Inside Insights 25 Oct 2010

Investment Intelligence|Inside Insights

A weekly, in-depth yet concise report on the most important recent market movements and economic developments.

Added on 25 October 2010 @ 9:44 AM

Next shots fired in the Currency Wars?

The People's Bank of China surprised the market by raising its official interest rate by 25 basis points to 5.56%. This comes as the inflation rate in fast-growing China rose to 3.6%, leading to fears that the world's second largest economy is over-heating. Even though economic growth has slowed somewhat, inflation is clearly on the rise. More specifically, authorities are worried that a buoyant property market could be a bubble in the making, which if burst could have severe consequences. Much hope has been pinned on the notion that China would be the world's growth engine over the next few years, so the interest rate hikes aimed at slowing the economy have come as a shock to many. However, a more sanguine view holds that interest rates are merely normalising after a period of being extraordinarily low.

The other option open to Chinese authorities is to allow their tightly managed currency to appreciate faster against the US dollar. This would slow inflation and help rebalance the economy away from investment towards consumption. It would also be good for countries exporting to China. But currency movements remain politically very sensitive and were a key talking point at the weekend's meeting of Group of 20 finance ministers and central bank heads. Broadly speaking a weak currency is good for exports, and all countries would love to export their way to economic recovery (obviously all can't at once). Over and above the fact that interest rates are at ultra low levels, causing capital to race round the world in search of yield, the Federal Reserve remains on track to launch another round of quantitative easing to support the US economy. These monetary factors distort currency levels, but are also supporting risky assets. Corporate earnings results have also surprised in many instances, causing US equities to end another week in the green.

Gold had its first weekly decline in 12 weeks as safe-haven demand decreased. The VIX, a closely-watched broad indicator of risk aversion, fell below 20 (an important resistance level).

Taming the rand

When Finance Minister Pravin Gordhan delivers the medium-term budget on Wednesday, he is expected to address currency volatility, or more specifically, currency strength. The rand hit a recent best level of R6.76/$, and ended the week below R7/$. Against a basket of currencies (the effective exchange rate), the rand is at its strongest level since January 2008. Other emerging markets, most notably Brazil, have introduced a ‘Tobin' tax to discourage short-term inflows. The likes of Japan and Switzerland have spent huge amounts in the open market to purchase foreign exchange in a bid to weaken the yen and franc, respectively. In all instances, the results have been ambiguous. Turnover on global foreign exchange markets amounts to around $4trillion daily. It is thus very difficult for any country to push its exchange rate one way or another in the absence of strict exchange controls (such as in the case of China). South Africa has modest exchange controls, and economists have argued that they be scrapped or further relaxed. This will allow capital ‘trapped' in South Africa currently to flow abroad, potentially offsetting the flood of foreign money heading for our bond and equity markets. Minister Gordhan is expected to make an announcement in this regard.

Gordhan's so-called mini budget will notable in another regard. It will come a week after his British counterpart, the Chancellor of the Exchequer, announced the biggest cut-back in government spending since the end of the Second World War. In an aim to reduce the UK's deficit from its present 11% of GDP to 2%, Chancellor Osborne will cut spending by £81 billion over the next four years. Close to half a million public sector jobs will be lost. South Africa's deficit is about half that of the UK, and so is our public debt relative to gross domestic product. Even so, while there is no urgent need here to cut back government spending, there is also not much scope for it to expand further to stimulate the economy. That job now falls, where necessary, on monetary policy in both South Africa and the UK. The local Monetary Policy Committee meets again on the 17th and 18th of November.

The Week Ahead

• The Reserve Bank releases its leading indicator on Monday.

• StatsSA releases the third quarter's labour force survey and latest unemployment rate.

• As noted above, the mini budget (or Medium Term Budget Policy Statement, as it is officially known) will be the key event of the week. Apart from an anticipated announcement on exchange controls, and other measures to curb currency volatility, economists will note the Treasury's updated estimates of GDP growth, budget deficit, and the debt to GDP ratio for the next three years.

• Also on Wednesday, StatsSA will reports September consumer inflation numbers. Year-on-year growth in CPI slowed to 3.5% in August and is expected to ease further to 3.3%, according to the Reuters consensus forecast.

• Producer inflation, to be released on Thursday, is expected to have increased to 8% year-on-year from 7.8% in August.

• The Reserve Bank releases private sector credit extension (PSCE) data for September. PSCE grew by 3% year-on-year in August, and is expected to have increased moderately to around 4.2% in September. Most of the growth in borrowing has come from the household sector. Borrowing by companies is still contracting.

• Global events and data releases of note this week: US durable goods and pending home sales for September; eurozone industrial new orders for August and economic and industrial confidence numbers for October; UK third quarter GDP.

Fairbairn Capital | Old Mutual

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