South Africa Watch – More vulnerable after downgrades

by: Marijke Zewuster , Georgette Boele

  • Recent cabinet reshuffle upset markets and resulted in downgrade to sub-investment grade
  • Zuma will most likely survive the no confidence vote, but the political situation remains tense
  • We maintain our growth forecast of 1% in 2017 and 2% in 2018, however downside risks have risen
  • Rand weakness returned, but we expect a recovery next year
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Ousting of Gordhan leads to downgrades

The combination of high fiscal and current account deficits has positioned South Africa among the emerging markets most sensitive to increased risk aversion. The recent downgrade to below investment grade levels have made things worse. Both S&P and Fitch lowered their rating to junk status, while Moody’s placed the country on a negative watch, after president Zuma ousted the highly respected finance minister Pravin Gordhan end March as part of a bigger cabinet reshuffle. The ousting increases the risks of a fiscal slippage and could lead to a further rise in government debt levels (which currently hovers around 50% of GDP).

Legacy of Apartheid

For years, South Africa has one of the lowest growth rates in Sub-Saharan Africa, with average annual growth of just 2% in the past ten years and 3% annual growth since the end of apartheid in 1994. The fragile economic situation is partly due to long-existing structural problems, such as social inequality, poverty and crime, which reflect the legacy of apartheid and keeps the country in a vicious circle. Since 1994, unemployment has consistently remained above 20%, while youth unemployment even hoovers around 50%. This has led to increased social discontent and severe labour disputes. Corruption is another rampant problem. On a positive note, South Africa is the most diversified and advanced economy in Africa, with a still relatively high GDP per capita and a healthy financial sector.

Political situation will remain tense at least until the general elections in 2019

Not only are structural imbalances a significant bottleneck for achieving stronger growth, but they are also undermining the ANC’s credibility and that of President Zuma. The recent cabinet shake-up also led to renewed calls for resignation of president Zuma, also from within the ANC. On April 19 Zuma will face a no confidence vote in parliament. However ANC seems to have closed ranks again as they did before in previous allegations of corruption against Zuma. Given their majority in congress, Zuma most likely will survive this vote as well and is expected to remain in power until the elections in 2019. But already in December of this year the ANC at their National Conference will choose the new party leader and presidential candidate. Zuma has been two terms in government so he will not be allowed to run for re-election. It is still unclear who will be the next leader and what direction the ANC will take. It is quite possible that in an attempt to regain the vote of the more radical parts, like the left wing Economic Freedom Fighters, led by the former ANC youth leader Jules Malena, the ANC moves to a more radical and less market friendly policy.

But while this might stop the rise of the Freedom Fighters, it could alienate the more centrist ANC voters and hence benefit the liberal Democratic Alliance (DA). In the 2014 elections the DA saw its share of the vote rise from 17% to 21%, while the share of the ANC fell from 66% to 62%. The DA did also well in the October 2016 municipal elections. All in all, even though the ANC will probably remain the single most important party in congress, they most likely will continue to lose votes, be it either to the left or to the centre. At the end this could be positive as a stronger opposition might help to improve the democratic checks and balances, but it could also lead to more destabilising political actions.

 

Economic growth stagnates, but…

Since 2014, economic growth has slowed down and last year the economy almost stagnated. Lower commodity prices are partly to blame, but a severe drought (resulting in power shortages) plus disruptive labour strikes played an important role as well. In the last quarter of 2016 the economy contracted with 0.3% qoq, and rose 0.7% yoy. Annual growth slowed from 1.3% in 2015 to 0.3% in 2016. While private consumption remained relatively robust, with a growth rate of slightly less than 1%, private investments took a big hit, falling with almost 4%. On the supply side, both mining and agriculture contracted sharply, while the service sector registered positive growth. Economic figures for the first quarter of 2017 are so far mixed. Retail sales contracted by -2.3% in January, pointing to a slowdown in private consumption growth, while manufacturing production contracted strongly in March as well. On the other hand, the PMI index jumped from 46.7 in December to 52.2 in March, pointing to stronger growth ahead.

…slightly stronger growth expected in the coming period

We expect growth to pick up in the coming two years, but it will remain at low levels and not surpass the annual growth rate of just 2% we have seen during the last decade. Weather conditions are less adverse and power shortages as a consequence will be much less frequent, while commodity prices are also slightly more supportive. But the overall economic policy mix will remain restrictive. Before the cabinet shake-up the assumption was that fiscal policy would become more tight, leaving some room for monetary relaxation. However as the risk of fiscal slippage has increased and inflation could rise, we expect monetary policy to become more restrictive. Inflation fell slightly in March, but remains high at 6.3% yoy. The weaker rand and higher energy prices could drive prices up in the coming months. It is further hard to predict what will happen with labour disputes and what the impact of recent downgrades will be on investments. Risks to our growth scenario therefore remain tilted to the downside.

 

South Africa’s vulnerability to external shocks has risen after the downgrades

The strong slowdown in economic growth and a weaker rand has led to some improvement of the current account deficit, falling from almost 6% of GDP in 2013 to an estimated 3.8% in 2016. But this most likely is a temporary dip. Exports will continue to grow driven by a relatively weak currency, but stronger investment growth and higher energy prices will lead to a pick up in imports growth as well. The EIU forecasts the deficit to rise to 5% again in 2018. The downgrade to sub-investment grade will make it more costly to finance this substantial current account deficit, as will tighter financial conditions, caused for example by Fed rate hikes. This increases the vulnerability to external shocks even more.

Rand has given up its gains

In the period start of 2017 until 24 March 2017, the South African rand was the strongest performing currency. It rallied by close to 10.5%. Then investor sentiment made a dramatic U-turn because of the internal power struggle in the ANC. Since 24 March the rand has given up more than gains and it is now again among the weakest emerging market currencies. This behaviour shows its main vulnerability. It may rally strongly, but investors could change their minds abruptly and sell it off aggressively. We expect some more ZAR weakness this year because the higher US Treasury yields will probably weigh on the ZAR. Our year-end forecast for USD/ZAR is 14 but it could temporary move above it. But we expect a recovery next year because higher commodity prices and our expectations of a weaker USD.