How Oil Saved SA from a Downgrade
After the Nene-gate scandal in December 2015, there were few people who argued against a rating downgrade in 2016. It seemed imminent and unavoidable: the rand was pushing R17 to the greenback and our financial stocks plummeted. President Zuma appeared to be setting up to have a few controversial decisions made by our new highly qualified Finance Minister, David Van Rooyen.
As it turned out, money still called the big shots in South Africa, and the rating agencies saved the day, for the time being at least. From then onwards, we had a few more scares (negative Q1 growth, State Capture, municipal elections, Gordhan charges) which had the pessimistic among us (myself included) buying USD ETFs, bitcoin and gold. It seemed virtually certain that come December we would join the likes of Portugal and Turkey. These were just the local issues, of course. We had Brexit and Trump, which added fuel to the fire.
So what does all this have to do with oil?
Let’s start with a few interesting facts about oil in South Africa, as well as the relationship between our trade deficit and the USD/ZAR exchange rate. Thereafter, I will discuss the impact an increase in the oil price could have on the South African economic environment.
Oil accounts for roughly 16% of all our imports by value (it becomes more significant as the price increases) which makes it our largest import1. The demand for oil in South Africa is fairly inelastic with the volumes fluctuating around 19 billion kg2. At the end of 2014 we saw the price of Brent crude halve from $110 per barrel to around $55, where it currently lingers3. At the same time, we saw the continued deterioration of the rand from around R12 (2015) to R14 to the USD (2016), which offset some of the benefits of cheaper oil, but not completely.
Traditional economic theory predicts that a weaker exchange rate will improve the trade balance. This is not entirely true in South Africa, in fact, it seems to do the opposite. There is a 0.42 correlation coefficient between the USD/ZAR rate and the trade deficit, according the research done by South African Market Insights4. This means that, if anything, a depreciation in the rand will result in the growth of the trade deficit and a reduction in GDP growth. The reasons for this are numerous and are explained in the research linked here. Essentially, it boils down to an elastic demand for our exports and an inelastic demand for our imports. Combine this with a global slowdown as well as diminishing foreign investment in SA, and the positive correlation emerges. I have mentioned this because it means that the weaker rand did not improve the trade balance and did not help us avoid recession. In fact, the weaker rand fuelled our inflation, which will be discussed shortly.
So let’s summarise: Since the end of 2014, the Rand has depreciated nearly 17%. The Oil price has fallen roughly 50%. Oil is our largest import and makes up a significant portion of the price we pay for goods and services on average. Oil demand is inelastic so changes in price do not have a large effect on volume. The weakening of the exchange rate has not contributed strongly improving growth in SA.
Oil (fuel) is an input in nearly every product or service in the economy. An increase in fuel prices result in an increase in inflation, all else equal. South African CPI inflation was above SARBs upper limit of 6% during the period Jan 2015- Jan 2016 (6.23%). The average for 2016 was 6.56%5. The deterioration of the rand as well as drought exasperated our inflation. SARB has an inflation targeting policy and is expected to raise interest rates when inflation is persistently above the 3-6% target. The repo rate has increased in South Africa by 200bp (2%) since Jan 20156. These higher rates, as well as higher consumer prices, resulted in a slowdown of investment and consumption spending. This culminated in negative growth in the first quarter of 2016. A technical recession is entered into when there are two consecutive quarters of negative growth. We managed to escape this in the following quarter, only to fall back to near zero growth in Q3. Essentially, we were on the edge of a technical recession. The various ratings agencies all cited economic growth as their main concern for South Africa’s credit worthiness. Next, I look at the logical sequence of events that may have occurred had the oil price rebounded since its crash in 2015.
If the oil price had recovered to anywhere near it’s heights of $110 a barrel, while at the same time the rand depreciated and the drought occurred as it did – we would have seen significantly higher inflation and consequently staggering interest rates. The knock-on effect would have hurt investment severely and almost certainly pushed us into recession. We would have, without much doubt, been downgraded to junk, following which further rand depreciation would be expected. The vicious feedback loop would then continue to put upward pressure on prices, interest rates and taxes. Petrol prices in excess of R20/litre would not be a far fetch. South Africa would, in all likelihood, take a very long time to escape that dark hole. Essentially the oil price crash at the end of 2014 could not have come at a better time. The drought and dollar strength (accelerated rand depreciation) would have certainly sunk us had it not been for cheaper fuel keeping inflation at level which SARB could justify looking the other way.
Fortunately for us, it seems that between OPEC and the US shale operations, we won’t see a high oil price for a while. If OPEC raises the prices, the US producers will become more profitable and should increase supply7. Thus, the competition between the two groups of producers should help keep the price down and buy SA much needed time to pick up momentum.