Well that escalated quickly. From a short-lived growth slowdown mid-February, to a full-blown global recession, the impact of Covid-19 is forcing many forecasters to revise growth projections almost daily as lockdowns set in or are extended. This morning, the SARB slashed its growth forecast from -0.2% at the time of the March MPC meeting to -6.1%. The IMF was mooting “tentative stabilisation, sluggish recovery” in January, but revised its global growth forecast from 3.3% to -2.8% this afternoon.
At first glance, these revisions leave a similar feeling to the time of the great financial crisis (GFC) of 2007 – 2009, but the global Covid-19 crisis (GCC – we are sure there will be many variations on naming this crisis) is very different. The GFC was a financial crisis that became an economic crisis. The GCC is a health crisis that is becoming an economic crisis with risks to the financial sector. The problem leading up to the GFC was deteriorating balance sheets. Now, at least initially, this is an income statement problem. Whether it becomes a financial crisis will depend on how quickly policy makers act and how apt the policy measures and facilities are in tiding over firms and consumers.
Yet there are numerous trade-offs that policy makers must factor in. The direct impact of the lockdown is saving lives, but destroying livelihoods in the process. For monetary policy, it is supplementing the incomes of the debtors, but punishing those living off their savings.
So far, the correct policy response has been to enforce strict lockdowns. This is based on the rapid flattening in infection curves where strict lockdowns have been accompanied by aggressive testing, tracing, and isolation measures, such as in South Korea and Singapore. In contrast, Italy, the US, and the UK have shown gradual lock-downs to be less successful. On this front, the local response has been encouraging, with the SA government lauded for its proactive stance in trying to flatten the curve.
Last week the president announced a two-week extension to the lock-down. Yet, in trying to flatten the infection curve, the recession curve is steepening rapidly, with estimates of a 5% – 10% contraction in GDP (taking into consideration direct and indirect channels). The knock-on to earnings estimates is still to come through, but the market has de-rated aggressively. We can estimate the hit to the fiscus more readily, with a double-digit deficit the most likely outcome for FY21 (10% to 12% of GDP).
So what have South Africa’s politicians and technocrats done? In short, a lot.
The SARB has been the most pro-active, in part because of its independence and because it has successfully flattened the inflation curve. This means it has not needed to abandon (at least not yet) its mandate and inflation-targeting framework to assist the economy. Following the larger-than-expected 100bp cut at the March MPC meeting, the Bank this morning reduced the repo rate by a further 100bp to a record-low 4.25%. Yet with inflation set to oscillate around 3% in the coming quarters, that still leaves a real rate of 1.25% – i.e. there is still more room to cut rates. This does not mean the SARB will do so with abandon – it has to be cognisant of capital flows and the currency, but we are some way off the zero lower bound.
In addition to the standard monetary response, the SARB has also been injecting liquidity into the banking sector via special and term repurchase transactions – this is very standard central bank policy. Where the SARB has moved towards the unorthodox edge is that it is now buying bonds in the secondary market to assist market liquidity and price discovery (and maybe even a flatter yield curve). This is certainly not yet “quantity easing” and given that legislation limits how much the SARB can directly fund the government, it does seem that the SARB will be very prudent in its bond-buying programme. Finally, the SARB is in the process of amending regulations to make it easier for banks to lend while maintaining the integrity of the financial system during this time of crisis.
The government announced various measures at the start of the lockdown, including health goods procurement and temporary tax measures, such as income-dependent employment tax subsidies, more frequent repayment of tax incentive reimbursements, and delayed tax payments for small and medium enterprises. With the extension, the Finance Minister has proposed a set of “phase 2” measures focussed on revising the fiscal framework and implementing (now very much overdue) structural reform. The Finance Minister’s previous clarion calls for structural reform have not been heeded. We know the lack of reform becomes evident in a crisis, but South Africa has wasted many previous crises. Will this crisis spur reform?
Tomorrow’s special Cabinet meeting is to approve the various proposals, as the government purse is set to shrink this year. The primary objectives will be the costing and funding of the direct health care response to the pandemic, as well as the temporary relief measures to address the recessionary impact of the health care response. At this stage, the emphasis will be on reprioritising spending and following through on the wage bill reductions, as set out in the February budget. Encouragingly, the Finance Minister has included consolidation of public entities and the closure of South African Airways and South African Express as potential reforms. The markets would take this as very positive, but time will tell whether this pragmatism (particularly if there will be less travel locally and globally after the crisis) will defeat the ideology of a developmental state.
But how will all of this be funded?
The government has little choice but to allow the budget deficit to widen sharply, as austerity now would be a double whammy to the economy. However, in doing so Treasury must have a clear plan on how to fund this record deficit and how to get out of a potential debt trap.
So far, there is little detail but all options are on the table. The domestic capital market has been forced to continue to take the weekly bond supply. We estimate that a best-case scenario would be a 20% increase in domestic issuance after the lockdown, but this would require a drawdown on cash balances and making use of external support (from the World Bank/IMF/New Development Bank). The UIF surpluses provide a buffer and part of this will be used to fund the response to the Covid-19 crisis.
Assets are cheap, but uncertainty remains elevated. There is ongoing speculation about whether government will fully lift the lockdown on 1 May, whether the SA infection data is accurate, and whether the COVID-19 pandemic will come in waves, mimicking the 1918 – 1920 Spanish Flu. Lockdowns buy health officials time to prepare, but are unlikely to fully contain the virus. The Wuhan lockdown was fully lifted after 76 days – SA is on day 19 (at the time of writing).
While previous epidemics and pandemics offer useful lessons to policy makers and the populace, the world today is a very different place. Moreover, the stimulus now exceeds that of the GFC and if it is indeed back to normal, then asset prices are in for a boom. That is a big if. Fear may linger and this crisis has probably been severe enough to result in behavioural change. For now, point forecasting is pointless. We need to think of ranges, and for many asset classes the tails could remain fat for some time.