- Rising macro risks increase upside risk to rates



* Fiscal slippage, largely due to wage costs. Ghana has a history of

running up bigger-than-targeted budget deficits in elections years,

particularly in the post-military-rule period (see Figure 1). The only

exceptions are 2000 and 2004, the year before Ghana qualified for debt

relief, 2005, when the authorities worked hard on narrowing the deficit to

improve the country's prospects. One of the country's worst fiscal

slippages was during the last election in 2008, when the outgoing New

Patriotic Party (NPP) government ran up a budget deficit of 8.5% of GDP,

which was significantly bigger than the target of 2-3% (under the rebased

GDP). The current National Democratic Congress (NDC) administration, which

inherited a large fiscal deficit, was compelled to adopt a fiscal

consolidation policy. The NDC administration managed to narrow the deficit

until 2011, when the budget deficit came in at 4.4% of GDP, below the

target of 5.1%. Given the below-target deficit of 2011 and the NDC

administration's fiscal consolidation credentials, our expectation was

that fiscal spending in 2012 would be contained, the fiscal slippage would

be minimal and the budget deficit would be close to the target of 4.8% of

GDP. However, in July, Finance Minister Kwabena Duffour proposed a

supplementary budget of GHS2.6bn ($1.34bn) that would allow for an

increase in spending of 1.9% of GDP and a wider budget deficit of 6.7% of

GDP. According to our estimates, 60% of the supplementary budget will go

towards the migration of public sector workers to the single spine salary

structure, and the implementation of the base pay increase of 18%. Twelve

per cent will go towards debt service costs and 11% to cover the

government's under-recovery of fuel and utility costs. The upside is that

public sector workers' migration to the new salary structure is near

complete, which should ease future wage cost increases.

* Weak cedi partly reflects financial outflows. Ghana's gross

international reserves declined by $1.1bn in 5M12 to $4.3bn or 2.5 months

of import cover in May, from $5.4bn or c.4 months of import cover at YE11.

Typically, economies with import cover of less than three months are

considered to be vulnerable to external shocks, such as a sharp increase

in the oil price. We think the sharp decline in Ghana's FX reserves is

partly due to the widening of the trade deficit in 5M12 by 57% to $937mn,

owing to a high international oil price that inflated the import bill and

lower-than-expected oil export volumes that undermined export earnings. We

expect this to have contributed to the widening of the current account

(C/A) deficit during this period, in addition to the increase in services

and income payments, which comes with the new oil industry. However, we do

not think a wider CA deficit alone explains the surge in the balance of

payments deficit of $1.3bn (11.9% of GDP) in 1Q12, from $154mn (1.7% of

GDP) a year earlier, when annualised, and the drop in FX reserves (see

Figure 2). We are of the view that financial outflows increased

significantly during this period, particularly short-term money. While we

had expected an increase in financial outflows as the December elections

approached, we had not anticipated them to begin so early in the year. The

subsequent drop in FX reserves explains the 20% depreciation of the

Ghanaian cedi in 7M12 to GHS1.96/$1. In order to stem what the Bank of

Ghana (BoG) viewed as speculative activity in the interbank FX market that

was exacerbating GHS weakness, the BoG implemented measures that would

ultimately stem cedi weakness, including hiking the policy rate by 250

bpts YtD, reducing the limits on net open FX positions of banks,

reintroducing BoG bills to provide additional avenues of cedi investment,

revising the application of the statutory reserve requirement so that

banks would need to maintain the mandatory 9% reserve requirement on

domestic and foreign liabilities in cedis only, and requiring all banks to

provide 100% cedi cover for their offshore account balances - to be

maintained at the BoG. We have noted the retracement of the cedi to

1.94/$1 from mid-August, suggesting that a combination of the

aforementioned policies may be taking effect. However, as it is still a

few months to elections, we project some further weakness to GHS2.0/$1 at

YE12.

* Downwardly sticky inflation. The acceleration of Ghana's inflation

has been significantly slower than we had expected (see Figure 3).

Headline inflation increased to 9.5% YoY in July, from 8.4% YoY a year

earlier, despite the cedi's 30% depreciation against the dollar over the

same period, to GHS1.96/$1. Yes, low food inflation has helped keep

headline inflation in the single-digit region. However, food inflation

also has edged up over the past 12 months, to 5.8% YoY in July, from 3.3%

YoY a year earlier. That said, we expected most of the inflationary

pressure to stem from non-food items, particularly from housing and

utilities' costs and transport prices, owing to particularly high oil

prices in 1Q12, and from clothing and furnishings, given that a

significant share of these goods are imported. However, non-food inflation

only increased to 12.4% YoY in July, from 11.3% YoY at YE12. All this

points to downwardly sticky inflation, which has delayed its return to the

double-digit region, in our view. We think a more stable cedi in 2H12, on

the back of the raft of policy measures that the BoG implemented in 1H12,

is positive for the inflation outlook; however, we still expect inflation

to rise into the low double-digit region by YE12, due to the proposed

increase in government spending and base effects.

* Pre-emptive rate hike likely. The BoG's 250-bpt hike of the policy

rate in 1H12 to 15% (see Figure 4) was largely intended to stem cedi

weakness. Although the cedi may have stabilised and retraced since 8

August, we still think the risk of a weakening cedi is significant as we

approach the YE12 elections. Along with inflationary pressures from an

increase in government spending in the order of 2% of GDP and strong

credit growth of 39.4% YoY in May (see Figure 5), compared to 18.5% YoY a

year earlier, this implies to us that the risk to inflation is definitely

to the upside. We think these factors will compel the BoG's monetary

policy committee to tighten by 50 bpts to 15.5% when it next meets on 12

September.



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