As the last post of 2018, I thought of giving a long term review instead of the year in review.
South Africa is in and out of a recession, but that should not come as a surprise to anyone who has looked at the underlying strength of the economy. Has SA reached its growth potential?
Ramaphoria seems like a distant dream, almost a fairy tale on how president Ramaphosa has taken the helm and in one swoop turned the stuttering economy around which his catch phrase “please send me”. His state-of-the-nation address was heralded as the start of a new era, and we can finally, unshackled of constant Zuma cronyism interference, proceed to grow again. With enthusiasm abound, investment banks rushed to upgrade their GDP growth forecast. But only 7 months later, the reality check: we slipped into a recession. While the rest of the world is growing strongly, we don’t. But to anyone, who looked rationally at the underlying capabilities of the South African economy, this should not have come as a surprise.
What might have surprised those number crunchers is how long the party seemed to continue. Looking at the performance of the JSE, as a measure on the strength of the economy, it would seem that South Africa is capable of keeping up with the best Asian Tigers. We would lead the African renaissance, famously proclaimed by the former president, Thabo Mbeki. But the reality is that we have been living on a toxic cocktail of steroids that mask the true performance of the economy, and therefore misguide on the potential for the medium term.
The JSE’s stock exchange index has increased by about 375% over the last 15 years (in Rands). That is a truly spectacular performance, and anybody who invest in shares would have done well. But that was just the index. Looking at the different components of the index, it becomes clear that we have had thee super phases, in addition to one over-arching theme.
Start with the three super phases. Firstly, we have benefitted enormously from the commodity boom of the mid 2000. China consumed almost all commodities quicker than anybody could produce, causing all commodity prices to rally sharply. That was a bonanza for the mines, which was reflected in their share prices. But South Africa had severe export transport constraints, and the throughput of Richards bay coal terminal and Saldana has hardly increased. Our mines were earning more Rands and Cents, but they struggled to push through the increase in volume they would have liked to. So what happened to the mining shares since then? Only the best managed companies managed to keep the share price at some reasonable level, many (especially SA focused mines) however are down more than 80%, a few collapsed totally and are no longer listed.
The second phase was the construction boom, spiced up by the Soccer World cup in 2010. There was a deadline, and plenty of projects had to be completed, almost at any cost. Luckily, the South African government had competent finance ministers and a very efficient tax collecting machine. We could afford it, and for the greatest show on earth, South Africa did deliver. This phase went on for a bit longer, because it partly coincided with the third phase, the retail boom, and the mushrooming of shopping centres. But the music has stopped, and the sector is down about 76% since its heydays. In fact, the share prices of most construction companies are down more than 80%. Well known ones, like Basil Read have gone into business rescue.
The third phase can be described as the retail boom. The index has increased by 325% over the last 8 years but seem to be running out of steam very fast. The start of the run was caused by the sharp increase in social grant beneficiaries. In 1994, about 4 million received social grants, by 2008 it was about 8 million. By 2017, 18 million South Africans received some form of social grants. And they spend it. Companies like Shoprite, Pep and mr Price reported dazzling growth figures. International retailers like H&M and Zara couldn’t wait to open more stores in South Africa. To turbocharge the trend even more, unsecured lenders were happy to finance the difference between the wants of consumers and their ability to have. But this trend, like the two before, was is not sustainable. Not only is the government constrained by their budget on how much they can expand their social spending, but the boom in the retail figures masked another trend: for the last 8 years, the private sector has been shedding jobs, while the government and state-owned enterprises (SOE’s) have been adding jobs. Overall the unemployment rate, though high, remained relatively constant. In 2016/17, national government spent about 7 out of every 10 Rands on grants and employee compensation. That leaves precious little to spend on project enhancing the competitiveness of our economy, like new highways, schools or hospitals.
And what was the overarching theme of the JSE Index? We have had a few, really big companies doing really well. The JSE is a very concentrated index. If one takes the market capitalisation of the index (the value of all companies listed on the JSE), and then divides it up into three equal “boxes”, then the first box consists of 2 ½ companies, the second of 16 companies and all the other companies (200+) combined would fall into the third box. Clearly, the biggest 10 companies have a far greater influence on the performance of the index than all the other companies combined. Within the top 10, you will find companies like British American Tabaco, Richemont, Naspers, BHP and Glencore. The only thing they have in common is that they hardly earn any money (or in Naspers case – any asset price value) from South Africa. All these companies have been doing well and kept the market at elevated levels, because of their foreign earnings.
So what are the underlying problems of the economy, and is it possible the fix them quickly?
It is complicated. Like the performance of a football team, there are a few quick fixes. But to be consistently winning, the foundation of the team needs to be such that there is a depth of talent. This would give the team the ability to perform well, no matter what challenge is thrown at them. To demonstrate one fundamental problem with getting the South African economy going again, lets look at how the economy developed between 1980 and 2016.
In 1980, manufacturing contributed 22%, mining 21%, agriculture 6% and finance 11%.
In 2016, finance is the biggest sector, contributing 20%, followed by government at 17%. Manufacturing declined to 13%, mining 8% and agriculture only 2%. In other words, the government has shifted the economy from a labour intensive to a skilled based economy. But the schooling and system has not produced more skilled labourers. They are needed in such a skills-based economy, because if you can’t read nor write fluently in English, or compound mathematical equations, you can’t be employed at a bank or as an engineer or similar professions.
According to Stanlib, an investment company, each year there are 1.24 million children starting their school career. By grade 10 there are only 1.11 million scholars. That number gets drastically reduced to 687 000 by the time they write their school leaving exams. Of those, only 270 000 will take the maths exam, and only one in three kids get a mark of 40% or more. So only 89 000 pupils will finish school with a pass in maths of 40% or more, that is a rate of only 7% of those who started school.
The story continues at University. Again, according to Stanlib, only 17% of all students at the public universities will obtain their degree. That is no more than 30 000 graduates each year, far too few to replace the skilled labourers retiring each year. The lack of skilled employees become obvious in all corners of the economy. For example, only 55 municipal technical divisions, out of 257 are headed up by an engineer.
The other fundamental problem of South Africa is that the Unions are too dominant. Their membership has been in decline for years, but they remain just as powerful as before – making up for the lack of new members by using increased violence. Year after year, they have demanded above inflation increases, thereby increasing the unit labour costs. Our average manufacturing wage are now 32 times higher than that of Ethiopia. Not surprisingly, China’s “one road” initiative is focused on countries north of Kenia.
Partly because of the high unit labor costs, industries like manufacturing are increasingly relying on robots (the BMW assembly plant near Pretoria is 95% robotic). Mining are shedding thousands of jobs and closing unprofitable shafts while mothballing marginal mines. Just to underscore the Unions complete lack of business understanding, they have now demanded that trying to keep a company profitable is not a strong enough reason to reduce the workforce. They want to make it even harder to fire employees. An analysis of Impala demonstrates the problem facing South African companies. Over the last ten years, the government got R19 billion, labour R77 billion and the shareholders had a loss of R228 billion (that includes the capital loss of the share price, which is now at levels last seen 20 years ago).
The poor education and the ridged labour laws cause a massively dysfunctional labour market. Out of 37.7 million working aged South Africans, 16.4 million are employed. Roughly half of those pay income tax, because most just don’t earn enough. This causes a tight spot for the South African government. They have hardly any room to raise more taxes. Taking into account World Bank indicators, South African tax-to-GDP ratio at 26% is much higher than the world average of 14.5%. In fact, South Africa has the tenth highest tax-to-GDP ratio in the world.
Under the Zuma administration, South Africa binged on debt, mostly through guarantees to their state-owned enterprises like Eskom and Transnet. They have reached now a debt ceiling where any further increase would surely convince the rating agencies to downgrade the South African debt to junk status. So where to from here? If the government under Ramaphosa is not able to take on massive amounts of debt and spend it on infrastructure projects, what can they do?
Firstly, they need to recognize that they need the help of investors, most of them foreigners. That means that the environment should be as investor friendly as possible. They would, for example, like to have policy certainty. When they make investments where the payback period is 20 years, they want to be sure that the rules don’t change midway through. The returns that they get from their investment should be attractive enough to convince them to invest into South Africa, and not Argentina, Chile, Vietnam or Portugal. The investment world is fluid, and investors are not limited to invest into South Africa – they can invest where ever they want to.
Secondly, they will have to rebuild the schooling system. It doesn’t help that a child in the rural areas will have a 1 in 100 chance of eventually being able to study, not because of costs, but because of their dismal schooling system. It also doesn’t help that all teachers are paid the same, even though the national average of absenteeism of teachers is 40%. Good teachers need to be paid more, and bad teachers (or absent teachers) need to be fired. Mathematics and English are crucial in today’s world and should be compulsory subjects. The pass rate should be calculated on the number of pupils starting schools each year, and the governments target should be for 80% of those to pass matric. The government should also focus much more on early child development (the first 1000 days), thus making sure that everybody gets the same chances in life.
Thirdly, the state-owned enterprises should be freed of corruption and returned to profitability by a management team that is employed based on their merits, not their political affiliation. The tender processes need to be transparent and accessible to everybody. Their debt levels need to be reduced by raising more capital through a partial listing on the JSE. They could contribute greatly to the economy but should not be an expense to the economy. Since the fiscal policy is a zero-sum equation, spending money on bail outs of the SOE’s means that there is less money available elsewhere, for example education or health.
Lastly, the government need to rebuild many public institutions. The Hawks need to be free of political interference and should have the capacity to investigate complex commercial crimes. Currently they don’t. We need more and better policing. It can’t be that the citizens live in fear of violence and crime. The courts need more capacity to hand down judgements quicker and more consistent. The public prosecutors need to operate free of favour and need to improve their competence. Red tape needs to be drastically reduced, and the government needs to be made leaner, more efficient and free of corruption. These are only some suggestions, but they would go a long way towards building a solid foundation for the economy to grow sustainable into the future, and therefor creating jobs and opportunities for everybody. It would raise the GDP per capita and make a real impact on the life of South Africans. They changes will take time to have an effect, but with a strong leadership, it should be possible. Until then, the economy is fragile. It will largely depend on external influences that it has no control over, such as the level of commodity demand of China, the health of European economies and the level of the Rand. Not only would international investors ignore any possible opportunities in South Africa, but talented South Africans would seek opportunities elsewhere.