Fiscus or Bust
The biggest domestic challenge is the lack of consumption in the economy, once among the strongest drivers of economic activity in the country. This is due in part to diminished economic confidence, stagnant wage growth, and persistently high unemployment – particularly among youth, and owed to rising political volatility as we move towards elections next year (which has also weighed on corporate investment). The most significant external challenges continue to be the broader bearishness confronting emerging markets, which has weighed on the Rand and foreign portfolio investment; global trade policy uncertainty (i.e. escalating trade war rhetoric); and general political volatility (i.e. Trump, Brexit, Italy, Hungary, and similar persistent flashpoints).
Although the ratings outlook hasn’t really changed much since the second quarter of this year, South Africa’s economic prospects still appear challenged. Moody’s has more than halved its forecast for GDP growth since the start of the year, and recently admitted the government is likely to miss its budget deficit target of 3.6% due to weaker than expected economic activity; its own ratings assessment – among others – seems to hinge largely on the country’s ability to assert control over its debt profile. On the deficit front, our own discussions with analysts in-the-know suggest a tax collection shortfall of close to ZAR5bn for the current fiscal year could add extra pressure to the fiscus and, crucially, weigh on expenditure – therefore threatening the likelihood of further stimulus, which many have called for in recent months.
The government is successfully working to address a key issue for ratings and investment analysts alike: contingent liabilities. In a bid to ensure it could mitigate the cost of borrowing for State Owned Enterprises (SOEs), the National Treasury had previously provided them with state guarantees which, in the instance of a credit event, could trigger cross-asset defaults on government debt. The National Treasury has become increasingly reluctant at providing any new state guarantees on debt linked to refinancing or working capital, and has made progress on instituting more robust asset and liability monitoring capabilities to ensure it pre-emptively mitigates any crises in waiting.
SOEs: Separating the Wheat from the Chaff with ESG
Domestic investors have come a long way since late 2016, when FutureGrowth Asset Management announced its decision to suspend new credit extension to most of the country’s SOEs due to concerns over governance and financial sustainability. These organisations account for a significant portion of economic activity in the country, and their strategic importance cannot be understated; the top 6 SOEs employ more than 105,000 employees together, with Eskom – the state-owned utility – alone accounting for nearly half that figure.
Eskom, South African Airways, Transnet and other SOEs grappling with the fallout from governance challenges, management scandals and outright financial mismanagement are starting to see the light at the end of the tunnel. Bolstered by a top-down shuffle at the highest echelons of these organisations and emboldened by Pravin Gordhan, the former Minister of Finance turned Minister of Public Enterprise, many have sought complete overhauls of their internal risk management practices in alignment with global standards.
That’s not to say some don’t remain in a precarious position. Eskom in particular still appears to be grappling with swelling costs – particularly since it agreed to wage increases that it told investors on a recent Eurobond roadshow were not commercially viable in its broader pursuit of financial sustainability – while its ‘too big to fail’ status means the state may need to provision more resources to compensate for potential challenges in attracting capital.
Despite piecemeal attempts being made to instil better governance and financial discipline, both Transnet and Eskom have yet to reveal comprehensive plans to mitigate excessive and irregular spending. But they are moving in the right direction.
Other SOEs that haven’t been directly implicated in governance shortcomings or financial negligence seem to be faring much better, including Landbank and Airports Company of South Africa, both of which embarked on substantial renovations of their balance sheets, and are in much better shape. Crucially, they – along with other SOEs – are working to ensure they integrate feedback from the Ministry of Public Enterprises’ myriad SOE reviews and insights from the global investment community into their corporate ethos and approach.
On aggregate, conviction for reform seems strong among treasurers in these SOEs, but time will tell whether execution will follow through. One of the more positive aspects to come out of the protracted SOE / state capture saga has been the increasingly vocal support for, and adoption of, ESG (environmental, social and governance) benchmarks among domestic investors.
There is broad recognition among the financial services community, and among CFOs and treasurers (within and outside the SOE community), that their willingness to provide, and ability to access capital, respectively, is likely to increasingly depend on their adherence to high ESG standards. Given the heightened volume around the issue over the past 18 months, borrowers, analysts, and observers believe we could be at the outset of a protracted shift in corporate culture – with ESG consciousness at the centre of that transformation.
Benign Economic, Funding Environment Creates Weird Distortions
Bond issuance has slowed dramatically this year, with full year volumes forecast to reach up to ZAR100bn in new issuance, down significantly from the ZAR140bn placed in the domestic capital markets last year. Slower growth and investment coupled with higher savings has led to a build-up of assets on the balance sheets of most of the country’s top banks, with corporates opting to raise funding on a shorter-term basis and for smaller working capital or capex requirements. The dynamic has created a range of distortions.
In the bond market, investors have been clamouring to hold high-quality assets which has contributed to extremely tight pricing on new issues and in secondary markets, despite rising political volatility and broader bearishness on emerging markets.
The lack of primary supply and thinness of the secondary market has created a tension between investors – traditional asset managers and long-term real money accounts – and banks, whose treasuries are aggressively pursuing the purchase of highly rated notes in a bid to boost High Quality Liquid Assets (HQLA) in line with Basel III rules.
A trend that has seen foreign fund managers rotating out of their South African positions – only to have them quickly snapped up by fund managers – has had a similar impact on pricing, with spreads on notes placed by the top 20 domestic issuers (including SOEs) oscillating within a very narrow band – often less than 30bp – in recent months.
The relative lack of private sector credit growth has also generated an extremely competitive loan environment – so competitive in fact that in many cases, banks are offering loans at all-in prices lower than their own cost of funding, with many leaning on ancillary business for additional revenue generation to make up the difference. Despite return on equity for many South African banks in the current environment reaching all-time highs, this dynamic is not sustainable. In any case, what this means is that it’s currently a borrower’s market.
Tough Spot for Borrowers
Despite ample access to funding, however, borrowers are in a difficult spot given the state of the economy. Agricultural production has plunged more than 45% over the past two quarters, due in part to persistent drought conditions in and around Western Cape, while transport, trade, and manufacturing all saw low single digit quarterly declines in Q3.
At the same time, mining, construction, electricity, and professional services saw marginal gains – though not enough to bring overall growth into the black; the mining sector should get a jolt from pent-up investment following the recently introduced, long-awaited changes to the country’s mining charter. Consumption has largely stagnated for three successive quarters. The economy is in a technical recession, and it seems the only thing likely to lift it out is an easing of political volatility and more policy certainty.
Notwithstanding the relatively benign funding environment, the challenged fiscal position of the country’s largest municipalities has made it difficult to finance critical upgrades to social infrastructure – hospitals, universities, water desalination and water transportation projects among other things.
Attracting private sector capital to these projects could become one of the most acute pain points for the country over the next five years, some believe; if this goes unaddressed, the long-term growth outlook could remain weaker than many expect, which is why many of the country’s cities – and development finance institutions – are seeking alternative sources of funding and structures (like bringing concessional funding into transactions alongside private sector capital). This will help reduce the overall cost of funding projects and create a replicable model for a wider pool of borrowers to follow.
Cessation of Political Volatility, Policy Uncertainty Key to Unlocking Economic Opportunity
It’s important to distinguish between political volatility and policy uncertainty, while recognising how intertwined the two are. Cyril Ramaphosa’s allure – eloquently dubbed ‘Ramaphoria’ – has indeed faded in recent months as the economy sank following a brief honeymoon period catalysed by Jacob Zuma’s ousting; his future is anything but certain despite some progress being made on key policy areas – mainly fiscal consolidation; mining reform; and SOE reform.
Some of the main political risks in play include rumoured infighting within Ramaphosa’s African National Congress (ANC), and his inability to control the narrative around controversial policy areas: attracting foreign investment back into the country; diversifying the economy; and land rights reform. The Economic Freedom Fighters (EFF) party, a far-left political party founded in 2013 by former ANC Youth League members, has despite its relatively small size managed to apply a great deal of headline pressure on the ANC, while creating additional confusion around the highly controversial land expropriation without compensation policy being crafted by the government.
The government’s proposal is to redistribute land that is currently unproductive or otherwise left unused to black South Africans, but the shift from a ‘willing-buyer, willing-seller’ approach to ‘expropriation without compensation’ was swift, and the logic behind it only faintly telegraphed to the population.
At the heart of the issue is the constitutional basis for altering private property rights, which would require a constitutional amendment, and given relatively undesirable experience with a similarly-branded policy adopted in Zimbabwe coupled with the above, the topic has become mired in emotion and misapprehension both domestically and abroad. Ultimately, given the sanctity of property rights in any liberal democracy, only a clear articulation of the policy combined with a robust and frictionless implementation plan will help create more certainty.
Solving the land expropriation issue won’t get Ramaphosa out of the weeds, observers say. He has made some bold commitments, among others a bid to attract more than ZAR1.2tn in new investment into the country over the next five years – but details of how and where these investments would be funnelled are conspicuously absent.
Also at issue are longer-term reforms, including changes aimed at shfting away from the highly centralised nature of its economy – an overreliance on SOEs that in many instances stifles healthy competition, corporate competitiveness and efficiency in areas of the economy that desperately need it; energy sector reform; and tax reform.
While there are no easy fixes, the good news is that economic confidence is clearly linked with movement on well-defined policy areas and political consolidation. As investors, borrowers, and the ‘man on the street’ become more certain of the political and legislative direction of the country, the more steadfast and rapid the recovery will be.