OPINION: Medals, spreads & hawks – a tale of two countries

by Dave Mohr & Izak Odendaal, Old Mutual Multi-Managers 9 views0


South Africa and Brazil have much in common, including volatile politics, corruption scandals, economic decline and ratings downgrades. What sets these two countries apart?

South Africa marked a historic haul of 10 medals at the 2016 Rio Olympic Games, equalling its best performance ever. Host country Brazil secured 19 medals, but its much larger population means that the country won 0.01 medals per million people, compared to 0.5 medals per million people for South Africa. For Brazilians, the Games were also mired in controversy over fears that venues would not be ready in time and would end up as white elephants, while the overall cost of the games was indefensible at a time when Brazil is suffering its worst recession in decades (never mind that the cost came in way over the initial budget).

Brazil is probably the country that resembles South Africa the most, given its extreme income inequality, resource dependence,  tendency to attract hot money capital flows, as well as its relatively sophisticated private sector. At the time of winning the bid for the Olympics, many South Africans were green with envy at the country’s progress in achieving rapid economic growth and eradicating poverty. It seemed as if Brazil had changed substantially for the better, recovering from the global recession relatively quickly, and was acknowledged as one of the most promising emerging markets. However, over the past few years, much like South Africa, Brazil was hit hard by the commodity price collapse. This also exposed how much of the country’s growth rate was inflated by a credit boom and overvalued currency.

Messy politics

The economic crisis in Brazil is to a great extent a political crisis. Deadlock in a fragmented Congress (with some two dozen parties), worsened by an epic corruption scandal involving nearly $3 billion in bribes and many lawmakers, prominent business people and the country’s largest company, Petrobras, all contributed to Brazil not being able to tackle the economic decline. It could not pass budget legislation to restrict spending and close the deficit, leading to a sharp rise in borrowing costs. Brazil’s government debt jumped from 53% of GDP in 2013 to 68% and is expected to reach 80% (South Africa’s debt to GDP ratio is expected to stabilise at around 50%). Although President Rousseff oversaw most of the Olympic preparations, she could not attend the ceremony because of an impeachment process against her.

South Africa’s politics are also quite messy with the rand, bonds and bank shares selling off after news that Finance Minister Pravin Gordhan may face criminal charges that could lead to his removal. Although Gordhan carries a lot of credibility among local and global investors, South Africa’s institutional strength is not centred only around our Finance Minister. While unnerving, the events of the past week also point to South Africa’s institutional strengths, including a vocal civil society, free press, independent courts and a central bank willing to stick to its mandate.

While Brazil’s budgeting process is in shambles, South Africa has ranked in the top three in the world for the transparency of its budget system. The Finance Minister presents a three-year budget to parliament in February each year with an update in October. There is no reason to expect this to change, irrespective of who the Minister is. Since 2012, Treasury has put in place an ‘expenditure ceiling’ which limits the rand amount of spending that can take place in a fiscal year (hence the talk around ‘reprioritising’ budget items in the aftermath of the ruling party’s local government election losses – the overall spending amount is fixed).

Downgrade risk remains

The risk of a credit rating downgrade for South Africa remains. Ratings agencies are interested in economic growth. There are signs of improvement in the data as the impact of economic shocks fade: electricity supply has stabilised, the drought should ease, and commodity prices are no longer declining. However, sustained growth requires policy reforms that do not appear to be forthcoming. Top of the list are more flexible labour markets and improvements in the performance and governance of state-owned enterprises.

Downgrades are unwelcome but not the end of the world. S&P stripped Brazil of its foreign currency investment grade rating in September 2015, and cut its rating by another notch in February this year. However, at around 11%, Brazil’s 10-year government bond yield is lower now that it is a “junk status” economy than for most of last year when it was still considered investment grade. The main reason is that global ‘risk free’ rates have tumbled. The simplest way to gauge market view of political and currency risk is the higher yield that the Brazilian government pays to borrow in its own currency compared to what the US government pays. This spread over the equivalent US 10-year government bond yields remains elevated, even though it has receded. In the case of South Africa, it remains even well above the long-term average. Unlike December’s ‘Nenegate’ episode, which happened against the backdrop of an emerging market rout (Brazil’s jumped to 16% and South Africa’s10-year yield to 10.6%), the global environment remains much more favourable.

Chart 1: Spread of local currency 10-year government bond yields over US equivalent

Chart 1 Spread Of Local Currencies

Source: Datastream

 Credit default swaps (CDS), instruments to insure against default, also reflect the downgrade risk (the higher the CDS, the greater the expected risk of a bond default). Although South Africa’s credit rating is higher, our CDS trade is in the same territory as Brazil’s (and fellow junk status economies Russia and Turkey).

Chart 2:Credit default swaps for key emerging market US dollar bonds

Chart 2 Credit Default Swaps

Source: Datastream

Inflation receding

One area where South Africa has performed differently to Brazil is in terms of inflation. Despite also suffering a currency collapse from 2011 onwards, South African inflation did not move outside the 3-6% target range on a sustained basis.

Brazil’s inflation target is also 3-6% , but its inflation rate soared, forcing the country’s central bank to aggressively hike interest rates, despite the worsening recession. Consumer inflation hovered around 6% between 2010 and 2014, but jumped to 10% by the end of 2015. It has receded only somewhat to 8.7% most recently. Brazil has a history of hyperinflation. Consumer prices increased by over 6 000% in 1990. A second bout of hyperinflation peaked at 4 922% in 1994. Therefore, its central bank has to work hard to maintain credibility, with policy rates at 14.15% (compared to the South African repo rate at 7%).

The most recent data show consumer inflation in South Africa falling to 6% in July, from 6.3% in June. This was slightly lower than expected. Food inflation accelerated to 11.5%, but we are probably close to the peak of the food inflation cycle. Given that food prices rose sharply late last year, the base effect will become much more favourable as we head into 2017. However, the currency remains the main risk factor to the inflation outlook.

Interest rates remain elevated

While rates have fallen in almost every other major economy in the world, they remain elevated in both Brazil and South Africa. However, the South African Reserve Bank (SARB) most likely wants to see inflation and inflation expectations head towards the midpoint of the range, rather than sticking around 6%. In a speech last week, Reserve Bank Governor Kganyago voiced his concern that inflation remained too high, fuelled in part by high wage increases. He also pushed for labour market reforms aimed at increasing employment, saying “We’ve built an economy that produces much more inflation than growth and spits out unemployment as a by-product.” Although the SARB won’t mention it, it is probably also worried about local political and policy uncertainty against the backdrop of potential US interest rate increases. Maintaining relatively high real interest rates acts as an insurance policy during times of economic uncertainty.

The ‘hawks’ that matter most

Central bankers are traditionally categorised as ‘hawks’ or ‘doves’ depending on their eagerness to hike rates. Ultimately, for South African (and Brazilian) financial markets, the hawks that matter are not a police unit, but the members of the US Federal Open Markets Committee who favour higher rates. However, the Fed chair Janet Yellen remains a dove for now. During the global central bankers’ annual meeting at Jackson Hole, she noted that the case for another US interest rate increase has strengthened, but she still expects rate rises over time to be very gradual.