Superimposing contagion risk

We are currently in the grip of a huge global contagion, brought about by rising oil and food prices. It has taken CPIX inflation from 3.5% two years ago to 10.4% today, with the peak (also allowing for Eskom and secondary forces) likely to crest 12% in coming months.

But oil and food aren’t the only potential sources of contagion. In 2001, our monetary disturbance came aboard mainly via a spectacularly freefalling Rand, responding to Asian events and global markets testing our non-existing defences and policy resolve.

A memorial run on the Rand followed, halving its value within months, imparting a massive 5% rise in inflation in its aftermath, which in turn triggered a near equivalent SARB tightening of interest rates.

This time we have not primarily been sandbagged by the Rand, although it has absorbed some weakening since 2005, reinforcing the primary inflation shocks contributed by oil and food.

But there is nothing ordained or exclusive about the sequencing of such events. There is a nightmare scenario out there, at least for indebted households (and quite the contrary for export-based producers) in which another Rand contagion gets superimposed on a cresting oil and food price contagion.

Just as you think things couldn’t possibly get worse, with oil and food price disturbances finally topping out, triggering hopes of an unwinding of the bulging inflation shock, one could get hit by a second bus, potentially just as virulently fatal as the first.

Internationally, there are certainly those analysts who hope that both oil and food prices are in peaking territory, raising hopes of an imminent inflation cresting and unwinding later this year, eventually followed next year by a partial undoing of monetary tightening, at least in those emerging countries that have led the tightening parade this year.

Falling inflation next year certainly would invite a partial unwinding of the interest rate increases of the past two years, giving renewed hope and impetus to asset markets and reducing the growth sacrifice currently underway.

But don’t get your hopes up just yet. As the past week has shown, global conditions don’t warrant such optimism.

Mere ECB speculation of imminently higher interest rates, and further US payroll declines and especially higher unemployment at 5.5% hinting at the absence of Fed rate increases this year, gave new impetus to the Dollar weakness scenario.

This remarkable combination of events resulted in a kneejerk reversal of oil market positions, taking the price towards $140 all-time highs. And heavy rains in US maize-producing regions, along with late plantings, also pushed maize prices to record highs.

Besides such financial and weather-related reasoning, there remain many analysts overseas who don’t think the oil and food fundamentals have been turned decisively yet, making for sustained price declines soon.

Instead, such analysts keep finding reasons for further trend gains in oil and food prices. For them, our inflation nightmare continues to have legs, having further to go before finally flaming out at levels well above today’s levels.

It would, however, be most inconvenient if there would be a second contagion making its appearance before the first one has been well and truly seen off.

For such an occurrence could spell double trouble, giving another major upward twist to inflation and interest rates, superimposing new upward momentum on top of the inflation bulge currently shaping.

The only really serious candidate for such an unwelcome surprise shortly would be another major Rand decline. The mechanism could have similarities with 2001, but there could also be differences, more reminiscent of the 1985 Rand decline.

Indeed the most powerful combination would be a 1985-2001 type of event. For there could potentially be various levels of intensity to any Rand fall, akin to measuring earthquakes (Richer Scale) or hurricanes (Beaufort Scale). A hurricane with force 5 winds is the most powerful reading possible.

What combination of events could trigger such a phenomenon?

Unlike 1985 or 2001, South Africa today doesn’t have a fatally weak foreign reserve condition. Even so, the impressive reserves ($34bn) we do have today are probably meant mostly for show rather than to be pressed into a forlorn defence of the indefensible.

Instead, like in 2001, the Rand is the true shock absorber of last resort. A massive loss of external confidence would be registered in a decline of the Rand, and would likely be allowed to play out, until contrarian market forces would be willing to undo the undershoot in response to the perceived opportunity shaping.

Unlike 2001, but far more reminding of 1985, South Africa today has a large current account deficit approaching 8% of GDP. In good times funding can quite easily be obtained, supporting relative Rand stability and preventing undue instability being passed on through to inflation, interest rates, asset markets and GDP growth.

But moments can occur when markets suddenly consider such deficits and their external funding needs with radically changed eyes. If events occur reminding markets of the deeper risks they are running in a country with such external deficits a failure of nerve can quite easily occur, often triggered in tandem with a wider change in perceptions (contagion).

Besides the toxic current account deficit, we are in the process of reducing our attractiveness to foreigners in two more fundamental ways.

In an effort to maintain price stability at a time of external oil and food price shocks, we are seemingly prepared to incur considerable growth sacrifice as we raise interest rates.

That tactic, however, is to be compared with an aircraft pilot throttling back speed. At some crucial point, such a move may take him below stalling speed, after which the aircraft can spiral out of control.

Uneasy financial markets are getting a little nervy on this score. How close are we getting to stalling speed, and should we panic early rather than late? This is clearly a warning sign that too much economic weakness could beget yet more penalty as withdrawing capital puts downward pressure on the Rand.

The other potential domestic source of unease is our political overlay. Will economic policies be changed, for the good or for worse? If the latter, more risk premiums may be demanded, potentially well in excess of what the Trahar/Mbeki exchange of some years back implied.

The more wrong signals we choose to send out to the world, the more unnerved markets could become, at some point potentially sandbagging the Rand and setting in motion new destabilizing monetary influences.

All these features are our own doing mostly, potentially weakening our attractiveness. If in such a condition we were to encounter another vigorous external shock, the fat could once again be in the fire.

And potentially there are international areas of weakness that could trigger wider contagion as markets reconsider the appropriateness of their risk premiums across classes of financial assets.

Abrupt US economic strength, higher US interest rates and Dollar firming could be such a source of pressure, but this looks unlikely to get activated soon. Instead, this volcano looks set to remain dormant for longer in the wake of the present housing and banking adjustments. And this despite recent musings about a firmer Dollar and higher US rates. The present US condition makes these premature speculations.

Another source of risk would be abrupt weakness occurring in the Asian economies, this time focused on China with a follow-through to commodities, reminding of 1998 Asian contagion events. There are adherents to such views, but it may also be premature.

But there are today exposed minor parts of the emerging universe that could suddenly be subjected to risk re-evaluation. In the process, re-assessment could spread wider in the asset class, drawing attention to unrelated areas showing similar features.

It is at such moments that our large current account deficit, our deepening growth sacrifice and uncertain political intentions could serve as multiple red rags to a herd of already enraged bulls.

Something unfunny happened only last week in Turkey, a country with a 7% of GDP current account deficit, inflation gone double digits, rising interest rates imposing potential growth sacrifice and a troubled political condition.

Turkey just blinked. It has politically decided to loosen fiscal policy, but has simultaneously decided to sharply raise inflation targets, thereby taking away the argument for higher interest rates in the face of sharply rising inflation fed by the global oil and food shocks.

Turkey is thereby signaling an unwillingness to accept growth sacrifice. But it is potentially sacrificing its credibility regarding macro stability (currency and inflation). And it is inviting global financial markets to vote on the matter.

Even if Turkey were not to get clobbered shortly in isolation, it is a closely watched compatriot of South Africa with a similar profile (fatally in the same time zone) and it has just weakened its defences and reduced its attractiveness to global investors.

A market response, demanding higher risk premiums, could potentially spill over to South Africa, even if we remain innocent of similar policy changes. It’s the profile, and the potential of it also happening here within the year that could make us suspect.

But even if Turkey in its own right doesn’t trigger a contagion, there is yet another candidate for triggering serious disturbances in the emerging market neighbourhood and that is Eastern Europe.

Enormous trade deficits mark the region, with rapid credit expansions, overworked asset (housing) markets, greatly increased household indebtedness, double-digit inflation and apparently not a care in the world as the fun continues.

Iceland shares some of these same characteristics. Earlier this year it found itself again under attack by foreign hedge funds and other speculators, necessitating huge interest rate increases and the arranging of foreign standby facilities to bolster its foreign reserve defences and its failing currency.

Iceland was at the time a largely isolated case of financial market unease, with no clear contagion developing towards the emerging market class.

Indeed, Iceland was probably itself the victim of a wider OECD contagion originating in the global banking and credit adjustment.

But Turkey is far closer to home for us, and like Eastern Europe in our time zone. That could be fatal if London players were to become activated in response to either situation, potentially handing out haircuts to similarly placed countries.

We are rather exposed in our make-up at the very moment that we are fully absorbing the global oil and food contagion currently disturbing our inflation, interest rates, asset markets and GDP growth.

No wonder our macro policymakers are rather proactive at present.

Now is hardly the time to have to absorb a second massive external disturbance, superimposed on the first. But that risk isn’t negligible. For which reason one should not think in terms of precise point-forecasts for things like the Rand, inflation, interest rates and the rest.

Instead, one should think out of the box in wide ranges covering all potential eventualities, especially downside ones, given global conditions and the risks they pose.

Cees Bruggemans is Chief Economist of First National Bank. Register for his free e-mail articles on www.fnb.co.za/economics