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.


SA Economy

The rand may be telling us something about SA politics

January 18th, 2017 by Brian Kantor

The rand weakened with the market rally and stronger dollar (and higher interest rates) that followed the US election result. Since then the rand has recovered, as some of the Trump impact on interest rates in the US and the US dollar moderated in mid-December. On a trade weighted basis, the rand has gained about 7% from its weakened immediate post Trump level.

The rand has also outperformed a basket of 11 equally weighted leading emerging market (EM) currencies after the Trump surprise. This basket includes the Turkish lira and the Mexican peso, which have been noticeably weak for their own specific reasons, such as the Trump threat to Mexican exports to the US. The rand moreover had gained strength relative to other EM currencies before the Trump election, relative strength that has continued since, as represented by the rand/EM exchange rate ratio.

The rand moreover has also strengthened against the developed market currencies as well as the US dollar after the initial Trump trade. It has also enjoyed a degree of strength vs the Aussie dollar, which can be regarded as a commodity currency.

It may be concluded that the rand has enjoyed a degree of strength for SA specific reasons. It is hard not to conclude that the rand has benefited from the assumption that President Jacob Zuma has become less likely to intervene in economic policy making. Perhaps this is the hopeful message to be read from the behaviour of the rand.

SA Economy

Trump and the SA economy – so far mostly good news

January 17th, 2017 by Brian Kantor

The Trump growth rally that began with his election success appeared to run out of steam in late December 2016. Real bond yields in the US, represented by the yield on a 10 year inflation-linked Treasury Bond reached a recent peak on about the 19 December. These real yields reflect the real cost of capital- the risk free required rate of return to which a premium must be added to compensate for investing in any asset or project with more risk to the expected return. Real rates have been exceptionally low in recent times as world-wide demand for capital to invest in extra capacity shrunk away and as global savings rose. The Trump-inspired increase in real rates portended faster economic growth in the US and the extra demands for capital that can be expected to accompany faster growth.

As may be seen in the figure below, real US rates for 10 year bonds have declined from 0.7% to the current 0.4% yield. This is still significantly higher than the negative real rates investors were accepting in early October. Thus the growth outlook for the US can be assumed to be more promising than it was in October but perhaps not as promising as it appeared in mid-December.

The Trump administration has to deliver on its promises to deregulate and lower taxes and also to bring jobs home. These are prospects that have received particular favour from small business in the US, whose confidence levels have reached record highs, as well as from the customers of the leading banks that apparently are now willing to borrow more. This was noted by bank CEOs reporting earnings on Friday – accompanying generally more favourable operating conditions.

It is this additional confidence of households and business that will influence their willingness to spend and borrow more. Balance sheets of US households have greatly strengthened in recent years, with more saved and more equity in their homes, while lower interest rates have reduced their interest expenses; similarly for business borrowers. It is not balance sheets that will stand in their way of increased spending, but the relative lack of confidence in income prospects.

It will also be of interest to note just how consistent has been the recent behaviour of the gold price in response to real interest rates. Real interest rates represent the opportunity cost of holding gold. The more expensive it is to own gold, the lower its price.

The difference between the lower yield on an inflation-linked bond and that of its vanilla equivalent bond of similar duration (that offers a higher running yield), represents the compensation to investors for taking on the risk that in inflation will prove higher than expected. By doing so it drive up interest rates to compensate for the now more inflation expected. In doing so it reduces the value of the conventional bond. In the figure below we show these recent yield differences, representing inflation expected, over the next 10 years in the US and SA bond markets. Inflation expected in the US has risen consistently before and after the Trump election to about 2% per annum. Real yields in the US have reversed course in the US recently. Inflation expected has continued to increase. The US Fed regards 2% inflation as one of its objectives for monetary policy.

The Trump election raised inflation expectations in SA to over 7%. Very recently, as the Trump rally faded, inflation expected in SA over the next 10 years, as revealed in the RSA bond market, has receded sharply to below 6.5%. This must be regarded as helpful for the SA economy. The Reserve Bank has a highly exaggerated view of the influence of inflation expectations on inflation itself. This retreat in inflation expectations as well as a much improved outlook for inflation itself may encourage the Reserve Bank to reverse the course of short term interest rates – an essential requirement if growth in SA is to pick up momentum.

The improved outlook for inflation in SA is also reflected in the declining SA risk premium, the difference in yields offered by a RSA 10 year bond and a 10 year US Treasury bond. This spread in 2017 has narrowed sharply, indicating that the rand is now expected to depreciate against the US dollar at a slower rate, close to 6.4% p.a. and thus consistent with less inflation priced into the bond market.

This better news about the outlook for the rand and so inflation in SA has come naturally enough with a stronger rand. The figure below indicates the trade weighted exchange rate since September. After initially weakening in response to the Trump election, the rand has benefitted from a strong recovery of about 7% since November. Clearly the extra growth and higher US interest rates associated with a Trump administration have neither raised long term rates in SA nor weakened the rand. Indeed the opposite has happened. This should encourage the Reserve Bank to focus on the downside risks to economic growth in SA rather than the upside risks to inflation. These surely have declined, both with the stronger rand and the prospects of lower food prices. The case for lower interest rates in SA has strengthened with the Trump election so that SA too can look forward to faster growth.

Hard Number Index

New vehicle sales: A closer look

January 12th, 2017 by Brian Kantor

What’s in a (growth) number? Vehicle sales volumes in December 2016 deserve a closer look.

Recently reported new vehicle sales of 41 639 units sold in in December 2016, some 15.35% fewer than sold a year ago, were greeted with general disappointment. The implication drawn was that the decline in sales volumes recorded in 2016 had accelerated.

But is this the right conclusion to be drawn about the most recent data release? A year can be a very long time in economic life and what has happened to vehicle sales in the months between December 2015 and December 2016 can tell a very different story about the underlying trends.

The data, when adjusted for predictable seasonal influences on monthly sales, indicate that while monthly sales volumes took a turn for the worse in the fourth quarter of 2015, by the fourth quarter of 2016, sales were in fact recovering from their lows of midyear 2016, when monthly sales are adjusted for seasonal influences, as we show below.

The important feature of the vehicle market is that unlike for other retailers, December is a typically well below average month for motor dealers. Holidays mean closed dealerships and so are not usually a good time to deal for an expensive new vehicle.

But a year ago in December 2015, with which sales comparisons are being made, was not a typical month for the motor dealers. The rand, it will be remembered, collapsed that month, portending higher vehicle prices, given their import content. And consequently buying ahead of the expected price increases seemed like a good enough idea to lift sales in December 2015 markedly, especially when seasonally adjusted. Actual sales in December 2015 were 49 158 units and had held up very well compared to November 2015 sales volumes of 51 338 – making December 2015 a very high base with which to compare sales a year later.

As we show in our table of seasonal factors below November is an average month for motor dealers, while December sales average about 13% below average monthly sales. By contrast for retailers generally, December sales volumes average as much as 36% above average monthly volumes.

Or in other words, to gain a full impression of trading trends in December 2016, retail volumes when recorded and reported should be scaled down (divided) by a factor of 1.36 while vehicle sales should be scaled up by a factor of approximately (0.87). Hence vehicle sales in December 2016 of 41639 units should be scaled up by (0.866476) to register the 48 055 sales seasonally adjusted indicated in the figures, and so well ahead of the much weaker, seasonally adjusted sales of 42 501 unit sales, recorded in July 2016.

In the figure below we compare growth rates in vehicle sales on an annual basis with growth calculated over consecutive 3 moth periods using seasonally adjusted monthly data. It may be seen that while annual growth rates are negative and in retreat, the quarterly numbers tell a more positive story.

Of interest is that the recent share price performance of two JSE listed motor dealers, Combined Motor Holdings (JSE code – CMH) and Imperial (IPL) seems to accord better with the more encouraging seasonally adjusted sales numbers than with the raw data (see below).

SA Economy

Lessons from the success of the Western Cape

January 12th, 2017 by Brian Kantor

The success the governments of the Western Cape have had in competing for resources with the rest of South Africa is highly evident in the building activity under way in the more expensive parts of the region. Any number of ordinarily valuable buildings are clearly worth more dead than alive – they are worth demolishing so that they can be replaced by more valuable structures, valuable enough to more than recover the costs of demolishing what stood before.

The demand for these expensive new residential structures has come mostly from migrants from other parts of South Africa where local government has proved much less competent in delivering services so essential to the quality of life, such waste removal, water and electricity supplies, easy access to homes, work and recreation as well as protection against fire, noise and criminals.

The more valuable the stock of buildings, the larger the tax base upon which the local authority can draw to fund service delivery, including in the more deprived parts of town. Moreover current revenues can be used to justify the raising of debt to fund a large capital expenditure programme in order to sustain and enhance the infrastructure that supports effective service delivery. This includes funding the additional roads and bridges and sewage works that support and make viable green field housing developments.

The extra tax these developments will generate over time can more than fund and repay the additional debt incurred. Bridges and new roads that improve access to undeveloped (often wastefully used land owned by government authorities) can prove highly profitable investments. They can be funded with tolls that can then pay off debt incurred in the building – no more or less than a user charge – rather than used to tax users as has wrongly been the case with most toll roads in the country, giving them their well-deserved notoriety.

A criticism one can make of the management of City of Cape Town is its reluctance to raise more debt to fund capital expenditure, that is to put its financial strength supported by ever rising values in the buildings and especially the land it services, to better and more immediate use.

Clearly regional economic development can become a highly virtuous circle of increased revenues and financial strength that leads to useful additional expenditure on improved service delivery that helps attract migrants to the region, rich and poor, that reinforces the growth under way.

It should however be fully appreciated (as perhaps it is appreciated in Cape Town), that the resource critical for faster growth and for which the competition is most intense (not only nationally but also internationally) are the skills, enterprise and wealth embodied in the high income earners of any community. Their contribution to economic development is indispensable for the incomes and the prospects of their poor neighbours. Moreover, providing this mobile resource with a globally competitive quality of local government service at a reasonable charge is essential to the purpose of economic growth. It is also essential to the incomes of the poor who will wish to migrate to the regions that promise better income opportunities.

Hence the relationship between the expensive real estate in a city that is demanded by the affluent and economically successful and the less expensive real estate, that is consistent with much lower earnings and less affordability, is a mutually supportive one. Improved competitive local government service delivery is very encouraging to the high income earners who deliver so much to an economy – including tax revenues – and so symbiotically also very valuable to the poor, who can expect improved services as well as improved income prospects.
If South Africa or any region of it is to succeed in the global competition for the all-important scarce resources that high income earners provide an economy, it will need to continue to offer them competitively priced and efficient services that local governments deliver. South Africa will also need to provide them and their children with competitively priced educational services and also competitive and competitively priced medical services. The role played in education by private suppliers of education and medical service is an obviously important one in these regards. Such quality service delivery will need to be nurtured and encouraged if South Africa is to succeed in overcoming poverty.

Global Financial Markets

No Trump tantrum

December 8th, 2016 by Brian Kantor

Overcoming the Trump shocks and drawing its implications for SA and Reserve Bank action

The Trump shock has been working its way through the markets. Expectations for US growth under Trump were revised upwards, which benefited US equities generally. Emerging market (EM) equities by contrast have suffered both absolutely and relatively, with the JSE in US dollars performing as it usually does, in line with the average emerging market, with both losing about 6% of their pre-Trump US dollar values.

The market and central bank governors have long feared the impact of higher bond yields in the US on EM currencies, inflation and interest rates. Long term RSA bond yields rose immediately, in sympathy with higher US bond yields. But recent interest rate trends in the RSA bond market have proved much more encouraging. Yields have receded as the spread between RSA and US Treasury bond yields have narrowed, leaving rates little changed from their pre-Trump levels. These are helpful trends and indicate that a feared “Trump tantrum” in the RSA bond markets has not materialised.

A related and similarly favourable reaction can be observed in the currency market. The rand weakened against the US dollar, along with other EM currencies, with the Trump election. But more recently the rand has regained its pre-Trump US dollar value and has performed better than the average EM currency since. More important is that the trade weighted rand has gained significant strength as we also show below. The trade weighted rand is now as much as 24% stronger than it was in mid-January 2016. This strength translates directly into lower import and export prices and so less inflation and less inflation expected.

Not all the recent economic news has been encouraging. The latest GDP release for the third quarter indicates that SA growth trends have deteriorated. Spending by households and the government is barely increasing while capital expenditure by private businesses and public corporations declined significantly. The GDP growth rate of a mere 0.2% in the third quarter can be attributed to an extraordinary growth in investment in Inventories in the third quarter that was enough to offset a very poor reading on net exports. A better net export performance in the fourth quarter and beyond may help compensate for a likely decline in inventories.

The economy will have to grow at a minimal 2-3% rate to cause the rating agencies to sustain our credit rating. It will take meaningful growth enhancing structural reforms to raise growth rates permanently to higher levels. These appear unfortunately unlikely and would take time to achieve results.

A cyclical recovery is however distinctly possible and could take GDP growth up to a 2-3% pace. Such a cyclical recovery would have to be led, as it always has to be led, by a significant pick-up in household spending propensities. Households have to spend more to encourage firms to invest more in equipment and people to meet their extra demands. Lower short term interest rates are essential to the all-important purpose of a cyclical recovery.

Inflation in SA is now very likely to recede below the upper band of the inflation targets. There is always a risk that these recently favourable trends may reverse. But there is a much greater probability that the economy will continue to stagnate dangerously, leading to political and economic stability for want of a stimulus to spending. Inflation is no self-fulfilling process in SA. The relevance of so-called second round dangers to inflation that may accompany inflation expectations is a theory for which there is no good evidence. Inflation expected is much more likely to follow than lead inflation as the evidence does reveal.

The Reserve Bank focus, narrative and action should respond accordingly by addressing the downside risks to the economy and lowering interest rates. And by recognising an improved outlook for inflation, rather than to focus further on inflation risks, over which they have no predictable influence. 8 December 2016


Will a national minimum wage help the poor? We beg to disagree with the expert panel

November 28th, 2016 by Brian Kantor

The National Minimum Wage for South Africa (NMW) – will it be helpful or harmful to the poor of SA? We beg to disagree with the expert panel.

A reality check

It is always salutary to be reminded just how dire are the economic circumstances of the average South African and how slowly their economic conditions have been improving. Over 51%, some 29,733,210 of our people, live on less than R1,036.07 per month. These and many other shocking statistics are reported by the Panel of Experts appointed to recommend the level of a National Minimum Wage (NMW) and on a process for its effective implementation (“Recommendations on policy and Implementation; National Minimum Wage Panel report to the Deputy President”).

The table calculated by the panel, included below, provides helpful detail about the lack of income and the associated unemployment.

The panel has no doubts about the helpfulness of an NMW in principle – only reservations about practice

The panel seems to have no doubts that a NMW would be a very helpful policy intervention in principle. To quote selectively from its substantial report of 128 pages”

“On its own it will not solve all of the challenges we face, but it is an implementable policy which is designed to have a measurable and concrete benefit on the poor. The minimum wage is therefore seen as one of the tools to close the wage gap, including between the genders, and thereby to overcome poverty.

“Furthermore, under the correct conditions and at the correct wage level, it is possible for minimum wage policies to contribute to improving economic growth. ……Given that the national minimum wage is essentially a policy to help the poor, it is generally accepted that exemptions and exclusions should be kept to an absolute minimum.”

Striking a balance – recognising employment dangers in scenario exercises

The panel was required by the social partners in Nedlac, who agreed to an NMW, to recommend an appropriate level for the NMW. Since it recognised a relationship between wages and employment the MNW had to strike a balance between the effects of increasing wages to a higher prescribed minimum level and its consequences for additional unemployment of which SA already has a great abundance. Some 26% of the labour force, those in work or looking for work, are currently unemployed, while many more potential workers have been discouraged from looking for work and have fallen out of the labour force. Adding them to the work force would imply a more broadly defined national unemployment rate well into the 30% plus range.

The panel recommended a NMW of R3500 per month or R20 per hour to be phased in by 2020 with 90% of the NMW to be applied in agriculture and 70% in Domestic Service provided to Private Homes. It also recommended annual reviews of the NMW and a gradual move to uniformity across all sectors of the economy. Using a so-called Computable General Equilibrium model of the SA labour market (as described and developed by Professor Harron Bhorat of UCT) that included assumptions (not predictions based on past performance) about the trade-offs between percentage increases in minimum wages and percentage reductions in employment (the relevant employment elasticities in economic speak) .

The aggregate employment losses were estimated as between 100,000 and 900,000 jobs lost in exchange for the recommended NMW. Clearly in the view of the Panel, the NMW had to be set high enough to make its contribution to poverty relief and yet low enough to be able to treat the extra unemployment as the acceptable price to the panel members of them doing such good for society. Another argument for breaking eggs to make omelettes from those unlikely to be harmed by the action and who might even benefit from helping to give effect to a new dispensation.

However the panel did qualify its judgment. It noted correctly:

“…..that there is no research or data that can accurately predict the outcome of any policy intervention. It is for this reason that strong emphasis has been placed on the need for good solid research to support the work of the NMW institution into the future. Any future changes to the level of R3,500/R20 per hour should be based on solid evidence of the impact of the national minimum wage.”

Would it be unkind to recognise that this would also be more grist for the economist’s mill?

The relationship between minimum wages and employment – what may be self-evident to the panel is not so to the society at large

It would have been helpful had the panel used the report to explain more fully why employment offers are negatively related to the wages or rather employment benefits provided by employers in exchange for hours worked. The relationship is much less self-evident than the panel may have presumed it to be – especially by members and leaders of trade unions who are inclined to attribute wage differences much more to political forces and bargaining power and even to race – than to the differences in skills and therefore of the contributions to output made by the well and poorly paid. And they are very inclined to believe that the wage gaps can be easily closed, with little consequence for economic growth by taking more from the well paid and giving to the poor. And so for ever higher NMW.

The relationship between skills, incomes and employment

The panel is well aware of an obviously important and highly consistent relationship to be observed of the SA labour market between measures of skills and wages earned. And as statistically significant is the relationship between incomes and employment. The lowest income South Africans have the highest rates of unemployment. The full income and employment details are shown in the table below (Table 5 Household Indicators of the Panel Report). Other reports from Stats SA have demonstrated the links between educational attainments and income and employment.

It may be seen in the Table, that of the 16,306,000 people in Quintile 1, 31.2% of the population with the lowest share of income, only 15,9% are employed, 25% strictly unemployed and the broad unemployment rate of this group is estimated as 65.8%. The average wage of those employed in quintile 1 is only R1017 per month. The second poorest quintile counts for a further 24.6% of the population, has a lower unemployment rate, a much higher participation rate in the economy and average wage incomes of R1707 per month. A large improvement but still a very low average wage.

The top income quintiles present very differently. Unemployment rates are much lower and participation rates and average incomes from work of the employed are much higher and well above the recommended NMW. Though it should be noted that the average wage income of those employed who fall into Quintile 3 of R2651 per month, is still well below the R3500 per month recommended NMW.

The implications of a NMW set so far above average wages- is there precedent that can help us predict the employment effects with any confidence?

This begs the question – is there any precedent for a NMW or a sectoral minimum wage determination –be set so far above average earnings – and if so what have been the consequences for employment? Or put in another way is there reason given the facts of the labour market to think that the employment elasticities in SA are a lot more negative than the range of assumptions considered by the models. Time will tell much more about the consequences of the recommended NMW as the Panel complacently assumes and adjustments can then made to the model and the recommendations. But who will care for the unemployed and their dependents in the meanwhile?

How can an NMW help the poor – who are now mostly not employed?

It is very difficult to understand why the Panel should believe that the NMW can be helpful to the poor of South Africa or reduce inequality. Because fundamentally the poorest South Africans those in first and second quintiles, are mostly not employed. And when employed they are able to only command wages far below those of the recommended NMW that still leave them objectively poor.

The recommended NMW will surely make it even more difficult for them to find work that might for some, especially young workers, prove a path out of poverty. Thus the NMW is very likely to increase further the unemployment of low skilled potential workers in SA and to widen the gap between the average incomes of the high earners and the low earners, mostly no earners of the population. The poor of SA deserve better opportunities to work and more so the opportunity for their children to acquire the education and skills that would help them qualify for and find well paid work. They do not need further interference in their search for work.

Employers will make the adjustments that will confuse the observers

Though to complicate the numerical outcomes to be observed in due course, structural adjustments to employment practice will be made by employers in response to higher minimum wages. The adjustments will include more reliance on mechanisation and automation- requiring more carefully selected and skilled employees, forces that substitute capital for labour, especially less skilled labour, that are already well at work in the economy.

Other adjustments employers will make will be to offer fewer hours of work and significantly less by way of other important employment benefits, food and accommodation and contributions to pension and medical aid for example, the cost to employers and value to employees the panel refuses to recognise in its money wage only determination. Evidence of such reactions so unhelpful to low income workers comes from previous minimum wage adjudications in the agricultural sector. Fewer workers were employed permanently – less accommodation was offered on the farm – and higher transport costs was incurred byr workers busing in from informal settlements. And there is also bound to be less compliance with the law given the availability of cheaper labour and additional employment offered to illegal immigrants.

Why does the labour market only work well for the higher income earners? Is it because they are much less encumbered by regulations and collective bargaining?

A further observation of the inconvenient and uncomfortable truths of the SA labour market is that the supply and demand for labour are very well matched for the well paid and very poorly matched for the low paid. A very high unemployment rate – a large number of potential workers unemployed at current wages – is surely evidence of wage levels that are too high rather than too low to the important purpose of providing work for those who would wish to work- at prevailing wage rates.

These are not considerations that receive much attention from the panel. Other than a presumption of “structural imbalances” or why these structural forces that discourage employment do not apply to the most expensive of workers in SA who are so readily employed?

It is to be conceded that employment at low wages for those with limited skills cannot overcome the poverty of the working poor. But then what can – other than them acquiring the valuable skills that are in short supply and well worth hiring. Wishful thinking- waving magic wands in the form of un-affordable to potential employers of high minimum wages will not solve their problem.

But unemployment makes their condition more onerous and denies them the employment and low wage benefits that they would be willing to accept. A willingness demonstrated by their seeking work. And being unemployed prevents the potential worker from acquiring skills on the job and the opportunity to demonstrate their capabilities that add to their employment credentials. These opportunities are particularly important to young, unskilled entry level workers whose unemployment rates are regrettably but understandably well above average unemployment rates as is well recognised by the panel.

The panel might have sought an explanation of the high rates of unemployment of low income South Africans in the structural impediments to their employment in South Africa. Barriers to employment offered or accepted in the existing highly pervasive regulations of their employment contracts. It is not as if minimum wages have not been tried in SA. They are widely practiced and have surely had their effect on the employment of the lowest paid and least skilled.

The current regulatory barriers to employment in SA

There are in fact 124 separate such sectoral minimum wage determinations. They cover approximately 5m workers and 33% of those employed leaving only 35% of workers uncovered including presumably many of the better paid also without Union representation. The lowest such monthly determinations in 2015 ranged from R1813 for Domestic Workers to R2844 per month per Contract Cleaner in the lowest grades. The highest sectoral minimum determinations – for more skilled work- were R6155 for workers in private security and R6506 per month in Retail and Wholesale businesses.

The newly fashioned NMW is intended to remove all this administrative complexity – and presumably also the possibility of recognising very different labour market conditions – supply and demand – that may apply in the different sectors and regions of the economy. Conditions that participants in specific labour markets, unencumbered by regulations would be much better informed about than even diligent officials to the advantage of workers and their employers.

The case for best leaving the determination of an employment contract to willing buyers and sellers of labour does not get any hearing from the panel. While the collective bargaining process in SA that can easily be shown to protect the established interests of employees and their employers – the insiders – at the expense of the employment opportunities of the outsiders – receives nothing but uncritical approval from the panel- and with an appeal for the wider application of collective bargaining arrangements.

The influence of welfare on employment

Nor did the influence of SA’s extensive welfare system on poverty and employment receive much more than perfunctory and rather condescending attention from the Panel as follows.

5.43. “While wages are low relative to living levels, there are arguably some offsetting effects from the social wage spending by Government. About 35% of South Africa’s budget is spent on programmes targeted at the poor, including free basic education, health care, water and electricity, and income support grants for children and the elderly”.

They may, as did the Davis Committee on Tax Reforms, have referred to a report of the World Bank on the influence on incomes and their distribution of SA of its welfare system. To quote this study:

“But while incomes earned in South Africa may well be the most unequally distributed in the world – the distribution of expenditure is much less unequal. The World Bank shows, in a recent study, that South Africa does more to redistribute income in cash and kind to the poor than its developing economy peers with similar average incomes , Armenia, Brazil, Bolivia, Costa Rica, El Salvador, Ethiopia, Guatemala, Indonesia, Mexico, Peru, and Uruguay (South Africa Economic Update Fiscal Policy and Redistribution in an Unequal Society, World Bank, November 2014).”

As this World Bank study also reports:

“South Africa ranks as one of the most unequal countries of CEQ (Commitment to Equality Methodologies applied by official statisticians in income measurement) participant countries, if not among all middle-income countries, given its Gini coefficient of 0.69. The proportion of the population living in poverty at 33.4 percent measured by the international benchmark of $2.50 a day(purchasing power parity, PPP, adjusted) — is also higher than in many other middle income countries with similar levels of GNI per capita. For example, the poverty rate is 11 percent in Brazil and 4 percent in Costa Rica”

To quote further from the World Bank report:

“Briefly, this Update has two main findings. First, the burden of taxes falls on the richest in South Africa, and social spending results in sizable increases in the incomes of the poor. In other words, the tax and social spending system is overall progressive. Second, fiscal policy in South Africa achieves appreciable reductions in poverty and income inequality, and these reductions are in fact the largest achieved in the emerging market countries that have so far been included in the CEQ. Yet despite fiscal policy being both progressive and equalizing, the levels of poverty and inequality that remain are unacceptably high. South Africa is currently grappling with slowing economic growth, a high fiscal deficit, and a rising debt burden. In this context, addressing the twin challenges of poverty and inequality will require not only much-improved quality and efficiency of public services but also higher and more-inclusive economic growth to help create jobs and lift incomes.” (p22)

These income transfers and benefits in kind may moreover, influence the willingness to supply labour services at prevailing wages – especially when wages on offer are very low. By providing an alternative source of benefits welfare raises the reservation wage – the wage at which it makes good sense to work or to seek work, work that may well be physically demanding and less than enjoyable for its own sake. The panel might have paid much more attention to the supply side of the SA to help explain low rates of labour force participation. Also to help explain why immigrants from Africa are much more likely to be employed – at market related wages.

Economic growth and employment – ignoring the evidence

The panel remarks somewhat self-evidently that:

“An additional problem faced by the country is that there is evidence that the growth in the demand for labour in South Africa has not been sufficient to keep up with the much larger growth in labour supply.”

The panel quotes with seeming approval a study that apparently shows growth and job creation are not well correlated. To quote the Panel:

“Recent empirical work by Mkhize (2016) finds that the economy’s capital intensity undermines its ability to generate jobs in times of economic growth. He finds that, in the long run, growth and job creation are not correlated, although there is some sectoral variation. This points to the broader economic policy challenge facing South Africa, which is that there are structural barriers that exacerbate unemployment, the solutions to which require more than economic growth”.

A surprising conclusion it would be thought, given the fact that in the developed world incomes (GDP), population and the size of the labour force have grown together, as indeed it did in SA until the 1980s – as our own work has shown (see below), though such work on the relationship in SA between GDP and numbers employed is complicated by the absence of an official continuous long time series of numbers employed. Though the structural break in the relationship in the 1980s is easy to recognise and to be self-evidently explained by the increasing degree to which the SA labour market came to be regulated and the increasing bargaining power conceded to trade unions in the 1980s.

The recommended NMW represents more of the same lack of faith in market forces that encourage regulation, rather than regulatory interventions to generate growth and employment.

Another case I would suggest of economists as are the governments they usually serve, being part of the economic problem rather than the solution. 28 November 2016



Global Financial Markets

Assessing markets after the US elections

November 16th, 2016 by Brian Kantor

The market reacts to a surprising US election. Is more growth expected in the US consistent with less growth in emerging economies? Perhaps not.

Donald Trump’s ascension to the White House surprised the financial markets. The bond markets have recorded the largest surprises. A heavy dose of shock and awe was registered in the Treasury bond market and the shock waves were also felt in emerging bond markets, including the market for RSA bonds. US 10 year Treasury yields ended last week over 30bps higher (as we write on Monday 14 November, the yield is 2.21% p.a). The RSA 10 year also ended the week higher at 9.11% p.a (now 9.17%) or 44bps higher, meaning a slightly wider SA risk spread of 6.95% p.a. – equivalent to the average rate the rand is expected to depreciate against the US dollar over the next 10 years.

The higher rates in the US were not confined to vanilla bonds. Inflation linked yields (TIPS) also moved higher on Wednesday 9 November, revealing that the Trump presidency was expected by market participants to not only bring more inflation but also faster growth; faster growth that was expected to increase the competition for capital, so making capital more expensive in real terms.

RSA yields indicated that more SA inflation came to be expected as real bond yields remained largely unchanged through the week. This indicated that little change in the SA growth outlook was expected. The wider spread between nominal and real RSA bond yields indicated more inflation expected that was consistent with the faster rate at which the rand was expected to weaken. More rand weakness, other things equal, means higher rates of inflation in SA (See figures 1-4 below).

Higher bond yields were also registered in Europe. German 10 year Bund yields that had been negative in October increased from 0.08% p. a. on the Monday to 0.235% by the Friday close, but not by enough to prevent the spread Vs US Treasuries from widening in favour of the US dollar, which made gains against the euro and much more significant gains vs emerging market currencies.

The rand was an underperformer within the world of weaker emerging market currencies. R13.35 bought a dollar on the Monday, but by Friday the USD/ZAR was R14.29, a decline of 6.8% (now R14.39) compared to our equally weighted basket of 11 other EM currencies that declined by a mere 3.8%. The currency market would appear to be pricing in additional SA-specific risks, perhaps associated with Zuma resilience revealed in the no-confidence in the President motion in the SA Parliament that failed on the Thursday.

Other signs that US growth assumptions were being revised upwards came from the market in high yield or junk bonds. These yields remained largely unchanged as the high risk spread narrowed even as Treasury yields rose. Faster growth reduces the risk of credit defaults and the market in high yield credit appeared to be drawing this conclusion.

Other signs of faster growth expected came from the metals market. While the gold and oil prices expressed in the stronger US dollar fell away, the CRB Index of Industrial Metals in US dollar increased by about 5% in the week while the weaker rand compensated to some extent for lower US dollar prices.

The stock markets also told the story of faster growth expected in the US and slower growth expected in emerging economies. The SA component of the emerging market equity benchmark lost over 6% in the week compared to the MSCI EM that ended the week 3.5% weaker. The large cap US S&P 500 Index gained 3.8% while the small cap index did significantly better, gaining over 7%. This move too could be regarded as supportive of faster growth that improves the prospects for riskier small companies.

The best performing sectors on the S&P 500 and the JSE in the week of 7 to 11 November proved to be the highly cyclical plays. Materials and resource companies did much better than the consumer-facing companies that had offered predictable dividend yields, yields and dividend growth that had compared well with what had been very low interest rates. The same direction could be seen on the JSE with the Global Consumer Plays, despite the weaker rand, proving distinct underperformers.

It is however not at all obvious why faster US growth should be associated with less growth expected fromemerging market economies; nor why strength in metal prices should be associated with a deteriorating outlook for emerging economies, including the SA economy. The opposite conclusion might have been drawn as appears to be the case for the Australian economy, which is highly dependent on metal exports.

The growth prospects for the SA economy would not have been improved by the changed outlook for short term interest rates. As we show below, the short term yield curve, as reflected in the Forward Rate Agreements (FRAs) offered by the banks, moved sharply higher last week. The money market, having much reduced the chances of higher short term rates earlier, has reversed course. The market is now expecting a further 75bp increase in the Reserve Bank repo rate. Such increases, where they to be imposed on the already hard-pressed SA economy, would eliminate almost any possibility of a recovery in household spending, a necessary condition for a cyclical recovery. The bond market is expecting more inflation to come and the weaker rand expected is consistent with such a view.

Yet the USD/ZAR, while now weaker, is stronger than it was in early 2016, indicating stable import prices. Furthermore the outlook for much lower food price inflation should see headline inflation and Reserve Bank forecasts of inflation recede well below the upper band of the inflation target in 2017. The case for higher policy-determined interest rates, given a further slowdown in the economy, is even weaker than it has been, even though the market may now believe otherwise of the Reserve Bank.

Lower inflation, should it materialise, will lead inflation expected in the same lower direction. The causation runs from inflation to inflation expected and not the other way round as the Reserve Bank has argued. Inflation takes its cue from the exchange rate and is much affected by the weather and the actions of the President. These are forces over which interest rates and the Reserve Bank have no predictable influence. The Reserve Bank should concentrate on what it can do to assist the growth prospects of the economy and that is to lower interest rates. Inflation is beyond its control; a fact of economic life in SA that is overdue official recognition but may yet receive it. 15 November 2016

Global Financial Markets

The market is a lot less scared of Trump than the pundits

November 10th, 2016 by Brian Kantor

The punditry not only greatly underestimated the presidential chances of Donald Trump, they also misread the implications of the known election outcomes for the financial markets. Far from the predicted rush for safety in the US dollar, US Treasuries and defensive stocks, the market, when given the opportunity, pushed US bond yields higher, indicating that faster growth and more inflation was to be expected post Trump (the 10 year Treasury yield initially increased from 1.85% to 2.08%, though it closed at 2%).

Further evidence of positive expectations of faster growth came with the outperformance of resource companies, including those listed on the JSE. The performance of the 12 sectors that make up the S&P 500 is shown below. Financials and Healthcare (expected to benefit from less obtrusive regulation and executive action) as well as Materials ( to benefit from growth and investment in infrastructure) were outperformers while sectors that offered protection against a weaker economy, including Consumer Discretionary and Staples underperformed as did interest rate sensitive sectors of the New York stock market.


Emerging markets, a risk off trade, did come under initial pressure, led by the Mexican peso, a currency especially vulnerable to any protection provided for US manufacturers, lost 8.8% of its US dollar value on the day. The rand ended 1.8% weaker while the Brazilian real was 2% weaker. The 10 year RSA yield moved higher, from 8.64% to 8.78%, leaving the risk premium vs US bonds at an unchanged and recently improved 6.79%. The MSCI Emerging Market (EM) benchmark in US dollars ended 2.5% weaker on the day, compared to the JSE that was 1.3% weaker in US dollars and 0.5% up in rands.

These outcomes must be regarded as satisfactory for EM financial markets, including those measured in rands. The exchange value of the rand has held up more than well enough to sustain a forecast of lower inflation and interest rates to come- essential for faster growth in SA.

What the pundits missed is that while Hillary Clinton represented business as usual for the US and its allies, business as usual under Obama had become increasingly less friendly to business. US and global business have come under increasing suspicion and hostility from more ambitious and obstructive officials emboldened with ever greater executive powers. The Trump administration, with the aid of a friendly Congress, could achieve some quick wins for US business by annulling or at least amending financial and environmental legislation and practice, as Trump had promised to do. The grossly dysfunctional US corporate tax system is an obvious target for a complete restructuring in ways that would be helpful to the owners of business in general and to the economy at large – though these are not necessarily synonymous.

Free trade for example (against which Trump argued and which helped him bring in the vote on the rust belt) is very good for consumers and their standard of living. Cheaper and better air conditioners produced in China have made living in the US South a lot more comfortable, for example. But they have not been helpful to the owners of air conditioning factories in the US or to the employment benefits of their employees. Protection unfortunately can be good politics and good for business owners, but not necessarily for their customers. Though if free traders are seeking consolation they may find it in the prospect of freer trade in services, with a far larger role in the economy (including the SA economy) than manufacturers. Exchanges conducted not over the waters but over the internet and are much more difficult to tax.

The Trump triumph, it should be appreciated, represents a successful attack on the conventional wisdoms and actions that have guided social and economic policies in the US and Europe. How wise and fair this consensus actually is, is a matter of very divided opinion as the US election has demonstrated. Given the opportunity provided by the highly unorthodox Trump, large numbers of Americans voted in effect against the comforts of the ruling establishments inside and their supporters outside Washington DC. Their discomfort in recent events is understandable and clearly geo-political risks are enhanced. Perhaps even the risks to the environment have increased. But the risks to doing business in the US and its growth prospects have as clearly declined, as the market has told us. 10 November 2016

SA Economy

The SA economy: The view from the rear view mirror is not encouraging

November 8th, 2016 by Brian Kantor

The SA economy: The view from the rear view mirror is not encouraging. Can we look down the road more happily?

The pace of the SA economy appears to be slowing down rather than picking up momentum – judged by the very latest data releases for October 2016. New vehicle sales and cash in circulation indicate that a trough in the business cycle, that is when economic conditions have begun to improve rather than deteriorate, has not been registered though may possibly be in sight.

New vehicle sales are nevertheless somewhat more encouraging than the latest money supply data. While new vehicle sales are well down on a year ago, sales volumes in October represented a modest improvement over sales made in August and September 2016, especially when viewed in seasonally adjusted terms, as we show below. When current vehicle sales are extrapolated, using a time series forecasting process, a cyclical trough, is indicated for early 2017. As noticed in figure 2 negative, year on year growth rates, may also have reached a low point.

By contrast the demand for and supply of cash still indicates weaker propensities of households to spend more. The demand for cash, as may be seen, is not keeping pace with inflation. Though, as may also be seen, the forecast is that the real demand for cash is about to turn marginally positive, indicating more rather than less spending to come.

When these two series are combined to form our Hard Number Index (HNI), its direction has turned lower after moving sideways for much of the year, indicating declining levels of economic activity. Extrapolating the HNI however also suggests an improvement in activity levels in 2017. As may be seen, the HNI based on two very up to date hard numbers – rather than based upon sample surveys – is a good predictor of the Business Cycle that is calculated by the Reserve Bank, for which the latest data point is for July 2017 (of somewhat distant memory given all that has happened to society and the economy).

The broader measures of money supply and of bank credit and retail sales volumes, updated to September 2016, indicate a similarly weak backdrop for the SA economy, as we show below. The growth in M3 (to September month end) has become negative in real terms while bank credit supplied to the private sector is somewhat more robust. Perhaps bank credit is being used to a degree, to fund offshore rather than domestic growth. As we also show in retail sales volumes shows a declining growth trend that is forecast to continue in 2017.

The hope for a cyclical recovery in 2017 must rest upon the inflation trends. A Reserve Bank forecast of lower inflation would allow for lower interest rates, which are essential to the purpose of a cyclical recovery. As may be seen in figure 6, the time series forecast of the CPI, using the latest data, is for less inflation to come. Recent data releases for the CPI (the latest being for September), do indicate a much shallower trajectory for the CPI. Between July and September 2016, the CPI was largely unchanged as we show below. A degree of exchange rate strength has helped restrain inflation. A normal harvest in 2017 would do more of the same. South Africans, under severe economic pressure, would be justified in praying for more rain combined with strength in emerging market currencies, including the rand.

SA Financial Markets

Bonds vs equities redux – including the outlook for inflation

November 1st, 2016 by Brian Kantor

Just under two weeks ago, we noted that 2016 has proven to be a very good year for investors in RSA (government) bonds (see Special focus). We revisit and update the topic in the light of recent events.

Bonds have outperformed equities and cash by a large margin this year. By 28 October, the All Bond Index (ALBI) had delivered a total return (including interest reinvested) year-to-date of 14.2%, compared to 2.7% provided by the All Share Index (ALSI) of the JSE. The inflation-linked RSA Bond Index (ILBI) had returned 8.1% by 28 October, while the money market would have returned 6.2% over the period (though it should be appreciated that bond yields had weakened sharply in December 2015 as had the rand in response to the President Zuma-inspired turmoil in the Ministry of Finance). On a 12 month view to 28 October 2016 – from 1 November 2015 the ALBI had returned 5.5% and the ILBI 7%; while R100 invested in the JSE ALSI on 1 November would have lost value and have been worth (with dividends reinvested ) R97.2 on 28 October 2016.

The JSE, when measured in US dollars, has performed very strongly this year, increasing some 14% this year (to 28 October), in line with a similar increase in the MSCI EM Index and well ahead of the S&P 500 Index, which is up by about 4% this year (see figure 2 below).

The strength in emerging market equities has given impetus to emerging market currencies, including the rand, as more capital flowed towards emerging markets and their currencies. Less global risk aversion and the capital flows that drive the MSCI EM Index higher are generally helpful for the rand as well as for the US dollar value of the ALSI. SA-specific forces acting on the rand can be identified by the ratio of the USD/ZAR exchange rate to the USD/EM basket exchange rate as we do below. A weaker rand relative to other emerging market currencies, indicated by an increase in the ratio of the foreign exchange value of rand to other emerging market currencies, represents extra SA risks and a lower ratio, less the SA risk that is priced into the exchange value of the rand.

The performance of the rand and other emerging market currencies is shown below, as is the relative performance of the rand. All emerging market currencies weakened against the US dollar between 2012 and 2015, though rand weakness was especially pronounced by year-end 2015. The rand not only strengthened in 2016 in line with other emerging market exchange rates, but has recovered some of this relative weakness vs the emerging market basket after mid-year. As may be seen in figure 3, the ratio of the rand to the equally weighted EM currency basket declined from 1.25 at the 2015 year-end to the current ratio (31 October) of 1.1 This indicates generally less SA-specific risk in 2016 – helpful to the bond market also, as expectations of inflation recede somewhat with rand strength and long term interest rates accordingly decline.

Recent interest rate trends are shown in the figure below. Long term interest rates in SA are significantly lower than they were in January – though are still above the lows of mid-August 2016. Hence the good returns realised in the bond market to date (though it should also be appreciated that the SA risk spread, being the difference between 10 year RSA Bond yields and the US Treasury 10 year yields, rose significantly in 2015 and spiked in December when President Zuma replaced his Minister of Finance. The spread is still significantly wider than it was in 2014 and before).

This spread is now 7.01% p.a. and is also by definition the expected depreciation of the rand over the 10 year period. In other words, the rand is expected to weaken on average by 7% p.a. over the 10 years. Any greater or lesser premium in the cost of buying dollars for delivery in 10 years would provide an opportunity for riskless profits – for borrowing dollars and lending rands, or vice versa – while securing the dollars or rands for future delivery at a known exchange rate, which eliminates the risk of the exchange rate depreciating or appreciating excessively . This spread is known as the interest carry, though it is one that can only be earned or helpful to borrowers taken on debt at lower rates, when taking on exchange rate risk. If this exchange rate risk is not accepted and the currency risk is fully hedged, the cost of borrowing or lending in the one or other currency will be approximately the same.

It is of interest to recognise that weakness in the USD/ZAR exchange rate is typically associated with a widening of the interest rate spread. Or, in other words, weakness in the USD/ZAR as registered in the currency market is associated with still further weakness expected. The evidence is demonstrated below in the scatter plots – those between the level of the rand and the interest spread on a daily basis since January 2015. The correlation between the levels of these two series is 0.70. We also show a scatter of daily changes in the interest spread and daily changes in the USD/ZAR. The correlation of these daily changes is also a high 0.56 (the 10 year spread is described in figure 6 as YGAP10).



Such a relationship is not intuitively obvious. Why would more weakness in an exchange rate today be associated with still more weakness tomorrow? It might be thought that a lower price (exchange rate) today would improve the prospects of a higher price tomorrow rather than weaken its prospects? For the developed market currencies a wider spread would ordinarily be associated with improved prospects for a currency under pressure and lead to currency strength rather than weakness.

Irrespective of the forces driving exchange rate expectations, more exchange rate weakness would surely be associated with more inflation to come and the reverse: a stronger rand today associated with less inflation to come. In figure 7 below we show the strong and understandable link between the risk spread, or the expected depreciation of the rand, with inflation compensation offered in the RSA bond market. Inflation compensation is the difference between the yield on a vanilla bond and the real yield provided by an inflation-linked RSA bond of the same duration, and is a very good proxy for inflation expected in the market place.


The rand has strengthened this year in line with other emerging market currencies and has also benefitted, as we have indicated, from improved sentiment about SA political trends in recent months. The decision today to withdraw fraud charges against Minister of Finance Gordhan has added further to rand strength relative to the other emerging market currencies. Accordingly, the outlook for inflation in SA will have improved. The outlook for lower interest rates therefore will also have improved, to the advantage of JSE-listed companies with full exposure to the SA economy, that stands to benefit from lower interest rates. RSA bonds clearly also have this character.

The chances of a cyclical recovery rest with the behaviour of the rand, with inflation and inflation expected and with the interest rate responses of the SA Reserve Bank. The recent news flow has clearly improved the prospects for less inflation and faster growth for SA. These improved prospects are helpful for investors in conventional bonds and for SA economy plays, like banks and retailers that benefit from lower inflation and lower interest rates as are revealed on the JSE. Rand (SA economy) plays do well with (unexpected) rand strength. They do even better in a relative sense when rand strength can be attributed to less SA specific risk. 1 November 2016

SA Economy

The SA economy needs a level playing field

November 1st, 2016 by Brian Kantor

A key role in a growing economy is played by the start-up enterprise. They introduce new ways of doing business- supply new products and services – that challenge established business practices and so help make the economy a more productive one. They can start small but if they get it right, and execute  well they can become large and successful.

They do so by serving their customers better than the competition did or sometimes could not have imagined. They also have to satisfy the interests of their employees who could work elsewhere and they also have to meet the interests of other suppliers of services or goods to them, including those of the suppliers of capital, for which they have to compete with all other firms. Most important is that by by attracting custom and covering their costs they can provide their owner-managers with benefits and returns on their savings (capital) far superior to those they might have realised working for somebody else.

But their chances of such success are not good ones. The owner-managers of most start-ups, even most small businesses, do not realise well above average returns for their founders- ahead of what they might have earned elsewhere or from their savings plans. This means judged by past performance these true entrepreneurs are not deterred by the prospect of low average rewards but are inspired by the (small) chance of realising exceptional rewards. This makes them risk lovers rather than risk averse and society has every good reason to encourage their unusual appetite for taking on risk. And so not to impose regulations that favour the large firm. Those large enough to afford specialised human resource and legal departments that keep key managers out of the time consuming mediation procedures – and able to employ skilled accountants that can complete complicated tax and other returns.  Should it however be easy for new entrants into the market place to succeed? Easy pickings would reflect an undesirable lack of market efficiency. If the market is working well it should be difficult to beat the market.

Better than promoting or discouraging small over large or large and established firms over smaller rivals would be to ensure that all firms can contend freely and openly in the market place. The proverbial level playing feel serves the interests of all the consumers, workers and taxpayers who will always be far more numerous than the owners or senior managers or professionals who engage with them.  .

But such freedoms to compete will always be threatened by the established producers who have a large and easily measured economic interest in limiting the competition through laws and regulations favourable to them. In the old SA a minority of suppliers of goods or services enjoyed such protections. Most others, as consumers and taxpayers and workers suffered from import and capital controls and maize and banana boards etc. that put some producers and some white workers and professionals first in line for jobs to the disadvantage of their potential competitors and the customers who stood to benefit.

It needs to be recognised that the producer interests that now tilt the playing feel against consumers and workers and taxpayers in SA and against the interests of perhaps more worthy beneficiaries of government spending, are those of the owners of black businesses and skilled black professionals. They are being favoured with higher prices and rewards by affirmative action. As before it is the economic interests of a minority of producers that are being served by regulation and law. As before, the politics of such actions are easier to understand than their economic consequences. Though the low growth trap that has now caught the SA economy should concentrate minds on the costs and benefits of interfering with competition.

SA Financial Markets

Bonds vs equities, a comparison over the short and long runs

October 21st, 2016 by Brian Kantor

2016 has proven to be a very good year for investors in RSA (government) bonds. Bonds have outperformed equities and cash by a large margin this year. By 17 October, the All Bond Index (ALBI) had delivered a total return (including interest reinvested) year-to-date of 14.2%, compared to 2.7% provided by the All Share Index (ALSI) of the JSE. The inflation-linked RSA Bond Index (ILBI) had returned close to 8% by 17 October, while the money market would have returned 6.2% over the period. By contrast, an investment in the S&P 500 would have lost ground this year as we show below.

The JSE, when measured in US dollars, has performed very strongly this year, having returned close to 10%, though these returns have trailed behind the emerging market benchmark (MSCI EM) that returned 15.5% year to date-well, ahead of the 6% return provided by the S&P 500, though much of the extra return from the MSCI EM Index came in October as the rand weakened, temporarily it would now seem, in response to the fraud charge raised against Finance Minister Gordhan (See figure 2 below).

The strength in emerging market equities has given strength to emerging market currencies, including the rand, as more capital flowed towards emerging markets and their currencies. Less global risk aversion and the capital flows that drives the MSCI EM Index higher is generally helpful for the rand as well as the US dollar value of the ALSI. SA-specific forces acting on the rand can be identified by the ratio of the USD/ZAR exchange rate to the USD/EM basket exchange rate as we do below. A weaker rand relative to other emerging market currencies, indicated by an increase in the ratio of the rand to other emerging market currencies, represents extra SA risks and a lower ratio less SA risk priced into the exchange value of the rand.

The performance of the rand and other emerging market currencies is shown below, as is the relative performance of the rand. All emerging market currencies weakened against the US between 2012 and 2015, though rand weakness was especially pronounced by year end 2015. The rand not only strengthened in 2016 in line with other emerging market exchange rates, but has recovered some of this relative weakness vs the emerging market basket after mid-year. This indicates generally less SA-specific risk in 2016 – helpful to the bond market also as expectations of inflation recede somewhat with rand strength and long term interest rates accordingly decline.

Recent interest rate trends are shown in the figure below. Long term interest rates in SA are significantly lower than they were in January – though are above the lows of mid-August. Hence the good returns realised in the bond market to date.

When the rand strengthens for SA-specific reasons (less SA risk) as has been the case since mid-year, the different sectors on the JSE will react differently. In these circumstances, the global plays listed on the JSE (companies with much of their revenue and costs located outside SA) that provide investors with a hedge against a weaker the SA economy, will tend to underperform the ALSI (and vice versa when the rand weakens in response to an increase in SA-specific risks rise as was the case for much of 2015).

We show these forces at work in the figure below. The USD/ZAR gained relative to other emerging market currencies from mid-year, indicating less SA-specific risk. The global plays, represented by an equal-weighted index of 14 such stocks we describe as global consumer plays, lost ground both absolutely and relatively to the ALSI. A strong rand, for global or SA-specific reasons, is good for the SA economy and the companies dependent on it. It means less inflation and so lower short term interest rates, which in due course can be expected to encourage extra spending and borrowing by households.

This year the rand value of the global consumer plays on the JSE has been negatively affected by both the strength of the rand and the weakness of sterling. Some of the companies we describe as global consumer plays are in fact more a play on the UK consumer, as can be observed. The global consumer plays on the JSE in 2016 performed closely in line with the S&P 500 – in rands – while lagging behind the ALBI and ALSI.

This raises the important question – under which circumstances can bonds be expected to outperform equities? The US markets over the long run provide some insights in this regard. As we show below, US Treasury Bonds consistently outperformed equities through two distinct phases, during the Great Depression (when deflation afflicted the US economy between 1929 and 1938), and more recently during the near deflation and slow growth that burdened the US economy for much of the period since 2008. It would that seem slow growth, especially when accompanied by low inflation or deflation, is good for the performance of bonds relative to equities.

JSE-listed equities have provided superior returns over bonds or cash since 2000, as we show below, as would have been expected given the greater volatility of their returns. R100 invested in early 2000 with dividends reinvested in the JSE ALSI would have increased by 10.5 times by 17 October, equivalent to an annual average return of 15.8%. The same R100 invested in the less risky bond market would have multiplied by 6.7 times if committed to the Inflation Linked Bond Index (ILBI) and by 5.3 times if invested in the ALBI. These returns are equivalent to impressive average annual returns of 12.4% for the ILBI and 11.3% for the vanilla bond index, the ALBI. This is impressive when compared to consumer prices that rose 3.7 times over the period. Measured by the standard deviation of these annual returns, that were 23% for equities and 6% and 6.5%t p.a for inflation linked and vanilla bonds respectively, the bond market in SA has clearly delivered very good risk-adjusted returns both absolutely and compared to equities.

Deflation seems a very remote possibility for the SA economy. But SA inflation rates can recede, as recent history has demonstrated. Less inflation than expected, even when inflation remains at high but generally declining rates, will bring down interest rates and increase the returns on bond portfolios as the value of bonds rise. Slower SA growth rates, independent of inflation, will also tend to improve the performance of bonds compared to equities. In other words, if past performance were to be our guide, the case for a larger weight in bonds over equities in portfolios can be made on an expected combination of less inflation with slow growth. The case for equities over bonds will be made with faster growth and less inflation.

In the figures below we compare the relative performance of equities over bonds with the phases of the SA business cycle. The ALBI significantly outperformed the All Share Index during the slow growth years between 1995 and 2003. As growth took off, because inflation came down between 2004 and 2008, equities more than made up for the earlier underperformance. During the brief recession of 2008-09, bonds again outperformed, but have since lagged behind equities. However bonds have held their own with equities since 2014, as household spending and capex by firms slowed in response to more inflation and higher short term interest rates.

The relationship between the relative performance of inflation linked bonds (only indexed since 2000) is even more closely identified with the business cycle. Inflation-linked real interest rates are strongly pro-cyclical. They rise and fall with growth rates: faster growth brings increased demands for capital and so higher real rates. As we show below, equities have outperformed inflation linkers during the expansion phases of the SA business cycle and underperformed as growth slowed. These comparative returns have level pegged since 2014.

A comparison of the performance of SA bonds and equities since 2000 leads to a similar conclusion to that drawn for the US. SA equities do best with faster growth while bonds can outperform when growth slows down. Faster growth in SA can only be anticipated when the rand stabilises (or better still, strengthens) enough to hold back inflation so that interest rates can decline to stimulate more consumption spending.

More growth with less inflation will be better for equities than bonds – especially when compared to inflation linked bonds. Less inflation expected will provide very good returns from vanilla bonds – but still better returns could be expected from equities in such highly favourable economic circumstances. It will take a combination of favourable global growth trends, and so less emerging market risk, combined with less SA specific risk, to make it all possible. 21 October 2016

SA Economy

Power Play

October 13th, 2016 by Brian Kantor

A power play unfolds before our eyes. Comedy as tragedy or farce?

Prospects for the SA economy early on Tuesday 11 October had improved significantly when we learned that SA’s first two independent privately owned coal-fired power stations (IPPs) had been given the go-ahead. Foreign interest in these projects, as suppliers of the equipment and technology and of the necessary capital, was welcomingly strong. Most important, the 863MW of additional electricity is to be delivered at an agreed wholesale price of 79 and 80 cents, plus inflation.

Alas later that morning a further very troubling scene in the opera buffo that has become SA’s fiscal affairs, was played out when Public Prosecutor Shaun Abrahams announced that he was charging Finance Minister Gordhan with fraud. The economic damage caused by a weaker rand, higher borrowing costs for the state and lower values for businesses that depend on the SA economy, was immediately registered, while firms with operations mostly outside SA gained rand value. The outlook for inflation deteriorated with the weaker rand and so the possibility of lower interest rates from the Reserve Bank has receded. The income and job prospects of SA households and their willingness to spend and borrow more, essential to any cyclical recovery in SA, has been undermined accordingly as has the willingness of SA business to invest more in meeting their demands and employment needs. Many billions, incalculable billions of lost economic opportunity, will have followed. Those responsible cannot possibly count the damage they cause.

The two announcements however are linked – perhaps in a way that can still produce a happy ending. Can we doubt that the fiscal power play has much to do with the prospect of nuclear power as opposed to power from coal or gas? The deal for nuclear energy, details of which are awaited and are to be reluctantly supplied, and about which the Treasury has had its serious reservations made well known, will be on a scale well beyond impressive sums now to be invested in additional coal fired capacity. Business Day referred to R40bn per private IPP. Capturing a chunk of this nuclear deal from the people of South Africa at the expense of their living standards is seemingly well worth fighting for.

The problem for advocates of nuclear power in SA, well intentioned or perhaps not, is the firm offer of 80 cents per kilo watt hour from the new IPPs. We have a strong recent indication of just how expensive nuclear power can be. Britain has just given the go ahead for the nuclear Hinkley Point Power Plant, that plans to deliver 3200MW of power at a “strike price” of, believe it or not, £95.5 per MW plus inflation after 2012, that is at current exchange rates only roughly, since these rates move around so much, the equivalent of R1660 per MW, or equally roughly twice the price tendered by the IPPs. The wholesale electricity price in the UK is now much lower, about £45 per MW leading the National Audit Office to estimate that electricity consumers in the UK having to spend an extra £29.7bn for the benefit. Similar calculations of cost per hour and extra spend that will have to be charged to pay for nuclear in SA cannot be denied. They have to inform the process.

There is a more important lesson to be learned about the business of capturing the state from the citizens who pay for the state and its failures – intentional or not. The opportunity for corrupting the state is only as big as the state itself. There is no good technical reason to place airlines, electricity or water production, ports and railways, toll roads, hospitals and schools in the hands of the state. The reason why the state as supplier, rather than private producers, is so strongly supported by the politicians, is because they can so easily be captured by the suppliers of all kinds to these organisations, at the cost of the consumers of the essential services and the taxpayers who pay for them. South Africans watching the stage unfold might wise up to these facts of life.

Monetary Policy

Sending in the helicopters – monetary and fiscal policy in the developed world and SA

October 3rd, 2016 by Brian Kantor

The term “helicopter money” has gained currency among economists and policymakers in recent times. We discuss the practical implications of this policy tool and contrast the challenges faced by developed markets with those of SA

After several years of quantitative easing (QE) – the process whereby the central bank buys up assets like government bonds in order to inject cash into the monetary system – the developed world has found that, while outright disaster may have been averted, it has not delivered the robust growth that was hoped for.

Economists and policymakers are now considering other stimulatory tools, including fiscal measures and “helicopter money” to lift developed market economies out of the apparent quagmire of very low growth.

The notion (metaphor) of helicopter money (also known as “QE for the people”) was first invoked by the foremost monetarist Milton Friedman and revived by Ben Bernanke, later chairman of the US Federal Reserve (Fed), to indicate how central banks might overcome a theoretical possibility that has become a very real problem for central bankers today.

The metaphor was derived from a parable in Friedman’s famous 1969 paper “The Optimum Quantity of Money”:

Let us suppose now that one day a helicopter flies over this community and drops an additional $1,000 in bills from the sky, which is, of course, hastily collected by members of the community. Let us suppose further that everyone is convinced that this is a unique event which will never be repeated.

The idea was picked up in subsequent years by others, including Bernanke, who noted in 2002 (while still a Fed governor) while speaking about deflation in Japan, how John Maynard Keynes “once semi-seriously proposed, as an anti-deflationary measure, that the government fill bottles with currency and bury them in mine shafts to be dug up by the public”. Bernanke added that “a money-financed tax cut is essentially equivalent to Milton Friedman’s famous ‘helicopter drop’ of money.”

The concept has gained further currency in recent years in the light of extremely low inflation in many developed economies. In this article, we look at some of the implications and practicalities of such measures and then contrast this with the policy approach that has been used in SA. First however, some context on the policy of QE that has become the mainstay for central banks in the developed world over the last eight years or so.

A question of QE

Central banks of the US, Europe and Japan, have created vast quantities of extra money in recent years through QE, quantities that would have been unimaginable before the Global Financial Crisis of 2008. Unfortunately, these have been bottled up in the banks who have held on to the extra cash received rather than used it to make loans that would have helped their economies along.

The cash was received by the banks or their customers from the central banks in exchange for government bonds and other securities bought from them in the credit markets and directly from the banks themselves. The cash shows up as extra deposits held by private deposit taking banks with their central banks – the bankers to the banks. This process of QE has led to the creation of trillions of dollars, euros or other currencies of extra assets held by central banks – matched by an equal growth in their liabilities, mostly to the banking system in the form of these extra deposits (see below).

Source: Federal Reserve Bank – Recent Balance Sheet Trends

Figure 2: Federal Reserve System of the US: Total assets and composition of assets

Source: Federal Reserve Bank – Recent Balance Sheet Trends

But why did these central banks create the extra cash in such extraordinary magnitude? In the US it was to rescue the banking and insurance systems from collapse in the face of their losses incurred in the debt markets following the failure of a leading bank, Lehman Brothers, that might have brought down the financial system with it. In Europe it was to prevent a meltdown in the market for most European government debt that could have brought down all lenders to government – not only banks but pension funds and insurance companies and their dependents. In Switzerland the cash came from purchases by the central bank of dollars and euros that flooded into the Swiss banking system and would otherwise have driven the Swiss franc even stronger than it has become. In Japan the extra cash was designed to offset the recessionary and deflationary forces long plaguing the economy.

The original purpose of QE in the US and Europe was to prevent a financial collapse. The second related reason was to fight recession and deflation. Extra money and the lower interest rates accompanying it are meant to encourage extra spending and lending. Extra money and lower interest rates usually do this to an economy – stimulate demand. Usually with extra demand comes higher prices and inflation.

The banks receive the extra cash directly from the central bank in exchange for the securities previously held on their own balance sheets or they may receive the extra central bank cash, with the deposits made by their clients when banking the proceeds of their own asset sales. Their clients deposit the cheques or, more likely, EFTs issued by the central bank in their private banking accounts and the banks then receive an equivalent credit on their own deposit accounts with the central bank as the cheques on the central bank are cleared or the EFTs are given electronic effect. And so in this way, through asset purchases by the central bank acting on its own initiative, extra central bank money enters the financial system, a permanent increase that can only be reversed when the central bank sells down the securities it has bought.

The banks have an option to hold the extra cash rather than lend it out to firms or households, who would ordinarily spend the cash so made available. And banks in the US, Japan, the Eurozone, UK and Switzerland have done just this in an extreme way. They are holding the extra cash supplied to them by their central banks as additional cash reserves, way in excess of the requirement to hold them.

The US money base shown below is the sum of currency and bank deposits (adjusted for reserve requirements) held with the central bank. Note how the US money base has grown in line with excess reserves held by the Fed and the extraordinary growth in the deposits held by Swiss banks with the Swiss National Bank.

Figure 4: Adjusted monetary base of the US

Figure 5: Excess reserves of US depository institutions

Figure 6: Swiss monetary base

Bringing in the helicopters

It’s here where the call comes in for metaphorical helicopters to bypass the banking system and jettison bundles of cash that people would pick up gratefully and spend on goods and services, so reviving a stagnant economy (stagnant for want of enough demand, not for want of potential output and employment that is the usual economic problem).

But will the helicopters come in the form imagined by Friedman, Bernanke and others? In reality they are likely to take a different form. They will have to be ordered by governments and budgeted for in Congresses or Parliaments. Central banks can buy assets in the financial markets and directly from banks. They cannot order up government spending that they can help fund. That is the job of governments, who decide how much to spend and how to fund it. Governments can fund spending by taxing their citizenry, which means they (the citizens) will have less to spend. This is never very popular with voters. They can also fund government spending by genuine borrowing in the market place – competing with other potential borrowers – crowding them out by offering market-related interest rates and other terms to lenders. Or they can fund their expenditure by calling on the central bank for loans that, as a government agency, they cannot easily refuse to do.

In taking up the securities offered to them by the government, the central bank credits the deposit accounts of the government and its agencies with the central bank to the same (nominal) value as the debt offered in exchange. Both the assets and deposit liabilities of the central bank then increase by the same sum, as the extra debt is bought by the central banks and the government deposit credited. As the government agencies write cheques on their deposit account – or do the EFTs on them – the government deposit runs down and the deposits of the private banks with the central bank run up. In this way, the supply of cash held by the private sector increases, just as it does in the case of QE.

And the private banks and their customers will have the same choice about what to do with the extra cash held on their own balance sheets. Spend more, lend more or pay back debts or hold the extra cash, as they have largely been doing.

But there is an important difference when the money is created to fund extra government spending. Spending by government on goods, services or labour (or perhaps welfare grants) will have increased, so directly adding to aggregate spending. By spending more, the revenues of business suppliers and the incomes of households will have risen with their extra money balances received for their services or benefits. This makes it more likely that they will spend at least some of their extra income, generating what is known in economics as a multiplier effect. This is why spending by government can be highly inflationary, as it was in the Weimar Republic of Germany after World War 1 or as it was in Zimbabwe not so long ago or as it is now driving prices higher in Venezuela.

But the current danger in the West is deflation, the result of too little, rather than too much spending. Inflation seems very far away, as revealed by the very low or even negative interest rates offered by a number of governments (in the form of negative yields on government debt) to willing lenders for extended periods of time. For some governments, issuing debt – at negative interest rates that produces an income for the government – is cheaper than issuing cash, that is the non-interest bearing debt of the government and usually the cheapest method for funding its expenditure. How can they resist the temptation to generate government income by issuing more debt for an extended period of time? Not easily, we would suggest.

The continued weakness of developed economies suffering from a lack of demand, despite low interest rates, calls for money and debt – or money creation by governments. The call for less austerity or more government spending relative to taxes collected, is being heard in Japan. It is a voice being sounded loud and clear in post-Brexit Britain. The Italians are very anxious to use government money to revive their own failed banking system. The Germans, with their own particular Weimar inflation demons, will however resist the idea of central banks directly funding governments, but for how long? Hillary Clinton promises spending on infrastructure. Donald Trump worries little about debt of all kinds – including his own (for now, as far as we can tell).

How long can weak economies co-exist with very low interest rates and abundant supplies of cash? It will not take helicopters but unhappy voters to stimulate more government spending, funded with cheap debt or cash. And the voters appear particularly restless on both sides of the Atlantic and, for that matter, the Mediterranean. The next few years promise to be intriguing ones for the governments and electorates of these countries.

Meanwhile in SA – a different world

At this point it is worthwhile to compare and contrast policy actions in the developed world with those in SA. The Reserve Bank (the Bank) has not practised QE. By contrast, SA banks, rather than being inundated with cash and excess reserves, have been kept consistently short of cash in support of the interest rate settings of the Bank. SA banks borrow cash from the Bank rather than hold excess cash reserves with it.

SA banks do not therefore hold reserves in the form of deposits at the central bank in excess of the reserves they are required to hold. As may be seen in the figures below, by contrast with their developed world counterparts, the SA banks are kept short of cash through liquidity absorbing operations by the Bank and, more importantly, by the SA National Treasury.

Also to be noted is the liquidity provided consistently to the banking system by the Bank in the form of repurchases of assets from them as well as loans against reserve deposits. Rather than holding excess reserves over required cash reserves, the SA banks consistently borrow cash from the Bank to satisfy their regulated liquidity requirements.

It is these loans to the banking system that give the Bank its full authority over short-term interest rates. The repo rate, at which it makes cash available to the banks, is the lowest rate in the money market from which all other short-term interest rates take their cue. Keeping the banks short of cash ensures that changes in the policy-determined repo rate is made effective in the money market – that is, all other rates will automatically follow the repo rate because the banks are kept short of cash and borrow reserves rather than hold excess cash reserves.

In the US, the Fed pays interest on the deposit reserves banks hold with the Fed. The European Central Bank (ECB), for its part, applies a negative rate to the reserves banks hold with it. In other words, Eurozone banks have to pay rather than receive interest on the balances they keep with the ECB as an inducement to them to lend rather than hoard the cash they receive via QE.

The cash reserves the SA banks acquire originate mostly through the balance of payments flows. Notice in the figure below that the assets of the Bank are almost entirely foreign assets. Direct holdings of government securities are minimal, as reflected on the Bank balance sheet. When the balance of payments (BOP) flows are positive, the Bank can add to its foreign assets and when they are negative, run them down. The Bank buys foreign exchange in the currency market from the private banks (and credits their deposit accounts with the Bank accordingly) or sells foreign exchange to them and then calls on their deposit accounts with the Bank for payment.

Thus, when the BOP flows are favourable, the Bank may be adding to its foreign assets and so to the foreign exchange reserves of SA via generally anonymous operations in the foreign exchange market. In so doing, it is acting as a residual buyer or seller of foreign exchange and, as such, will be preventing exchange rate changes from balancing the supply and demand. With a fully flexible exchange rate, no changes in foreign exchange reserves would be observed, only equilibrating movements in exchange rates. The exchange rate will strengthen or weaken to equalise supply and demand for US dollars or other currencies on any one trading day without causing any change in the supply of cash, that is in the sum of bank deposits held with the Bank.

The foreign assets on the Bank balance sheet have however increased consistently over the years as we show in the figure below. Hence influence of the BOP on the money base (on the cash reserves of the banks) has been a strongly positive one.

Without intervention in the money market, these purchases of foreign exchange by the Bank would automatically lead to an equal increase in the cash reserves of the banking system. Their deposits at the Bank would automatically reflect larger deposit balances as foreign exchange is acquired from them and their clients. This source of cash however has been offset by SA National Treasury operations in the money and securities markets.

To sterilise the potential increase in the money base of the system (defined as notes plus bank deposits at the central banks less required reserves) the Treasury issues more debt to the capital market. The debt is sold to the banks and their customers – they draw on their deposits to pay for the extra issues of debt – and the Treasury keeps the extra proceeds on its own government deposit account with the Bank. Provided these extra government deposits are held and not spent by the Treasury – as is the policy intention – the BOP effects on the money base (on bank deposits or reserves) will have been neutralised by increases in government deposits. (The money base only includes bank deposits with the Reserve Bank. Government deposits are not part of the money base.)

It is to be noted in the figure representing Reserve Bank Liabilities, how the Government Deposits with the Reserve Bank have grown as the Foreign Assets of the Bank have increased – extra liabilities for the Reserve Bank offsetting extra foreign assets held by the Bank. It is of interest to note that about half of the Treasury deposits at the Reserve Bank are denominated in foreign currencies.

Figure 7: SA Reserve Bank balance sheet: Assets

Source: SA Reserve Bank and Investec Wealth & Investment

Figure 8: SA Reserve Bank: Selected liabilities

Source: SA Reserve Bank and Investec Wealth & Investment

The net effect of recent activity in the money market has meant much slower growth in the supply of cash and deposits with the banking system. Despite the accumulation of foreign exchange reserves and because of the sterilisation operations undertaken by the Treasury, the money base in SA has grown relatively slowly, as have the broader measures of the money supply, M2 or M3, that incorporate almost all of the deposit liabilities of the banks to their creditors. This has been matched by equally slow growth in the supply of and demand for bank credit that makes up much of the asset side of bank balance sheets. This slow growth has been entirely consistent with weak growth in aggregate spending and GDP. Compare and contrast this with how rapidly money and credit grew in the boom years of 2004-2008 (see below).

Figure 9: Growth in SA money base (adjusted for reserve requirements) and broadly defined money supply (M3)

Source: SA Reserve Bank and Investec Wealth & Investment

Figure 10: Growth in S money supply (M3) and bank credit and direction of the business cycle

Source: SA Reserve Bank and Investec Wealth & Investment

The shortcomings of SA monetary policy

One test of monetary policy is its ability to moderate the amplitude of the business cycle. The strength of the boom between 2004 and 2008 and the subsequent collapse – and the persistently slow growth in money credit and spending after 2011 – indicates that monetary policy in SA has not been notably counter-cyclical. Nor can it claim much success in limiting inflation even as growth in aggregate spending (Gross Domestic Expenditure – GDE) and output (Gross Domestic Product – GDP) has remained very depressed.

Economic activity picked up when inflation subsided between 2003 and 2005, because the exchange value of the rand recovered strongly and because interest rates declined with less inflation. The SA economy enjoyed boom time conditions between 2004 and 2007. The interest rate cycle turned higher in 2006, well before the Global Financial Crisis broke in September 2008 and yet was accompanied by rand weakness. Inflation accelerated in 2006-7 as the exchange rate weakened and inflation rates remained high as exchange rate weakness persisted until early 2009. Lower interest rates followed a rand recovery in 2009 and lower inflation rates that continued until mid-2010. Interest rates were stable to marginally lower until the end of 2013, but reversed course in early 2014 after inflation picked up and came to threaten the upper band of the inflation targets set for the Reserve Bank. This higher inflation followed the high degree of rand weakness after 2011 that was linked (mostly) to global risk aversion and lesser flows to emerging market bonds and equities. This rand weakness persisted until May 2016 as the economy slowed down markedly under the influence of higher prices and higher interest rates. These higher interest rates further weakened demand that was already under pressure from higher prices, without appearing to do anything to slow down inflation. Inflation continued to tack its cue from a persistently weaker rand, while a drought and higher prices for staple foods added materially to measured inflation in 2015-2016.

These dilemmas for a monetary policy that attempts to meet inflation targets, without regard to the causes of inflation – the result of fewer goods and services supplied rather than more demanded – has meant having to sacrifice growth without reducing inflation. Such unfortunate trade-offs for monetary policy – achieving slower growth yet accompanied by more inflation – will persist if exchange rate changes remain largely driven by global forces or other supply side shocks. These include drought or higher expenditure taxes, to which the Bank has responded with higher interest rates regardless of the causes of inflation. For the history of inflation, interest and exchange rates since 2000, see the figure below that identifies the phases of higher and lower interest rates.

Figure 11: Interest rates, inflation rates and the trade weighted rand (2000-2016)

Source: SA Reserve Bank and Investec Wealth & Investment

The recovery in the rand over the last few months offers the hope of a cyclical recovery, similar to events after 2003 – though should it materialise it is unlikely to be of the same strong amplitude. The stronger rand brings less inflation in its wake, as would any normal harvest. Less inflation means less inflation expected and a much improved chance of interest rates falling rather than rising, as they have been doing since January 2014.

Corporate Finance

Lessons from Edcon

September 27th, 2016 by Brian Kantor

The Edcon story – was it a failure of capital structure or of management? Or a bit of both?

Bain and Company, a private equity fund, has thrown in the towel on its involvement with Edcon, a private company that it has owned and controlled since 2007. When it took over, it immediately converted the equity stake it had acquired from Edcon shareholders for some R25bn (with almost no long term debt on the Edcon balance sheet) into additional Edcon debt of some R24bn, with some additional finance of about R5bn provided as loans from its controlling shareholders. It has now reversed this transaction, converting the considerable outstanding debts of Edcon back into equity. Edcon is the owner and manager of Edgars, a leading clothing retailer as well of other retail brands, including CNA and Boardmans.

The 2008 balance sheet reported total Edcon assets of R38.1bn, up from R9.5bn the year before. Much of the these extra assets were created by writing up the intangible assets, including goodwill, that Bain had paid up for and raised Edcon debt against. The cash flow statement for 2008 reports “investments to expand operations: R24.4bn”. This was a euphemism – the cash was patently used to reconstruct the balance sheet, not to expand operations.

More important for the new shareholders than the description in its financial reports, it failed to persuade the SA Revenue Service (SARS) that the extra borrowing was undertaken to produce extra income. As a result, Edcon continued to have to use some of the cash it was generating from operations to pay significant amounts of tax as well as the interest it was committed to paying. In the early period, the 47 weeks to 29 March 2008, it paid cash taxes of R246m. And despite the fact that large ongoing accounting losses that were incurred as interest expenses greatly exceeded trading profits, it continued to deliver cash to SARS at the rate of over R100m per annum. More recently, according to the cash flow statement in the 13 weeks to 26 December 2015, cash taxes paid amounted to R32m.

This appears as a large mistake when Edcon was originally reconstructed. Presumably, had Bain registered a new company to buy out the Edcon assets from its shareholders and this company had then funded the purchase with debt, the interest expense would have been allowed as incurred in the production of income. And the consequent losses could have been carried forward to offset future income and to raise the current value of the company.

Much of this debt was to mature in 2014-15 (a commitment that Edcon was unable to fulfil) as was long apparent and well-reflected in the much diminished market value of its debt that traded on global markets. It will be appreciated that the Edcon financial losses have mostly been incurred by its creditors, not by Bain and Company. The statement of Edcon’s financial position in December 2015 reports a shareholders’ loan of R828m, well down from the more than R5bn recorded in 2008. Clearly Bain and its co-shareholders have walked away with nothing to show for their efforts. The company is by all accounts now worth less than was paid for it in 2008.

In the charts below we convert the 71% of Edcon euro debt it incurred into rands at current exchange rates. In January 2008 a euro cost R11.12. As may be seen, the rand value of this euro debt is now significantly higher than it was in early 2008. But the rand value of this original debt had actually fallen significantly by 2010, providing an opportunity to restructure the debt with profit that apparently was ignored.

And if the burden of this euro debt burden was dragging down the operating performance of the retail operations (denied essential working and other capital, as it has been argued by management) then there was ample opportunity surely to add more equity capital with which to compete with the competition. And the competition has been doing very well, partly at Edcon’s expense, as measured by value of the General Retail Index of the JSE.

We have rebased this index and the retailers’ dividend per share to January 2008. We have also converted these additional rand values into euros at current values. As may be seen, the share market backdrop for clothing retailers and their ilk on the JSE was encouraging, but more so in rands than in euros (until very recently) with its combination of weaker retail share prices and a weaker rand. It seems clear that had Edcon operated in line with its competition, it could have added value for its shareholders and its debt, particularly had it been converted to rand debt (which would have been manageable).


With the agreement of its creditors, who now own all of the shares in Edcon in exchange for cancelling its loans, and with new debt raised of about R6bn, Edcon can continue to operate normally, much to the relief of it managers, workers and landlords. The horrors of business rescue have thus been averted, to the presumed advantage of its creditors and its future prospects. Given that Edcon continues to realise significant trading profits, it makes every sense for it to stay in business to deliver value for its new shareholders. For the third quarter of F2016 Edcon reported a trading profit of R763m and depreciation and amortisation of R248m, making for cash flows from operations of over R1bm for the quarter (though down by 7.7% on Q3 of F2015). Net financing costs of R958m for Q3 F2016 were also reported, 10% higher than Q3 in F2015. Coincidentally the debt on the Edcon balance sheet of F2016 was of about the same rand book value of about R22bn it reported in F2007. Its euro value, as may be seen, is considerably lower.

Bain and its funders clearly failed to realise the prospective gains they envisaged when they geared up the Edcon balance sheet. The potential rewards to the owners of the much reduced equity capital were potentially very large had the company proved able to service its debts. On returning to public company status, the possibly R5bn of equity finance provided might have doubled in value had the market value of the company gained an additional R10bn of value over the 10 years.

To put it another way: had Edcon performed as well as the average general retailer did on the JSE over the period, these gains would have been realised. But the average JSE-listed clothing retailer was not encumbered by nearly as much debt, particularly the 71% of its debt denominated in euros. This appears as the major original strategic error made by Bain to which it never made the adjustment. Combining rand revenues that Edcon would generate, with hard currency debt, represents a highly risky strategy. Perhaps the SA debt market would not have been willing to subscribe the large amount of the extra debt raised. But there was surely always the opportunity to fully hedge the foreign currency risk. But this would have meant paying interest at a South African rather than a euro or dollar rate, a cost that, had it been incurred, may well have (correctly perhaps with hindsight) undermined the investment case for a highly leveraged play on the SA retail market.

The Edcon experience has unfortunately not been able to add to the case for private equity over the public equity alternative in SA, that is to say, to use public money to take a (large) listed company private. The case for private equity is not based on its superior financial structure of more debt and less equity, though clearly the leverage adds greatly to the potential returns for equity holders (assuming all turns out well for the company). Moreover, the conversion of a public company to a private one, through private equity funds, or more or less the same thing, through a management buyout, may not be possible without significant reliance on debt finance. The case for private equity is that the few shareholders with much to gain and lose have every incentive to closely and better manage their stake in the company. They will be very active shareholders with highly concentrated investments, unlike those of the average listed company with wider stakeholders, as opposed to shareholder interests, to serve. The large publicly funded private company represents therefore a very helpful competitive threat to the public company, from which shareholders (including pension funds) the economy and its growth prospects can benefit.

It is thus no accident that the number of companies listed on all the US stock exchanges has declined dramatically over recent years, by between 40% and 60% over the past 25 years according to different estimates, as pension funds and endowments have increased their allocations to alternative investments and especially to private equity funds. Private companies may well, on a balance of full considerations, serve their owners better than public companies.

The competitive threat therefore should be encouraged and not discouraged (including by SARS). The objective of tax policies should be much wider than merely protecting the tax base. Private equity, by adding to the growth potential of an economy and especially adding to the willingness of the system to bear additional risks for the prospect of additional returns, deserves no less or more than equal tax treatment.

For its errors of commission and omission, Bain and the managers it chose for Edcon, were unable to improve its operating performance. How much this equity is now worth is a matter of conjecture that can only be resolved when, as is the intention, these Edcon shares are re-listed on the JSE. The sooner the current Edcon shareholders get to know what their shares are worth, surely the better and the sooner the shares can be listed and so could pass into the hands of perhaps more active investors, the better the company can be expected to perform. 27 September 2016