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Current account deficit not a hurdle to further rate cuts

19 September 2017 Dave Mohr, Izak Odendaal, Old Mutual
Dave Mohr, Chief Investment Strategist at Old Mutual Multi-Managers.

Dave Mohr, Chief Investment Strategist at Old Mutual Multi-Managers.

Izak Odendaal, Investment Strategist at Old Mutual Multi-Managers.

Izak Odendaal, Investment Strategist at Old Mutual Multi-Managers.

South Africa’s current account deficit unexpectedly widened to 2.4% of gross domestic product (GDP) in the second quarter, from 2% of GDP in the first quarter. The current account balance, published by the Reserve Bank, measures current transactions between South Africa and the rest of the world involving goods, services, income and transfers.

Larger trade surplus

It is worth analysing the separate components of the current account to understand the drivers (set out in chart 1). The trade balance is the most volatile component of the current account, since it is influenced by the exchange rate and commodity prices. South Africa posted a third consecutive quarter surplus on the trade balance, increasing from R57 billion in the first quarter to R64 billion in the second quarter. Import volumes grew slightly faster than export volumes, but the terms of trade (export prices relative to import prices) has improved over the past year.

However, the larger trade surplus was more than offset by a deficit on the service, income and transfer account, which is permanently in deficit (equal to between 3% and 4% of GDP) and increased further in the second quarter, from 3.3% in the first quarter of 2017 to 3.8%.

One element of South Africa’s current account that is fairly unique is the transfer to the other members of the Southern African Customs Union (SACU). When it comes to import tariffs and customs, South Africa, Botswana, Namibia, Lesotho and Swaziland share a single external border and all customs revenue is shared on the basis of an agreed formula. In practice, it means South Africa contributes much more to the customs pool than it receives. Efforts to renegotiate the formula have failed thus far. This ‘transfer’ amounts to around 1% of GDP and contributes to a structurally large current account. In the second quarter it jumped from R49 billion to R65 billion (annualised). Arguably, the SACU payments should be excluded when comparing South Africa’s current account deficit to its peer group countries since they do not represent an external vulnerability.

The services balance of the current account is relatively small and includes transport fees, insurance and cross-border IT, legal and accounting services.

The income balance captures flows of dividends and interest (purchases of the underlying bonds and shares forms are captured in the financial account) as well as cross border salary payments. Despite the persistent trend of South Africans investing abroad, we still pay foreigners around 2.5 times more in dividends than we receive from abroad. In the second quarter it amounted to R84 billion annualised in dividend outflows and R90 billion in interest payments. It does appear, however, that AB Inbev’s acquisition of SABMiller has influenced the timing of dividend inflows, and that subsequent quarters could see net outflows moderate.

Deficits matter less now

At its worst point in 2013 – when the prices of our export commodities had declined sharply but the price of oil, our main import, was still above $100 per barrel - the trade deficit was 3% of GDP, leading to a current account deficit of almost 7%. At the time, global investors lumped South Africa with India, Indonesia, Brazil and Turkey as the ‘fragile five’ countries with large fiscal and current account deficits. The rand weakened sharply and the Reserve Bank was forced to hike rates several times over the course of the next three years. Despite the second quarter’s slight disappointment, the improvement since then has been substantial. Moreover, not only has the current account deficit narrowed (while the budget deficit stabilised), but the global climate has turned much more favourable to emerging markets compared to the 2013 to 2015 period. Deficits matter much less now than they did three years ago, but this doesn’t mean they won’t matter again at some point in the future. Emerging market spreads (the extra compensation investors demand for holding risky emerging market debt) peaked in early 2016 and have come down substantially. Global investors have piled into emerging market bonds and equities. Emerging market equities are up 30% this year in US dollars, while local currency emerging market bonds have returned 14%.

Financial flows still supportive

A deficit on the current account has to be financed by capital inflows, which in the case of South Africa is mostly portfolio inflows. South Africa experienced portfolio inflows of R74 billion in the second quarter, up from R25.9 billion in the first quarter. Foreign investors bought bonds to the value of R49 billion in the second quarter, following an inflow of R42 billion in the first quarter. Foreign investors were also more positive on local shares, acquiring R25 billion in the second quarter of 2017 after net sales of R16.1 billion during the first quarter.

These inflows are considered “hot money” that can quickly flow out should global risk appetite shift. Ideally, South Africa would attract more direct investment relative to portfolio flows, since this money is stickier and also tends to create jobs and support economic activity. However, foreigners are unlikely to invest in new or existing businesses as long as growth is weak and uncertainty high. South African firms certainly aren’t. Over the past five years, local firms have spent R330 billion on mergers and acquisitions abroad, with R30 billion being spent in the second quarter alone. The latest RMB/BER Business Confidence Index shows that local corporate executives are still pessimistic, although at least the level of pessimism is no longer increasing. The index increased from 29 to 35, with 50 being the neutral level.

Interest rate implications

A key question for investors and policymakers is therefore whether the favourable global climate will persist, allowing South Africa to fund its deficit with portfolio inflows. This will greatly depend on the path of interest rates in the major economies. If there is a shift in global risk appetite and the hot money flows out, the rand could weaken sharply. Before flexible exchange rates were adopted in the 1970s and 1980s, countries facing outflows would often have to force the current account deficit closed by choking off domestic demand, inducing a recession with high interest rates. Letting exchange rates bear the brunt of the adjustment is much less painful, but it can lead to higher inflation.

Next week’s monetary policy committee (MPC) meeting will take all of this into account. As discussed above, the MPC has in recent years placed great emphasis on South Africa’s external vulnerabilities, despite the negative impact on the weak domestic economy. Since the start of the year, however, the dollar has weakened, inflation has declined, South Africa’s growth prospects have deteriorated (the second quarter bounce notwithstanding) and household borrowing remains weak. These are all factors that provide further support for rate cuts.

Chart 1: South Africa’s current account components, % of GDP

Source: SARB

Chart 2: South Africa repo rate and consumer inflation, %

Source: SARB

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