Category: Current

Instead of thinking about how to make the pie bigger, it seems like Namibian politicians are more concerned about how to carve up the pie in new ways. This has expensive consequences.

 

The Namibian government is determined to complete and implement its National Equitable Economic Empowerment Framework, in short NEEEF, by the end of 2018. It requires all white owned businesses to sell 25% of their business to black people, a concept designed to correct the wrongs of the apartheid years, almost 30 years after gaining independence. It is not a new concept, in fact it has failed to make a difference to millions of poor people in South Africa, where a similar concept called BEE (and its successor BBBEE) was implemented shortly after the awakening of the Rainbow Nation. The reason was simple: few could afford to raise funds to pay for the shares. It made wealthy or connected South Africans extremely wealthy but did little to the average South African.

 

In deals further down the line, there was an effort made to make it more accessible to average South Africans. All sort of complex financial structures were put in place, whereby the companies would be able to provide vendor finance, where banks issued preference shares to finance deals and where interest was capitalised and hopefully a rising share price would take care of the fact that borrowed money needs to be serviced. The BEE shareholders were “locked in” for a pre-determined number of years, until the borrowed money was paid back, and afterwards they could benefit from some real wealth creation. But just ask any of the shareholders of MTN, Sasol or Resilient Property Fund about their experience, and one quickly realises what a mess it can create if the share price goes South instead of North.

 

Although it was encouraged that all companies sold some of their shares to black South Africans, it was enforced only at the listed ones. Namibia wants every white business, no matter the size to sell their shares. No matter if it is a big listed company or a small closed corporation. That is insane. There is no liquidity (the ability of in this case black shareholders to find other black investors relatively quickly to sell the shares to at a reasonable price, should you wish to) for small and unlisted companies. I very much doubt that the banks would be prepared to take unlisted shares as security for extending the loans to buy the shares. The only thing certain is that NEEF makes investing in Namibia more expensive, since you now have to generate your return on your investment on 75%, thus requiring a higher return on the investment. Lastly, what ever money is used to buy into the white companies is money that is not available to be deployed elsewhere in the economy. I very much doubt that it would cause more economic growth, the reverse is more likely.

 

It is also astounding that politicians always assume that they can rectify the results of history. Nowhere in the world has it ever worked. Politicians would be more effective if they come up with policies on how to grow the economy. By growing the economy aggressively, i.e. above 5%, they will make sure that everybody will be better off. It will lift poor out of poverty, it will offer opportunities to young entrepreneurs and it will make everybody wealthier. Taking from Peter to give to Joe will not.

When we look back on the period from 2008 to now, we will comment that it was a time when central bankers did too much and politicians did too little to get the economies started again.

The financial banking crisis of 2008, which lead into the sovereign debt crisis was a massive shock to the world economy. The days after Lehman Brothers collapsed could have easily changed the world we know on a permanent basis, were it not for the unprecedented coordinated intervention of Central Bankers around the world. Lehman Brothers, is by far the biggest US bankruptcy with over $691 billion in assets (that is almost twice the size of South Africa’s GDP at the time, measured on a nominal basis), more than ten times bigger than Enron’s bankruptcy. But what was worse was that Lehman Brothers was an integral part of the US financial system, and its collapse could easily have triggered a run on all financial institutions. At the time politicians neither understood the full implications of a bankruptcy, nor did they have the political will to act against the general anti-banks mood and try and save Lehman Brothers.

Banks didn’t trust each other anymore, reflected by the extraordinary spike in the overnight interbank lending rates. If the banks don’t trust their competitors anymore, and if the public doesn’t trust the banking system as a whole, the faith in the US Dollar (and other currencies) would have disappeared, and faith is all that keeps the value in currencies these days. Thanks to the unorthodox response from Ben Bernanke (Fed Chairman), the absolute loss in trust of the financial system has been avoided. The start of the “great recession” could not be avoided however.

To do their bid to restart the economies again, Central Bankers around the world (lead by the Fed) decreased their lending rates to all time low. They did this by buying their own countries bonds, driving those yields un-naturally low and in turn making cash a very expensive asset. Cash fund, most of which are located in the USA began the search for yield and found it in the emerging markets. In South Africa, for example, foreigners bought more bonds in 2010, than they did in the ten previous years out together (on a net basis). In 2011 they bought even more than in 2010, and in 2012 they bought almost as much as 2010 and 2011 put together, thereby financing our current account deficit (and keeping the Rand at very overvalued levels).

All this liquidity from the developed world central bankers didn’t kickstart the economy as they hoped. Companies are sitting on piles of cash, but are not expanding production even though they are operating at record high profit margins. Banks have returned to being profitable, but not by lending out money but by using the cheap finance available for them to buy bonds, thus making a cut of the yield differential. So why is the liquidity not deployed in more productive capital?

While the central bankers went out of their way to revive the economy, politicians did their best impose more rules and regulations and thereby red tape. The American act written in response to the great Depression in the 1930’s was 37 pages long. It set out the rules and regulations regarding the banking industry. It was not perfect, but it could be expected that every senior executive would have read it and thus acted within the rules and regulations. The new act, the Dodd-Frank act is 848 pages long, and it is not finished yet.

Similar overwhelming regulations are imposed all around the world. And while the politicians are at it, they have also tighten up on labor regulations, putting more onus on the employer and thus making it more risky to take on new recruits. Instead of opening up their boarders, politicians opted to increase barriers to international trade. In fact, politicians who were voted into office were more socialist and thus appeared to be anti-business. Take Frances Francois Hollande as an example. His agenda included extraordinary high taxes on the wealthy, supporting trade unions in their fight to force companies to stay open (and at the same time demand higher wages), increasing welfare support and reducing the retirement age. So why am I arguing that politicians did to little? Well, as it turns out the wealthy in France were preparing to leave (some did so rather quickly) and companies like Michelin and Goodyear had to close down some of their manufacturing plants. And mr Hollande recoded the lowest popularity rating of any French president. What most politicians seemed to have forgotten was that an economy can only grow if the private sector grows. Instead of making them as competitive as possible, and making the business environment as accommodative as possible, politicians went the opposite way, at least in most of the developed world, but also in places like South Africa.

The massive support of the Central Bankers however caused huge imbalances, and unwinding the support will cause un-intended consequences, which started last year May (when the Fed hinted at tapering off their asset purchasing programs, and the emerging currencies fell in a heap) and will not end for any time soon.

The South African Reserve Bank (SARB) has once again hiked interest rates, although only slightly, confirming that we are on a definite upward trend. This, even though the economy is weak and seems to get weaker still. The main reason was that inflation seems to be creeping higher, albeit slowly. It is widely accepted that higher interest rates (lending rates) will curb inflation, but at the same time slow the economy. This puts the SARB in a very difficult position. I am not sure that they have made the right decision. This is once again a situation where I think Reserve Bank governors want to do too much, and politicians do too little.

 

Some of the reasons given by the Reserve Bank were that the weakening Rand leads to imports being a lot more expensive, and that food costs are going up. I don’t think that a hike in the rates would achieve any of the desired effects. When it comes to food costs, South Africa is in a very unique position, different than America, Europe and Asia. Theoretically we produce largely enough for our own consumption, however if we fail to do that we need to rely on imports to make up for the shortfall. But in contrast to let say Germany, we can’t rely on our neighboring countries to supply our shortfall. Firstly, they are not big producers of crops themselves, and often have to import to make up for their own shortfall. Secondly, if our crop harvest is down by 10% it is the equivalent of the consumption of the whole of Namibia and Botswana combined. So if we do have a shortfall, we will have to import, and given the geographical position of South Africa, the transport costs will be high. This means that as soon as South Africa doesn’t produce enough crop, we will experience inflation as all crops are then sold at import parity pricing.

 

So would a rate hike curb food inflation in SA? As long as the inflation is supply driven, I doubt it. In fact it might even make it worse. There are many ways to increase the yield of crops, thus making sure that South Africa has the required food security. But these rely on economies of scale, and using modern technology to optimize the planting and harvesting process. These require big capital outlays which are often partly financed by banks. Increasing interest rates make such investments less feasible. The Governments latest comments about farm ownership (see previous article) also deters any such investments.

 

One of the other reasons given was the weak Rand, which would cause imports to be more expensive. Unfortunately the Rand was too strong after the world financial crisis, as investors around the world were searching for yield, since they got nothing at home. Thus a big demand for Rand came from investors, not from sustainable trade requirements. At that point, the SARB should have lowered the interest rate substantially to make the short term investments in South Africa less attractive.

 

In the subsequent years, consumption was one of the main drivers of the economy, as imports became cheaper and South Africans splashed out on new cloths, TV’s, cars, etc. Without any support of the producing side of the economy, the growth was only driven by the stronger Rand (which had nothing to do with the underlying economic factors) and thus unsustainable. Basically we helped countries like South Korea, Vietnam, Mexico, Thailand but also Spain and Italy amongst others achieve sustainable growth by buying all the products they produced.

 

Yet again, the government could do a lot more to foster growth. One of our natural big economic advantages are resources. We have a wealth of natural resources and in theory that should be one of the main drivers of economic growth and thus prosperity. Added to that we had just experienced the biggest commodities bull market since the sixties, but South Africa has not been able to increase production and thus benefit from these extraordinary times. In fact, due to the fast rising labor costs, poor electricity supply and a lack of infrastructure many of the small mines had to close down. Many of the big mines had to turn to their parent company or their shareholders for additional cash injections, just to survive.

 

A hike in interest rate will not make South Africa suddenly more attractive to international investors. A change in politics will though. Thus I am not sure that we are on the right course, however only history will determine the correct outcome.

In a series of short articles, I will write about how to run a government that encourages economic growth with stable policies, something that is much needed here in South Africa.

 

In this article I write about a buzzword that has been making headlines courtesy of the German government over the last few years: Austerity. In the very basic format, austerity is when the government tries to save any unnecessary costs and cuts down on their spending. In general this is seen as a good thing, and thus should be endorsed. Germany is the most prominent country advocator of it. They have managed to present a balanced budget, thus they would not need to incur any new borrowings. Thus they have been trying to force everybody else to follow suite, with mixed results. The Greeks for one, can’t stand the word and are trying to get away with less. Brazil ended up in a recession, partly due to the government’s austerity drive.

 

So is austerity really the medicine everybody need to get their economy on a track for growth? The basic idea is right, the timing if when to do it is almost more important though. It is good to save some costs while the economy is on a sustainable recovery, and the private sector is beginning to boom again. It can have the opposite effect however, if the economy is in tougher times. Just imagine yourself running a business, and just as trading slows down, and you are more reliant on existing customers, the biggest of them all tells you that they are focusing on saving money, thus they will not buy as much anymore. Since most governments contribute between 25% and 35% to the local economy, they are most certainly the country’s biggest “customer”. John Keynes already said that governments should run counter-cyclical budgets, ie save in the good time and spend in the bad times.

 

But what should countries like South Africa, Greece and Brazil do, whilst they are in a situation where it is almost impossible to spend more (because of debt restraints)? Should they spend their way out of their situation or are they better advised to embark on austerity? Well certainly most of the countries facing such difficult economic times have a third option – make the private sector as attractive as possible to investors. That means reduce tariffs, get rid of restrictive policies and red tape, show that the rights of investors are upheld in courts and focus on reducing corruption. Without much fiscal spend, the governments would be able to make their economies more competitive, more lucrative to investors who would be more willing to take a risk and invest in the hope of benefiting through the up-cycle.

The new land reforms set out by the Rural Development and Land Reform Minister Gugile Nkwinti caused a fair amount of up-roar and rightly so. The land reform set out that half of big farms should be handed to the workers on the farm, with the longest serving workers benefiting the most. The farm owner will not be directly compensated, but will receive a share in a fund that funds the small farmers and in return benefits from the returns of the fund (if there are any).

 

The basic idea that everybody should own some land, especially if they work on it is amended from the communist principle that says that everybody should be able to benefit from the land, thus all land should be owned by the government. It sounds fair enough, but as we have witnessed so many times before (it happened in almost every African country) it always has a devastating effect, especially on the poor. And it will be the same for South Africa, where our poor population once again get left further behind because of poor policy choices by the government.

 

To understand why, one needs to understand a bit about the business of farming, the food chain and inflation. Let’s start with the first one:

 

The business of farming:

 

Farming is a highly competitive and, in my mind, volatile business to be in. Essentially you are producing a homogeneous product (since the chickens or maize produced by one farmer is not very different than that produced by another) thus your selling price will be the biggest determining factor of the quantity sold. Added to that, the farmer is often subjected to very unpredictable events that are not within their own control, like the weather and nature (think of locust plagues). Because of this, the income stream is often uncertain and very difficult to predict.

 

If a farmer is a price taker, there are only two ways to increase profits (or in most cases, just survive). The one is to decrease the costs of producing, the other is to increase the yields by increasing the efficiency. The trouble is that most of the innovations done to increase the yields cost money, requiring a cash outlay to buy expensive machinery. The only way to make it feasible somehow, is to be as big as possible, thus reducing the incremental cost per unit (the benefits of economies of scale).

 

The food chain:

 

A lot depends on our maize production. The reason is very simple; maize is one of the main input costs of other foods, like chicken and pork. Thus a lower maize price should reduce the price of chickens (maize cost are about 40% to 50% of the costs of your chicken in the supermarket). We are currently producing about enough maize to supply most of South Africa’s needs. That means that if we loose any more production capacity in South Africa (as we surely will, it has always been the case in previous attempts to distribute land. Farm production of farms that have been redistributed through a the lands claim program before has fallen by more than 90%), we will have to import maize. That doesn’t sound too bad? Well, because of the geographic distance to other major exporting producers (like USA), the imported maize will be substantial more expensive. No local farmer in his right mind would sell his maize at a lower price, thus the local price will adjust to import parity. The effect will be that all foods further down the food chain will become more expensive, just because we have lost the ability to produce enough, which will have a devastating effect on the third topic, inflation.

 

Inflation:

 

Inflation is the percentage at which goods and services get more expensive every year. The official target rate of SARB is 6%. This means that if something costs R100 today, it will cost R106 in a years’ time. With that rate, prices double roughly every 13 years (with an inflation of 2% they would double in about 36 years). The trouble with the inflation figures is that it is a compounded number of the average household. Poor households typically spend more on basic demands (as per Marslow’s hierarchy) such as food and shelter. Thus poor people are more exposed to volatility in food prices (we have recently seen double digit food inflation). A rise in the price of maize will have a devastating effect on the ability of poor families just to get by.

 

I am of the opinion  that the impact  of the land reforms  on the wider economy have not been thought through properly. It is based on sentiments instead of realism, and should it be passed as is, would nudge South Africa one more towards repeating the failed expectations of Argentina in the early 20th century, rather than living up to the potential it could be.

AB Inbev has recently announced that they intend to complete one of the biggest mergers in history, namely that of them and SAB Miller. It is astounding to see that a well-run South African company is being valued at about R1.4 trillion Rand. The SAB share price rose by 30% (just slightly lower than the suggested take over price) since AB Inbev intentions became clear, because most investors assume that AB Inbev will be able to pass all the regulatory hurdles and thus complete the deal. SAB Miller certainly was no cheap buy, since their share price always traded at a slight premium to other brewers partly because of their exposure to the growth markets, and partly because they were always seen as a take-over target. If the shares were expensive before the take-over rumors started, they are certainly very expensive now. So you might ask what has all of this to do with buying Index trackers?

The problem with the South African stock exchange is that it is dominated by a few really big companies. If you add up the market capitalization (ie the value of all the companies), you get to a figure just slightly higher than R10 trillion. If you then divide the market cap into 3, the top third of companies is made up of only 3 companies, the next third of 14 companies and the bottom third of 153 companies.  Thus our market is very concentrated, and share price moves of a few big companies have a far greater impact on the index than the performance of many smaller companies. So which are the top 3 companies? The biggest weight is British American Tabaco (BAT), closely followed by SAB and then Naspers. The performance of these three shares have got as great of an impact as the performance of 153 smaller companies.

The problem at the moment is that the top 3 companies are all trading at a P/E more than one standard deviation above their long term mean. Even though the historical P/E is not a precise determination of value, it is a fairly good indicator. SAB’s P/E is above 34 now, and Naspers above 100. This is astronomical stuff, and you would have to expect massive earnings growth to justify such high P/E’s. As a fund manager, you would have to have really strong conviction to buy such highly priced shares. Surely there are better opportunities that offer better risk-reward returns. However, an index tracker fund does not do such decisions. 1/3 of your money would be spent on buying such expensive shares. I am not sure if that is such a good idea. This environment definitely favors good fund managers with an established track record.

The Oxfam inequality reports once again shows that South Africa is the most unequal society in the world. The two richest people are as wealthy as the poorest 50%. These are worrying figures, and the contributing factors are clearly many. In summary it shows that we have a big poor population, and compared with countries like Germany or the UK, our wealth gap would lead to increased levels of dissatisfaction. But this is where one has to be cautious to not to reach too quick conclusions from the report.

 

It is very difficult to draw blanket comparisons  between nations. South Africa, for example has got a large self-subsistence farming community. They live according to their own traditions. It is very hard to quantify their wealth, which clearly can’t be zero. Since they are only marginally active in the real economy their output is very hard to count, and thus their wealth is normally understated. But I am not sure that they would necessary live a better life if they all learned a trade, become factory workers and live in big cities. South Africa is also unique in the way that we have very complex industrial sectors that easily compete with the best of the developed world. We have a financial sector that seems often a lot more robust and advanced than the European and American peers, since we have very developed and liquid financial markets. We have some of the best engineers and doctors in the world.

 

Thus while we have a massive wealth gap, we also have a massive skills gap. We have some of the most talented people, while the majority of our population (mainly the young ones) had to endure a very poor educational system. The education system was focused more on providing education for everybody, instead of keeping high educational standards while expanding the system to include everybody. So while most school leavers have not had mathematics (one of the core subjects) and only had to get every third answer right in order to pass their matric, some kids were lucky enough to be in private schools or model C schools,. Those lucky ones probably passed their matric with flying colors and then went on to further their education in Universities and Colleges. Their skills are sought after by established businesses and because they are so scarce they are highly paid. This trend will continue until our quality of education to everybody increases.

 

So while we are topping the list of most unequal societies, it should not be seen as how to make to wealthier poorer (by increasing Taxes or other social burdens), instead it should be seen as how to give the poor masses the opportunity to earn more money. Clearly a better quality of education will have a major impact.

Once again, Greece has been bailed out, and taken on more debt provided by the other European countries and in return have promised to implement reforms. The Greek politicians hate the deal, but have agreed to implement it. At least try and implement it, their track record for implementations is not that good. And the other European countries, notably Germany, Netherlands, Finland and Latvia have expressed their distrust of the Greek politicians and have questioned why they should bail out Greece once more. They are also deeply against any write off of debt and very much for more austerity measures. But the essential question one would have to answer is – does this deal provide for a better, more secure and stable Europe, or are there more significant changes needed?

I think that all we have done is to kick the can down the road once more, because the systematic flaws of the European Monetary Union has not been addressed. Sure there is a lot more that Greece can do to make their economy competitive. They could relax their labor laws, get rid of cartels, make sure that everyone pay their fair share in Taxes and reduce the size of their overcrowded, corrupt and inefficient  public sector and government. They could raise the age of retirement even more and try and get rid of many Tax loopholes by implementing a flat Tax rate system. And they should get rid of the attitude that they are the victims, because nobody forced them into this mess but their democratically elected government. But the other European countries should also realize that they benefited from a larger Union, partially because the exchange rate is once within the union (obviously) but also because the exchange rate reflects the competitiveness of all economies put together.

Just imagine what would happen if the Germans decide to exit the Union and adopt their Deutsch Mark (DM) again? The DM would soar (at least vs the Euro), slowing the export driven economy substantially. This would hurt the German economy. So the Germans have benefitted by not having the DM, while the Greeks have had to realize that they have to restructure their economy to be able to compete with the European peers. You generally find a very similar situation within countries. In Germany for example, most of the car manufacturing is in the south, thus they have a bigger Tax base than counties like Bremen. In the USA, you have states like Alabama, where the GDP per capita is much lower than that of New York. But because many of the taxes are collected on a Federal system, the governments of the US and Germany can implement transfer pricing, where some “underachievers” are being supported by “overachievers”. Thus some counties or states get more Tax income per GDP allocated than others, thereby helping them achieve their goals.

The Euro Monetary Area doesn’t have this, because each country wants to preserve their federal independence. But that is like wanting the best of both worlds. This is clearly not achievable, and even though everybody is better off if they stay together, nobody wants to share their part of their success.

Why should Greeks vote “yes” on Sunday?

 

The Greek debt crisis has been dragging on for so long that it seems an eternity. They have almost been as long in a crisis mode in the European monetary union as “out of crisis mode”. Considering that the debt burden is 340 billion Euro, they have a serious question to answer: Is it all worth it? Would it not be easier to go back to the Greek Drachma? At least then they have more control over the currency, they have their own reserve bank, and they could print money to pay back the loans.

 

In simple economic terms, it would make sense. But such decision would be short sighted and naïve. In fact, the fallout could be so severe for the Greek population, that they could have mistaken it with Zeus, the god of thunder, returning. The Drachma would immediately devalue against all other major currencies, since the exchange rate always acts as the pressure release valve in an inefficient economy. Any company, who has taken out debt in Europe will see their debt burden skyrocket, and probably make it unsustainable. Banks would only be able to survive with the support of the Greek central bank, because in accounting terms they would be bankrupt. You would probably see high inflation coming through, wiping out any value of cash savings by pensioners, and the venerable parts of society would be thrown into poverty with little help or hope. That’s because the Greek government has still not sorted out one of their main problems: Tax collection. Going back to the drachma would not enable the Greek government to collect more Taxes, which they need to help to support the faulting economy.

 

Once the massive devaluation has taken place, the Greek economy will start to gain traction again, but from a much lower level. If the GDP falls by another 25% in real terms, after the Grexit, and the economy then grows by between 3 and 4%, they will need 20 -30 years to arrive at the level they have been at in 2008. That is a big price to pay.

 

All these doomsday scenarios would certainly advocate a “yes” vote this weekend, yes to stay in the Euro area and yes to reforms. But there is a much more fundamental reason why Greece should stay in the Euro area. As mentioned earlier, the currency exchange is a pressure-release valve to uncompetitive and in-efficient economies. In the global village, countries compete more and more head on against each other. Thus, over the long run, countries that produce the most efficient will benefit (in constant currency terms), while countries, that are marked by restrictive practices (such as ineffective and corrupt governments, high licensing fees, tight labor laws, etc), will perform badly. Either the economy will do badly, or, if they have their own currency, the currency should depreciate each year to make up for the inefficiencies (often coupled with inflation).

 

Greece is doing badly because they are not as competitive as their European counterparts. Their government employs more people in questionable and unproductive positions, the labor laws are more restrictive, the Tax collection not as efficient and they protect more industries resulting in companies being less efficient because high local barriers to entry which are restrictive. In a fast changing world dominated by disrupters like the Tax service Uber, you can’t try and protect your own Taxi industry by restricting it and charging high license fees. At the end of the day, the main people who suffer from such bad policies are the Greeks.

 

To end this ongoing crisis, the Greek people have a chance to vote “yes” this weekend and give a clear signal: Yes, they want to be part of Europe; Yes, they want reforms to make Greece, including their government more competitive; and yes, they want they want to be proud to be a Greek again, a nation that rises up to the challenge a conquer it, rather than blaming others for their own faults.