In June the SA Reserve Bank (SARB) surprised the financial markets, raising the repo rate by 0.5%. Earlier this month the SARB again hiked by 0.5%. Judging from the behaviour of bond yields and most economist forecasts, the consensus expects this interest rate cycle to be very subdued compared to previous cycles.

Whilst we agree that the interest rate cycles of the 1980's and 1990's are unlikely to be repeated, we believe that the consensus view could be surprised on the upside.

The case for a subdued cycle for interest rates usually rests on three arguments. Firstly, it is argued that inflation is in structural decline and should remain in the SARB's target range, at worst breaching it moderately on the upside. Although the structural decline in domestic inflation cannot be denied, it does not imply that our recent inflation experience is indicative of where we are in the structural decline. From 2002 the massive appreciation of the rand undoubtedly played a pivotal role in suppressing inflation via falling import prices, particularly for manufactured goods.

Without the major discipline of an ongoing appreciation of the rand, it remains to be seen whether goods inflation (which is about zero) would remain contained against the backdrop of booming domestic demand. The recent experience with building cost inflation would strongly suggest that strong domestic demand can still generate substantial inflation pressures. The building industry is not as exposed to the deflationary pressures of an appreciating rand as for example the manufacturing industry.

A further ongoing pressure point on inflation comes from the high(er) commodity prices. With a stable to weaker rand, higher US$ commodity prices have already pushed PPI inflation to 7.5%. Some of these inflationary pressures will inevitably spill over to consumer inflation. In addition, international food prices are also escalating.

Furthermore, some of the prices surveyed on a periodic basis appear to be inflating at an unrealistically low rate at present. Housing costs (excluding mortgage rates) and domestic worker wages fall in this category. Upward adjustments from new surveys would probably accelerate the measured consumer inflation rates in the next year.

Secondly, the sound state of government finances is not putting upward pressure on rates. One could even argue that the low budget deficits of recent years should call for an easier monetary policy. Whilst one cannot fault the healthy state of government finances, it must be recognized that the low budget deficit is primarily the result of a huge surge in government tax revenues. Improved tax collection, combined with a buoyant economy account for this tax windfall. However, on the other hand government spending has also surged and should receive a further boost from the promised infrastructural program. Any setback to growth could easily expose the growing share of GDP allocated to government spending. Such a development would not necessarily be benign for interest rates.

Thirdly, following three decades of suffering a severe balance of payments constraint (i.e. mostly forced to run current account surpluses) the last four years felt like "seventh heaven" and most analysts argued that the balance of payments constraint was removed. From 2002 SA attracted an almost unprecedented inflow of largely portfolio capital, as international investors were chasing wide interest rate differentials, low equity valuations and exposure to commodity/China plays (companies, countries and currencies). This flood of largely portfolio inflows easily financed a growing current account deficit, boosted the rand, suppressed inflation, cut interest rates and led to a boom in asset prices. These benign financial conditions fed a growing belief that current account deficits did not matter anymore.

Without an apparent balance of payments constraint, any thought of a return of the vicious interest rate cycles evaporated - thus contributing to economic behaviour that encouraged a further widening of the current account deficit. This view was also strengthened by the consensus view that emerging markets were financially sound and could borrow US$ in international markets at spreads lower than 2% above the equivalent the US government would pay. For the SA government it meant borrowing US$ for 10 years costing just over 1% more than the Bush government would have to cough up.

However, in recent months international investors have started reassessing the emerging markets. With US interest rates rising back to more normal levels (increasing more than 4%) the focus turned on those emerging markets that had a great need for international capital inflows to sustain domestic spending levels. South Africa, Turkey and Hungary were caught in the spotlight.

These recent events strongly suggest that, although the balance of payments constraint has eased significantly, the ongoing widening current account deficit and associated domestic spending levels are starting to bump against some real constraints.

With rising international interest rates and initial signs of waning investor risk appetites, the constraint on the balance of payments appears to be tightening. In the absence of ever increasing commodity prices and capital flooding emerging equity and bond markets, the current size of SA's current account deficit probably requires a meaningfully higher interest rate premium to attract sufficient funds to meet the financing short fall.

Amazingly, the current account deficit widened to current levels, despite historically high commodity prices. Other commodity exporters do not find themselves in a similar situation.

Despite several positive structural adjustments in the SA economy, the risk of a more severe interest rate cycle, than currently discounted by markets, appears real.

Constructing a scenario for a possible peak in the current cycle consists of three steps. Firstly, international research indicates that the real level of interest rates tend to approximate the real sustainable growth rate of an economy overtime. Recent research from the SARB suggests that 4% to 5% could be the sustainable real growth rate for the SA economy.

Secondly, in addition to this real rate, the current state of our balance of payments and rising international interest rates would strongly suggest that an interest rate premium above this real rate could be demanded by international financial markets. With moderately less benign world economic conditions, such a premium could be in the region of 2%.

Thirdly, projecting an inflation rate of 5% seems to be a reasonable assumption.

Adding up the assumed real rate determined by SA's growth potential, an interest rate premium demanded by the widening current account deficit and waning investor risk appetite and a reasonable inflation assumption, a projected repo rate in the region of 11% appears to be a plausible scenario.

Although the future is always uncertain and tends to surprise, our analysis indicates that interest rate hikes are likely to continue and could easily surprise markets on the upside.

ISSUED BY:

CITADEL
Private Client Wealth Care

For further information please contact:

Dave Mohr, Chief Investment Strategist
(021) 940 7200
davem@citadel.co.za

OR

Daleen Cornelissen
Media Liaison
Citadel
083 302 0827
daleenv@citadel.co.za