate for revenue underperformance. The large part was to support Eskom, to smooth out the schedule for funding requirements (i.e. the delay in the Eurobond issuance) and pre-fund some of the future commitments.
The Treasury believes that switch auctions were disruptive to the back-end of the curve and were therefore paused. This led to a review of the switch program in its entirety. It should resume once the review is completed.
We expect $4bn (R61bn) issuance in Eurobonds – not necessarily all in one go
The procurement law constrained the Treasury to issue Eurobonds by about $2bn last year (relative to the planned $4bn). We expect the Treasury will issue $4bn until the end of the current fiscal year to compensate for last year's under-issuance and this year’s $2bn planned issuance. We think markets can easily absorb this given tight South African CDS relative to peers.
Implementation of the National Health Insurance and debt relief would be slow
The National Health Insurance (NHI) Bill has now been passed. The Bill proposes free essential healthcare, regardless of employment status and the ability to make a direct monetary contribution to the NHI Fund. It would take funds from the national health budget, private healthcare expenditure and higher personal income tax to be able to provide additional financing.
According to the Treasury, full implementation of the NHI would require R150bn per year (equals a 7 percent to 8 percent increase in VAT) under conservative assumptions. This makes its implementation difficult in the next six to seven years. Legislation would allow the Board and the NHI framework to be set up in the short term. However, funding constraints would lead to gradual implementation of the program over the medium term.
Rollout is expected to begin by 2022 with full implementation by 2026. We see limited scope for tax allocations towards the NHI for now, given tight fiscal space, with delays to implementation likely.
The National Credit Amendment Bill has also been passed. It allows for the unsecured debts of over-indebted consumers to be rescheduled and in certain circumstances, cancelled. It allows for the suspension of debt for up to two years and, if chances of rehabilitation don't improve, cancellation. Debt repayments can be rescheduled for periods of up to five years. We think this will lead to an increase in bad debt provisions due to moral hazard, stricter lending requirements limiting loan growth and increased cost of credit for households.
Locals are impatient on the pace of reforms
There is broad acknowledgement of reform progress albeit at a slow pace and in less priority areas. There have been positive changes at the cabinet level, leadership changes at tax administration, increased responsibilities for the auditor general, announcements around spectrum licensing/visa reform, investment announcements from Ford and Pepsi and a reconfirmation of Sarb independence.
We think that fiscal consolidation, restructuring state-owned enterprises, fighting corruption, and increasing security should be the priority. Nevertheless, government bureaucracy and technocracy are occupied with reforms like free health and debt relief that distract attention from priority reforms. We think recent moves by President Ramaphosa to address the ANC policy agenda should help him consolidate power and pave the way to implement reform in the medium-term. The downside is that fiscal risks are mounting and reforms will be difficult to implement into the next election cycle.
Some positives on visas but spectrum delays likely
Visa waivers have been granted to Qatar, Saudi Arabia, United Arab Emirates and New Zealand with more countries to be added. This should support tourism inflows on the margin. The announcement of broadband spectrum licensing was positive but roll-out is now expected to take up two years. The government has published guidelines for smaller operators.
Ferhan Salman is a senior economist at Merrill Lynch.