South Africa: After Zuma, A Light at The End of The Tunnel
We’ve recently returned from South Africa, where we met officials from the country’s National Treasury and the South African Reserve Bank (SARB), current and former politicians, rating agencies and local investment managers. 

The Political Drama Is Finally Over

When we were there, there was already a palpable change in the air following the December conference of the African National Congress (ANC), at which Cyril Ramaphosa was elected as the ANC’s president. Since then, the country had been holding its breath, waiting for President Jacob Zuma to resign before his term ends in 2019. Zuma’s nine-year tenure has been marred by allegations of corruption and cronyism, and deterioration of institutions and the economy.  During this period, Africa’s most industrialized nation eked out an average annual growth rate of only 1.77%,1 not enough to make up even for its population growth. As a result, South Africa’s per-capita income declined while that of all other emerging markets forged ahead.

The drama surrounding Zuma’s departure might have seemed difficult to believe for the outside observer, but the potential of further splits in an already-divided ANC are a clear risk in a pre-election year, especially because of the ANC’s declining electoral majority to a mere 53.9%.2 This position seems to have induced the party’s heavyweights to try to preserve unity by engineering a smooth transition of power, and in the process they made the exit painfully slow for most South Africans. 

With the resignation of President Zuma at the urging of ANC and the swearing in of Cyril Ramaphosa as the new president, we believe the light has emerged at the end of this tunnel of political uncertainty for South Africa.

The market has already priced this renewed hope—expressed by a major strengthening of the South African Rand (ZAR) and lower bond yields since December. However, the road is long and arduous to begin addressing the country’s challenges—including low economic growth, high unemployment and pervasive inequality—while rooting out corruption and reversing the degradation of South Africa’s institutions.

Next, we expect a reshuffling of the cabinet very soon to bring in individuals with needed expertise and political credentials who will stem widespread graft and begin devising and implementing policies to restart growth.

The Effort to Restart Growth

So far, the changing political winds are reflected only in improving consumer and business-confidence metrics—and real economic activity remains subdued following the technical recession in early 2017. Despite strong tailwinds from the global economic cycle and buoyant commodity prices, the export sector seems unable to pick up the slack in domestic demand, especially following a multi-year weakness in fixed investment. And this phenomenon is very much linked to the political crisis of confidence and uncertainty about economic policies.  Economic slack is reflected in the decline of inflation to 4.4% in January3 for the first time in several years, aided by the strong Rand. One positive side effect of this weakness has been the correction in the current account deficit, which declined to about 2% of gross domestic product (GDP) from more than 5.5 % of GDP four years ago.4

With political uncertainty out of the way, we believe there is some lower-hanging fruit the new government will pick to kindle economic growth. First, we expect them to finalize the mining charter expeditiously to ensure optimum use of the country’s vast mineral resources and send a signal to the broader industry, beyond mining, regarding policy certainty. In our view, this is an essential measure for reigniting fixed investment.

Another uncertainty stems from land expropriation without compensation plans as agreed by the ANC conference in December. While President Ramaphosa in his maiden State of the Nation Address5 indicated that this has to be done in a way to ensure increased agricultural production and food security, investors will be looking for more details.

His speech also emphasized a plethora of other efforts to create jobs, some of which would require concerted action not only at the national level but also at the local level, where challenges for implementing such measures remain daunting. 

On confidence effects alone, we expect a cyclical pickup in growth to more than 1.5 % this year from about 1% in 2017. By our estimation, growth in excess of 2%–3 % is needed to reduce high unemployment and inequality, and would require deeper structural reforms, including in education, labor, and product markets. We believe those more difficult structural reforms could test the already-fragile unity of the ANC and are not likely to reach the government’s agenda until after the 2019 elections, if at all. Notwithstanding the more business-friendly inclination of the new president, the party’s vision for the country remains a radical agenda of wealth redistribution to address pervasive inequality, and its model for economic growth is still focused on state-owned enterprises, many of which are no longer viable.

Securing Fiscal Sustainability

While the agenda of bringing back growth will take time to enact, the markets’ focus has been the announcement of the government’s fiscal budget for fiscal year 2018-2019. Without any corrective measures, the South African Treasury expected a fiscal deficit of 3.9% of GDP in fiscal year 2018-2019 and an explosive rise in the country’s debt in its October update.

Following Standard & Poor’s downgrade of South Africa’s local debt rating to junk in 2017, the country’s inclusion in various local debt indices is at stake, with a pending review by Moody’s. A downgrade may increase the country’s already-high financing costs and further shrink its fiscal latitude for development expenditures. 

We think the new budget reduced this chance significantly by delivering a credible path toward debt consolidation. The boldest of the measures to fill the fiscal hole was the announcement of a general value-added tax (VAT) rate increase by one percentage point. This was a necessary but difficult choice before the general elections in 2019, and it showed resolve by the new administration. In addition, there were some easier revenue measures taken, such as “bracket creep”, new sin and sugar taxes,6 more progressive estate taxes, and higher excises on luxury items. Social grants were increased to minimize the impact of these taxes on the poor.

Despite the additional fiscal burden resulting from the government’s commitment to provide free tertiary education—a recently announced policy by Zuma, which was adopted by the ANC— additional expenditure reductions would reduce the deficit from an estimated 4.3% in fiscal year 2017-2018 to 3.6 % this year and next, and to 3.5 % in fiscal year 2020-2021. This consolidation is expected to stabilize the debt-to-GDP ratio at 56.2 % in the medium-term—a marked improvement as compared to before. Nonetheless, South Africa will require additional fiscal effort in the next few years to reduce its debt further and potentially receive an upgrade to its credit rating.

One area in which a lasting solution is needed is the high public wage bill, which accounts for about 14 % of GDP, or nearly 35 % of the budget, and which needs to be lowered. Expectations of sizable real wage increases in the public sector are at odds with the country’s fiscal reality, especially in light of the high unemployment in South Africa. Pending wage negotiations will be important to watch. They will test the president’s skills in negotiating with the unions. Going forward, we expect to see a genuine discussion about shrinking the size of civil service to bring the total public sector wage bill to a more sustainable level.

We think this budget is the beginning of a new era in which the country will make continued efforts to secure debt sustainability, reduce high financing costs, and create room in the budget for more growth-supportive spending in the medium term.

Addressing Weak State-Owned Enterprises

An important burden on the fiscus has been the spiraling debt of state owned enterprises (SOEs), such as electricity utility Eskom and South African Airlines. Some SOEs do not have a viable revenue model and will not be able to finance their way out of debt. The recent change in the leadership of Eskom to address its weak governance has been encouraging. Yet the markets will be on the lookout for more substantive measures from Eskom to secure its financial viability, and we foresee management changes at other SOEs as likely first steps to stem their financial bleeding. At some point, as unthinkable as it may seem now, the ANC may need to question its SOE-based model for economic development. So far, privatization has not been part of the ANC’s vocabulary, but that, too, may change after the 2019 elections. The government’s recently announced budget has not specified any details, but it does note the sale of some non-core assets—and restructuring—among the ways to address the financial vulnerabilities of SOEs moving forward.

Our Investment Positioning

Notwithstanding South Africa’s structural policy challenges, we have become more constructive on the country’s ability to halt the slow deterioration of its economic and social prospects following the leadership change and the new budget announcement. We also believe that it is quite possible for the SARB to deliver one or two rate cuts over the next 12–18 months, if the impact on inflation from the VAT rate increase is benign. As a result, we have recently added to our duration7 and currency exposure in South Africa and will be watching the country closely as it emerges from this tunnel of uncertainty.

  1. ^Source: World Bank (average for 2008–2017).
  2. ^Source: Electoral Commission of South Africa, 2016 municipal election results.
  3. ^Source: Bloomberg, as of February 21, 2018.
  4. ^Source: Bloomberg.
  5. ^An annual event at which the president reports on the status of the nation to a joint sitting of Parliament.
  6. ^A sin tax is a tax on items considered undesirable or harmful, such as alcohol or tobacco.
  7. ^Duration measures interest rate sensitivity. The longer the duration, the greater the expected volatility as rates change.