Economic Review

Bifm Economic Review 2nd Quarter 2008

The past quarter has been one of almost

uniformly bad economic news. Domestically,

there has been rapidly rising inflation, two

interest rate hikes, and setbacks for two

major development projects. To the extent

that there is any good news, it is that

Botswana is not alone; internationally, it is

a similar story, with rising inflation almost

everywhere, tighter monetary policy, and

a slowdown in economic growth. In this

issue, we take a closer look at recent

economic developments, and the extent to

international economic developments are

impacting on Botswana.

Inflation

Inflation has continued to rise rapidly in

recent months, and is up from 8.2% at the

end of 2007 to 12.1% in May 2008. The

increase is almost entirely driven by higher

international food and fuel prices. Food

price inflation reached 18.5% in May, while

inflation for the component of the CPI that

comprises mostly fuel prices reached 42%.

Indeed, apart from these items, inflation

has been quite well behaved; inflation

excluding food and fuel was only 5.2% in

May – a rate that has remained remarkably

stable even as food and fuel prices have

rocketed (see Figure 1).

These inflationary pressures are almost

entirely driven by international developments.

Food prices have been rising around the

world, especially for dairy products, cereals

and oils & fats whose prices have more than

doubled in international markets over the

past two years (see Figure 2). The overall

Food Price Index published by the UN Food

and Agriculture Organisation has risen by

two-thirds over this period. This inevitably

feeds through to domestic prices in a food-

importing nation. The only positive news

is that international food prices appear to

have peaked, with a slight price decline in

all commodity groups except meat between

March and May 2008. Even if prices do not

fall much, price stabilisation will at least

mean that the impact on inflation will begin

to reduce.

International fuel prices have also risen

steadily, doubling over the year to June.

In contrast to food prices, there is no sign

of an end to the upward movement in oil

prices. One difference between the two

commodities is that higher food prices are

quite effective at generating additional

supply as farmers plant more crops, and this

helps to contain price increases. For oil, by

contrast, the scope for increasing supply as

prices rise is limited in the short-term, and

price stabilisation is much more dependent

upon reducing demand; although demand

for oil has fallen in the major industrialised

countries during 2007 and 2008, demand

from the major developing countries has

continued to grow.

The international origin of these inflationary

pressures means that almost all countries

are affected in similar ways. In the major

industrialised economies, inflation has also

risen sharply, albeit from lower levels, and is

set to reach the highest levels since 1991.

Inflation in South Africa has more or less

doubled over the past year, and inflation in

many developing countries is at the highest

rate for several years.

What are the prospects for inflation in

Botswana over the next year or so? In the

short-term, inflationary trends will continue

to be dominated by fuel prices. Domestic

pump prices have risen by less than

international oil prices, and even if oil prices

stabilise, domestic prices will still have to

rise further (see Figure 3). In all likelihood,

inflation will rise by at least another 2%,

and will peak between 14% and 15% in

Summary of Economic Developments Dr Keith Jefferis Chairman of Bifm Investment Committee

Introduction

Figure 1: Food & Fuel Price Inflation

Source: CSO, Econsult

Economic Reviewthe third quarter of the year, on the basis of

events that have already occurred. However,

if international oil prices rise further, then

Botswana’s inflation could move even

higher.

On the bright side, as mentioned above,

inflation continues to be focused on the

specific areas of food and fuel, and apart

from these commodity groups inflation

remains very low; there is no sign yet of

the second-round effects that would result

from inflation spreading more widely in

the economy. This may be just a question

of time, however; higher fuel costs will

eventually affect many other prices, and

there will undoubtedly be pressure for wage

increases as a result of higher food and

other prices. If second-round effects can

be contained, then inflation will fall rapidly

once fuel prices stop rising. However, if

second-round effects take hold, then it will

take much longer to bring down inflation.

Apart from monetary policy (discussed

below), what can be done to minimise

the impact of inflation? One area that

needs to be considered is trade policy.

Countries such as Kenya and Mauritius

have countered the impact of imported

inflation by cutting import duties on food

items. Botswana could lobby for similar

moves by the Southern African Customs

Union (SACU), using the channels that are

open to all members under the 2002 SACU

Agreement. The SACU tariff structure is

unnecessarily complex, and in general the

tariffs are too high; the need to bring down

food prices provides a good opportunity

for the reduction and rationalisation of

tariffs, and as well for Botswana and the

smaller SACU members to use the available

mechanisms to influence the tariff structure

in a way that suits their interests.

Instead, Botswana has scored something of

an own goal by imposing an additional 40%

import duty on UHT milk, which has pushed

up the price of imported UHT milk by a

similar amount – on top of steep rises in milk

prices which have occurred internationally.

This duty has been imposed under the infant

industry provisions of SACU to protect a

new local UHT milk producer. Whether the

new producer really needs 40% protection

is a moot point, but the downside is that the

price of a key consumption item – especially

for the poor – will be artificially increased,

adding further to inflation and poverty. In

addition, the 40% tariff is in contravention

of Botswana’s commitments to the World

Trade Organisation (WTO), under which the

maximum permitted tariff is 20%.

In a further strange policy move that will add

to inflation and undermine competitiveness,

the Ministry of Trade and Industry has

imposed an additional tax on computers

and related items under the Copyright

and Neighbouring Rights Act. The tax on

computers is 10%, and ranges from 5% to

15% on items such as printers, cellphones,

digital cameras, blank CDs etc. The apparent

intention is to establish a fund for musicians

who may be disadvantaged by the illegal

copying of their music. A noble objective,

one might think. However, the levy is wide-

ranging and completely disproportionate to

the matter at hand. Many of these items,

but especially computers, are essential

items of business equipment, especially

in service industries which Botswana is

trying to promote through entities such

as the IFSC. For a country that is already

challenged with regard to international

competitiveness, and is suffering from an

inflation problem, this policy measure is

completely counterproductive, and the tax

should either be removed or drastically

reduced.

2

Figure 3: Fuel & Crude Oil Prices

Source: DEA

Figure 2: International Food Prices

Source: UN FAO* to April

In order to assess whether higher interest

rates are likely to be effective at bringing

down inflation, empirical evidence is needed

based on analysis of the sources of inflation

and what economists call “the transmission

mechanism of monetary policy”. The Bank

of Botswana’s monetary policy decisions are

based on its own modelling of inflation and

the transmission mechanism. However, the

results of this work has not been published,

and greater transparency regarding the

modelling results, inflation forecasts and

empirical analysis of impact of interest

rates on inflation would help to enhance

the credibility of monetary policy, and

convince the sceptics that there is a sound

basis for higher interest rates in the current

inflationary environment.

Economic Review3

The international economy is suffering from

a slowdown in growth as well as sharply

higher inflation. While the world economy

is not (yet?) in recession, growth is falling

almost everywhere. The USA is amongst the

worst affected countries, with close to zero

growth, and other developed economies

also experiencing growth down to around

1%. In major developing economies, growth

is also falling, but remains more robust,

with 2008 GDP growth projections of 9.5%

in China, 7.4% in India, 4.8% in Brazil and

3.6% in South Africa – all 1-2% lower

than in 2007. The main causes of slower

growth are the fallout from the US sub-

prime and financial sector crisis, resulting in

risk aversion and reduced credit availability,

compounded by the impact of higher food

and oil prices. The latter has resulted in a

massive shift of wealth and purchasing

power from oil importing nations to oil

exporters, with an associated loss of real

income amongst the oil importers that has

inevitably caused growth to slow, especially

as the additional earnings received by oil

importers have largely been saved rather

than spent.

To what extent has this growth slowdown had an impact on Botswana? So far, the impact seems to be limited. The latest GDP growth data only go as far as September 2007, but show that, at least up until then, growth was powering ahead. In the year to September, total GDP grew by 5.9%, and the non-mining private sector by a striking 11.1%, with particularly rapid growth in the manufacturing, trade, hotels & tourism, and transport & communications sectors (see Figure 5).

However, export data – which are more up to date - tell a less encouraging story. Total exports in the last quarter of 2007 and

the first quarter of 2008 were down 12%

Monetary Policy

In response to rising inflation, the Bank of

Botswana has raised interest rates twice

in quick succession, by a total of 1%. This

takes the Bank Rate (the BoB’s benchmark

lending rate) to 15.5%, and the commercial

bank prime rate to 17%. This marks

the highest ever level of interest rates in

Botswana – even when inflation previously

reached high levels of 14.2% in 2006 and

17.6% in 1992, the Bank Rate had never

exceeded 15.25% (see Figure 4).

As discussed above, virtually all of the

inflation being experienced by Botswana is

imported from international sources, and as

such interest rate policy can have no direct

effect on inflation. The intention, however,

is to prevent inflation from moving beyond

food and fuel to become more generalised

in the economy. As we have noted, inflation

other than for food and fuel has remained

relatively low, at just over 5%. Monetary

policy, through higher interest rates, is

intended to prevent this from rising. This

channel works through reducing the level

of demand in the economy, by increasing

the cost of borrowing and hence reducing

credit growth.

To what extent is this likely to be effective?

This is difficult to answer definitively.

Certainly, it is widely accepted that interest

rates can be effective in reducing demand

and containing inflation, and this is one

reason why many central banks around the

world have been increasing interest rates

in response to recent increases in inflation.

It is sometimes argued, however, that this

is not relevant in Botswana, because only

a small portion of inflation is determined

locally – rather than by import prices or

exchange rates – and hence monetary

policy is unlikely to be effective. Monetary

policy is much more effective when high

inflation is caused by domestic demand

pressures, which is not the case at present.

When inflation is imported, interest rates

can only influence inflation by moderating

second round effects, and cannot affect the

direct causes of inflation.

Figure 4: Bank Rate

Source: IMF, BoB

Economic Growth

Economic Review4compared to a year earlier, with particularly

sharp falls in exports of beef (down 44%),

and textiles and diamonds (both down

Figure 5: Real GDP growth (annual)

Source: CSO, Econsult

Figure 6: Change in Exports6 months to March 2008

Source: CSO, Bob

17%). The reduction in these exports, which

almost entirely go to developed country

markets, suggest that the effects of the

growth slowdown may be biting, and does

not augur well for export led growth over

the next couple of years (see Figure 6).

A major characteristic of the economic

crisis affecting developed countries is the

credit crunch – the reduced availability of

credit from banks and financial markets,

and rising spreads which mean that riskier

projects and borrowers have to pay higher

interest rates – if they can get credit at all.

There appears to be no equivalent credit

crunch in Botswana, where the financial

markets are relatively insulated from global

financial developments. Domestic financial

markets remain very liquid, and credit

growth has been robust; total bank credit

grew by 28% in the year to March, the

fastest growth since 1999 (see Figure 7).

Growth has been particularly rapid in credit

to the private business sector, which was up

by 35%.

Looking specifically at mortgage markets,

which have been at the forefront of financial

sector problems in the major developed

economies, in Botswana it appears to be

“business as usual”. Total mortgage lending

by the commercial banks and the Botswana

Building Society rose by 12.3% in the year

to March 2008, and although lower than

overall credit growth, demand for mortgage finance reportedly remains robust.

While the Botswana Stock Exchange (BSE) has experienced a period of decline since the third quarter of last year, there are only superficial similarities with the declines in stock markets around the world. The BSE domestic index (DCI) fell from a peak of 9866 in August 2007 to 6908 in May 2008, a drop of around 30%. The MSCI World index (representing movements across all major developed and developing country stock markets) fell by 18% from its peak over a similar period, and almost all stock markets around the world have experienced sharp falls.

However, the decline in the BSE index largely reflects local developments. A year ago, there was widespread agreement that the stocks of commercial banks, which account for the majority of BSE capitalisation, were overvalued, with price-earnings (P/E) ratios up around 30, and a P/E ratio for the market as a whole of 19. Since that time, the decline in the value of bank stocks – of up to 50% - has been the main driver of the falling stock market index. Bank stocks now have P/E ratios of less than 20, and the market a P/E ratio of 12.9. This has been associated with declining bank profitability, which has largely domestic rather than

international causes.

Financial Markets

Figure 7: Growth of Bank Credit

Source: BPC, BoB

Economic Review5Threats on the Horizon?

costs for the project – up from an initial $350m to an estimated $1500m - meant that the project was no longer viable. These rising costs reflected higher construction, equipment and project management costs. The regional power shortage was also an important contributory factor to the decision to postpone; the Activox refinery would have been Botswana’s largest single consumer of power, and given the shortfall in power supplies projected for Botswana over the next four years or so, Tati Nickel could not be assured of receiving the required power to commission the project on time, with the resulting delays reducing project viability even further. Falling nickel prices, - down to $22 000 a tonne at the end of May 2008, from a peak of $54 000 a year earlier – also contributed to the demise of the project. Contrary to some reports, however, the Tati Nickel mine itself is not threatened; it will keep on producing concentrates which are then smelted into copper/nickel matte at BCL in Selebi-Phikwe. There remain good prospects of an expansion of the Phoenix open pit, and also for a re-opening of the nearby Selkirk underground mine. However, the postponement of the project may prompt a review of the tax concessions that were granted to Tati Nickel to support the Activox project, which would appear to be no longer justified.

The second major mining-related project to experience severe problems has been the Mmamabula Energy Project being

Although Botswana’s growth does not seem to have been badly affected by the international economic slowdown, and credit is still readily available, the situation may not last. There have been a couple of high-profile corporate failures in the transport sector (Lobtrans and African Express), which may make the banks more reluctant to provide corporate credit, or impose tighter terms and conditions which would restrict credit availability.

More generally, growth prospects for 2008 are uncertain, despite strong economic growth in the second half of 2007. Growth is likely to be negatively affected by the global economic slowdown (through reduced demand for exports) and the regional electricity shortage (discussed in detail in the previous issue of this Economic Review), although strong government spending domestically should help to support growth rates. Views in the private sector are mixed: the Bank of Botswana’s Business Expectations Survey conducted in March 2008 reported that businesses expected an average growth rate of 5.9% in 2007/08 (compared to 6.1% in 2006/07, the most recent actual data), rising to 6.4% in 2008/09. At the same time, business confidence levels have fallen slightly, with the overall percentage of firms rating current business conditions satisfactory falling to 70%, from 71% in September 2007 (see Figure 8). Perhaps more telling is that the proportion of firms who are optimistic about business conditions in 12 months time fell from 85% to 73%.

The impact of deteriorating economic conditions has already had a negative on two of the major development projects that were expected to boost growth in coming years. In May it was announced that the Activox Nickel Refinery Project being built near Francistown by Tati Nickel, a subsidiary of Russia’s Norilsk Nickel, had been indefinitely postponed. The refinery was intended to process nickel and copper concentrates from Tati Nickel’s nearby Phoenix Mine into finished metal. However, Norilsk decided that rapidly rising capital

promoted by CIC Energy and International Power. Following similar concerns about rising construction and equipment costs, it was announced in late June that it had not proved possible to reach agreement on the sharing of risks between the various project stakeholders. Reading between the lines, it appears that the preferred supplier of power station equipment (Siemens of Germany) and the main off-taker (Eskom of South Africa) were unwilling to shoulder sufficient financial risks (besides contracting as supplier and purchaser, respectively), resulting in risk levels that the project promoters (CIC and International Power) and other funders were unwilling or unable to take on themselves. Besides rising costs, the project has also fallen victim to tightening credit conditions in international markets. While there may still be a power station built at Mmamabula, it is likely to be much smaller than the 2x2400MW project that has been discussed up to now. There may also still be potential for development of the coal mine for coal exports and/or a coal-to-liquids project, but coming on top of May’s cancellation of the Activox refinery, the problems at Mmamabula are indeed unwelcome news. Both projects had been seen as major contributors to Botswana’s efforts to diversify the economy through value addition to minerals produced in the country, a task that will become more difficult as international economic conditions deteriorate.

Figure 8: Business Confidence Index (% of firms rating current business conditions satisfactory)

Source: BoB

Bifm Botswana Limited Asset Management. Property Management. Private Equity. Corporate Advisory Services. Private Bag BR 185, Broadhurst, Botswana Tel: +(267) 395 1564. Fax: +(267) 390 0358. Website: www.bifm.co.bw

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