South Africa Battles Against the Elements

When we speak to Ballim, Fitch has just downgraded the country (to BBB-, the last chance saloon of the investment grade world) and S&P put it on negative watch. “The rating agencies have been damning since 2012,” he says. “But judicious.”

Indeed, Moody’s, seeing trouble ahead, downgraded South Africa in November 2014, and if anything things have gone worse than even they foresaw because they naturally couldn’t predict the drought. “That has exacerbated the slowdown, so the outcome in terms of growth is even weaker than we anticipated,” says Kristin Lindow, senior vice president in the sovereign risk group at Moody’s.

There is a tendency to suggest that South Africa, as clearly the most developed country on the continent, must be less exposed to the commodity price downturn than less developed peers; that might be true on a relative basis, but it doesn’t mean South Africa isn’t suffering. “South Africa is still very much dependent on commodities, and processed commodities, in terms of its export mix,” says Lindow.

Drought itself is a problem whose impact is difficult to quantify, since it is only now really taking hold and it’s not clear how long it might last. Worthington says agriculture directly only constitutes 2.3% of South African GDP, but it has knock-on effects to numerous other industries and the economy more generally, through farm incomes, bank credit and trade balances. It is significant that South Africa will this year become a net maize importer for the first time. The drought might also lead to widespread water shortages, with dams today averaging 62% of capacity, though they have been far lower during two previous droughts in the 1980s and 90s.

Electricity is unreliable, which helps nobody. “It is a constraint, because if businesses don’t know there will be an affordable and reliable supply, they won’t attempt energy-intensive projects,” says Worthington. “A lot of potential investment projects may simply be sitting on the sidelines because the cost-benefit analysis can’t be done.”

In fact, electricity is so much of a problem that it no longer constrains growth, but makes the very idea problematic. “If we grow any quicker [than 1-2%], we run into electricity issues,” says Dennis Dykes, chief economist at Nedbank. Similarly, Ballim notes that the last few months have brought respite from frequent brownouts, “but admittedly that respite was forged out of a weak economy and low demand from heavy mining.” So, clearly a double-edged sword, but it has at least allowed national utility Eskom to maintain and stabilise supply. “It is damning that this comes as a consequence of weak economic growth, but it is to be cherished that it provides the occasion for maintenance and greater stability of the grid. If there’s an upswing, we will have a relatively more robust grid to build upon.”

Then there are headwinds at the individual level. “The consumer is under a bit of pressure,” says Dykes. “Interest rates are going up, and what’s not commonly understood is that on new loan origination the spreads have increased.” Before the financial crisis, mortgages might have been sold at prime minus 2%; now, prime plus 1.5% is more common. “So the same level of prime is actually hurting the consumer a bit more than it did in the prior years.” Indebtedness, while not as high as some developed markets, is high in the context of recent South African history, with household debt to income ratios around 77%. “So if we have big interest rate increases, it will bite quite a bit.”

To Dykes, the biggest problem is “the lack of employment generation. We saw a bounce back from the financial crisis to 2012-13, but subsequent to that it has been very flat.” Furthermore, what bounce has taken place has been in public sector employment. “On the private sector side, there has been no job creation for the last seven years.” That naturally impacts disposable income, consumer spending, and ultimately industry.

At a policy level, Dykes believes “the government instinct is to become more interventionist and to try to do more things itself, whereas the actual solution is for it to withdraw.” Electricity regulation, he says, is a case in point: with a few regulatory changes and offtake agreements, “things like cogenerated electricity could be ramped up significantly and we’d be solving the energy problem in the short term, generating fixed investment spending, with very little risk to the government. But there’s a concern about letting go.” Despite that, renewable energy has been a true success story of recent years, built on power purchase agreements. “It’s an example of what can happen if the regulatory environment is conducive,” Dykes says.

Meanwhile, awaiting greater freedoms, the private sector is in most industries quite limited: “baseload capacity building mode,” as Ballim puts it, “maintaining existing operations without any sense of risk taking.” He highlights the mobile telephony industry as an example of how things can work where the private sector is left to unleash its capital and the government sticks to creating the right environment for it to thrive. “Mobile telephony stands as the poster child of that healthy balance between the state in the regulatory fold, and private sector pursuing execution.”

Nevertheless, it’s not all bad news. The banking sector is in good shape, institutions are strong, and no other African state has a comparable financial market. Additionally, Lindow points to “an important improvement in the tax base and tax compliance,” improving public finances and leading to a budget deficit roughly in line with what Moody’s had expected even though economic growth has been below expectations. Better still, South Africa budgets very conservatively on tax buoyancy. “They were very explicit about that,” Lindow says. “They show a degree of budget transparency that earns South Africa the number three ranking in the world in that respect.” By under-promising on the tax collection side, they have avoided disappointing market participants, and shown discipline in budgeting.

No discussion of the economy can ignore politics. South Africa is a vibrant democracy: it is now 21 years since the first true multi-racial election in 1994, so a whole generation has now come through with the expectation of being able to effect change at the ballot box. “The political situation is very noisy in South Africa, increasingly so as the political framework matures,” Lindow says. The dominant ANC party is part of a tripartite alliance, and like all such things, it has fault lines. “It had common goals at the time of democratic transition, and continues to have common goals, but with very different opinions on how to get there,” Lindow says.

There are likely to be local, municipal elections in the second quarter of 2016, and these could be pivotal. Worthington believes they are “the most important elections South Africa has had since 1994. For the first time, significant metropolitan areas are up for play, in the sense that the ANC may not win a majority.” Worthington mentions Johannesburg, Tshwane (where Pretoria is), Nelson Mandela Bay (the renamed Port Elizabeth constituency) and Ekurhuleni as places where the ANC could lose its majority.  “I am very curious to see what happens with the local government elections, and for ANC the stakes are very high. The metropolitan areas are the economic powerhouses of South Africa and therefore of vital interest to political parties.”

A poor showing by the ANC then might have consequences at the national level. Dykes says: “From the national political perspective, the response if the ANC gets a severe wake-up call in the local elections could be positive – pull our socks up and get things moving before the general election – or negative, with it becoming even more interventionist.”

Surely a wake-up call has already been offered in the last general election, where the ANC saw significant slippage in, in particular, the Gauteng province which includes Johannesburg.

Some believe the solution is simple: a new president. “I don’t think it is possible to overestimate the damage he has done to South Africa,” says one banker in Johannesburg. “I don’t mean the corruption. There are plenty of quick-growing markets that have corruption. I’m talking about the complete lack of leadership.”

Certainly, among economists and fund managers, there is a sense that potential change is a plus. Ballim says “healing the political economy would be the most seismic intervention we could have,” though he does feel that tentative positive steps have been made over the last two years: spending roughly in line with budgets, compared to three previous years of fiscal overreach. “This seems to signal the political establishment has begun to tentatively appreciate South Africa’s precarious financial position.”

Charles Robertson, chief economist at Renaissance Capital, shares the widespread outlook for weak GDP growth and currency, “but the good news is the prospect of political change – which you don’t have in Russia, Turkey or Brazil. So in terms of there being some potential shift in the country’s direction, South Africa is a little bit stronger in EMEA than most of its peers.”

Robertson takes a slightly more positive view of policy than many who are actually in the country, perhaps because of the peers he compares it to.

“It’s changed in the last five years. There is an improved focus on education, the wages of teachers are going up, and there is investment in electricity, which helps to explain the large current account deficit. These are shifts that will produce rewards on a five to 10 year view, but the market is impatient.”

Corruption remains a considerable challenge in South Africa. The latest Transparency International survey showed that four out of five South Africans believed corruption to be on the rise. “This is a problem,” says Lindow, “because there’s a perception that corruption is prevalent at the very top of government, and that can lead people below that level to feel emboldened to be corrupt themselves. When this happens, people become very disenchanted with the system, and it tends to compound the sense that they have that the country is moving in the wrong direction.” Which, from a rating agency perspective, it surely is: although it has always been considered investment grade ever since Moody’s first rated it in 1994, it has been downgraded three notches since 2009.

Robertson notes that South Africa’s peer group, in per capita GDP terms, in the mid 90s were countries like Poland and Estonia. Their corruption ratings are now “streets ahead of where South Africa is now,” he says, and so is the per capita GDP. Today, the contemporaries – on both corruption and per capita GDP – are Iran and Romania. “South Africa is not in a great place if it is being compared to Iran,” he says.

Like any twin-deficit emerging market, South Africa appears exposed to the Fed raising rates, though the impact this will have is difficult to be sure about.

Lindow notes “it has relied on capital inflows to finance its current account deficit, and these are non-debt creating inflows. South Africa doesn’t have a very substantial external debt burden: it’s actually quite small, by emerging market standards. Its net external position is in deficit by less than 10% of GDP.” Nevertheless, to avoid its already-pressured central bank reserves diminishing, it does need to maintain capital inflows in order to fund the current account deficit. “With a negative investment climate in the country, and a general aversion to emerging markets, that is always a risk.”

The positive view is the bad news is long since digested. “It’s different this time,” says Worthington. “We’ve already had pressure on the currency – we have a very flexible exchange regime  – but we have not seen meltdown in the financial markets. We may see further pressure on the Fed liftoff, but I doubt it’s going to be a meltdown – so much is already priced in.”

Robertson is not quite so sure. “It’s particularly exposed because it’s the easiest currency to short if you want to short EM,” he says. “It’s the perfect proxy, and it is very easy to do. It’s also not expensive because interest rates are not particularly high at around 6%.” Also, the rand has fallen so far that it is making imports problematic, though it is great for exports and the current account deficit.

That said, the same trend could spur FDI. “This rand-dollar rate is extremely competitive now,” says Robertson.  “A billion dollars invested in South Africa a few years ago was worth something, but put in $700 million today and it’s worth a lot more.” Perhaps BMW’s R6 billion investment to build X3s in Pretoria, announced in November, is a sign of this.

“There are two things happening that will change the story for South Africa a little: a better current account thanks to horribly weak GDP, and better foreign investment. Put the two together and the picture looks a little brighter.”

FDI is distinctive: unlike most emerging markets, South Africa has a very large domestic financial system so the financing of direct investment usually happens within it rather than cross-border. “This is actually a very positive thing, but is not very well understood by financial markets,” says Lindow. “If investments needed to be financed by foreign banks, you would see the flows of finance coming in. But because they’re financed domestically, you don’t see the flows in the balance of payments. That doesn’t mean that FDI doesn’t exist; statistics show that FDI was equivalent to 40% of GDP at the end of 2014.”

And while net FDI figures are low, that’s just because there’s a lot of outbound investment from South Africa too. Inflows commonly touch $20 billion, says Robertson, “clearly suggesting that people do think South Africa is worth investing in.”

So a bleak outlook, but not hopeless. “The stable outlook suggests to us that we think the situation can be overcome,” says Lindow, “but there are considerable downside risks related to the growth story and the socio-economic problems that confront the country.”