Old Mutual Wealth: Greece, deal or no deal?

BY SUPPLIED - FEBRUARY 24, 2015

It is with a real sense of déjà vu that the term “Grexit” meaning a Greek exit from the eurozone is being discussed. Back in 2011 and 2012, it was the centre of market attention until a series of bailouts and the promised intervention of the European Central Bank (ECB) diffused the crisis, not only for Greece, but also for Ireland, Portugal, Spain and Italy. But only the crisis on financial markets was resolved. The Greek economy has been in a depression for many years with the real value of economic activity some 25% lower today than in 2008. This is in part because of the state being forced to run sustained large budget surpluses as part of its bailout obligations. In other words, the state is taking more out of the economy through taxes than it is putting back through spending. The required surpluses have almost no precedent in history. As the economy has shrunk, the debt-to-GDP ratio has increased, rather than fallen.

The final problem is that real interest rates have been far too high for Greece, since monetary policy is set in Frankfurt, not Athens. It is not surprising that the Greek people elected a new government with a mandate to change. The demands of the new Syriza government are broadly speaking not unreasonable. They want to run smaller budget surpluses (i.e. less austerity), and link some of their outstanding debt obligations to economic growth. The rest of the eurozone is against this proposal, and not only Germany, who would be expected to take a hard line on negotiations.

Crisis averted, for now

The current bailout expires on 28 February. Greece still needs bailout money to run the government and has to face large loan repayments to the International Monetary Fund later this year. Tax receipts have fallen sharply over the past few months. On Friday, European finance ministers and Greece agreed to a four-month bailout extension with a slight softening of the austerity conditions. Greece will have to provide details of its reform plans by today, and these will have to satisfy European leaders. There is still a chance the agreement could be scuppered and the drama of the past month might be repeated in July.

South Africa won’t go the Greece route

Ahead of the local budget speech, one might also wonder whether South Africa could end up in a Greece-like situation. The answer is no for three reasons. Firstly, it is normal for countries to run large budget deficits in the wake of a recession. Greece’s problem was that it had large deficits, and a government debt-to-GDP ratio of more than 100% on the evening of the 2008 recession. South Africa’s government debt-to-GDP ratio is far lower, but we cannot be complacent as this ratio increased from 28% in 2007 to 44%. This is not far from the 50% level suggested by a recent research piece of an International Monetary Fund employee to be the safe maximum debt-to-GDP ratio. Hence the Finance Minister is expected to reaffirm his commitment to reduce the deficit and stabilise the debt ratio.

Secondly, South Africa has full control over its monetary policy, so the Reserve Bank can set interest rates appropriate for the local economy. If the Greek economy could grow consistently, a big part of its debt problem should be resolved. Finally, and perhaps more importantly, is that the South African public and private sectors can borrow, and have borrowed, in local markets and in the local currency. Greece’s debt is by and large owed in euros, a currency it cannot control (or create itself). Having your own currency has the other advantage of allowing the exchange rate to carry out part of the necessary economic adjustment. The euro has simply been far too strong for Greece for too long. Therefore it had to adjust ‘internally’ by forcing down prices, wages and incomes. The rand, on the other hand, has weakened substantially over the past three years. While this resulted in upward pressure on inflation (although far less than expected), it also led to increased export revenues and tourism income and slower import growth (less than expected). South African companies with foreign operations benefited handsomely from this.

The markets recognise the difference, as shown in the chart below. The JSE All Share returned 330% (including dividends) since bottoming in rands in March 2009. The Athex Composite lost 40% in euros over the same period.

Chart 1: South African equities in rand and Greek equities in euro since 2009

 

Source: Datastream

January inflation sharply lower

Consumer inflation slowed sharply to 4.4% year-on-year from 5.3% year-on-year in December, broadly in line with market expectations of a 4.5% reading. The consumer price index (CPI) was 0.2% lower in January compared to December.

Food and petrol inflation lower

Food and non-alcoholic beverage inflation declined further from 7.2% to 6.5%. Most categories of food prices showed slower growth on an annual basis. The local maize price jumped over the past month due to a drought, which, if sustained, should place upward pressure on food inflation towards the end of the year.

Annual petrol inflation was -17.6% in January from -5.5% in December. Petrol inflation should fall further in February (around -26%).The rebound in the oil price to around $60/barrel and the weaker rand mean the current average under-recovery is around 77c/l, which will limit the year-on-year decline in March to around -23%.

Lower inflation unlikely to lead to rate cuts

Core inflation – excluding food and energy prices – rose back to 5.8% from 5.7%. Of the main core items, insurance, household services and purchase of vehicles saw marginal increases in annual inflation. In the case of the latter, new vehicle prices rose by 7.9%, while used vehicle prices fell by 7.9%. In the absence of sustained declines in the core inflation rate and notable declines in inflation expectations, the Reserve Bank is unlikely to change its current monetary policy stance of gradually hiking after a pause. The Governor reaffirmed this policy stance in a speech delivered at a trade union conference.

With the repo rate having turned positive in real terms, part of the rate normalisation process that the South African Reserve Bank (SARB) wanted to get underway before the US starts hiking rates has realised. A narrowing of the current account deficit due to the lower oil import bill takes further pressure off the SARB, as will a renewed commitment to fiscal consolidation in this week’s budget speech (although certain types of tax increases could result in higher short-term consumer inflation readings). The SARB Governor has noted that the bar for rate cuts is very high, with recent rand weakness not helping. However, central banks across the world are cutting rates (most recently Sweden and Indonesia) and inflation has become a scarce commodity in many parts of the world. The SARB will obviously also keep an eye on domestic spending growth.

Can a good fourth quarter carry over into 2015?

Mining and manufacturing rebounded in the fourth quarter, but electricity blackouts will probably limit further upside.  The outlook for consumer spending has improved. The year to end December saw 0.9% growth in employment, while the lower inflation rate could see the growth in real wages rise to around 3% in 2015, which would be the best year since 2011. Finally, the postponement of expected rate hikes should also support consumer confidence, with debt service ratios still within a historically low range. On the downside, expected tax increases and a double-digit electricity tariff hike will likely limit upside in consumer spending, while the rolling blackouts will probably limit job creation. There is also no sign of higher household credit growth.

The better outlook for household finances has already resulted in spending growth. Real retail sales rose by 3.4% year-on-year in December, up from 2.5% in November. Nominal retail sales growth was 9% year-on-year up from 8.1% in November. Retailers are therefore benefiting from volume growth as well as turnover growth.

Seasonally-adjusted real retail sales rose by 1% in the fourth quarter compared to the third quarter. This suggests a positive boost to fourth quarter GDP growth (along with the mining and manufacturing sectors which also posted positive fourth quarter growth). Tuesday’s GDP numbers could show quarterly growth rebound to around 3.5%, but that would take growth in 2014 to 1.4%, down from an already-mediocre 1.9% in 2013.

Chart 2: South African inflation

Source: Datastream

 

Caption (main Image):  Izak Odendaal, Investment Analyst at Old Mutual Wealth  Images supplied.