Optimism Gives Way to Reality in South Africa
South Africa desperately needs to generate economic growth but the policies of the governing African National Congress (ANC) party are not likely to deliver a fast turnaround. We find comfort in a large domestic investor base, liquid financial markets, a strong central bank, and gradually improving governance. However, if policies after the May 8 general election fail to signal that meaningful changes are on the horizon, we see the risk premium for South African assets increasing.

As we noted in our last blog on South Africa, the country’s deep-rooted structural problems – unemployment, poverty, and inequality – are not easy to address in a short period of time. Restarting growth requires structural reforms that are not yet in the vocabulary of the ANC, which has a radical economic transformation agenda of wealth redistribution to address pervasive inequality. The ANC’s economic growth model is still focused on state-owned enterprises (SOEs), many of which are no longer viable.

On a recent trip to the country where we met with policymakers, politicians, investors, and bankers, we noted that the reality of the economic situation has started sinking in and the euphoria following the February 2018 election of President Cyril Ramaphosa has already faded.

The erosion of state institutions during the nine years former President Jacob Zuma held office before resigning amid allegations of corruption may have been arrested under the leadership of President Ramaphosa, who changed the management of several SOEs and important institutions such as the tax collection agency. However, corruption runs too deep in various institutions to turn them around in a short time, let alone enact meaningful structural reforms. Hence, we think that there is still not enough recognition domestically that it will take more than a few good women/men and better governance at state institutions to reverse the direction of the economy.

As a result, despite optimism following the change in political leadership, South Africa’s economy failed to recover in 2018. GDP growth was only at 0.8% last year, well below the population growth rate. The official unemployment rate, at 27.5%, remains the highest in the world. This puts South Africa in a unique camp among emerging market economies, with its per capita income on a downward trend since 2009, when President Zuma took office. Continuously shrinking pies in an emerging market economy – absent wars, a full-blown crisis or natural disasters – are rare and socially or politically unsustainable.

Limited Room for Macroeconomic Policies to Support Growth

The fiscal space is extremely limited. South Africa has postponed fiscal consolidation for three consecutive years, since the government was not able to contain the high wage bill for civil servants in the pre-election period and non-viable but strategically important SOEs need capital injections. This creates an unpleasant debt dynamic, where debt service payments already account for over 12% of fiscal expenditures.

The plans to turn around Eskom, the dysfunctional state-owned electric utility, are at an early stage. However, resolving Eskom’s problems goes against the heart and soul of ANC policies of no privatization, no job retrenchment, and Eskom’s preferential procurement policies that undermine cost effectiveness. Hence, any meaningful change will require not only significant political capital but also time to implement. We will be watching the next steps following the May elections. At a minimum, the fiscal pressures are here to stay for at least the next four to five years and they limit room for growth-supportive spending, notwithstanding Moody’s recent decision to keep South Africa’s debt rating outlook at stable.1

Inflation has been declining from its peak of 5.2% in November 2018 on the back of lower food and oil prices, as well as a stronger rand. However, in the period ahead we expect inflation to pick up gradually due to recent administrative price hikes as well as base effects from food and oil, despite weak domestic demand. Consequently, we believe a rate-cutting cycle by South Africa’s central bank to support growth is not very likely, although it is possible to see a one-off rate cut later in the year should inflation surprise on the downside.

Business confidence indicators are at their lowest in two years and close to 2008 financial crisis levels.2 Private investment has been missing in action for the last three years. Consumers — the main driver of growth —are also not feeling well, given weak job growth, tax hikes needed to limit the slippage in the fiscal deficit last year, and administrative price increases this year.

On the external front, slowing global growth is not supportive of South African exports. If anything, the current account deficit, which has declined since the 2013 Taper Tantrum to a low of 2.2 % of GDP in 2017, is up to 3.6% of GDP. On top of this, rolling blackouts by Eskom are undermining economic activity.

Is There Any Hope for South Africa?

We still expect a cyclical, but only moderate, recovery in growth for the remainder of this year, to about 1.2% in 2019, from 0.8%. Our view is predicated on gradually improving business and consumer confidence after the elections, as well as a better global backdrop in the second half of 2019 as China’s easing efforts gradually pass through and global demand normalizes.

However, several uncertainties temper our optimism on the domestic outlook:

  • Valuable time will be lost, especially in implementing reorganization plans at Eskom, until a new cabinet is formed after May’s general elections and governing can restart after electioneering.
  • Besides its impact on consumer and business confidence, turning around Eskom is an urgent matter to ensure a consistent, reliable supply of power.
  • More fundamentally, we are not sure how the divisions within the ANC will translate into post-election policy priorities that could encourage investment and job growth in South Africa.

Post-Election Policy Uncertainties

One could be tempted to think that a higher vote share for ANC (above its previous 53.9% in the most recent local elections) may help more reform-minded groups under Ramaphosa’s leadership to consolidate power. After all, he is the sitting president. However, ANC’s roster of election candidates remains populated by unsavory characters linked to allegations of corruption being revealed through various commissions of inquiry. Recent corruption allegations implicating President Ramaphosa are clearly not helpful either. This suggests that power will remain divided within the ANC even after an election victory.

On the other hand, a poor showing, especially in Gauteng province — the economic heartland of the country — could also backfire on President Ramaphosa’s power within the ANC. Furthermore, the party’s election manifesto reads as if the ANC believes it is still in revolution mode despite being in control of the government for the past 24 years. We hope that much of this is just electioneering.

Nonetheless, some of the ANC’s proposals should worry markets. For example, ANC is considering an employee-ownership scheme in the private sector. Though details are scant, the idea appears to be to transfer ownership shares to employees of firms above a certain size. Who pays for this or whether it would be mandatory or voluntary is to be decided.

Another ANC proposal would require financial institutions and pension funds to invest a certain percentage of their holdings in “prescribed assets,” i.e., government-owned assets and SOEs to finance social and economic development projects favored by the ANC. In our view, this sounds like an attempt to force locally trapped savings to invest in assets they don’t want. Clearly, financial repression is not a new tool in the emerging market world and can co-opt foreign inflows as domestic savings provide a backstop for asset prices. Nonetheless, they do not necessarily translate into more efficient capital allocation.

Land reform, an issue virtually everyone agrees is overdue, is awaiting a constitutional change. Various aspects of the reform plans, including appropriation without compensation, have the potential to be tied up in courts for years, adding to uncertainty.

Government Debt Yields Appear Attractive for Now

None of these are likely to encourage private investment in an economy that desperately needs more jobs. In this environment, the real yields on South African government debt are clearly becoming a better bet than risky real sector investments with uncertain returns. This is a clear example of government crowding out the private sector, and it is not sustainable.

We will be watching the election results and post-election policies closely. Until then, we remain invested in government securities in the longer end of the curve, taking advantage of a steep yield curve and the current elevated nominal and real yields, while tactically hedging part of the position with interest rate swaps,3 depending on the level of the asset swap4 spread.

  1. ^Source: “Moody’s Confirms South Africa’s Baa3 Rating and Changes the Outlook to Stable,” Moody’s Investors Service, 3/23/18.
  2. ^Source: Bloomberg; Bureau of Economic Research South Africa Composite Business Confidence Index.
  3. ^Interest rate swaps are forward contracts where one stream of future interest payments is exchanged for another based on a specified principal amount; interest rate swaps can be fixed or floating rate in order to reduce or increase exposure to fluctuations in interest rates.
  4. ^An asset swap spread is the spread between the cash bonds and interest-rate swaps for the same maturity.