Monetary Policy

Monetary Policy in SA; Exchange rate volatility and exchange rate risks – that should best be ignored

June 19th, 2017 by Brian Kantor

[The text has been revised to correct an earlier version that failed to recognise the sharp reduction in interest rates after the Global Financial Crisis]

The Reserve Bank kept interest rates on hold in May because, as it explained, there were upside risks to the exchange rate. The risk was that if the rand weakened significantly it might have called for an immediate reversal of any interest rate reductions. Since then the Bank has provided further helpful detail of how its Monetary Policy Committee (MPC) goes about its risk adjusted exchange rate forecasting. We quote extensively from a recent address by Brian Kahn, Advisor to the Governor. [1]

To quote Mr.Kahn:

How do we deal with the exchange rate in our (inflation) forecast? We make a simplifying assumption of a stable real effective exchange rate over the forecast period. That implies an expectation of a rand depreciation over that period in line with inflation differentials with our major trading partners. We then use our judgement to assign a risk to this assumption, which then feeds in to the overall risk to the inflation forecast…”

 And to quote further

“….It is not just the forecast itself that is of importance, but also how we perceive the risks to the forecast. Any particular forecast trajectory could have a different policy outcome depending on how we assess the risks. MPC members may have differing views of these risks, which explains to some extent why we do not always have unanimity in the decision-making process…”

And on the forecasting method itself Mr Kahn explained

“…The critical issue then is the level of the starting point. As a general rule, we set it at the prevailing index level of the real exchange rate. However, if we feel that the exchange rate is clearly over- or undervalued at that point, we may adjust that level. In other words, should we regard the current strengthening or weakening of the rand as being temporary, we may not adjust the assumption fully until we have greater confidence of its persistence at those levels. The level that we choose has an important implication for the forecast. In 2016, for example, we saw a progressive improvement of the inflation forecast over the year. Most of this was due to revisions to the exchange rate assumption, following a recovery of the rand ……”

Mr Kahn made it clear that

“…While the exchange rate is one of the important variables in our inflation forecast, it is not the only one and we have to look at its impact in conjunction with the movement of other variables. And we certainly do not conduct monetary policy with a view to impacting on the rand itself…”

Forecasting the ZAR is easier said than done. In reality it is an impossible task to fulfil with any degree of confidence.  If past performance of the USD/ZAR is anything to go by the chances of the rand going up or down is statistically about the same. This is not surprising given the size of the market in the ZAR and the advantages an accurate forecast would offer any professional currency trader. In practice all that might be known by professional traders about what might determine the value of the ZAR in the future, will already have been incorporated in the current price of a US dollar. And so the exchange rate moves randomly from day to day, or minute to minute, as more information about the forces that influence the exchange rate are continuously revised.

Daily percentage moves in the USD/ZAR since 2006 and June 2017 have averaged very close to zero, .000230% per day to be exact. The worse day for the ZAR over this period was a 16% fall on the 15th October 2008 during the height of the Global Financial Crisis and the best a 7.5% gain registered on the 28th of that fateful October 2008. Monthly moves in the ZAR are also a random walk with a weaker long term bias. On average since January 1995, the USD/ZAR has declined by 0.59 per cent per month, the worst month being October 2008 when the ZAR lost 20% of its value and the best month was April 2009 when the rand gained over 11% against the USD (See below)

The real rand exchange rate – that is the value of the rand adjusted for differences in inflation between SA and its trading partners – indicates some tendency to revert to its Purchasing Power Parity (PPP) value over an extended period of time. Or in other words faster inflation that follows a weaker ZAR helps to strengthen the real rand given enough time. Given also some stability in or absolute strength in the nominal ZAR.  On these grounds and given the recent level of the real rand this might have led the MPC in a less rather than more risk reverse direction.  But on a day to day, or even year to year basis, the value of the real rand will be dominated by much wider movements in the nominal, that is the market determined, exchange rates, rather than by differences in more stable inflation rates. An exchange rate that as we have pointed out that fluctuates randomly and so for which the best estimate of tomorrow’s price of a USD value is today’s rate.

In figure 3 below we show how the USD/ZAR exchange rate has deviated from its PPP equivalent value since 1970. Exchange rate shocks- when the exchange rate moved sharply away from its PPP value can be identified in 1985, 1998, 2001, 2008 and also 2011. Though between 2011 and mid 2016 the real rand was subject to an extended period of growing weakness. This was a period of persistent USD strength and weakness of most other Emerging Market currencies.

As may be seen the USD/ZAR has been persistently weaker than would be predicted by the ratio of the Consumer Price Indexes in the two economies since 1995. In 1995 the SA economy was permanently opened to capital flows that had been tightly controlled before – with a brief interlude of freedom from capital controls for foreign investors between 1983 and 1986. It is of interest to note that when capital flows to and from SA were tightly controlled, the exchange rate, conformed very closely to PPP- truly levelling the trading field for importers and local producers competing with them. This currency, used for foreign trade purposes, was known as the Commercial Rand to distinguish it from the consistently less valuable Financial Rand used for transactions of capital undertaken by foreign investors in SA. After 1995, variable flows of capital to and from SA have come to dominate movements in the market determined unified ZAR exchange rates. Any assumption that these exchange rates would conform to PPP would not be a realistic one given the record of exchange rates since 1995- as shown in figure 3 and 4.

This real weakness was largest in percentage terms in 2001 and the real rand was again very weak in 2016. (See figure 3 below) The real trade weighted rand, as calculated by the Reserve Bank, varies about 100 to conform to PPP, as it was assumed to do in 2010. Real strength is represented by increases in the real exchange rate. The real trade weighted rand is compared with the real ZAR/USD exchange rate that uses the respective CPI Indexes In figure 4. The figure indicates a very strong real USD/ZAR exchange rate in the late seventies and early eighties when the USD itself was very weak on its own trade weighted basis. The real trade weighted ZAR rate has a current value of 89 compared to a less valuable 83 for the real USD/ZAR exchange rate.

As Mr.Kahn has explained the exchange rate has a very important influence on the SA inflation rate in SA given the openness of the SA economy to imports and exports- that together amount to over 50% of the GDP. Ideally from the perspective of monetary policy and appropriate interest rate settings, the ZAR exchange rate would be well behaved. Well behaved in the sense that exchange rate trends would closely follow domestic inflation and help maintain the level trading field when exchange rates largely compensate for differences in inflation – that is PPP more or less holds. That is movements in exchange rates compensate for differences in inflation rates between trading partners to neither add to or subtract from the competitiveness of local suppliers in either the local or foreign markets.  If so the price of a dollar (and so the rand value of exports or imports) would be determined by the same forces that simultaneously determine the prices of all the goods and services that make up the CPI. In which case prices might rise faster or slower and the exchange rate would depreciate  in line. When demand exceeds supply prices, including the rand price of a USD would tend to rise faster – and vice versa. Too much demand and the inflation and exchange rate weakness associated with it would obviously call for higher interest rates. And too little demand- associated with low rates of inflation and a stronger rand would call unequivocally for lower interest rates.

But unfortunately for SA the ZAR exchange rate is not well behaved. It often takes an unpredictable course set quite independently of the forces of demand and supply in the economy. Inflation – depending on the exchange rate and other forces- then follows more or less closely the independent direction of the exchange rate.  And interest rates in SA then follow inflation, usually higher sometimes lower, regardless of the causes of inflation and the prevailing state of the economy. They therefore may rise even though domestic spending is growing ever more slowly- as they have done in SA since 2014. These higher interest rates in turn help depress spending further that is already under pressure of higher prices. These forces are known in the economics literature as supply side shocks to prices- less supply means higher prices – as they would in a drought that reduces supplies to the market place and raises price. And supply side shocks, according to the same literature, are considered to be reversible with temporary not permanent effects on inflation- and not to call for monetary policy responses

As Mr.Kahn has explained the current weakness of demand in SA makes it harder for firms to pass on higher costs to their customers- so reducing inflationary pressures to a degree- but simultaneously making it all the more difficult for the firms to invest more or hire more workers. This repression of domestic demand has added to the other recessionary forces under way. Without having any predictable influence on the exchange value of the rand – which as Mr.Kahn has also indicated, is anyway not a target for monetary policy.

The sooner the Reserve Banks lowers interest rates the better the chance of the economy recovering from recession. Delaying the interest rate reductions for fear of what might happen to the exchange rate prolongs rather than relieves the economy agony. There is surely much more at stake than forecasting the exchange rate accurately- a task surely well beyond the capabilities of the MPC or indeed any other forecaster.

There is an obvious way out of this dilemma – of having to increase interest rates to fight inflation, when interest rates have had nothing to do with the exchange rate and the inflation under way. And higher interest rates can only slightly inhibit inflation by further depressing spending that is already depressed. The alternative is for the policy makers to treat exchange rate shocks to inflation as what they surely are – a temporary supply side shocks that will increase prices perhaps for a year and then fall out of the CPI, off a higher base level.

The narrative that suggests all inflation-  whatever its cause- demand or supply side – needs to be met with higher interest rates needs to be a very different one. Not raising rates in the face of a supply side shock should moreover not be allowed to indicate any tolerance for higher inflation rates over the longer run. But it would be a narrative that would not allow inevitably risky exchange rate forecasts to influence interest rate settings that induce recessions. Monetary policy should allow a volatile exchange rate to help absorb the pressure of more adverse economic circumstances, not to exacerbate them

South Africa has a very poor record managing exchange rate shocks. The response to the emerging market shock to the ZAR in 1998 was one such particularly disastrous example. The interest rate increases that followed the 2001 exchange rate collapse was also not an appropriate response. Interest rate increases that were then sharply reversed after 2004 when the ZAR recovered and the economy picked up boom like momentum.  A less severe hiking of interest rates prior to the 2008 Global Financial Crises, that was accompanied by ZAR weakness might have served the economy better. Though when the rand strengthened markedly soon after the crisis  interest rates were lowered very sharply by as much as 7%. This undoubtedly helped the economy overcome a brief recession. Furthermore would inflation been any higher had interest rates not been increased after 2014 – in response to rand weakness and higher inflation and the recession perhaps avoided? (See figure 5 below)2

Had these exchange rate shocks to inflation been ignored, it can be strongly argued that SA inflation over the longer run would not have been very different and that growth rates would have been on average higher and less variable. The logic of inflation targeting – in the presence of un-predictable exchange rates that do not conform to purchasing power parity – needs to be seriously re-considered. The impaired logic of inflation targeting in SA can surely be reassessed without appearing soft on inflation.

Given that any immediate change in monetary policy philosophy is unlikely the improved outlook for inflation is such and further improved by recent stability in the ZAR- that lower interest rates will follow at the next MPC meeting in July 2017. The pace of further declines in the repo rate will follow inflation lower. The chances of a cyclical recovery in the economy depend crucially on lower short term interest rates – the sooner they come and the steeper the reductions the better.

 1 “Check in” from the South African Reserve Bank

Address by Brian Kahn, adviser to the Governor,

to the 6th Annual Nedgroup Investments Treasurer’s Conference,

Summer Place, Hyde Park, 8 June 2017;

 2 This paragraph in italics corrects an earlier version that failed to recognise the sharp reduction in interest rates after the Global Financial Crisis 

SA Financial Markets

Making sense of a sideways moving JSE

June 12th, 2017 by Brian Kantor

Making sense of a JSE moving sideways and the conditions necessary to send the trajectory upwards

The recent performance of the JSE will have been disappointing to many South African shareholders. Since 1995, the JSE All Share Index has had its severe drawdowns. But these were more than compensated for when it came to the buy and hold investor. Since 1995 average annual returns, calculated monthly, were 12.9% compared to average headline inflation of 6.2% over the same extended period.

The worst months were when the JSE All Share Index was down by more than 30% in August 1998, 34% in 2003 and were as much as 43% down in February 2003. The best months came in the aftermath of these severe declines. Total 12 month returns were 40% in January 2001, 41% in July 2005 and 37% in March 2010.

By sharp contrast, between January 2016 and May 2017, the share market has moved very little in both directions, with comparatively little movement about this low average. The worst month over this recent period was February 2016, with negative annual returns of 4.4% and the best the close to 10% that were realised at January month end, 2017. (See Figure 1 below)

The JSE, since early 2016 however, presents very differently when the All Share Index is converted into US dollars. In dollars the Index itself (excluding dividends) is up by 24% since January 2016, a gain that compares very well with that of the emerging market benchmark (up 28%) over the same period and the 19% gain achieved by the S&P 500. (See figure 2 below)


In US dollar terms the JSE has, over the past two years, sustained its very close correlation with the EM Index of which it is a small part, perhaps 8%. Or in other words, the EM indices on average have recovered ground lost vs New York between 2011 and mid-2016, but have realised much more in US dollars than in local currencies, including the rand, which has strengthened materially against the US dollar since mid-2016. The JSE in 2017 to date (8 June) has gained 3% in rands; the EM Index is up 10% in rands, while the S&P 500, at record levels in US dollars, has gained but a mere 2% this year, when converted to the rand (now R12.84).


The rand has gained 6.3% vs the US dollar this year and is 20% stronger than its worst levels of R16.85 of early January 2016. The rand has also gained ground against most EM currencies over the same period. The rand blew out against the EM peers in December 2015 on the initial Zuma intervention in the Treasury. But it then recovered consistently against its peers as well as the US dollar after mid-2016 and is almost back to the level of 2012. The second Zuma intervention in Treasury affairs in late March 2017, when he sacked Minister of Finance Pravin Gordhan, has had very little effect on the USD/ZAR and on the value of the rand compared to a basket of eleven other EM currencies that have gained Vs the USD. (See figure 4 below)

Judged by this performance of the rand compared to other EM currencies shown in figure 3, the risks of doing business in SA rose significantly in December 2015 – but have receded markedly since. Moreover the spread between the yields offered in US dollars by the South African government, compared to the yield offered by the US Treasury, an explicit measure of country risk, is now no higher than it was before December 2015. The RSA, five year Yankee (US dollar-denominated) bond currently offers a yield of 3.7%. The safe-haven five year Treasury currently offers 1.75%. This risk spread rose from about 1.9% in mid-2015 to 3.7% in January 2016. It is currently about 2% or back to where it was before the Zuma threat to SA’s fiscal stability first emerged in December 2015 (see figure 5 below).

The Zuma interventions in South Africa’s fiscal affairs have clearly influenced the rating agencies. They have downgraded SA debt. The market place, it may be concluded, has largely got over the threat. The market must have concluded, rightly or wrongly, that the influence of President Zuma and the threat he represents to SA’s ability to service its debts is in decline. As it is often said, time (and perhaps leaked e-mails) will tell.

It should be appreciated that rand strength, considered on its own, is not directly helpful to about half the stocks listed on the JSE. These are the global companies with a listing on the JSE whose major sources of revenues and profits are outside the country. As such they are rand hedges and perhaps more important, hedges against SA specific risks. A combination of rand strength, especially for SA specific reasons, is not likely to be helpful to their rand values. A given dollar value for their shares, largely established by the global investor outside South Africa, will then automatically translate into lower rand values. Another way of making this point is to recognise that when the rand gains 20% against the dollar, it would take a more than 20% annual appreciation in the US dollar value of a stock to translate into an increase in the rand value of a dual listed company. This 20% or so is a very demanding US dollar rate of return.

This is a rate of return that Naspers, but few others of the global plays listed on the JSE, have been able to meet. Indeed, some of the important global plays listed on the JSE have suffered from weaknesses very specific to their own operations. For example MTN (Nigeria exposure), Richemont (luxury goods) and the London property counters (sterling) as well as AB-Inbev (the beer market) and Mediclinic (regulations in Dubai) have all had earnings problems of their own. Enough to drag back the JSE All Share Index in US dollars and even more so in the stronger rand.

But while rand strength is a headwind for much of the market, it can be a tailwind for the other half of the JSE much more dependent on the fortunes of the SA economy. But to help them, the strong rand and less inflation that follows need to be accompanied by lower interest rates. Lower interest rates stimulate extra household spending and borrowing that then becomes helpful for the earnings of retailers and banks. This move in interest rates has been delayed by the Reserve Bank, despite the recessionary forces that higher interest rates since January 2014 have helped to produce. But the recession coupled with the strong rand and the outlook for less inflation would make lower interest rates irresistible.

These recessionary forces have also been revealed by the earnings reported by industrial and financial companies listed on the JSE. Trailing Findi earnings per share are not yet back at 2015 levels – though they are now growing. In US dollars, Findi earnings per share are yet to recover to levels realised further back in 2011. (See figure 6 below)

These reported earnings moreover do not suggest that the Findi is undervalued – given current interest rates. They suggest the opposite, a degree of overvaluation that will need to be overcome by sustained growth in reported earnings. Naspers, with a weight of 27.3% in this index will have to play a full further part in this earnings growth. A regression model of the Findi, using reported earnings and short term interest rates as explanations run with data captured from 1990, explains the level of the index very well. The model suggests that fair value or model predicted value for the Findi was only 59 964 compared to the actual level of 72 732 at May 2017. That is, the model suggests that the Findi is now some 20% overvalued and has remained so for an extended period of time since 2013. This theoretical valuation gap has grown despite the stagnant level of the market as shown in figure 7 below.

The market has implicitly remained optimistic about a recovery of earnings, a recovery now under way but, that has taken an extended period of time to materialise given recession-inducing higher interest rates in SA. Lower interest rates – perhaps significantly lower rates – would be essential to justify current market levels. They will help by discounting current earnings at lower rates, but help more by stimulating currently very depressed levels of household spending and borrowing.

A stronger global economy will also help improve the US dollar value of the global plays listed on the JSE and, depending on the USD/ZAR, perhaps also their rand values. A weaker rand may help the rand values of the offshore dependent part of the JSE. But rand weakness might (wrongly) delay lower interest rates. The best hope for the JSE is a strong global economy, combined with a strong rand and a recession-sensitive Reserve Bank. Is this all too much to hope for?

Monetary Policy

Staying on a destructive path

May 31st, 2017 by Brian Kantor

The Monetary Policy Committee (MPC) of the Reserve Bank last week found reasons to deny any relief to the hard pressed SA economy in the form of lower short term interest rates. And to do so despite the very good prospect of less inflation and still slower growth to come.

According to the MPC statement:

“The MPC assesses the risks to the inflation outlook to be more or less balanced. Domestic demand pressures remain subdued, and, given the continued negative consumer and business sentiment, the risks to the growth outlook are assessed to be on the downside.”

Concern about the possible direction of the rand appears as the principle reason for the MPC to delay any action on interest rates and wait for further evidence of lower inflation.

To quote the MPC further:

“The rand remains a key upside risk to the forecast. The rand has, however, been surprisingly resilient in the face of recent domestic developments. This is partly due to offsetting factors, particularly positive sentiment towards emerging markets and the improved current account balance.”

But as the MPC must surely know, the future of foreign exchange value of the rand – weaker or stronger – will always be uncertain because it is at risk of political and global forces well beyond the influence of Reserve Bank actions or interest rate settings. Over the past year the rand has strengthened for global reasons, common to all emerging market currencies and, as acknowledged by the MPC, despite the Zuma-induced uncertainties about the future course of fiscal policy.

What is known about changes in the exchange value of the rand is that it will make exports and imports more or less expensive and usually lead the inflation rate higher or lower. In the figures below we show how the Import Price Index leads the Producer Price Index that in turn leads the Consumer Price Index in a consistent way. Given the recent strength in the rand, the trend is strongly pointing to lower inflation to come. Indeed, the MPC was surprised by the latest lower headline inflation rate reported for inflation, a lower rate that has still to be incorporated into its own forecasts of inflation.

t1 t2

The so-called pass through effect of the exchange rate on domestic prices, will also depend on also uncertain, global prices that also effect the US dollar prices of imported goods and services- particularly the dollar price of a barrel of oil. Other uncertainties will also influence domestic prices as the MPC acknowledges (for example electricity prices) as will expenditure taxes and excise duties – again forces not influenced by the interest rates. The unpredictable harvest is another major uncertainty that influences prices in SA – for now this is helping materially to reduce the inflation rate.

Exchange rate moves and other shocks, unconnected to the level of spending in the economy, are regarded as supply-side shocks that register in the CPI temporarily. Unless the shocks are continuously repeated in the same direction, they fall out of the CPI after 12 months. Hence monetary theory tells us these are temporary forces acting on prices that should best be ignored by monetary policy.

Interest rates will however influence spending in the economy in a predictable way and are called for when there are excess levels of demand. This is usually accompanied by increases in the money and credit supplies. This is far from the current case in South Africa, where spending and credit growth remains subdued and hence calls for lower interest rates, perhaps much lower.

This all raises the rationality of interest rate settings in SA that react to forces that are impossible to predict with any confidence – for example the exchange rate, over which monetary policy has no influence. Supply side shocks on inflation in SA have (wrongly in my opinion) allowed to influence interest rate settings with all inflationary forces treated as the same threat by monetary policy, regardless of its provenance. This has been the case since early 2014 in response to rand weakness and a drought that both forced prices higher. But a positive supply side shock on prices of the kind South Africa is now benefitting from (a stronger rand as well as a much improved harvest) is surely to be acted upon with urgency. Waiting to see what will happen to the exchange rate is simply to prolong the agony of tolerating slow growth for no good anti-inflation reason.

And in response to the inevitable Reserve Bank retort that failure to act on inflation will lead to more inflation expected and hence more inflation to come, I would suggest that this theory, on which the Reserve Bank relies so heavily to justify higher interest rates, has little support from the evidence of the inflationary process in SA. Inflation expectations have remained persistently high, as has the expected weakness of the rand, even as inflation itself has moved higher or lower. Evidence furthermore suggests that inflation expected, if anything, follows rather than leads realised inflation.

More important, it is highly unlikely that inflation expected can decline with the persistent market view that the rand will weaken by 6% p.a. or more each year for the next 10 years, as has been the persistent trend. Inflation expectations have proved very hard to subdue, despite the determination of the Reserve Bank to act against inflation, without obvious benefits for the inflation rate and regardless of the negative impact higher interest rates have on the subdued growth in demand.

Inflation expectations are measured below by the difference between nominal bond yields and their inflation-linked equivalents of similar tenure. The expected path of the USD/ZAR is measured by the difference between RSA bond yields and their US Treasury equivalents. These are compared to actual inflation in the graph below. As may be seen, inflation has been far more variable than inflation expected or the expected weakness of the rand. For the record, since 2005, measured at month end, the headline inflation rate has averaged 5.9% p.a, with a standard deviation (SD) of 2.2% p.a. Inflation expected has been much more stable, while it also averaged 5.9% p.a with a reduced SD of 0.71% p.a, while the spread between 10 year RSA yields and US Treasuries – a very good proxy for the extra cost of buying dollars for forward delivery – averaged 5.25 p.a. at month end with a SD of 1.2% p.a.

It will probably take an extended period of low inflation to reduce these expectations of inflation and rand weakness. Sacrificing economic growth for an inflation rate that has proved largely beyond the control of the Reserve Bank has never seemed to me to be good monetary policy. And it makes even less sense now that the inflation outlook has improved, even if this should prove temporary. 31 May 2017



Global Financial Markets

From underperforming BRICS to the now less Fragile Five. Lessons for Brazil and SA

May 31st, 2017 by Brian Kantor

We can recall the days when the BRICS, Brazil, Russia, India, China and, a later inclusion, South Africa, were the darlings of the commentators. Their growth prospects were fueled by the super-cycle of commodity prices and improved equity markets – until the global financial crisis of 2008 intervened.

Commodity prices and emerging market (EM) equities recovered strongly after the crisis, but then in 2011 fell away continuously, until mid-2016. This took down the exchange value of EM currencies, including the rand, with them and forced inflation and interest rates higher, so adding further to the BRIC misery.

The economic and political reports out of Brazil in recent days are particularly discouraging. Its current constitutional crisis and likely upcoming elections will make it more difficult to enact the economic reforms that could permanently improve the economic prospects for the country. The trajectory of its social security expenditures and lack of revenue from payroll taxes will take the social security funding deficit, currently 2.4% of GDP, to 14% by 2022, according to the IMF. But these fiscal problems are compounded by a recession that shows little sign of ending.

The disappointments of the BRICS moreover forced attention on the “Fragile Five” of Turkey, Brazil, India, South Africa and Indonesia. These are economies with twin deficits – fiscal and current account of the balance of deficits, that makes them especially vulnerable to capital flight. Some investors have found consolation in this slow growth. Slow growth has seen these current account deficit decline markedly. In the case of South Africa the current account deficit – the sum of exports less exports, plus the net flow of dividends and interest payments abroad – has declined markedly from near 7% of GDP in 2013 to less than 2% in Q4, 2016, and is likely to have fallen further since.

These trends have made the SA economy and its fragile peers appear less dependent on inflows of foreign capital, thus making the spread between the yield on its bonds and safe-haven bonds attractive enough to attract inflows of capital and provide support for the local currencies. In mid-2016 the declining trend in EM exchange rates and commodity prices (not co-incidentally) was reversed, as was the outlook for inflation.

These reactions however neglect the more important vulnerability of the SA and the Brazilian economies to persistently slow growth. That is the danger slow growth presents for social stability. The capital account inflows no more cause the current account deficits, than the other way round. The force driving both sides of an equation is an equality is the state of the domestic economy and its savings propensities. In the case of SA, Brazil or Turkey, should the growth rate pick up, so will the current account deficit and the rate at which capital flows in. If the capital proves expensive or unavailable, the exchange rate will weaken, inflation will rise, the prospective growth will not materialise and the current account deficit will remain a small one.

Were Brazil or South Africa to adopt a mix of policies that reduces risks and improves prospective returns on capital, the long-term growth outlook will improve and their economies will grow faster. And they will have no difficulty in attracting the capital to fund the growth. Growth could lead and capital will follow in a world of abundant capital.

South Africa and Brazil have more in common than slow growth and fiscal challenges. They have similar degrees of political difficulty in adopting growth-enhancing reforms. The best they can now do, absent a credible growth agenda, would be to aggressively lower short term interest rates. This would improve the short term growth outlook and help attract capital and, if anything, help rather than harm the exchange rate. It remains for me a source of deep frustration that the SARB remains so reluctant to take the opportunity to improve growth rates, without any predictable impact on inflation. 26 May 2017

SA Economy

Get South Africa Going

May 15th, 2017 by Brian Kantor

My book has been published. ( See below for details ). It should be available in the book stores and on-line very soon. The chapter outline included in the Foreword is shown below.


Get South Africa Growing

Jonathan Ball Publishers
Johannesburg and Cape Town

Brian Kantor

Published in South Africa in 2017 by
A division of Media24 (Pty) Ltd
PO Box 33977
ISBN 978-1-86842-763-5
ebook ISBN 978-1-86842-764-2


Chapter outline

In the first chapter, I address the current very unsatisfactory state of the South African economy seen as a whole – the macro environment – and what might be done to improve it. I accept that the global economy has made it more difficult for our economy to grow faster in recent years and I consider what more favourable cyclical forces might spark faster growth. But, I would argue that our problems are not with our stars but with ourselves, and while the challenge to government is to live within the taxpayer’s means, it is a call for not just more competent government but also less government.

In Chapter 2, I make the argument for market forces properly understood – why they are fair to the participants in markets while delivering the goods, services and incomes that people want more of. I make the case for the market meritocracy and why much greater reliance on the free play of market forces is called for in South Africa. As support for this contention, I refer to the proven ability of these market forces, of individuals given essential freedom and encouragement to pursue their economic interests and protection of their gains, to lift billions of people out of absolute poverty in recent years. The global economy bears witness to an unprecedentedly successful poverty relief programme that deserves greater recognition appreciation than it has received and emulation for other economies playing catch-up. The chapter attempts to do this.

Chapter 3 attempts to answer a burning question: given its well-demonstrated achievements, why do these market forces, and the business enterprises that are their prime instrument, not receive more approval? Why are they so often regarded with hostility rather than respect? Why are they regarded as opposed to the economic interests of the many they serve, thought capable of dishonesty unless proved otherwise, rather than the other way around – recognised as beneficent forces for economic progress, unless in exceptional cases proved otherwise? In doing so I challenge those with these attitudes to perhaps reconsider their motives and to change them – so that markets in this country can more easily get on with their important task of delivering goods, services, incomes and jobs in abundance.

Chapter 4 provides further exhortation to South Africans and arguments to back up this essential view of the world and how it works. It attempts to explain how we as a society would do much better to focus on the growth in incomes and wealth rather than their redistribution. The danger to the growth opportunity is redistribution – redistribution not necessarily to the poor that are deserving of assistance, but to the better-off with a strong sense of opportunity. Opportunities that can advance the economic welfare of a privileged minority but are taken at the expense of a better functioning economy and are often to the disadvantage of the objectively poor and disadvantaged. More redistribution – taking from the more successful to give to the economically less successful – inevitably follows economic growth. It has always done so, as the history of other economies reveals. But it is vital to get the sequence right and not to let redistribution – of which we already do significant amounts – get too much in the way of faster growth by undermining the incentives of enterprising and efficient individuals to contribute their skills and assets to the economy. Discouraging rather than encouraging such individuals means that they could easily decide to supply their services to other economies rather than ours.

Chapter 5 and 6 look more closely at the labour market and at policies for regulating the South African economy and encouraging competition. Chapter 7 examines competition policy in more detail and looks at why activist policies are not good for business and so the economy. My scepticism about the beneficence of such policies will be apparent, as will hopefully the reasons for my critique. I hope that public opinion will share such views and help inhibit the ever-flowing tide of more onerous regulation and more active competition policy, which discourages rather than encourages economic efficiency in a world of continuous innovation that effectively threatens what are temporary powers to control markets.

Chapter 8 shares insights about the all-important role played by privately owned corporations and the stock exchanges that help them raise capital and monitor their use of capital. I analyse the sources and uses of savings in South Africa and why our corporations have succeeded, on both sides of the saving–investment nexus, for their owners, who are mostly members of pension and retirement funds and collective investment schemes. I celebrate the opportunities that South Africans, the pension funds that act as their agents for acquiring wealth, and the companies that they own on their behalf have been given in recent years to diversify their wealth across other jurisdictions. I explain why being able to reduce South Africa-specific risks to the wealth of South Africans has been very helpful to the economy. This has encouraged risk-taking in South Africa rather than elsewhere. This chapter also discusses the costs and benefits of black economic empowerment (BEE).

To conclude, Chapter 9 supports the thrust of my argument by turning to measures of South African economic performance. It considers how South Africa ranks relative to our competitors in the global economy. The measures of our standing in the world are mostly very discouraging – and encouraging of reforms that would add freedom and competitiveness and enhance both incomes and standing, as well as respect for our economy as a place to do business.

The text is supplemented by shorter essays, entitled ‘Point of View’, previously published on my www.zaeconomist blog and elsewhere, that substantiate and concentrate the argument without repeating too much. If you like, they offer a short reinforcement of the message.


Brian Kantor

February 2017



Monetary Policy

Message for the Reserve Bank- act now on interest rates

May 15th, 2017 by Brian Kantor

When President Zuma intervenes in the Treasury alarm bells were set off in the market place and by the credit rating agencies. The danger is that fiscal conservatism in SA – the willingness to fund government spending without printing money – will be sacrificed to other interests. So making the government more prone to raising loans from the central bank rather than raising additional revenue or issuing more debt. And when a government borrows heavily from its central bank and spends the proceeds credited to it adds to the money supply. This usually brings more spending, more inflation and a weaker exchange rate in its wake.

Zuma interfered initially in December 2015. The negative impact on the SA bond and currency markets was immediate. The spread between RSA bond yields and their US Treasury equivalents widened dramatically by close to an extra 2% p.a. to 8.14% p.a. This 8% p.a became the faster rate at which the ZAR was expected to depreciate against the US dollar over the next ten years thus still more inflation expected.

The difference between an inflation protected real yield offered by the RSA and a vanilla bond of the same duration is another good measure of inflation expected. This other spread also widened on the Zuma intervention from around the 5.5% level in mid- 2015 to well over a 7% p.a (See figure 1 below).

Fig.1: Measures of expected rand weakness and inflation in SA. (Daily Data 2013-2017)

Fig 1 - Measures of expected rand weakness and inflation in SA - Daily Data 2013-2017

Source: Bloomberg and Investec Wealth and Investment

A further direct measure of the Zuma effect on SA risk is to examine the spread between a RSA obligation to pay interest and principle in US dollars (a so called Yankee bond) and a US Treasury obligation with the same duration. This spread indicates the compensation for carrying the risk that SA would default on its debt- also the concern of the credit rating agencies. This risk spread widened from less than two per cent p.a. on offer through much of 2014-2015, to as much as 3.6% extra demanded in early 2016 for a five year obligation. (See figure 2 below)

Fig.2: The default risk spread for a 5 year RSA dollar denominated bond. (Daily Data – 2014-2017)

Fig 2 - The default risk spread for a 5 year RSA dollar denominated bond - Daily Data - 2014-2017

Source: Bloomberg and Investec Wealth and Investment

All these measures of SA risk and inflation expected declined consistently through 2016 as the rand strengthened. That is until president Zuma replaced highly respected Finance Minister Gordhan and his deputy on March 23rd 2017. Whereafter the rating agencies downgraded SA debt and the risk spreads widened and inflation expected increased. But these reaction to the second Zuma intervention have proved much more muted. The spread on the RSA Yankee bond is now no higher than it was in 2014.

The exchange value of the ZAR – a major force acting on actual if not expected inflation – has been much enhanced – from the weakest levels of more than R16 for a US dollar in early 2016 to the approximately USD/ZAR today- a gain of approximately 20%. In figure 3 below we show the exchange value of the rand compared to the USD value of eleven other Emerging Market (EM) currencies. Not only has the ZAR strenghtened – it has gained ground against the other EM currencies similarly influenced by global events. This ratio (ZAR/EM) declined from 1.25 in early 2016 to close to 1 in early 2017 aslo indicating less risk attached to the SA economy. This ratio then was bumped up by the second Zuma interevention but again only modestly so as may be seen.

Fig.3: Zuma and the exchange value of the rand

Fig 3 - Zuma and the exchange value of the rand

Source: Bloomberg and Investec Wealth and Investment

Why the market place, if not the credit rating agencies, have become more sanguine about the credit worthiness of SA is a matter of conjecture. Perhaps it is because the chances of President Zuma being removed from his high office has improved?

But the current state of the markets have an important reality. The outlook for lower inflation in SA has improved significantly with a stronger rand and a much improved harvest. The case for lowering interest rates to stimulate a now prostate SA economy is all the stronger. Uncertainty about the exchange rate, over which short term interest rates have no influence whatsover, is no reason at all for the Reserve Bank to delay much needed relief for the depressed local economy. Faster growth without any more inflation or inflation expected, is surely the right option to exercise.

SA Financial Markets

Making sense of low JSE returns – and identifying the conditions for better returns

May 5th, 2017 by Brian Kantor

Over the past 24 months the returns realised from most asset classes available to the rand investor have been well below their long term averages. Since May 2015, as may be seen in figure 1, only rands invested offshore in the S&P 500 would have provided anything but pedestrian returns.

The returns over the past 12 months are shown in figure 2. The RSA bond market provided good returns of over 12% over the past 12 months, while the other asset classes, including inflation-linked RSA bonds, generated low returns. The S&P 500 has also provided poor rand returns since May 2016. This is an understandable outcome given the strong rand (it gained about 10% Vs the US dollar over the 12months to end April 2017). The S&P 500 delivered impressive US dollar returns of 15.9% over the same period.


Figure 3 shows how the performance of the rand over the two years contrasted strongly. Significant weakness was recorded through 2015 and the first half of 2016, with a strong recovery since. The JSE as a whole moved mostly sideways independently of the rand. This is because about half the companies on the JSE, weighted by their market values, can be regarded as rand hedges and the other half defined as rand plays. The effect of changes in the exchange value the rand on the JSE as a whole therefore becomes unimportant. The rand hedges are companies whose rand values can be expected to rise with rand weakness (other forces remaining the same) and the other half, the rand plays, are those whose rand values can be expected to decline with rand weakness and increase with rand strength. This is because rand strength can be expected to lead to lower inflation and lower interest rates and additional impetus for the SA economy.

Many shares listed on the JSE have their primary listing offshore, meaning often that the SA component of their share registers is a small one, as is the case with the dual or multiple listed British American Tobacco or AB Inbev, or the resource companies, BHP-Billiton or Glencore. In such cases the translation of their US dollar value – determined offshore – into rands at prevailing exchange rates is automatic and maintained by arbitrage operations in both markets. And so a weak rand translates automatically to higher rand values for these essentially offshore companies and vice versa when the rand strengthens. The same translation effect is at work for those companies whose primary listing is on the JSE but whose shares are held largely offshore. If so the dollar value of these shares may be regarded as being determined off shore and automatically translated into rands at prevailing exchange rates.

The largest company included in the JSE All Share Index, with a weight of about 17%, is Naspers and may be regarded as falling within this category. Thus a strong rand, up say 20% on a year before, as has been the case in early 2017, means that Naspers must have gained more than 20% in US dollars to provide positive returns for a rand investor. This becomes a very demanding target for US dollar returns that most companies would be very hard pressed to overcome. Most of the resource companies listed on the JSE however gained more than enough extra dollar value in 2016, to more than overcome the effects of a stronger rand.

In figure 4 we show the rand value of 14 stocks listed on the JSE (in this grouping all equally weighted) that we regard as global consumer and UK property plays, compared with the US dollar / rand (USD/ZAR) exchange rate since early 20161. They are global economy plays because their revenues and earnings are derived predominantly offshore. Their fortunes do not depend much on the state of the SA economy. Some of the companies on the list did poorly both in rands and in US dollars. They performed poorly for a variety of their own company-specific reasons. We show the sharp decline in trailing earnings per share (market weighted) of this grouping of global economy plays in figure 12. These companies account for a very significant proportion of the market value of the JSE, perhaps as much as 40%.


In figures 5 and 6 we compare the performance of this JSE global 14 with the S&P 500, with both groups of companies valued in rands. The JSE global 14 matched the S&P 500 well until approximately October 2016, where after, until year-end 2016, the S&P enjoyed a period of marked outperformance. More recently the two groups of companies have again been following a similar path.


The largely sideways movement of the JSE Index since 2015 is moreover consistent with the downward direction of index earnings per share over the same period. Figure 7 shows how JSE All Share Index earnings per share, measured in rands or US dollars, had lost 20% and 30% of their early 2015 levels by mid-2016 after which a recovery in earnings ensued. A time series extrapolation of these recent trends would suggest earnings per share at only 10% higher than their 2015 levels, by mid-2018.

A similar pattern of declines in earnings and their incipient recovery may be observed of the JSE sub-indices for financial and industrial companies and for JSE listed resources. See Figure 8 and 9, where the particularly sharp reduction in resource earnings and their subsequent recovery may be observed.


The trend in JSE earnings has not been supportive of higher share prices. The trend in share prices and earnings per share has closely followed the trend in earnings as we show in figure 10. Something of a re-rating of the JSE – given an expectation of improved earnings to come – occurred in 2016, making the JSE appear demandingly valued by its own standards. The recent recovery in earnings, especially resource earnings, has meant a reduction in the PE multiple (see figure 11).


In figure 12 we break down further the earnings of some of the major companies listed on the financial and industrial indices of the JSE. We divide companies into the same global plays and the SA interest rate plays. In this grouping the earnings per share are weighted by the market value of the companies. The earnings disappointments of 2015-2016 have come from among the ranks of the global plays, while the SA economy plays have continued to grow their earnings per share slowly, despite the weakness of the SA economy.



A number of these global plays have fallen from their once lofty perches for a variety of company-specific reasons that have had little to do with the behaviour of the rand. As we show in figure 13, the worst of the global companies on the earnings front have been MTN and the UK property counter, Capital and Counties. Aspen, Mediclinic and Richemont have also suffered significant declines in their rand earnings per share since 2015 – despite assistance form a generally weaker rand since 2015. Were it not for the continued success of Naspers, with its growing market value and ever larger share of the JSE, JSE index earnings per share would have presented a still weaker state.



These underperforming global companies will benefit from better management as well as a stronger global economy. A stronger global economy is more likely to be associated with rand strength r than rand weakness. Such rand strength in 2016 became a headwind for rand investors. Though it should also be said that their SA shareholders are well hedged against rand weakness associated with SA political developments of the Zuma intervention kind, as they were until mid-2016 assuming the absence of value destroying company specifics. They are even more likely to provide good returns when rand weakness (for SA reasons) is combined with global economy strength, provided again they do not run into further problems of their own making.

Rand strength for SA-specific reasons is something of a headwind for these global companies, as was the case in 2016 when the rand recovered both because the outlook for emerging market economies and their currencies was improving (and because it appeared wrongly that President Zuma’s willingness to interfere in the SA Treasury was contained). The current value of the rand, around the R13.30 level to the US dollar, still appears to depend to some degree on the chances that President Zuma will be forced out of office.

The earnings of SA economy plays benefit from rand strength, provided it is accompanied by less inflation and lower interest rates. So far they have been subject to a degree of recent rand strength, but as yet this strength is unaccompanied by lower interest rates. Without lower interest rates, a cyclical recovery of the SA economy, from which SA focused business and their shareholders stand to benefit, will not occur.

The Zuma interventions in fiscal policy have reduced the degree of rand strength made possible by an improving global economic outlook. It has moreover undermined the confidence of SA business and households in their economic prospects and their willingness to spend more. Yet the outlook for lower inflation has improved, given the partial recovery of the rand and lower food prices. The case for cutting short term interest rates in SA has therefore become more compelling. Perhaps there is enough of a case for the Reserve Bank to do what it can for the real economy by lowering interest rates. Its influence over the value of the rand remains limited, as one can only hope its Monetary Policy Committee finally realises. The case for rand plays on the JSE is the case for lower interest rates and at worst rand stability at current levels. The case for the global plays would have to be based on an improved outlook for the global economy, ideally for their SA shareholders, accompanied by rand weakness for SA reasons. But as important will be the ability of the managers of the fallen angels to restore growth in US dollar earnings.


1The fourteen companies included in this grouping with equal weights are British American Tobacco, Richemont, Mediclinic, Aspen, Steinhoff, Reinet, MTN, Naspers, Sappi, Intu, Capital & Counties and Netcare

SA Economy

Why property rights matter – and could matter more

May 2nd, 2017 by Brian Kantor

I recently asked a class of senior law students what they thought the purpose was of all the laws that protect property (wealth or assets or capital by other names) against theft, fraud or seizure, including by the state, and the purpose of the many laws that facilitate the exchange of assets.

The students did have a sense of the fairness of such laws protecting owners. They did not recognise the importance of the economic incentives at work: that unless rights to property were exercised, there would be little incentive to create wealth; to save, to build and to sacrifice immediate consumption for later benefits for society at large.

Who would wish to save up to build a house or a business or improve a tract of land, providing goods, services and incomes to others, if someone more powerful could move in and take over? But I also pointed out that the value of assets owned can be severely damaged by regulations of their use (perhaps of net benefit to society at large) for which compensation is seldom allowed by the courts. I spoke of the proverbial little old lady and her children whose only meaningful asset is a house, whose value is much diminished by declaring it of historical interest – for which compensation could be offered but in practice is never offered or awarded.

I made the point that property rights or their absence (or the dangers of regulation of the use of assets) would be reflected in the market value attached to such always vulnerable assets. Threaten for example a wealth tax or a mining tax and the value of assets and the incentive to create wealth will be undermined in ways that are very likely to harm the poor.

But the state not only has the power to take wealth, it also exercises the power to take from wealth or income from some and give it to others. South Africa has supplied very large numbers of houses to essentially lucky recipients – lucky because the waiting lists for gifts of this value are very long and will never be exhausted. The numbers of such interventions in the housing or accommodation space are not known with certainty, nor is it fully known what happens to the houses once handed over.

The important question is how should the value of these gifts of housing or land or low rentals be best protected by law? Protected surely best by full rights of ownership attached to them, as is the wealth protected when created through the sacrifice of consumption or the sweat of a brow. Living in a potentially valuable home without food on the table has little logic to it. Effectively exchanging the house for more food and cheaper informal shelter may be a sensible choice to make. Leasing out and combining small parcels of farming land can provide a better standard of living for its new owners than subsistence farming on it.

Our laws that most unfortunately restrict property rights – for example that only allow the transfer of RDP homes after eight years of occupancy or prevent formal rental contracts – accordingly leads to widespread losses and waste. To houses that exchange hands at far less than their cost or potential and that can never form part of any inheritance or tax base. To potentially valuable farms that become wastelands.

We should make all transfers of government assets to private ownership immediately come with full rights of ownership. And we should be making every effort to convert currently fallow government owned and tribally managed land to private ownership with full rights, whoever are the initial beneficiaries. This will then allow the market place take over to make the best use of these assets. The impact on the economy will be as favourable for the creation and preservation of wealth and the generation of extra incomes in SA, as secure property rights always prove to be. 28 April 2017

SA Economy

When Zuma goes

April 19th, 2017 by Brian Kantor

Click here for a shorter version of this article

There will be good economic reasons for rejoicing should he go. The rand would strengthen – it would move back into line with its emerging currency market peers. Today this would have meant a USD/ZAR of approximately R12.6. Yesterday, April 12th a day of protest and a day when the probability of Zuma going sooner rather than later improved, saw a basket of EM currencies gain seven cents vs the weaker USD while the ZAR gained 34 cents, indicating less SA specific risk priced into the rand.

If the rand maintains these better values lower inflation will follow the lower costs of imports and the lower prices for exports and would bring lower short term interest rates in its wake. Cheaper than otherwise goods and services and credit would encourage households to spend more- as would the higher house prices and equity in homes that accompany lower mortgage rates and a more hopeful outlook for South Africa. And the firms that supplied them would be much more inclined to add, rather than contract capacity and hire more rather than fewer employees, as they are now doing. The SA business cycle would turn up rather than down.

The yield on longer dated RSA debt would also tend to go back to where it was, reducing the cost of servicing our national debt –easing the burden on SA taxpayers and opening up the possibility of more help for the poor and improve the prospects of growth friendly, lower tax rates. The first Zuma attempt to control the Treasury in December 2015 took the yield on RSA 10 year bonds from 8.5% p.a in early December that year to about 9.6% by early January 2016. This move also widened the spread between RSA and US debt by about the same 100bp ( see figure below) from about 5.7% p.a to 6.7%. The latest Zuma intervention in the Treasury has seen this risk premium rise further, but not dramatically, from a still unsatisfactory 6.46% level in early 2017 to the current 6.6% p.a level.

The ZUMA factor driving SA risk



Source; I-net Investec Wealth and Investment

This spread may be regarded as the SA risk premium, the extra returns in rands, all South African investments have to be able to offer to justify their viability – in addition to their covering the additional business risks associated with a particular enterprise.  This extra return is also the rate at which the rand is expected to depreciate over the next ten years. And the weaker the rand the more inflation expected. The Zuma interventions have understandably have resulted in the rand being expected to lose dollar value at a faster rate and so also, in a consistent way, to increase the expected inflation rate. The market place understandably expects a weakened Treasury to be less able to control government spending and less conservative in how such spending is funded. That is less able to raise taxes and less willing to pay ever higher rates of interest on its debts and so more inclined to print money, an approach that would be clearly inflationary.

Another way of measuring risks would be to convert the calculation of required returns and risk into to much less inflationary USD. The yield on US dollar denominated debt issued by the SA government provides an appropriate bench mark for measuring required risk adjusted returns on South African assets. As we show below these dollar yields rose significantly from around 3.6% in early 2015 to as much as 5.12% p.a. by year end. Since then this rate has receded but increased by a significant 36bp since mid- February.  The cost of insuring SA 5 year dollar denominated debt against default, an accurate measure of real sovereign risk has followed a similar pattern rising from 1.82% p.a at its lowest in 2017 to the current 2.15% p.a. That is when converted into USD an investment in a South African asset would be required to return over 2% p.a. more in USD than an equivalent US investment to justify its value.

Zuma risk measured in USD


Source; Bloomberg, Investec Wealth and Investment

More risks demand higher returns (sometimes described as the hurdle rate capital raisers have to leap over) and the higher the required returns the fewer investment projects will qualify – to the grave disadvantage of the economy and its growth prospects. The object of economic policy should be to reduce such risks rather than to raise them- something the Zuma presidency has clearly failed at.

These required returns that add business risk to sovereign risk may also be regarded as the discount rate used to present value any flow of income from businesses or government agencies. The higher the discount rate attached to SA assets the less they are worth. Adding risk makes SA immediately poorer as well as undermining their income prospects as less is invested in SA projects that could add to incomes and demands for labour.

Yet given the reactions of the credit rating agencies that have down rated SA credit indicating a higher probability of default on our debt these market reactions as we have identified them must be regarded as surprisingly subdued.

The rand, and the market in RSA bonds, clearly benefit to a degree from the prospect that Zuma might not survive the campaign to remove him.  Were Zuma certain to stay rather than possibly go, we would be facing even more risk aversion more inflation expected, higher interest rates and a very likely recession as confidence in the prospects for the SA economy ebbed away.

Were Zuma to go the benefits could extend well beyond the promise of a revival of fiscal rectitude and less inflation and lower interest rates. It would offer the prospect of a radical economic transformation. By which I mean the cleaning of the Aegean stables that the State Owned Companies (SOC’s) have become. It would not require any Hurculean effort to do. A few investment bankers could do the job of converting the SOC’s into ordinarily valuable and well managed business. So converting them into assets from their current state of very expensive and potentially ever larger liabilities, that SA tax payers and consumers have to cover. Converting these burdens into private businesses that will compete for their custom, that will be run efficiently and deliver their goods and services at lower competitive prices – as business have to do to survive the market test would be a large plus for South Africans. And they would become taxpayers rather than incur vast contingent liabilities that damage our credit rating and raise our costs of finance.

Can any SA seriously believe that these SOC’s are essential to the purpose of developing the SA economy?  Or fail to understand that their actions are driven by the narrow interests of their managers and employees and what their suppliers can extract from them. Their monopoly powers that make this behaviour possible need to be removed by breaking them up into smaller units by selling off their assets to a variety of owners and operators. And the capital to fund these purchases will be abundantly available from domestic and foreign capital providers at market determined values.

The proceeds from their privatization could be used to pay of much of SA’s debt and dramatically reduce the interest burden of serving it and open up the prospect for genuine poverty relief. This transformation – turning great weakness into strength – would help raise the growth potential of the SA economy – and truly transform the economic prospects of all South Africans


SA Economy

When Zuma goes

April 19th, 2017 by Brian Kantor

There will be good economic reasons for rejoicing should President Jacob Zuma relinquish his post in the near future.

The rand would in all likelihood strengthen and would probably move back into line with its emerging currency market peers. Today this would have meant a USD/ZAR exchange rate of approximately R12.60.

Lower inflation will follow a stronger rand and bring lower short term interest rates in its wake. Cheaper goods and services and credit would encourage households to spend more, as would the higher house prices and equity in homes that accompany lower mortgage rates and a more hopeful outlook for South Africa. And the firms that supplied them would be much more inclined to add capacity and hire more employees. The SA business cycle would turn up.

The first Zuma attempt to control the Treasury in December 2015 took the yield on RSA 10 year bonds from 8.5% p.a in early December that year to about 9.6% by early January 2016. This move also widened the spread between RSA and US debt by about 100bps from about 5.7% p.a to 6.7%. The latest Zuma intervention in the Treasury has seen this risk premium rise further, but not dramatically, from a still unsatisfactory 6.46% level in early 2017, to the current 6.6% p.a level.

This spread may be regarded as the extra returns in rands that South African investments have to be able to offer to justify their viability – in addition to their covering the additional business risks associated with a particular enterprise. This extra return is also the rate at which the rand is expected to depreciate over the next ten years. The weaker the rand, the more inflation expected.

The cost of insuring SA five year, US dollar-denominated debt against default, an accurate measure of real sovereign risk, has followed a similar pattern, rising from 1.82% p.a at its lowest in 2017 to the current 2.15% p.a. When calculated in US dollars, an investment in a South African asset would be required to return over 2% p.a. more in US dollars than an equivalent US investment, to justify its value.

Greater risks demand higher returns and the higher the required returns, the fewer investment projects will qualify – to the grave disadvantage of the economy and its growth prospects. The object of economic policy should be to reduce such risks rather than to raise them, something the Zuma presidency has clearly failed at. Yet, given the reactions of the credit rating agencies, which have downgraded SA credit (indicating a higher probability of default on our debt), these market reactions must be regarded as surprisingly subdued.

The rand, and the market in RSA bonds, clearly benefit to a degree from the prospect that Zuma might not survive the campaign to remove him. Were Zuma to go, the benefits could extend well beyond the promise of a revival of fiscal rectitude and less inflation and lower interest rates. It would offer the prospect of a radical economic transformation. By this, I mean the cleaning of the Aegean stables that the state-owned companies (SOCs) have become. It would not require any Herculean effort to do.

A few investment bankers could do the job of converting the SOCs into a number of ordinarily valuable and well-managed businesses that compete with each other. They would be run efficiently and deliver their goods and services at competitive prices – as business have to do to survive the market test.

Can anyone seriously believe, in light of the evidence, that these SOCs with monopoly powers are essential to develop the SA economy? Or fail to understand that their actions are inevitably driven by the narrow interests of their managers and employees and what their suppliers can extract from them?

The proceeds from their privatisation could be used to pay off much of SA’s debt and dramatically reduce the interest burden of serving it, thus opening up the prospect for genuine poverty relief. This transformation – turning great weakness into strength – would help raise the growth potential of the SA economy – and truly transform the economic prospects of all South Africans. 18 April 2017

Corporate Finance

On Eskom: act soon or it will be too late to get back our investment

March 31st, 2017 by Brian Kantor

One offers commentary on matters of broad SA national interest that might helpfully respond to and benefit from the analysis and arguments raised. It is a tradition that – perish the thought – goes back to colonial times.

The notion that a concern for economic efficiency and economic development in the interests of society at large will prevail in the policy choices SA makes and the economic direction we take, has alas, become increasingly suspect. No other set of policies will be as important for the ability of our economy to raise future incomes, output and employment and to compete globally as taking the right path for delivering energy. Yet following the tempting money trail open to a few potential beneficiaries of energy procurement as currently practiced is much more likely to predict the future of energy production and consumption in SA than any objective analysis can do. But however objective such analysis could be it is still very unlikely to make the right choices- given the unpredictability of the future of energy. The best the government of SA and its agencies – Eskom and the municipalities that have monopoly powers over the generation and distribution of electricity in SA – could do for SA, would be to get completely get out of the business as soon as possible and on the best possible terms. Terms that are very likely to deteriorate the longer they delay their exit.

The reason for getting out and handing over the responsibilities to the fullest possible set of competing privately owned generators and distributors is that the future of energy is impossible to predict with any degree of confidence. Therefore the decisions to be taken in this regard by a government monopoly (with its narrow interest as a monopoly even an honest monopoly) are almost certain to be the wrong ones from which the society and economy will suffer permanent damage.

The most efficient, lowest cost methods of delivering energy in the future cannot be known. It will be discovered in the market place as all such discoveries are made. Discovered, as will be the case with every product and service to be delivered over the next thirty years, by trial and error in the market place, by constant experimentation by owners and managers with their open capital at risk where winners may be rewarded handsomely and losers punished severely with the loss of their capital. It may well turn out to be a future where the cheapest energy is delivered off-grid, making large capital intensive generating plants generating electricity with coal, uranium or gas redundant in time – but just how much time?

Permitting and encouraging such a market place in energy to fund the future demands for electricity on competitive terms , is the right path for SA to take. Adding further highly capital-consuming power plants using whatever kind of input, is surely a most dangerous step for the SA tax base or electricity consumers to have to support. Such plants supported by monopoly powers as were granted their developer Eskom fifty years ago, were arguably then the right way forward. They delivered satisfactory outcomes until recently, in the form of what were globally competitive electricity prices. But they are surely not the way forward today given the risks that technology poses and especially since Eskom itself has become close to bottom of its class of electric utilities on efficiency criteria – as judged by a recent study commissioned by the Intensive Electricity Users Group in SA – who have much at stake.

Eskom has proved very good (predictably so given its monopoly) only at providing employment and generous employment benefits as well as it would appear generous terms to its suppliers – at the expense of its users – who could have proved much better at delivering employment, profits and taxes (with lower electricity costs) including benefits of energy intensive beneficiation of metals and minerals.

There is little time to be lost if the SA tax payer is to recover its investment in and debt guarantees provided for Eskom given the uncertain future. If the plant and equipment were to be privatised soon, they might well fetch a price that would pay off the debts and avoid subsequent white elephants. And help open up, perhaps only gradually, a competitive market for electricity where different owners of generating capacity could compete for customers through the privately owned grid, treated perhaps as a regulated private utility.

The plants Eskom is now mothballing could attract bids and be kept running at a low enough asking price. And help produce electricity at highly competitive prices, enough to cover operating costs and a return on capital, that could perhaps, for a while, keep alternative electricity generators at bay, long enough for SA to get its money back.

*The views expressed in this column are those of the author and may not necessarily represent those of Investec Wealth & Investment


SA Financial Markets

Stock market indices: Swix in the mix

March 22nd, 2017 by Brian Kantor

The very large weighting of Naspers in leading indices like the JSE Swix and the JSE All Share Index has major implications for active and passive investors alike. Investors need to be aware of what this means for the risk attached to their portfolios.

 The original reason for constructing a stock exchange index was simple: to provide a statistic that summarised the price performance of the average company listed on a widely followed stock exchange. The calculation of such an average or index is supposed to represent the general direction of the equity market.

The most famous and oldest of the indices that tracks share prices on the New York Stock Exchange, the Dow Jones Industrial Average (DJIA), simply aggregates the US dollar share prices of the 30 largest US companies. The higher the prices of the individual shares included, the higher the DJIA and vice versa. The S&P 500 was introduced later and has become the most important of the global indices. In contrast with the DJIA, the S&P 500 tracks the market value of the 500 largest companies listed on the New York stock exchanges. The share price moves of the largest companies carry the most weight in the index and move the index proportionately.

Indices that attempt to summarise equity market performance, however, have much more than simply an informative role. They are also widely used to measure the ability of fund managers who actively manage their share portfolios and compete with other managers for assets to manage. Relative, as well as absolute price performance and returns, matter to both fund managers and their clients.

The performance (total returns in the form of price changes plus dividend income) of the funds they manage are not only compared to those of their rivals, but also to some relevant equity index. The ability to generate returns ahead of the benchmarks – the returns (theoretically) generated by the index (positive or negative) – becomes their measure of success or failure. Conventional wisdom now dictates that index-beating returns, beating the market (after fees), is the only reason for active management. We will show why this is incorrect.


A passive approach


Because of the difficulty that the average equity fund manager faces in trying to perform better than the index, there has been a large move to so-called passive equity investment strategies. Investors simply track some index by dividing their equity portfolios in exactly the same proportions (weights) as the shares included in the index.

Index tracking funds (under the banner of the so-called exchange traded funds or ETFs) have been created in large numbers by different fund management houses to facilitate such an investment strategy. This process generates no more or less than index-equivalent returns for the investor. The advantage for the investor is that since no knowledge or experience of the market place is needed – only a suitably programmed computer – the fees charged for the service (usually measured as a percentage of the assets under management) can be far lower than the fees typically paid for actively managed portfolios. These latter fees are charged to cover the higher costs of active managers, for example the salaries of the stock pickers and their analysts, as well as the trading and marketing costs incurred by the firms.

The ETFs and their originators and managers are therefore taking full advantage of highly efficient and competitive equity markets, without contributing to the process of price discovery. It is this efficiency in processing information about companies and the economic and political forces that will influence their future profitability (and their current value) that makes the share market so difficult to beat. Such information comes without expense for the passive investor.

Another expensive responsibility incurred by active shareholders is the surveillance of the managers of the companies in which they invest client wealth. This responsibility and the accompanying costs are largely avoided by passive investors.  Good corporate governance demands that shareholders cast their votes on corporate actions by exercising proper diligence, which has a cost. Engaging actively with company managers is essential for active investors but not for index trackers.

The index trackers are free riders on the investment bus, paid for by others. The proportion of funds that would have to be actively managed to make for a well-informed, efficient marketplace and to keep the investment bus rolling cannot be known with any degree of certainty. If all investors simply followed rather than led, the market would be full of valuation anomalies, from which only a few active investors could become fabulously wealthy by exploiting the valuation gaps.


The relevance of risk

Prospects like these are what encourage active investors to take risks. Think of hedge fund managers who take large risks in exchange for prospectively (not always realised) large returns. They also add helpful liquidity to the market that facilitates trading activity by risk averse investors. It is the expected distribution of returns, the small chances of a big win on the markets and the potential to achieve long run returns sustained well above average market returns that explains some of the preference for active managers. A select few of these (though we never know which few) will always beat the market by a large and sustainable margin.

This raises an all-important issue. Investment decisions and the make-up of investment portfolios are not determined only by prospective returns. The risk attached to such prospective returns is at least as relevant for the average wealth owner saving for retirement or a rainy day. This is the risk that the portfolio can lose as well as gain value. Stock market indices and the ETFs that track them can be more or less risky, depending on their character and composition. An essential requirement of a low-risk equity portfolio, actively or passively managed, is that it should be well diversified against risks that individual companies are exposed to.

This is achieved by spreading the portfolio among a large number of shares, none of which should account for a large proportion of the portfolio. The threats to the value of a share of a company that comes from adverse circumstances beyond the control of all company managers – i.e war, revolution, taxation, expropriation, regulation, inflation and financial crises – can only be mitigated by diversifying the wealth owners’ total portfolio across different asset classes, such as bonds, cash or real assets – or different jurisdictions. Index-tracking ETFs can simulate a particular equity market or well traded sector of it. But designing an optimal, risk-aware total portfolio – how much equity or other risks a wealth owner should assume – calls for more complicated considerations.

An important consideration for any investor tracking some equity market index is the issue of how well diversified the index being tracked is. A further consideration is which equity markets should be tracked given their very different risk profiles and how they are constructed.

The S&P 500 is very clearly well diversified against US company specific risks. The JSE All Share Index, by contrast, is not well diversified, nor is the JSE Top 40 Index nor the JSE Shareholder Weighted Index (Swix), which has largely superseded the other JSE indices as the benchmark for measuring the performance of SA equity managers. The Swix is weighted by the shares of the company registered by the JSE itself, as opposed to shares registered for transfer on other exchanges where the company may also have a primary or secondary listing. The larger the value of the shares registered by the JSE (Strate), the larger the weight that company will be allocated in the Swix. It should be understood as a measure of the proportion of the shares registered for transfer in SA, not necessarily of the share of the company owned by South Africans.


How diversified is your index?

The largest company currently included in the S&P 500 Index is Apple, with an S&P 500 Index weighting of only about 3%. The largest 100 of the S&P 500 account for about 60% of the index. In strong contrast, the largest company included in the market capitalisation-weighted JSE All Share Index in November 2016 was Naspers, with a weight of 17.14% in the Index. The next largest company included was British American Tobacco, with a much smaller weight of 4.31% followed by Sasol with 4.08%. The largest 10 companies included in the All Share Index now account for as much as 42.6% of its weighting – it’s clearly a much less diversified index than the S&P 500. Until its recent takeover, SABMiller was accorded a large weight in the All Share Index and the other leading indices. It is no longer represented and its new owner, AB Inbev, while already listed on the JSE, at the time of writing had still to make an appearance in the indices. The weights in the Swix have become similarly lopsided as we show below in figure 1. The weight of Naspers in the Swix is now even larger than that accorded to it in the All Share Index.



The weight of Naspers in the JSE indices has risen automatically with the extraordinary and persistent increases in its share price. Naspers shares are also all registered on the JSE, though foreign investors hold a large proportion of the company. As important for increasing the weight of Naspers in the indices has been the near stagnant value of resource companies that once had a very large weight on the JSE, but whose valuations have increased very little over the same period.


From mining to media

In figure 2 we compare the Naspers share price with that of the JSE Resources Index. The Naspers share price has increased 26.4 times since June 2002 while the JSE Resources Index has not even doubled over the same period. In figure 3 we show consequently how the weight of resources in the JSE All Share Index has declined from over 40% in 2008 to about 15% today, a lower weighting than Naspers on its own. The Swix reveals a very similar pattern, according a very high weight and importance to the Naspers share price moves and much less importance to resource companies in the direction the index takes (and so any ETF that tracks the JSE All Share Index or Swix).




It is the rising Naspers share price and its growing and larger weight in the Swix that has made the latter the best performing of the local indices over the past 14 years. The differences in performance are significant. R100 invested in the Swix in 2002 with dividends reinvested (before fees and taxes) would have grown to R864 by November 2016. The same investment in the JSE Top 40 would only have realised R645, with the All Share Index and an equally weighted index of the 40 top companies performing somewhat better. Not only did the Swix deliver higher returns, but it did so with less volatility than the other indices, thanks to Naspers (see figures 4 and 5 below).

Clearly, choosing the right index to represent and track the JSE and measure the performance of active managers is an important decision for investors or their advisers to make. All indices are not alike and some can be expected to deliver returns with much greater risk or volatility than others.

The major JSE indices that might be used to deliver market equivalent returns by some tracker fund or others are not suitable for diversifying the specific company or sector risks that investors tracking the index will be exposed to. Naspers carries far too much weight and therefore exposes index-tracking investors to much more danger than would be appropriate for any risk averse portfolio. The same criticism could have been made of the composition of the JSE indices in 2008: they were too exposed to the specific risks that faced resource companies. Investing over 40% of an equity portfolio in resource stocks – with their well known dependence on highly unpredictable metal prices – is not something a risk averse investor would want. The same argument could be made of a current exposure to Naspers: investing up to 20% of a portfolio in one company would be regarded as highly unwise.

Wise and risk averse active managers presumably would not have allocated 40% of their portfolios to resource companies in 2008. And, they would have been much more likely to have outperformed the indices over the subsequent eight to nine years as resource valuations fell away. They would also have done even better with a larger-than-index weight in Naspers. But the risk conscious fund manager would have had to become ever more cautious about exposure to Naspers after 2013, when its weight in the index began to exceed 10%. Prudence would suggest that no more than 10% of any equity portfolio should be invested in any one company.

Given this, along with the current 18% plus weight of Naspers in the leading SA indices, active managers are therefore much more likely to underperform the index when Naspers is outpacing other stocks, as has been the case until recently. Conversely, they would outperform should Naspers lag behind the other stocks included in the index. The case for or against active management in SA should not have to depend on the fortunes of one company.

Judging the performance of a fund manager in South Africa by reference to a very poorly diversified Index like the JSE All Share Index or Swix would not be an appropriate exercise. Realised returns should always be compared to the risks that were taken to achieve those returns. The task of the active manager is not simply to aim at the highest returns for their clients, they should also be managing risk.

Recognising the risk tolerance of their clients and allocating assets and planning savings accordingly is a large part of a fund manager’s duties. This is even more important when the market (index) carries identifiable and unjustifiable risk as the JSE indices have done and continue to do. Even when the active investor has not beaten the market, the advice offered can be very valuable.

There is incidentally no risk when calculating past performance. Risks apply only to expected performance – not to known past performance. Investing in an index tracker is not a decision that can be made passively because such advice is not easily provided by a robot and is worth paying extra for, or ignored at the investor’s peril.



Note: I am indebted to Chris Holdsworth of Investec Securities who painstakingly undertook all the Index and return calculations that are used and represented in this report. All the indices used in the study are dynamic ones representing the indices and the sector and share weights in them, as they occurred over time.



Corporate Finance

The curious case of Curro

March 16th, 2017 by Brian Kantor

To reward shareholders you have to over deliver- executing well is not enough

When the CEO of a highly successful JSE-listed business aims to “reward shareholders” with a maiden dividend, as Curro CEO Chris van der Merwe has recently promised, one takes notice (Business Day 1 March 2017), particularly because the company is undertaking an impressive programme of investing in new private schools (now 128 of them) with room for the company to grow further and faster. Its plan is to open seven new campuses a year, housing 15 to 18 new schools, intended to take the company to 80 campuses and 200 schools by 2020 and to increase its enrolment from the current 47 000 to 80 000. A longer term potential market for as many as 500 fee paying schools in SA has been suggested.

The 2016 financial year was an extraordinarily good and busy one for Curro. It raised an additional R1.75bn in equity capital to fund about the same amount of capital expenditure. Since 2013 Curro has been investing over R1bn a year in expanding the business. But the growth in the operating lines in 2016 were equally impressive, so helping to maintain a superb track record in executing its business plan. Profits after tax (which was minimal thanks to large depreciation allowances) have grown from R40m in 2013 to R168m in 2016 while the growth in cash generated from operations (helped by the same heavy depreciation and amortisation) has been even more impressive, from R106m to R404m in 2016. These were excellent improvements in organically generated cash flows, but not enough to fund the large current capital expenditure programme.

Why then pay out cash to shareholders rather than continue to reinvest in additional assets? These assets appear to be able to return more than would ordinarily be required by shareholders from other investments with similar risks. Is the value added for Curro shareholders in the form of returns on their capital that are well in excess of the (opportunity) cost of such capital, not reward enough to encourage retaining cash on behalf of shareholders rather than paying it out?

After all the rewards for shareholders come in the form of total returns: capital appreciation plus dividends. And as Warren Buffett has long demonstrated, paying dividends is by no means essential for generating high total returns, indeed dividends may reduce them if paying out cash constrains the scale of value-adding investment programmes that shareholders would have great difficulty in finding for themselves.

The problem however for Curro and its shareholders and managers is that, despite its considerable operational achievements and well executed growth plans, the company has not in reality rewarded shareholders since late 2015. It was then that the value of Curro shares reached a peak of over R52 but are now trading below R48. As may be seen in the figure below, Curro shares performed spectacularly well between 2011, when they traded at R8.92 and its peak of R52.65 in December 2015, equivalent to an annual average compound return of about 42%.


Curro has run into a problem faced by many well-managed companies. That is investors come, understandably, to expect excellent operating results and re-value the company and its management accordingly. They expect more and therefore prove willing to pay up more in advance to own a share of the much appreciated company and its management.

Hence it becomes ever harder for the company to perform well for shareholders given the much more demanding starting values. Unusual share price appreciation (best measured relative to the market as a whole) of the Curro kind, realised until year-end 2015, comes with surprisingly good outcomes, not just good outcomes. Surprisingly poor performance is as likely to be punished in the share market. Under promising and over delivering is the mantra for rewarding shareholders, of whom managers will be an influential minority. Curro clearly greatly surprised the market between 2011 and 2015 as it delivered fully on its promises, but since 2015 has not been assisted by the share market, which has moved mostly sideways. In recent years it has performed well but not better than expected (though offshore investors, measuring performance in US dollars, will regard 2016 with much more favour than their SA partners, given the stronger rand, which was up by about 20% in 2016).

To address this issue, Curro has indicated not only a willingness to pay dividends but to raise debt and debt ratios to supplement internally generated cash flows to fund growth. Cash flows are still expected to increase even though they are somewhat depleted by dividends to be declared.

The company has also revealed an intention to list separately a further entity on the JSE to pursue promising opportunities in tertiary education in SA. Why then list a separate company rather than pursue this opportunity from within the existing structures?

The answer may be that to do so would raise a new opportunity (Curro reprised) to surprise the market with a successful new listing, that is to surprise investors and so achieve capital appreciation more easily than it could do within the established Curro. To expand the tertiary education offering within Curro, with its already large scale, such a build-up of tertiary capacity may not make a very obvious difference to its growth trajectory and the already highly favourable expectations of investors revealed by a demanding share price.

Therefore paying dividends to shareholders will help them fund the new company. Note that the controlling shareholder, PSG, which helped launch Curro and owns 52% of it, must support any new listing. Cash withdrawn from Curro will help PSG fund its share of the new venture that with its small beginnings could surprise the market all over again and reward its shareholders accordingly by over delivering.

It might be sensible for the minority shareholders in Curro to follow any lead given by the controlling shareholder – that is to receive cash dividends from Curro and invest in the new venture and hope to be rewarded for doing so. 15 March 2017

Fiscal Policy

The SA Budget for 2017-18 – Cross road or dead end?

March 3rd, 2017 by Brian Kantor

The Budget speech and accompanying Review refer to an economic cross roads, suggesting a new path is to be taken to accelerate growth in SA. There is little in the Budget proposals to indicate a way out of our economic dead end of persistently slow growth and ever higher tax rates. Yet both government spending (up 3% in real terms) and government revenues (up slightly more) and their share of a slow growing economy are expected to rise. The negative feedback from higher tax rates and higher tax revenues to fund an ever larger role for the SA government in the economy – on the growth outlook – is simply not recognised.

Higher income and expenditure tax rates may help to balance the books but will not do anything to revive the creative and entrepreneurial spirits of the key economic actors, the high income earners. The dependence of all South Africans on them goes much further than the taxes they pay to fund welfare benefits. They earn their higher incomes (competing with each other) by directing the markets for jobs, for essential goods and services, and for capital. And they help organise the education, training and skills that make workers more productive and capable of earning more. And they take risks with their capital, human as well as financial, to innovate in the search for better methods and better products and services that is the very stuff of economic advances. This Budget and the accompanying rhetoric will not encourage them; it is likely to do the reverse.

The scale of the redistribution of income from the best rewarded in SA to the wider community is large. One can refer in this regard to Figure 1.3 of the Budget Review that most strikingly demonstrates these outcomes. It shows that the top 10% of income earners contribute 72% of all taxes (VAT etc included) while the bottom 50% receive 59% of the benefits of government spending while contributing 4% of taxes. The middle 40% receive 35% of the benefits (valued at their cost not quality) for 25% of the taxes paid. Clearly there is little scope for further redistribution from the top 10%.

There is much scope for faster economic growth. But this will take less redistribution from the high earners and much better returns (in the form of delivering the extra skills that command jobs and higher incomes) from the large sums the government spends on education and training. It will take much better delivery by the state owned companies that perform so poorly for all but their own employees and directors. Privatisation is the obvious solution to wasteful government spending (the solution to egregious government failure) but alas is not on offer.

What is offered by the Budget as the solution is Transformation for better or for worse (depending on whether you stand to lose or benefit) and the promise of Radical Economic Transformation. By Transformation is meant, presumably, a diminished (proportionate) role in the economy for white South Africans who – presumably – still dominate (disproportionately) the ranks of the movers and shakers of the economy despite impressive transformation to date and despite the indispensability of their contributions to the economy.

It is well recognised in the Budget that economic growth is and has been transformational and that transformation without growth impossible. To quote: “Growth without transformation would only reinforce the inequitable patterns of wealth inherited from the past. Transformation without economic growth would be narrow and unsustainable…”

In a similar vein:

“If we achieve faster growth, we will see greater transformation, enterprise development and participation.”

Economic growth is transformational for SA. Faster growth would mean a greater pace of transformation as the economy would call more urgently upon the skills and abilities of all South Africans and thus help to create improved outcomes. Transformation with growth is inevitable, most desirable and most helpful to the economy. But policies for transformation that intend to handicap white South Africans, who play a crucial role in the economy, to favour a few well-placed, advantaged black South African business people will only frustrate economic growth, rather than grow it, and slow down transformation.

The Rand

Can the strong rand be more than a headwind for the JSE?

March 2nd, 2017 by Brian Kantor

South African investors on the JSE will be only too well aware that it has moved mostly sideways over the past few years. The performance of the JSE in US dollars however presents a very different picture, given the strong recovery of the rand last year. The US dollar value of the JSE, the focus of foreign investors, fell away badly in 2015 and then recovered strongly in 2016. The JSE All Share Index (ALSI) is now back to its value of early 2014 and 2015 having gained nearly 20% in US dollars since January 2016 as can be seen in figure 2. The rand itself is worth about 20% more against the US dollar – compared to February 2016.


The reason for these very different outcomes, when expressed in different currencies, is obvious enough – it is the result of rand weakness in 2014 and 2015 and its significant strength in 2016-17.

Clearly the very strong rand, up 20% year on year, represents a strong head wind for the value of shares expressed when expressed in rands. Or, in other words, for a share to have provided positive rand returns over the past 12 months, would have had to have seen its US dollar value appreciate by more than the 20% gain in the rand, a very high rate of return.

Naspers, with the largest weight on the JSE of about 17%, delivered coincidentally about a 20% increase in its US dollar value since January 2016. This was satisfactory enough, but not quite enough to provide appreciation in 20% more valuable rands.


Resource companies on the JSE did much better than the average listed company, especially from mid-year. Their US dollar value has increased by about 50% since early 2016, more than enough to provide highly satisfactory rand returns, despite the stronger rand. It may be a source of some confusion to market observers that JSE Resources could do so well, despite rand strength. In other words, Resource companies did not behave as a rand hedge in 2016: in reality they performed as rand plays (companies that do especially well when the rand strengthens).

They would have enjoyed much higher operating margins had the rand been weaker – other things remaining the same – including underlying metal and mineral prices in US dollars. But the rand was strong because underlying metal and mineral prices in US dollars had risen, by more than enough to offset the pressure on operating margins that comes with a stronger rand.

Therefore it is always important to establish the sources of rand strength or weakness. Rand weakness for SA-specific risk reasons can make Resource companies or companies with largely offshore operations effective hedges against rand weakness. Their rand values will go up as the rand weakens because they are selling into world markets where business continues as usual and so earn more rands doing so. The opposite influences are at work on SA economy companies when the rand weakens, especially on the rand and US dollar value of companies with an important element of imported components and inventories. The weaker rand not only crimps operating margins; it means higher prices and less disposable income. More inflation also is likely to bring higher borrowing costs in its wake, further depressing the demand of households and firms. Rand strength for SA-specific reasons will have the opposite effect, all other things equal, including the state of global markets, especially commodity markets. But as we have seen in 2016, other things do not necessarily remain the same for global growth reasons. Resource companies can benefit from higher commodity prices, in US dollars, and from higher metal prices in rands – even when the rand appreciates.


The increased global demand for commodities and for the shares of the companies that produce them not only increased their US dollar values. They also increased the demand for the rand and other emerging market currencies and equities generally that have a strong representation from resource companies. In the figures below we show the rand has moved in line with other emerging market currencies- represented by eleven such currencies all equally weighted in our basket. It is also shown how the rand in 2016-2017 has been stronger than its emerging market peers have been against the strong US dollar, with its recovery from a relatively weak position in late 2015.


Of particular interest is how strongly the USD/ZAR rate has been connected recently to emerging market equities. (In turn the JSE in US dollars is as usual strongly connected to the average emerging market equity as we have shown above). The rand is more than ever an emerging market equity currency. It can be assumed (Zuma permitting) that the rand will continue to move in line with them (see figure 7 below).

Furthermore, emerging market equities will continue to be strongly influenced by the behaviour of commodity prices, as they have been recently. Hence the performance of the rand and other emerging market currencies and equities (in US dollars) in the months ahead will depend on the behaviour of commodity prices. Commodity prices will reflect the pace of the global economic cycle. If this cycle continues in its upward direction, the rand could continue to gain value against the US dollar, provided SA specific risks are not elevated, as they were in late 2015.


Furthermore, if the USD/ZAR remains well supported, SA inflation will recede and short term interest rates will belatedly reverse direction. This combination of lower interest rates and lower costs of imports will be helpful to those listed business dependent on the spending and borrowing decisions of SA households. Their rand earnings will grow faster to help add rand value to their shares, perhaps even enough to offset rand strength. Headwinds from the strong rand can become tailwinds for SA economy-dependent business, as was the case between 2003 and 2008. 2 March 2017

Global Financial Markets

Some helpful financial market trends for SA to respond to

February 9th, 2017 by Brian Kantor




Interest rates, exchange rates and the JSE (in US dollars) before and after the Trump Shock: all have been good for the SA economy. Now it’s over to the Reserve Bank

US 10 year yields, nominal and real, after declining to very low levels by mid-year 2016, then began to rise. The Trump election added further momentum but, as may be seen, long term interest rate levels in the US have largely stabilised at higher levels in 2017.


US Yields

Nominal rates are now about 100bp higher than they were in mid-2016 while real rates have gained about 50bp from approximately zero rates in mid-year. Accordingly the spread between the nominal and real yields that offer compensation for the inflation risks that holders of nominal fixed interest bonds assume, has widened. This indicated more inflation expected over the next 10 years, of the order of 2% p.a. The higher real rates indicate increased real costs of capital – a sign of faster growth expected and the increased demands for capital that come with faster growth. Thus the US bond market indicates that both more inflation and faster growth are now expected in the US. The rising US equity markets have regarded improved earnings growth prospects as more than adequate to off-set higher discount rates.


Long term interest rates in SA have taken a somewhat different course to those in the US. As may be seen below, RSA 10 year yields have edged lower while real yields have edged higher. The spread, indicating inflation expected over the following 10 years in the RSA bond market, has generally moved lower, from a very high near 8% in early 2016, to current levels of about 6.5% indicating still elevated inflationary expectations.

That longer term rates in the US have moved higher and equivalent rates in SA lower means that the spread between RSA and US rates have declined. This spread may be regarded as a SA risk premium, the extra yield required to compensate for the expected weakness of the rand, and equivalent to a forward exchange rate.

The difference in real yields may be regarded as the extra, after inflation yield required by foreign investors to compensate them for all the risks associated with investing in SA assets. As may be seen in the figures below, SA risk, that is the rate at which the rand is expected to depreciate against the US dollar, has declined as the rand strengthened, while the real risk premium offered to investors in SA has remained largely unchanged.

SA Risk

The faster the US and global economies are expected to grow the higher the expected rates in the US. But faster growth is helpful for commodity prices and emerging market currencies and equities and their profitability and reduces the risks associated with investing in emerging market economies.

Commodity 2017-02-09_081722

Evidence of these helpful trends is clear enough, as may be seen in the figure above that graphs the similar responses of commodity prices, emerging market and JSE equities over the past year as interest rates have risen in the US.

What remains for the SA economy to benefit from improved outlook for the global economy is for the Reserve Bank to reduce its anxiety about the prospect of higher interest rates in the US and focus its attention on the downside risks to the real SA economy, rather than the upside risks to the rand and inflation, and to lower short term interest rates accordingly (President Zuma naturally permitting – and what he permits by way of his cabinet choices will be known this week).

*The views expressed in this column are those of the author and may not necessarily represent those of Investec Wealth & Investment

Fiscal Policy

Budget time is approaching – higher tax rates are part of the problem not the solution

February 3rd, 2017 by Brian Kantor

South Africans will soon learn how much more of their disposable incomes and wealth will be extracted to sustain the nation’s credit rating. They have been forewarned, though they do not appear forearmed, to resist the incoming tide of still more tax and less income to dispose of.

They will be told, correctly, why limiting the borrowing requirements of government (the fiscal deficit) is essential for holding down interest rates and the cost to taxpayers of servicing the debt (old and new) incurred on their behalf.

What will not receive much attention from the Minister of Finance is a recognition of the influence of taxes and tax rates on the ability of economically active South Africans to pay these taxes – so that tax rates have to rise even as the economy continues to flirt with recession.

Evidence of policy failure, in the form of persistently dismal growth in SA incomes, is there for all to recognise. The rating agencies have identified the lack of economic growth in SA and so of its tax base, as the long term threat to the solvency of SA government debt.

It is not good economic policy to tax some goods and services at a much higher rate than others. Nor does it help to subsidise more favoured (by politicians and officials) sources of income. The economy needs less of both taxation and subsidisation that can significantly alter the patterns of consumption and production; interventions that prevent prices and output from revealing the economic value of the resources used in production and distribution. Transport and energy costs, including the particularly adverse taxes on fuel and energy, have a large influence on the prices of everything consumed and produced in SA.

It is a mystery why South Africans appear so complacent about the ever higher specific taxes levied on their demands for transport and energy, yet are so defensive of the inviolate 14% VAT rate with all its significant, hard to justify exemptions that in reality help the better off more than the poor.

The Treasury is now looking to a tax on sugar added to soft drinks. It’s looking to add as much as 20% to the price of a litre of the offending liquid and also, not co-incidentally, hopes to produce significant additional revenue. This focus on extra revenue will deflect attention from the full, perhaps unintended, consequences of such penal taxes: that is not only less sugar consumed but added incentives for producers to avoid taxation, not just the sugar tax but also all the other taxes, VAT and income taxes that accompany the legal production of soft drinks. This has been the case with cigarettes, where highly penal tax rates have driven much of their production and distribution underground. When the price of a cigarette is cheaper on the street than in the supermarket, the practical limits of the ability to tax and also to influence the prices charged, have been exceeded.

The way forward is for the government to spend less, especially on the benefits provided to the nannies employed by an increasingly nanny state, who thrive on an ever-growing but largely dispensable tide of regulation that inhibits production and employment. The full costs, as well as the often marginal benefits of a regulation, need to be better recognised.

The government also needs to recognise the cost savings, were the private sector allowed to deliver more of the services that taxpayers fund, including education and hospital services as well as electricity and transport. And it should look to sell off the assets of these superfluous state-owned enterprises (SOEs) in order to reduce government debt and interest payments that the SOEs have been so assiduously adding to, given their poor operating results.

South Africans should fully recognise that ever-higher tax rates are not helpful to their economic prospects. They should be calling loudly for less government, less spending and interventions by government. This would lead to lower tax rates, faster growth and indeed more revenue collected. 3 February 2017

SA Economy

The recent SA business cycle trends may have become friendlier

January 24th, 2017 by Brian Kantor

The SA economy appears to have gone through something of a cyclical trough, judged by the latest statistics for December 2016 (note issue, vehicle sales and CPI) and for retail sales for November 2016. Encouragingly, Reserve Bank notes in circulation at December month-end increased on a seasonally adjusted basis, enough to raise the annual year on year growth to 11.3%. If these trends continue, the note cycle, having pointed lower since Q3 2015, may well turn higher in Q2 2017.

As we show below, the note issue has proved a reliable indicator of retail sales, though the sales cycle may well lead rather than follow the money cycle. This is because the Reserve Bank accommodates the demand for cash that the economy exercises – via the banking system. It has no target for the supply of either cash (so called high powered money) or broader measures of money. Thus, the more households intend to spend and borrow from banks and the more cash that they will wish to hold, the more cash will be automatically supplied to them as the banks borrow the extra cash from the Reserve Bank.

The information supplied by the Reserve Bank on the note issue (available within a week of the month end) however precedes that of the retail values and volumes, so making it a useful leading indicator of retail activity. Retail volumes picked up in November and it is likely (judged by the demand for cash in December) that the better retail trend was sustained by the year end. The retailers themselves, through their trading updates, appear to support this contention of a marginally improved trend in sales under way.

When adjusted for consumer prices, the real money base cycle also appears to support the view that a cyclical trough in the money supply has been reached, or is about to be reached in the near future. If the past cyclical regularities can be relied upon, then the latest trends in the demand for and supply of cash indicate that real retail sales volumes may well increase from a very subdued pace of about 1% p.a. to a still subdued, but faster pace of about a real 2% p.a. by mid-2017. No reason to break out the Cap Classique nor for a stiff brandy and Coke.


As we reported earlier, the new vehicle cycle looks a lot happier if December 2016 unit sales (down over 15% on a year on year basis) are seasonally adjusted. On a seasonally adjusted basis, sales volumes, having declined sharply by mid-year, picked up by year end. Extrapolating these recent trends suggests that vehicle unit sales in SA could be growing (slowly) again by mid-year.

We combine the vehicle sales cycle with the cash cycle to establish our Hard Number Index (HNI) of the immediate state of the SA economy. Given the better news about both the cash and vehicle cycle, the HNI has picked up, reversing to some extent the declines in economic activity registered earlier, as may be seen in the figure below.

We also compare the HNI to the Reserve Bank coinciding business cycle indicator, updated only to September 2016. The HNI and the Reserve Bank may be regarded as well related over the long run. Therefore the HNI, which can be updated very soon after any month end, should be regarded as a good leading indicator of the SA business cycle; and one that appears to be turning up marginally rather than down. The HNI indicates that economic activity in SA in 2017 will show slow but positive growth, perhaps slightly improved on recent slow growth rates.

The HNI also appears to be doing a much better job of predicting the state of the SA economy than the Reserve Bank’s own leading indicator (updated to October 2016). This indicator has continued to turn down, until very recently, even as the economy made some progress. The role the JSE plays in accurately predicting the business cycle (included as a leading indicator by the Reserve Bank) may have changed as the JSE itself has become much less exposed to the SA economy and much more directly affected by global rather than SA economic forces.

The direction of commodity prices will remain important for the state of the SA economy. As may be seen below, the commodity price cycle, as reported by the Commodity Research Bureau in Chicago has recovered, when measured in US dollars, but has largely moved sideways when converted into rand, thanks to rand weakness and then a degree of rand strength enjoyed in 2016. As may also be seen, industrial metals have had a stronger recent run than commodities in general that include a large weighting (over 20%) in oil.

Higher commodity prices – the result of faster global growth – would translate into a stronger rand and inflows into emerging market equity and bond markets, as they have done in 2016. Less inflation and lower interest rates also become more likely with a stronger rand, a force clearly helpful for the SA economy plays, such as the banks and retailers listed on the JSE. Without lower interest rates, leading to a strong recovery in money supply and bank credit, a meaningful cyclical recovery – with GDP growth rates trending higher to above 4% p.a. – will not be possible.

It needs to be appreciated however that the JSE, when seen from offshore, has provided excellent recent US dollar returns since early 2016 – as have emerging equity markets generally.

The stronger rand has yet to lift the SA economy and the SA economy plays listed on the JSE. It will take a changed view on the interest outlook and stable commodity prices to lift the JSE meaningfully. For now however, the market still believes short rates are more likely to increase than decline. Further rand stability and lower food prices will reverse such expectations and in turn the direction the interest rate cycle itself. 24 January 2017

SA Economy

Brand Trump and the US Presidency

January 20th, 2017 by Brian Kantor

Being President can be very good (and honest) business

Donald Trump likes to remind us what a great businessman he is (or rather was). He may be right and perhaps his best business decision was to run for US President. It has greatly enhanced the value of his brand. As they like to say in Hollywood, there is no such thing as bad publicity.

Moreover he did not apparently have to spend much of his own wealth on his triumphant publicity campaign. A generally hostile media provided him with all the exposure he needed and did not have to pay much for. They thought, as did Hillary Clinton, that exposing his exceptionalism would be enough to put off potential voters. As we now know, they were wrong. The daily Trump tweets became the news events of the campaign (and, alas, continue to make the news) and were to his advantage at the polling booths. A tweeting President Trump, like much else of what he will now do and say, breaks the mold and we may well just have to get accustomed to his style (or lack of it).

What he does in office, with the help of his cabinet colleagues and many appointments, will matter more than his Tweets or intentions. The promise of a very different and more encouraging approach than that provided by the Obama administration to doing business in the US has resonated strongly with business – especially small business whose confidence levels are at record highs. Confidence in future income prospects is the most important ingredient in the recipe for more spending by households and firms that will raise US growth rates if it materialises.

Separation of US powers, between the House, the Senate, the states and the courts, is designed to complicate and constrain the realisation of any Presidential agenda or campaign promise. Tax reforms, of which much is expected, are initiated in Congress where much work has been done over the years by the Republican leaders in the House. We, as well as Trump, await with some anxiety the essential details. The implementation of a border tax, or rather a system where costs of imports may be disallowed as a deduction from taxable income, will deserve particular notice. The implications are vast – and not just in the US – and may well threaten the system of corporate taxing practiced everywhere else.

Taxing imports

This border or import tax will be intended to compensate the IRS for a lower corporate tax rate – given the excess of US imports over exports. The lower the corporate tax rate however, the less will any expenditure deduction matter for after-tax incomes. This includes the deduction for interest incurred or capital expenditure, both of which will be subject to debate and possible reform. It will be deemed protectionist by the World Trade Organisation and the US will argue otherwise but irrespectively. Net-net it may mean higher prices in the US but only if net-net taxes have risen for business enterprises in general. That will not be the intention though different businesses will be affected differently in ways that will be worth anticipating. It is effective after tax profits that influence the required returns on capital that have to be recovered in the prices that consumers or customers must pay if the firm is to succeed. Even income taxes find their way into prices.

Managing conflict

President Trump is not bound by the conflict of interest regulations that apply to all others responsible for government business. Trump however has elected to recuse himself fully from the Trump enterprise while President. His sons will run the business and manage the Trump brand. The cry from the anti-Trump brigade is that such arrangements, even should Trump stay fully uninvolved in the decisions made by Trump Enterprises, still represent a conflict of interest. In other words, the Trumps should abandon the Trump business and eliminate the brand, including presumably removing the Trump insignia that currently adorns buildings and merchandise – not a practical possibility. Selling the brand would not have eliminated the connection with the Presidency.

The Trump brand therefore lives on and understandably so given its value, calculated as the present value of the difference a Trump branding can make to rentals or prices that a Trump enterprise or franchisee can realise and pay royalties on. But this does not mean any conflict of interest. The better Trump does in discharging his responsibilities as President, the better his contributions will be appreciated by the public at large and the more valuable his brand will become. The economic interests in his brand and that of the US are well aligned, just as they were well aligned with the Obama brand. The lecture and consulting fees he will now be able to charge depend on the regard in which he is held.

SA Financial Markets

Naspers (NPN) – a great story with an opportunity to add additional value for its shareholders

January 19th, 2017 by Brian Kantor

 A brilliant success story

When the financial history of South Africa in the first two decades of the 21st century comes to be written, the role played by Naspers (NPN) will surely be a prominent one. Its achievements reflect many of the important themes of our financial times- not only that of outstanding returns to share-holders that made NPN by far the most important contributor to the JSE – with a weight in the JSE market Indexes of about 17% and a market value that rose from R7b in 2003 to nearly R85b by the end of 2016. But as important and interesting is that the value added for shareholders came from participating in the new digital economy and by taking excellent advantage of South Africa’s newly acquired democratic credentials and consequent access to global markets in goods services and capital.



Fig.1; Naspers (NPN) Market Value and share of the JSE Swix Index


Source; Bloomberg, Investec Wealth and Investment

The most important decision made by NPN management was the decision taken in 2001 to purchase 46.5% of Tencent (a Chinese internet business listed in HongKong for USD34m.[1] This stake has since been reduced to a 34.33 per cent holding. As we show below the rand value of Tencent itself, when converted to ZAR at the current rates of exchange, is now over R3000b and the theoretical or potential worth of the NPN stake in Tencent to over R1000b.

Fig 2. Market Value R millions of Hong Kong listed Tencent and the theoretical value 34.33% NPN stake in it. 2007-2016. Month end data


Source; Bloomberg, Investec Wealth and Investment

The theoretical not actual value of the stake in Tencent

The theoretical nature of this estimate deserves emphasis. Firstly because its holding in Tencent is worth more than the value of NPN itself as we show in figure 3- some 22% or R216b less than its holding in Tencent.  This implies that all the other assets of NPN in which it has made very large investments have a large negative value for shareholders of as much as R216b.

Fig 3; The market value of NPN and its stake in Tencent (Rm) (Month end data 2014-2016)


Source; Bloomberg, Investec Wealth and Investment



The link nevertheless between the share value of NPN and Tencent Holdings is very close – notwithstanding the fact that NPN now seems to be worth significantly less than its holding in Tencent. The correlation of the daily level of two share prices measured in ZAR is 0.99 indicating that almost all of the price level of NPN in ZAR can be attributed to its holding in Tencent and the current value of a Tencent share.

NPN is much more than a holding company for Tencent shares- but what is its other business worth?

NPN, as a business enterprise, however is much more than a holding company for its investment in Tencent, as its cash flow statement for the latest financial year to March 2016, demonstrates very fully. NPN reports dividend income in 2016 (mostly from Tencent) of USD146m compared to net cash utilised in investment activity by NPN in FY 2016 of USD1,384m. This investment activity in 2016 was facilitated by additional equity and debt raised in 2016 of USD4470m of which USD2270m was applied to repaying existing debts.

The implication often drawn by investment analysts when comparing the value of NPN to its sum of parts- including the Tencent holding – is that all this investment activity undertaken by NPN management destroys rather than adds significant value for its shareholders. But such a conclusion, or rather the scale of this presumed value destruction, is perhaps not nearly as obvious as it may seem on the surface.

It is firstly not at all clear that NPN would ever be willing or indeed able to dispose of its holding in Tencent.  Even if NPN were willing sellers, such a disposal might well be subject to the approval of the Chinese authorities. These authorities would be concerned about who might acquire these rights to the revenue and income from NPN- for example US internet companies that have a dominant share of the global internet business that might not be welcome in China.

Thus valuing the NPN holding in Tencent, as if it could be easily disposed of a current market prices – or even unbundled to its NPN shareholders- may well be an invalid assumption. In reality the NPN stake in Tencent may well be more conservatively valued in the market place as an illiquid asset and so worth less than it appears on the surface- that is valued at less than the prevailing market value of Tencent- but exactly how much less would be a matter of judgment.

Moreover if there is no NPN intention or ability to dispose of its Tencent stake then its value to NPN shareholders will depend on the uses to which NPN puts the dividend income it receives from Tencent, and perhaps more important the borrowing capacity its stake in Tencent may give NPN and the debt capital it raises to fund investment expenditure.

The NPN cash flow statement for financial year indicates significant investment and financial activity as discussed above. The cash flow statement also refers to NPN dividend payments of USD254m in 2016. That is dividends paid to NPN shareholders in 2016 exceeded the dividends received from Tencent and other investments. Clearly these dividend payments are not valued as highly as dividends paid by Tencent a point to which we return below.

Tencent listed in Hong Kong is no ordinary company

The full nature of the holdings of NPN and other shareholders in Tencent Holdings in Hong Kong deserves full recognition. These holdings do not represent an ownership stake in the usual sense. Tencent Holdings in Hong Kong provide its shareholders with contractual rather than ownership rights. They only have rights to the revenues, earnings and dividends generated by the Chinese owned operating company provided by Tencent Holdings- not to the assets of the company in China that have to be owned by Chinese citizens. Accordingly these right holders have no claim on the assets of the company should they have to be liquidated, unless they are Chinese owners. The contractual right is only to a share of revenues earnings and most obviously to dividends- not to the assets of the company operating in China that is limited by law to Chinese citizens.

Foreign ownership of internet and media companies in China including Tencent is prohibited. These ownership restrictions were however overcome and access to foreign capital achieved by Chinese entrepreneurs, including those who founded and developed Tencent, through contractual arrangements known as Variable Interest Entities (VIE’s) of which Ten Cent Holdings listed in Hong Kong is but one of many such entities listed outside of China. The note from Reuters on Alibaba written in September 2016 – a large rival to Tencent Chinese owned internet company –more recently listed in New York –explains the nature of a VIE.

Report from Reuters on VIE’s September 2016

Sept 9 (Reuters) – When Alibaba Group Holding Ltd sells more than $20 billion in shares on the New York Stock Exchange next week, investors won’t be buying equity in China’s biggest e-commerce company. Instead, they will buy into a firm that owns the rights to participate in the revenue created by a handful of Alibaba’s e-commerce and advertising businesses.

* Alibaba Group is set up as a traditional variable interest entity (VIE) structure – an elaborate legal arrangement designed 14 years ago to help Chinese tech and financial companies that hold restricted government-issued domestic licenses raise money overseas.

* VIE structures allow offshore-listed companies to consolidate domestic Chinese firms in their financial statements by creating the appearance of ownership.

* Of the more than 200 Chinese companies listed on the New York Stock Exchange and the NASDAQ, 95 use a VIE structure and have audited financial filings for 2013, according to ChinaRAI, a Beijing-based business consultancy. They include China’s biggest internet companies, such as Baidu Inc and Inc.

* VIE structures typically involve offshore holding companies in the Cayman Islands and British Virgin Islands; Hong Kong subsidiary enterprises; Chinese wholly foreign-owned enterprises (WFOEs); and local operating companies. The Chinese operating companies that anchor the arrangement are called the VIEs and hold the Chinese licenses that are restricted to domestic companies – in Alibaba’s case, primarily internet content provider licenses.

* Alibaba’s VIE structure comprises five local operating companies, each of which is 80 percent-held by co-founder and executive chairman Jack Ma, and 20 percent by long-term executive Simon Xie – except for Zhejiang Taobao Network Co, which is 90 percent-held by Ma.

* A series of technical services, loan, exclusive call option, proxy, and equity pledge agreements bind the domestic firms to the WFOEs and create the “variable interest” – allowing offshore Alibaba Group shareholders the appearance of control of the local companies.

* The contracts also are meant to provide a legal framework of checks and balances to guarantee that the ultimate stakeholders of the local operating companies act in accordance with the wishes of the offshore listed company’s shareholders. On occasion, such contracts have been broken. In 2010, for example, Ma unwound the contracts for Alibaba’s Alipay unit, triggering a dispute with major shareholders, including Yahoo Inc.

* The VIE structure has never been tested by courts in China.

* In its pre-IPO filings, Alibaba cautions investors that it can’t guarantee its VIE shareholders “will always act in the best interests of our company”, and that if the Alibaba VIE shareholders breach their contracts, “we may have to incur substantial costs and expend additional resources to enforce such arrangements.” (Compiled by Matthew Miller; Editing by Ian Geoghegan)

Thus the value of these contractual right to the revenue, earnings and dividend streams generated by these VIE’s is subject to significant uncertainty that is surely recognised in the prices of their shares listed outside of China. Thus any negative impact on the value to the beneficiaries of these VIE’s arrangements will however also apply to the rights enjoyed by all owners in Tencent Holdings listed in Hong Kong- including those held by NPN. Any VIE discount attached to the rights in Tencent traded in Hong Kong would already be reflected in the Tencent share price.

The value of the dividends paid by Tencent- valuing dividends to recognise value destruction- and the value add opportunity.

The direct benefits to NPN shareholders have come in the form of dividends received from Tencent. These as may be seen have grown spectacularly both in USD and even more so in ZAR. By year end 2016 the .3433 per cent of the dividends flowing to NPN would have been of the order of USD200m or R2700m at current exchange rates. These dividends have grown spectacularly- at an average annual compound rate of about 42% p.a. in USD and 51% p.a when measured in ZAR since 2017. (See below)

Fig 4. Tencent dividend and earnings flows to shareholders. (2007-2016)


Source; Bloomberg, Investec Wealth and Investment

These growth rates and the expectation they would be sustained, have been reflected in the values attached to shares in Tencent Holdings. As we show below the Tencent shares as at December 31st 2016 traded at 42.1 times reported earnings and an even more spectacular 403.6 times reported dividends. (see figure 5 and 6 below where we show the trailing Tencent earnings and dividend yields and multiples.) The dividend yield (D/P) as at end December 2016 was 0.247 and the earnings yield (E/P) 2.37.



Fig 5; Tencent Holdings; Earnings and Dividend Yields Daily (Data 2007-2016)


Source; Bloomberg, Investec Wealth and Investment

Fig 6; Tencent Holdings; Price/Dividends and Price/Earnings Ratios (Daily data 2007-2016)


Source; Bloomberg, Investec Wealth and Investment

Were the dividends received from Tencent by NPN shareholders accorded the same price multiples as those accorded to Tencent shareholders themselves this .3433 share of the dividends paid by Tencent would command a value of about USD79b or ZAR1,085b, at prevailing exchange rates, that is well ahead of the ZAR850b of NPN market value recorded at year end 2016. Another way of putting this would be to say that the dividend stream paid by Tencent to its shareholders would now be worth R200b more if NPN shareholders could receive these dividends directly rather than via NPN. As indicated earlier unbundling these shares is not a choice NPN is likely to make- nor may it be a feasible option given Chinese sensitivities. What however might well be possible would be for NPN to create a Tracking Stock to track its Tencent Holding[2]. It could in other words further contract with its shareholders to pay out all the dividends it receives from Tencent directly to them and that these rights to the Tencent dividends could be traded separately in the market place. NPN would continue to own its Tencent rights so no change in control would have occurred and such ownership rights as before would be reflected on its balance sheet. The NPN, Tencent tracking stock would then presumably be a pure clone of Tencent itself and so command the same value- that is 400 times the dividends paid out. NPN shareholders would then be about ZAR200b better off.

Furthermore the shareholders and NPN managers would then know very precisely the value added or lost by the investment activity undertaken by NPN. The rump of NPN- net of the explicit value of its Tracking Stock – would very objectively measure how much the other assets of NPN – in which it has invested so heavily – are actually worth to shareholders. The case for adding to such assets- including raising debt to the purpose – would then presumably have to be a good one. In addition, with dividends flowing through the tracking stock, NPN could make the case for reducing its own dividend payments- and investing the cash. That is if NPN could realistically expect returns that would exceed its cost of capital, above required risk adjusted returns, and so add value for shareholders.

In line with much market commentary, is it unfair to suggest, that the complications inherent in valuing the Tencent stake in NPN has encouraged poor capital management by NPN? The large difference, approximately R200b between the value of the Tencent dividends received by NPN and the value of NPN itself strongly suggests that NPN is not expected to add value for its shareholders through its investment activity.

Recognising objectively the value of the Tencent stake through the market value of its tracking stock will help expose the significant other business of NPN to the essential disciplines that should govern the use of shareholder capital. This surely would be good for NPN shareholders.


For all its past success the management and directors of NPN have a very large problem with investors. The market reveals that NPN would be worth much more to its shareholders if it sold off all its assets and paid off its debts. The assets it has invested so heavily in (in addition to its investment in Tencent) would have significant positive value in other hands- surely many hundred of billions of rands. But such sales or unbundling of assets is regarded as a very unlikely event hence the lower sum of parts value attached to NPN.

What the market is telling NPN management is that its impressive investment programme is expected to destroy many billions of shareholder value. That is the cash to be invested, by NPN, is thought to be worth many billions more than the value of the extra assets the company will come to own and manage. This investment programme is a very ambitious one. In FY 2016 the company reported development expenditure of USD961m and M&A activity of USD1495m.

Clearly the NPN directors and management must believe differently, that the cash it intends to invest on such a large scale will add value for shareholders- that is return more than the cost of this capital- that is achieve an internal return of at least 8% p.a when measured in USD or 14% p.a in rands. If it achieves such returns it will add rather than destroy value for shareholders.

But there is room for an important compromise between sceptical investors and confident managers. And that is to separate the Tencent investment from the rest of the business. If NPN established a tracking stock that passed on the dividends directly to its shareholders this tracking stock would be valued at approximately 400*R2.7b, or approximately R1080b – about 200b rand more than the current market value of NPN itself. This tracking stock would be a pure clone of Tencent- perhaps also listed in Hong Kong and can be expected to trade on the same dividend generating basis as Tencent itself.

Shareholders would surely greatly appreciate an immediate  R200b plus value add – and the growing dividend flows from Tencent- via NPN. And the quality of NPN management could then be measured much more clearly without the complications and comfort of its Tencent stake.


[1] The listing in HK on the Hang Seng exchange is abbreviated as 700HK

[2] For a full analysis of Tracking Stocks and their feasibility see

J Castle and B Kantor,  Tracking stocks – an alternative to unbundling for the South African group, The Investment Analysts Journal, 2001 51(4), also to be found on the website, Research Archive.