A shorter version of this essay was published in the Financial Mail (Special Edition 1959-2019) October 24th– October 30th 2019
A full version is available here: Understanding the past and future of the rand
The dangers of a divided world of inflation expectations
Developed and emerging markets have very different expectations of inflation. The monetary authorities should think carefully about the consequences of austerity
The developed world is much agitated by very low interest rates. Rates are so low that it is hard to imagine them declining further, so emasculating monetary policy.
Interest rates reflect a relative abundance of global savings. Hence inflation (prices rise when demands exceed available supplies) is confidently expected to remain at these very low rates. Interest rates accordingly offer compensation for expected inflation. The US bond market only offers an extra 1.56% annually for bearing inflation risks over the next 10 years (see figure below).
The US Treasury bond market (10 year yields) 
Deflation or generally falling prices, have rather become a threat to economic stability. When prices are expected to fall and interest rates offer no reward to lenders, cash (literally hoarding notes and coin) may be a desirable option. If prices are to be lower in six months than they are today, it may make sense for firms and households to postpone spending, including on hiring labour. Hence even less spent and more saved, compounding the slow growth issue.
An economy-wide unwillingness to demand more stuff is not a normal state of economic affairs. If demand is lacking, resources – land, labour and capital – become idle. In these unwelcome circumstances a government and its central bank can always stimulate more spending, including its own, without any real cost to taxpayers or economic trade-offs. More demand means no less supplied – therefore no output or income will be lost and more will be forthcoming, should demand catch up with potential supply.
Most simply, spending can be encouraged without limit by handing out money or jettisoning cash from the proverbial helicopter. For a government to be able to borrow for 30 years at very low interest rates is as inexpensive a funding method as printing money.
One can confidently expect unorthodox experiments in stimulating demand – should the developed economies continue to grow very slowly – and interest rates and inflation to remain at very low levels until growth and inflation picks up. Cutting taxes and funding a temporarily enlarged fiscal deficit with money or loans is another (better) option.
Quantitative easing (QE), the process whereby central banks create money to buy government bonds on a very large scale, mostly from banks, was highly unorthodox when first introduced to overcome the Global Financial Crisis of 2009. QE prevented the banks from running out of cash and defaulting on their deposit liabilities, thus preventing the destruction of the payments system that banks provide. But the banks, when selling bonds to their central banks, mostly substituted deposits at the central bank for previously held Treasury Bills and bonds. Bond holdings went down while deposits held by banks with the central bank went up by similar amounts.
The banks did not (much) turn their extra cash into loans. It would have been more of a stimulus to spending had the central banks purchased assets from the customers of banks (retirement funds and their like) rather than the banks. Had they done more of this, the deposits of the banks as well as the cash of the banks would have increased immediately. The growth in bank credit and bank deposit liabilities has remained very modest, especially in Europe, though the recent pick-up in growth in bank loans is noteworthy. Hence the persistently slow growth in spending in Europe.
Growth in bank loans in the US and Europe
Source: Thomson-Reuters, Federal Reserve Bank of St Louis and Investec Wealth & Investment
While the developed world struggles with low interest rates and subdued inflation and expectations of inflation, the world of emerging markets present very differently. Interest rates remain persistently high, with elevated expectations of inflation (and exchange rate weakness) to come. Accordingly, interest rates, after adjusting for realised inflation, remain at high levels as do inflation protected interest rates.
South African financial markets have continued to perform very much in line with other emerging financial markets. The JSE All Share Index gained about 2.6% in US dollar terms in 2019 (to 11 October) while the MSCI Emerging Market Index was up by 4.7% – both distinct underperformers when compared to the S&P 500, which was up by over 18% over the same period. The rand and emerging market currency basket had both lost about the same 2% against the US dollar over the same period (see figures below).
The USD/ZAR and the USD/emerging market currency exchange rates in 2019
Source: Bloomberg and Investec Wealth & Investment
The JSE and the emerging market equity benchmark in US dollars
Source: Bloomberg and Investec Wealth & Investment
On the interest rate front, emerging market local currency bond yields remain elevated – above 6% per annum on average for 10 year bonds. While the average emerging market bond yield has edged lower in 2019, SA bond yields have moved higher this year (see figure below). The market in SA bonds is factoring in more rather inflation and a still weaker USD/ZAR exchange rate. Unlike in the developed world, the cost of capital, that is the required rates of real return to justify expenditure on additional plant and equipment, remains elevated in SA. This means a continued discouragement to such expenditure and is negative for the growth outlook.
SA and emerging market bond yields (10 year)
Source: Thomson-Reuters, Federal Reserve Bank of St Louis and Investec Wealth & Investment
Capital remains very expensive for SA borrowers and growth rates remain subdued.
Interest rates and spreads in the SA bond market
Source: Bloomberg and Investec Wealth & Investment
A combination of more inflation expected with less inflation realised, because demand has been so subdued, has been toxic medicine for the SA economy. As in the developed world, the slack in the SA economy calls for stimulation from lower interest rates. And, unlike the developed there is ample scope for traditional monetary policy – in the form of rate cuts.
The inflation expected of the SA economy reflects the well-understood dangers of a debt trap and that the SA economy will print sometime in the future print money to escape its consequences. Yet fighting these expectations, which have nothing to do with monetary policy, with austere monetary policy makes no sense at all. Rather it means more economic slack, less growth, a larger fiscal deficit and enhanced inflationary expectations. Eliminating slack with lower short-term interest rates would do the opposite.
Earning profits, not acting like governments, remains the central task of business
One of my pleasures is to listen in conference to the accounts of great business enterprises, as told by their CEO’s and CFO’s. They seldom fail to impress with their grasp of the essentials of business success in a complex world. One that always contains the threat of competition from close rivals and even more dangerous the disruption of their business models and their relationship with customers from quarters previously unknown. They are in it for the long run – not the approval of the stock market over the next few months. Short termism does not make for business success.
They sense the growing opportunity data collection and analysis offers to produce distribute and market their goods and services more efficiently. To scale the advantages of their intellectual property and culture, they must have global reach that inevitably includes managing successfully in China, with all its opportunities challenges and trade-offs. They are well aware of meeting the demands society and its governments may make on them for them to be able operate legitimately. They know they have to play by rules over which may have little influence.
And one senses from them a new urgency about a more disciplined approach to the management of shareholders capital. Business success and the performance of managers is increasingly measured by (internal) returns on capital employed, properly calibrated, that adds value for investors by exceeding the returns they could expect from the capital market with similar risks.
The business corporation is the key agency of a modern economy. The success of the developed world in raising output and incomes – improving consistently the standard of living is surely attributable in large part to the design that accords so much responsibility to businesses large and small. The improvement in the average standard of living, and of those of the least advantaged of the bottom quartile of the income distribution (helped by tax payer provided welfare benefits) in what we define as the developed world has been at a historically unprecedented rate over the last 70 years or so. While the rate of economic improvement may have slowed down in the past twenty or ten years it sustains an impressive clip. Over the past 20 years GDP per capita in constant purchasing power parity terms in the largest seven economies (G7) as calculated by the IMF has grown by a compound average 2.8% p.a. Over the past 10 years this growth rate has slowed only marginally to an average of 2.7% p.a. A rate rapid enough to double average per capita incomes every 26 years or so.
One might have thought that the proven capabilities and potential of the modern business enterprise would enjoy wide appreciation and respect. That is for its ability to deliver a growing abundance of goods and services that their customers choose, many of which thanks to innovations and inventions sponsored and nurtured by business that were unavailable or inconceivable to earlier generations. In so doing to provide well rewarded employment opportunities to so many and to provide a good return to their providers of capital – both debt and share capital. A large majority of whom, directly and indirectly, are not rich plutocrats but are the many millions of beneficiaries of savings plans, upon which they rely for a dignified retirement.
But this is not the case at all. Even for the commentators in the leading business publications who present a view of the modern economy and its dependence on the corporation as in deep crisis. A sense of grave economic crisis that given the much improved state of the global economy and of the role corporations play in it that is very hard to share for the reasons advanced.
For example Martin Wolf in an op-ed in the Financial Times (September 18 2019) Why rigged capitalism is damaging liberal democracy Economies are not delivering for most citizens because of weak competition, feeble productivity growth and tax loopholes
To quote Wolf’s conclusion on the reformed role of the corporation
“……They must, not least, consider their activities in the public arena. What are they doing to ensure better laws governing the structure of the corporation, a fair and effective tax system, a safety net for those afflicted by economic forces beyond their control, a healthy local and global environment and a democracy responsive to the wishes of a broad majority? We need a dynamic capitalist economy that gives everybody a justified belief that they can share in the benefits. What we increasingly seem to have instead is an unstable rentier capitalism, weakened competition, feeble productivity growth, high inequality and, not coincidentally, an increasingly degraded democracy. Fixing this is a challenge for us all, but especially for those who run the world’s most important businesses. The way our economic and political systems work must change, or they will perish.”
However much you might or might not share this view of the corporation, a state of being that is not at all apparent in the accounts of the threats and opportunities provided by business leaders- or in their actions as suggested earlier. Particularly when they are seen as rentiers given some guaranteed source of income provided by a conspiracy of protection against competitive threats. You might agree that he would have the leaders of the large modern corporation accept much greater responsibilities for the (apparently) failing human condition – responsibilities that are surely the essential purview of government. It is to ask corporations to achieve much more than they are at all capable of achieving to the satisfaction of society at large. It is to set them up for failure and to threaten the essential role given to them by society
The bad news- it takes a weak rand to keep South Africans at home. There is a better way to attract capital- human and financial
What inflation adds by way of higher prices, revenues or incomes, weaker exchange rates can be expected to reduce their value abroad. If the move in exchange rates was equal to the difference in inflation rates between SA and its foreign trading partners, the different fields on which we work or play across the globe would be a level one.
Clearly economic life does not work that way. Our rands almost always have bought us more at home than they do abroad – when exchanged at the prevailing exchange rates. The difference between what our rands can buy at home or abroad can be calculated as the difference between the market rate of exchange and its purchasing power equivalent, as determined by the differences in inflation rates.
Since December 2010, when a US dollar cost R6.61, consumer prices in SA have increased on average by 58%. In the US average prices were up by a mere 16% over the same period. If the USD/ZAR had moved strictly in line with the changing ratio of consumer prices in the two economies (168/116 or 1.36) the dollar would have moved from 6.61 rands to 9 rands for a dollar in August 2019. (9/6.61 =136) A weaker exchange rate of 9 rands to the US dollar would have levelled the playing field. (see chart below)
2010 is a good starting point for such a calculation. The rand then was very close to its PPP equivalent were you to use 1995 as a starting point for the calculation. It was in 1995 that the rand became subject to largely unrestrained capital flows. Until then the (commercial) rand traded consistently close to its purchasing power value
The reality is that exchange rates are determined by forces that may have very little to do with actual price changes in the markets for goods and services. They move in response to global capital flows between economies that can dominate the flows of currency rather than to the flows of exports and imports that are price sensitive to a degree.
As a particular economy becomes more risky capital tends to flow away and exchange rates weaken and interest rates rise to balance supply and demand for the local currency. And if the shocks to the exchange rates are sustained, the inflation rate will respond as the prices paid for imported and exported goods in the local currency, increase or decrease- but with a time lag. This time lag determines the degree to which exchange rates diverge from PPP. The exchange rate leads and inflation follows – not the other way round – as theory might have had it. And convergence to purchasing power equivalent may take a long time.
Converting your SA wealth or incomes from rands into the equivalent purchasing power in the US at August month end would therefore have required the following adjustment. That is to reduce the 6.6 dollars received for R100 at market exchange rates by about 60%. This being the ratio 9/15.2 Having to pay only nine rand for a dollar would have been enough to net out the inflation impact. Rather than the R15.2 you actually had to give up for an extra dollar to spend in New York. (9/15.2*6.6 =3.9)
Thus any R100 of spending power in SA would have provided the equivalent of less than 4 dollars of roughly equivalent spending power in the US. Or in other words what would be regarded as a substantial fortune of R100m in SA would have provided a mere 4 million dollars of buying power in the US. Perhaps not enough to live well – or not nearly as well – as you could live in SA off your capital.
Consumer prices in SA and the USA and exchange rates (2010-2019)
Source; IMF World Economic Outlook Data Base. StatsSA, Federal Reserve Bank of St.Louis and Investec Wealth and Investment
This purchasing power discount (((6.6-3.9))/6.6)*100= 40% at August month end) is a significant deterrent to the relocation of wealthy and skilled South Africans with only rands to support a life style in the developed world. Mobile younger South Africans, with a life of income earning and saving opportunities ahead of them, could undertake a similar calculation. That is multiply the prospective hard currency salaries they might be offered abroad, when measured in current exchange rates, by approximately 6/10’ths to account for their lesser purchasing power. Earning and saving rands at home (and perhaps investing abroad) might yield improved life-time consumption.
We should be relying more on better economic fundamentals than on an undervalued exchange rate to keep capital at home- especially our most valuable human capital. If South Africa would play the economic growth cards more effectively and reduce its risk premium it would retain and attract more capital on better terms. The nominal rand could then again approach its PPP value and the cost of borrowing rands (and dollars) would come down with less inflation expected. SA Incomes after inflation could grow at a much faster rate – encouraging immigration rather than emigration of capital and skills.
A vicious cycle of slow growth and low investment can be replaced by a virtuous cycle, if the political will is there
We are well aware that slow economic growth depresses the growth in tax revenues. What is not widely recognised is the influence that tax rates and taxation have on economic growth. The burden of taxation on the SA economy, measured by the ratio of taxes collected to GDP, has been rising as GDP growth has slowed down, so adding to the forces that slow growth in incomes and taxes.
Trends in government revenue, expenditure and borrowing
The GDP growth rate picked up in Q2 2019. But GDP is only up 1% on the year before while in current prices, it has increased by only 4.4%. That is slower nominal growth than at any time since the pre-inflationary 1960s, which is not at all helpful in reducing debt to GDP ratios (something of great concern to the credit rating agencies). This 4.4% growth is a mixture of the slow real growth and very low GDP inflation, now only about 3.5% a year.
Annual percentage growth in real and nominal GDP
GDP and CPI inflation
In the first four months of the SA fiscal year (2019-2020) personal income tax collected grew by an imposing 9.7% or an extra R14bn compared to the same period of the previous financial year. Higher revenues from individual taxpayers was the result of effectively higher income tax rates, so-called bracket creeps, on pre-tax incomes that rise with inflation.
Income tax collected from companies, however, stagnated, while very little extra revenue was collected from taxes on expenditure. Lower disposable incomes resulted in less spending by households and the firms that supply them. The confidence of most households in their prospects for higher (after-tax) incomes in the future has been understandably impaired.
Treasury informs us that total tax revenue this fiscal year, despite higher income tax collected, is up by only 4.8%, compared to the same period a year ago, while government spending has grown up by 10.3%, or over R51bn. The much wider Budget deficit of R33bn (Spending of R156.6bn and revenue of R123.6bn) represents anything but fiscal austerity. It has added to total spending in the economy, up by a welcome over 3% in Q2 2019 – after inflation.
But deficits of this order of magnitude are not sustainable. Nor can they be closed by higher income and other tax rates that would continue to bear down on the growth prospects of the economy and the tax revenues it generates. A sharp slowdown in the growth of spending by government, combined with the sale of loss-making and cash-absorbing government enterprises is urgently called for if a debt trap is to be avoided. Given that the debts SA has issued are mostly repayable in rand, rands that we can print an infinite amount of, a trip to the IMF and the “Ts and Cs” they might impose on our profligacy is unlikely.
More likely is a trip to the printing press of the central bank rather than the capital markets to fund expenditure. Such inflationary prospects are fully reflected in the interest we have to pay to fund our deficits. These interest payments add significantly to government spending. The spread between what the SA government has to offer lenders and those offered by other sovereign borrowers has been widening.
The SA government now has to pay 8.7 percentage points a year more in rands than the average developed market borrower, ex the US (Germany and Japan included) and 7.6 percentage points a year more than the US has to offer for long-term loans. We also have to pay 3.1 percentage points a year more than the average emerging market borrower has to pay to borrow in their own currencies.
The difference between RSA interest rates and other sovereign borrowers. Ten-year bonds in local currencies
When countries choose freedom, the economic outcomes are dramatically improved
It has proved very possible for average incomes and spending power to improve consistently over long periods of time. In the West economic progress has now been sustained for centuries. Over the past 70 years the improvement in global per capita incomes has been especially impressive as the process of economic growth has been extended more widely.
Download PDF with full article here: Kantor – When countries choose freedom
Déjà vu all over again – making sense of the recent rand weakness
The wise thing for the SA Reserve Bank to do is to leave the exchange rate to find its own level, while basing its interest rates decisions on the outlook for the domestic economy
The famous phrase by Yogi Berra, “It’s déjà vu all over again,” does not quite do justice to the recent turmoil in the SA currency and debt markets. The hope for a weaker dollar and stronger rand, as well as the lower interest rates, inflation, and faster growth that comes with a stronger rand, has once more been dashed.
Trade wars and currency manipulation do less damage to the US economy than to others, simply because the US is less dependent on global trade and more dependent on the US consumer. Hence in times of trouble, capital flows towards the US, raises the exchange value of the US dollar and depresses bond yields. Emerging market exchange rates weaken more than most and emerging market bond yields rise. The rand generally falls more than most other emerging market currencies.
Funding government debt has become more expensive, even as the volume of debt to fund extraordinary spending on Eskom increases at a very rapid rate. Long-dated SA government-issued (RSA) debt now offers an extra 8% over US Treasury bonds and almost as much extra when compared to other developed market issuers (many of whom now borrow at negative interest rates). SA is now paying 3% more than the average emerging market on its debt (in their domestic currencies).
For the government, raising US dollars has also become more expensive. Raising five-year dollar-denominated debt now requires an extra 0.4 percentage points (40 basis points) more than it did in early July 2019. The cost of insuring RSA foreign-currency debt against default has risen similarly and more than it has for other emerging market borrowers.
Sovereign risk spreads for RSA and other US dollar-denominated debt
Source: Bloomberg, Investec Wealth & Investment
The rand moreover has performed particularly poorly when compared to other commodity and emerging market exchange rates. Since early July, the rand is about 6% down vs the US dollar, 3% down on the Chinese yuan and about 2% weaker vs the Aussie dollar and a basket of nine other emerging market currencies.
The USD/ZAR compared to the yuan and Aussie dollar (1 July = 1)
Source Bloomberg, Investec Wealth & Investment
The USD/ZAR vs an equally weighted basket of nine emerging market exchange rates
Source Bloomberg, Investec Wealth & Investment
The cost of buying dollars for forward delivery has thus also widened, as has the compensation for bearing inflation risk in the RSA bond market. Both spreads are now over 6% for 10-year contracts. The attempts by the Reserve Bank to reduce inflation expected, by containing inflation itself (now about 4.5%, an outcome achieved by depressing domestic spending), have accordingly failed.
The RSA bond market interest rate carry and inflation compensation. July- August 2019 (10 year yields)
Source: Bloomberg, Investec Wealth & Investment
It should be recognised that the relative weakness in the rand and RSA bonds actually preceded the impact of the latest Trump tantrum. The Trump tariff threats came only at month-end. The earlier attacks of the Public Protector Mkhwebane on President Ramaphosa moved the market ahead of Trump.
What then can be done to mitigate this volatility and the damage it causes to the SA economy? The Reserve Bank cannot hope to anticipate exchange rate volatility with any degree of accuracy, or impose higher interest rates that offer no defense for the rand; they can only depress demand and growth further. The wise thing to do would be to leave the exchange rate to find its own level and accept higher inflation or the expectation of higher inflation that might follow (and which can easily reverse). The case for cutting or raising interest rates should be made only on the outlook for the domestic economy, which has not been improved by recent global events.
The Reserve Bank has called correctly for structural reform of the kind the President and his cabinet has responsibility for. It demands reforms so that SA can avoid the debt trap that Eskom has lead us into. Any confident sense that SA can address its structural weaknesses will bring immediate reward, in the form of lower interest rates and lower expectations of inflation.
There is some consolation in recent events. The oil price in rands is no higher than it was. It would have been more comfortable had SA still been producing gold on something like the scale of previous years. A mining charter that revives the case for investing in SA mining, would be a confidence booster.
Brent oil rands per barrel
Source: SA Reserve Bank, Bloomberg, Investec Wealth & Investment
Is Libra a bank by another name? Answers, important for a modern economy, are about to be found out.
Is the new block chained backed payments system (LIBRA) to be introduced by Facebook a pure and much lower cost payments system? Or a bank, or equivalently a money market fund, upon which transactions can be drawn conveniently for low or no fees.
The operating costs for a bank that provides a payments facility are largely covered by the difference between the interest paid on deposits (perhaps zero) and the interest earned by the bank/payments provider making loans- of varying degrees of default risk. Unlike a Visa that collects fees to cover its costs –and does not make loans.
The banks have cross-subsided the fees that might otherwise have to charge with the revenue earned from their lending activities. The profitability of banks depends in part on managing their cash reserves, keeping them as small as possible to meet demands for cash back. And holding no more than prudent reserves of equity capital to cover non-performing loans. And provide shareholders with enough of a return to keep them in the banking business.
It is this leverage (banks holding fractional reserves of cash) that exposes the bank shareholders (and the broader economy that depends upon sound banks facilitating transactions) to the danger that non-performing loans may exceed the equity of the bank. However it is not only the deposits (liabilities of the banks and assets of depositors) that may be destroyed by the failure of a banking system. Of greater importance is that the payments system, can go down with the banks, with truly catastrophic effect for any modern, highly specialized economy that depends on its payments system.
Perfect safety for a payments system can only come with deposits fully backed by cash issued by the central bank with its power to create as much extra cash as the system might need. Block chain may well offer enormous savings in protecting the transactions they give effect to, against fraud. Savings that mean low enough fees that would cover the full costs and still provide a profitable return on capital. And avoid the dangers of leverage. SA banks lose as much as R800m a year to credit and debit card fraud. They likely spend even more on trying to prevent fraud.
Leaving banks to make the trade-off between risk and return, has worked well enough for most, but not all the time. The Global Financial Crisis of 2008 (GFC) demonstrated why it is very important to be able to deal with a banking crisis – should banks or more specifically- the payments system delivered by banks, be threatened with failure. The solution to any run on the banking system is for the central bank to supply more than enough cash to the banking system to stop any run on the banks- as the GFC also proved.
Perhaps modern information technology will allow a 100 percent, central bank deposit backed (not private bank backed) fee collecting payment providers, to compete effectively with the deposit taking banks for our transaction balances. If so, deposit taking banks, supplying a bundled service of payments with the aid of leverage, may fade away to be replaced by other forms of financial intermediation. That is by other financial institutions that can provide essential credit and take on leverage profitably, but without accepting responsibility for effecting payments.
This new world (of fully backed transaction accounts) may be the next phase in the evolution of the modern financial system. One that would provide for the separation of the payments system from the dangers of leverage. Wisdom would be to let a profit seeking, competitive financial system to evolve in response to the preferences of lenders and borrowers. And for regulators to stay out of the way so that a pure payments system could possibly evolve. However, if Libra is a bank- dressed up as a money market fund, carrying risks on its balance sheet, it should also be required to play by the same rules as its banking competitors. However these rules applied to vulnerable banks could be relaxed if the payments system were secure.
Dealing with the unpredictable rand–better judgment, not luck called for
The rand (USD/ZAR) has not been a one-way road. Yet SA portfolios are more likely to be adding dollars when they are expensive and not doing so when the rand has recovered.
The rand cost of a dollar doubled between January 2000 and January 2002 – but had recovered these losses by early 2005. The USD/ZAR weakened during the financial crisis, but by mid-2011 was back more or less where it was in early 2000. A period of consistent rand weakness followed between 2012 and 2016 and a dollar cost nearly R17 in early 2016. A sharp rand recovery then ensued and the USD/ZAR was back to R11.6 in early 2018. Further weakness occurred in 2018 and the rand has been trading between R15 and R14 since late 2018. Weaker but still well ahead of its exchange value in 2016. The rand in March 2019, had lost about 20% of its dollar value a year before. It has recovered strongly since and t on July 5th at R14.05, the rand was a mere 4% weaker Vs the USD than a year before
The USD/ZAR exchange rate; 2000-2019 (Daily Data)
Source; Bloomberg, Investec Wealth and Investment
Two forces can explain the exchange value of the rand. The first the direction of all other emerging market currencies. The USD/ZAR behaves consistently in line with other emerging market (EM) currencies. And they generally weaken against the USD when the dollar is strong, compared to its own developed market currency peers.
When the USD/ZAR weakens or strengthens against other EM currencies, it does so for reasons that are specific to South Africa. Such as the sacking of Finance Ministers Nene in December 2015 and Gordhan in March 2017. These decisions that made SA a riskier economy, can easily be identified by a higher ratio of the exchange value of the rand to that of an EM basket of currencies. The reappointment of Gordhan as Minister of Finance in late December 2015 improved the relative (EM) value of the ZAR by as much as 25% through the course of 2016. His subsequent sacking in March 2017 brought 15% of relative rand underperformance. The early signs of Ramaphoria was worth some 15% of relative rand outperformance – and its subsequent waning can also be noticed in an increase in the ratio ZAR/EM.
The rand compared to a basket of emerging market exchange rates (Daily Data)
Source; Bloomberg, Investec Wealth and Investment
This ratio has remained very stable since late 2018- indicating that SA specific risks are largely unchanged recently. Emerging market credit spreads have also receded recently – as have the spreads on RSA dollar denominated debt. The cost of ensuring an RSA five-year dollar denominated bond against default has fallen recently to 1.62% p.a. from 2.2% earlier in the year. The USD/ZAR exchange rate -currently at R14 – is very close to its value as predicted by other EM exchange rates and the sovereign risk spread. It would appear to have as much chance of strengthening or weakening.
The exchange rate leads consumer prices because of its influence on the rand prices of imports and exports that influence all other prices in SA. A weak rand means more inflation and vice versa. And given the Reserve Bank’s devotion to inflation targets, the exchange rate therefore leads the direction of interest rates. Despite a renewed bout of dollar strength and rand weakness in 2018 import price inflation – about 6% p.a. in early 2019 -has remained subdued.
Import and Headline Inflation in South Africa (Quarterly Data)
Source; SA Reserve Bank, Bloomberg, Investec Wealth and Investment
This has helped to subdue the impact of rand weakness against the US dollar that might have brought higher interest rates and even more depressed domestic spending. The dollar prices of the goods and services imported by South Africans has fallen by 20% since 2010 and by more than 10% since early 2018. This has been a lucky deflationary break for the SA economy.
SA Import Prices (2010=100)
Source; SA Reserve Bank, Bloomberg, Investec Wealth and Investment
Given that the rand is driven by global and political forces largely beyond the influence of interest rates in SA, it would be wise for the Reserve Bank to ignore the exchange value of the rand and its consequences. And set interest rates to prevent domestic demand from adding to or reducing the pressure on prices that comes from the import supply side. The SA economy can do better than merely hope for a weak dollar.
Making the most of the investment holding company
Investment holding companies have long played a large role on the JSE. Two of the more important of them, Naspers and PSG, have provided spectacular returns for their shareholders in recent years. R100 invested in PSG in January 2010 with dividends reinvested in the stock has grown to R1435 by late June 2019. The same R100 invested in Naspers would have almost as well for its shareholders over the same period having increased its rand value by 14 times.
Not all holding companies are equal. A one-time darling of the JSE, Remgro has barely managed to keep pace with the JSE All Share index- R100 invested in Remgro or the JSE in 2010 would have grown to about the same R250.
Total returns; Naspers, PSG, Remgro and the JSE All Share Index (2010=100)
Source; Bloomberg, Investec Wealth and Investment
The advantage enjoyed by the managers of an investment holding company is that the capital made available to them is permanent capital. It cannot be cashed in, as is the case with a mutual fund or unit trust, that may be obliged to redeem capital and may have to sell down their assets to do so.
It therefore can invest in potentially market return beating companies, companies that will return more than their opportunity costs of capital – if only in time. Its often significant shareholdings may give it a useful, active role in improving the performance of the operating companies it invests in.
While shareholders in a listed investment holding company cannot force any liquidation of assets, they can always sell their shares. At a price that would have to be attractively low enough to promise the buyer a return at least as good as is promised elsewhere in the market place – for a similar degree of risk.
This market-clearing price, multiplied by the number of shares issued will determine the market value of the holding company. And this market value, as in the case of Naspers (since 2014) and Remgro (continuously since 2010 )– has been well blow their Net Asset Value (NAV). That is the holding company is likely to be worth than the sum of its parts – were the parts unbundled to its shareholders. No doubt to the chagrin of its managers when their company is judged to be worth more- sometimes much more – dead than alive. And who may well have delivered market beating returns in the past.
The market and net asset value of the holding company will always have much in common. The market value of its listed assets and its net debt would be included in both- as would the value of its unlisted assets- though the market may judge them to be worth less than the director’s estimates included in NAV.
The market value will however be influenced by two other important forces, not reflected in its marked to market, balance sheet, its NAV. Included in market value, but not NAV, will be two unknowns -the expected implicit costs to shareholders of running the head office- and the present value of its ongoing investment programme. Past performance may not be a good guide to expected performance as we are often reminded. The economic value expected to be added by the extra capital to be invested by the holding company may be presumed by the market place, to be insufficiently promising to compensate for the costs of running the head office. Hence reducing market value relative to NAV
The way for the managers of a holding company to close the value gap between NAV and Market Value is clear. That is to adopt a highly disciplined approach to acquisitions and investments. And be as disciplined in the rewards offered managers. A plan to list major unlisted assets to prove their value and to unbundle them when their investment case has been proved, will help add market value. Market value adding – performance related pay – can also be well aligned with the interest of shareholders if made dependent on closing this gap between NAV and market value.
The Investment Holding Company. How to evaluate its performance and how to align the interest of its managers and shareholders
The importance of recognising economic profit or EVA
Owners of businesses could set their managers a straight-forward task. That is to earn a return on their capital they will deploy to exceed the returns shareholders could realistically expect from another firm in the same (risky) line of business. If the managers succeed in this way, that is realise an internal rate of return on the projects they undertake that exceed these required or break even returns, they will be generating an economic profit for their owners. They will have created what is now widely known as Economic Value Added (EVA) in proportion to the amount of capital they put to work. EVA=I*(r-c) where r is the measure of the internal rate of return, c is the required return or as it is sometimes described as the cost of capital and I is the quantum of capital invested.
Continue reading the full paper here: Applying EVA to the holding company
The restructuring of Naspers has been very well received by the market- place. What does the future hold for its shareholders?
The Naspers value gap (net asset value less market value) has narrowed significantly since the restructuring – which will see a Newco being listed in Amsterdam – was announced to the market. What does this mean for shareholders?
The proposed restructuring of Naspers, first mooted in March and now confirmed in a circular to shareholders on 29 May, has been favourably received by the market. The intention is to restructure Naspers into two linked companies: a Newco (to be named), with a primary listing in Amsterdam and a secondary listing on the JSE, and a new Naspers with its primary listing still in South Africa.
The Newco will hold the international assets of Naspers, including its 31% of Tencent, and will focus on global opportunities. The South African Naspers will have a 73% share of the Newco, will hold the local assets of Naspers and will also pursue investment opportunities – presumably mostly in South Africa.
Naspers shareholders in absolute terms were, at the start of June, about R120bn better off than they were three weeks previously, according to calculations by my colleague Thane Duff of Investec Wealth & Investment. The Naspers share price has outperformed that of Tencent recently.
To explain, the large gap between the net asset value (NAV) of Naspers (the sum of its parts of which the holding in Tencent dwarfs all the others) and the market value of Naspers (now R1.462 trillion rand) has narrowed by as much as R120bn in recent weeks.
This value gap (NAV less market value – which we can describe as the difference in the value of Naspers were all its assets unbundled to shareholders and its value as an ongoing business) however, remains a considerable R386bn. The value of the Naspers holding in Tencent is currently worth 127% of the market value of Naspers – or as much as R1.85 trillion.
This value gap emerged only in 2015, with the appointment (coincidentally?) of Bob van Dijk as CEO. The value gap has been as much as R800 billion since then and is now close to its post-2015 low. Its further direction will be of crucial importance to shareholders and, one hopes, also the senior managers of Naspers who control its destiny through the high voting shares they own.
Figure 1: Naspers – NAV minus market value (R billion)
The NAV and market value of Naspers have much in common. Common to both is the market value of the listed assets it owns (Tencent and MailRu being the most important). Also common is the value accorded to the unlisted assets of Naspers, though the value ascribed to these unlisted assets by the directors and included in the balance sheet may well be greater than the value accorded them by the market.
This could be one reason why NAV exceeds market value. What will not be recorded in the Naspers balance sheet or in NAV, but will affect the market value, is the expected cost of running the Naspers head office, as assumed by investors and potential investors. The more shareholders are expected to pay management for their services in the future – including the extra shares to be issued to managers that will dilute their share of the company – the less Naspers shares will be worth today.
A further force that can add to or subtract from the value of a company is the expected value to its shareholders of the business that the company is expected to undertake in the future. The more profitable the investment programme of a company is expected to be, the more value a company will offer its shareholders. Profit in the true economic senses means the difference between the internal rate of return on shareholder capital invested by the firm and its opportunity cost, that is, the returns its shareholders could expect from similarly risky investments made with its capital when invested outside the company. It is the economic, not the accounting profit earned after allowing for the cost of utilising equity as well as debt capital, that matters for the market value.
This cost of their capital for SA shareholders – or the required return on the capital they have entrusted to Naspers – is of the order of 14% a year. This 14% is equivalent to the returns currently available to wealth owners in the RSA bond market (about 9% a year for a 10-year bond) plus a premium, to compensate for the risks that these returns may not be met from the averagely risky SA company.
If Naspers were expected to achieve consistent returns of more than 14% on the large capital investments it makes every year, this programme could be expected to add to its market value. If the market expected otherwise, where the returns on the investments would fall short of their costs, then the investment programme would be expected to destroy the wealth of shareholders. And the more Naspers was expected to invest, the more value destruction would be reflected in its share price: that is, the larger the difference between NAV and market value would become.
We draw on the Credit-Suisse-Holt database for estimates of the recent investment activity of Naspers. The sums invested are large in absolute terms as may be seen in figure 2 below: they’re estimated as of the order of R200bn per annum in recent years. Holt also estimates a currently negative return on capital invested by Naspers – that is, a negative cash flow return on investment (CFROI). If the estimate of the scale of the Naspers is correct, then the investment programme is large enough to account for a large reduction in its market value accorded by a sceptical share market.
The recent sale by Naspers of 2% of its Tencent holding realised nearly US$10 billion. A large additional war chest it must be agreed, but not perhaps enough to result in as much value destruction of the order recently observed.
It suggests that shareholders also attach significant costs to them of the rewards expected to be awarded to managers – perhaps particularly in the form of share issues and options – that over time can consistently dilute their share of the company. If the number of shares issued as remuneration amounts every year to as much as 1% of the shares in issue, this becomes an expensive exercise for shareholders.
Figure 2: Naspers – gross investment
Source: Holt and Investec Wealth & Investment
Will the future be much different for Naspers shareholders?
The critical issue for shareholders in the restructured Naspers remains as before. How successful – how economic value adding or destroying – will its investment programme become, and how generous will the company be to its managers?
There seems little likelihood of much change in behaviour of either kind that would cause investors to change their assumptions about Naspers. The managers are unlikely to become less ambitious in their search for game-changing investments of the kind it made in Tencent. But it will soon be doing so out of two highly interlocked companies.
The international investment activities will presumably be conducted out of Amsterdam. The South African company will also have an investment programme of its own, presumably in South African and African opportunities. One imagines, however, that the larger investments bets will be made internationally by the Amsterdam-listed company, given the much larger opportunity set. Dividends (largely from Tencent) that flow out of Amsterdam back to South Africa will presumably be influenced by the scale of this investment programme.
One anticipates that both companies will not easily convince investors that they are capable of undertaking enough value-adding investments to compensate for the cost of management. Therefore, the Naspers shares will be priced lower (to compensate for value destruction and head office costs) for an expected return in line with market averages. Given a lower than otherwise share price for both companies, both are likely to stand at a discount to NAV and should continue to offer a value gap of significance.
Yet the Amsterdam company will also be priced to offer a market-related return for a company listed in Amsterdam and, under the jurisdiction of the Netherlands, a developed economy. The owners of the 27% free float in the new Amsterdam company will accordingly attach a lower real discount rate to the expected benefits of their share of the company. They will be satisfied with lower expected nominal and real returns, because they will attach less risk to doing business with the government of the Netherlands than with the SA government.
The lower returns required of a company in the Netherlands will be equivalent to the yield on a Netherlands government bond (close to zero, even negative) plus the same 5% risk premium. This makes for a required nominal return of 5% rather than the 14% required of a South African-listed company, where inflation is expected to be much higher and the sovereign risk premium is higher.
The important difference in real expected returns (returns adjusted for expected inflation) is an expected average real 5% in the Netherlands (given no expected inflation, only a risk premium) and a real return in South Africa of about 3% higher (8% real return expected from the average South African company). This 8% real is the equivalent of the 14% nominal required return, less the 6% inflation rate expected in South Africa.
This lower real discount rate makes Naspers shares worth more in Amsterdam than they would be worth in South Africa (all else remaining unchanged) and also worth more for shareholders in Naspers South Africa with their Amsterdam investment.
But all else will not remain the same, including the market value of Tencent shares. This will still be the main force driving the value of the Naspers companies. What could change the game for shareholders – and help further lower the gap between NAV and market value – would be for the company to reward its managers on their ability to close this value gap. That surely would align the interest of managers and shareholders and therefore add value.
An interesting week- unfortunately- but will it lead to the right outcomes?
10th June 2019
It was one of those interesting weeks that optimistic South Africans could have done without. Early in the week we were informed that the economy did even worse than we had expected – going backwards at a 3.2% annual rate in Q1. The news immediately weakened the rand -not only against the USD – the ZAR also lost about 5% to a peer group of other EM exchange rates. EM currencies generally ended the week stronger against a weaker USD that fell back against the Euro and other developed economy currencies as Fed interest rate cuts loomed.
The spread between declining US bond yields and rising RSA yields widened, indicating that the rand was now expected to weaken further at a 7% p.a average annual rate over the next ten years. Consistently with this rand weakness and all that it implies for the higher prices of imported goods in weaker rands, still more inflation to come was priced into the RSA bond market. Inflationary expectations, as measured by the spread between long dated vanilla RSA bonds and their inflation protected alternatives, widened to about 6.5% p.a for 10 year money. The debt trap that might follow slow growth, less tax revenue, wider deficits and printing money to get out of it – seemed a little closer than it was (See charts below)
Fig.1; The ZAR and the EM Basket (2019=100) Daily Data
Source; Bloomberg and Investec Wealth and Investment
Fig.2; The USD/ZAR compared to the USD/EM currency basket. Daily Data (2019=1)
Source; Bloomberg and Investec Wealth and Investment
Fig.3: Long dated RSA and USA Government Bond Yield and Risk Spread (RSA-USA 10 year yield) Daily Data 2019
Source; Bloomberg and Investec Wealth and Investment
And then to compound the weakness in the ZAR and RSA’s markets the surviving Zuma factions in the ANC later in the week mounted a further diversionary attack on the independence of the Reserve Bank and its anti-inflationary zeal. Further rand weakness and higher interest rates followed.
There was however some consolation for investors on the JSE- including everyone with a SA pension plan. The global plays on the JSE – those companies with major interests outside SA – acted as they could be expected to do given rand weakness absent emerging market weakness as was the case. They helped meaningfully to diversify SA specific risks (up over 5% in the week as did Resource companies that were up 6.5% – enough to lift the All Share Index by 3.3% by the week-end. (see below)
Fig. 4; Weekly Performance on the JSE (2nd– 7th June)
Source; Bloomberg and Investec Wealth and Investment
One hopes the Reserve Bank was watching these developments very closely. That is slower growth is associated with more not less inflation expected. Not perhaps what you might find in the macro texts. And more important that the reverse is also likely to be true. That is faster growth will be associated with a stronger rand and so less inflation expected and lower bond yields and less spent paying interest. Even our good friends at Moody’s now expect and would appear to welcome a cut in the repo rate to boost growth. As does the money market that now expects short rates in SA to decline by 50 b.p. over the next twelve months.
The Reserve Bank would be well advised to do what is now expected of them and do what they can to stimulate faster growth in SA. Faster growth leading to less inflation expected and as likely, no more actual inflation, should be very welcome. And also help resist those with ulterior motives when they attack the Bank.
The Reserve Bank attempts to control inflation and inflationary expectations that, in large measure, are beyond its influence. As recent events in the currency and bond markets surely confirm. Supply side shocks (the rand, the weather, the oil price, Eskom and expenditure taxes) dominate the direction of prices and all serve to inhibit disposable incomes and consumption spending. And inflation expected has a political course of its own that can add to upward pressure on prices.
Interest rates set by the Bank do influence the demand for goods and services. Demand has been consistently weak in South Africa for a number of years. Weak enough to counter to some degree the supply side pressures on the price level. But weak enough to inhibit any cyclical recovery. The trade off – less growth for marginally less inflation – has been much too severe for the economy. A more nuanced approach to interest rate settings and a more nuanced narrative to support it would better have served the economy and the Reserve Bank’s independence.
Bringing down interest rates – a task for the cabinet and for the SA Reserve Bank
The immediate challenge for the newly appointed SA cabinet is to do what it takes to stimulate faster growth in output incomes and employment over the next few years. And to instill a strongly held belief that they will succeed in doing so.
The benefits of any more optimistic belief that growth will accelerate would be immediate. The interest rate on longer dated RSA bonds would come down as the danger of a debt trap for SA receded. As it does with faster growth in tax and other revenues for the Republic.
Governments cannot formally default on the loans they issue in the local currency. But they may be tempted to pay down such debt by issuing more currency – should the interest burden on the debt become politically intolerable. Printing more money than economic actors are willing to hold, leads inevitably to more inflation as they get rid of their excess money holdings. Investors are very well aware of the process of inflation- led as it always is by governments unwilling to accept harsh economic realities.
Such inflationary dangers call for compensation for lenders in the form of higher interest rates. There is a lot of inflation priced into long term interest rates in SA that makes borrowing particularly burdensome for SA taxpayers. Very low interest rates of the kind now demanded of European and the Japanese governments, practically eliminates any possibility of a debt trap, even when the Debt to GDP ratios are more than double the ratio in SA, as they are. South Africa would look so much healthier were interest rates a lot lower.
The running yields provided to match supply and demand for RSA bonds provides a very clear and continuous measure of how well the government is rated by investors for its ability to avoid inflation- and stimulate growth. The difference between the yield on a vanilla RSA bond and an inflation protected bond of the same period to maturity indicates how much inflation is expected by investors. It is a risk that the owner of an inflation linked bond largely avoids. Hence the difference between the yield on a five year vanilla RSA bond (currently around 8% p.a) and the lower yield on an inflation protected bond (currently 2.4% p.a) reveals that inflation in SA is expected to average 5.6% p.a. over the next five years and about 6.5% p.a. over the next ten years. Headline inflation is now significantly lower at 4.4% p.a.
Fig.1: RSA Bond yields and compensation for expected inflation (5 year bonds)
Source; Thompson Reuters, Bloomberg and Investec Wealth and Investment.
Another important signal comes from the difference between RSA rand bond yields and those on US Treasury Bonds of the same maturity. This spread indicates how much the rand is expected to depreciate over the years. The difference between 10 year RSA yields and US 10 year Treasury bonds is of the order of 6.6% p.a. That is the rand is expected to depreciate against the US dollar at an average over 6% p.a. over the next ten years. This clearly implies much more inflation in SA compared to the US- hence a further reason for much higher interest rates.
Fig. 2; RSA and USA Treasury Bond Yields (10 Year) Daily Data 2019
Source; Thompson Reuters, Bloomberg and Investec Wealth and Investment.
The very latest news from the RSA bond market has not been encouraging about the prospects for growth enhancing reforms. If anything these interest rates spreads have widened rather than narrowed – indicating more not less inflation expected and no more growth expected. Hopefully the selection of the cabinet members and better knowledge of their good intentions will raise expected growth and lower long-term interest rates. Unfortunately SA has not benefitted from the global decline in government bond yields as have other emerging market borrowers.
Fig.3 Global Bond Yields. Movement in May 2019.
The level of short-term interest rates will be set by the Reserve Bank. We can hope that the Bank will recognize that inflationary expectations are largely beyond their influence. More inflation expected can add upward pressure to prices as firms with price setting powers attempt to recover the higher costs of production they may expect. But such attempts to raise prices can be thwarted by an absence of demand for their goods and services.
Very weak demand for goods and services over which Reserve Bank’s interest rates have had a direct influence has contributed to very slow growth -and lower inflation. But without reducing inflation expected.
The Reserve Bank should recognize that lower inflation- achieved by deeply depressing spending and growth rates to counter more inflation expected- will not bring less inflation expected over the longer run. That is a task for the cabinet. The role for the Reserve Bank is to do what it can to stimulate more growth by lowering short term interest rates.
A post-script on debt management in SA
The SA Treasury has long adopted a policy to lengthen the maturity of RSA debt. The policy appears to have been reversed somewhat recently in response to the pressure on the budget placed by more debt funded at higher interest rates. We show the maturity structure of RSA debt issues in recent years below. We also show how debt service costs have risen as a share of tax revenues. [1]By international standards the duration of RSA debt is exceptionally high.
Borrowing long has been more expensive for the RSA than borrowing short. The term structure of rand denominated bond yields has been consistently upward sloping since 2008. The average monthly difference in these yields has been 2% p.a. between 2010 and 2019. See the figure below that charts the difference between 10 year and 1 year RSA yields.
Fig.4: The slope of the RSA yield curve RSA 10 year – RSA 1 year bond yields
The case the Treasury makes for extending maturities is to avoid the danger of so described roll over risk. The longer the maturity structure of the debt incurred, the less often has debt to be refinanced. Though surely the breadth and depth of the market for RSA bonds is surely enough protection against not being able to refinance debt when it comes due, or before it comes due. As are the large cash reserves the Treasury keeps with the Reserve Bank. Paying so much more to borrow long rather than short seems a very expensive way to avoid the unknown danger that it may be difficult to place debt at some unknown point in time.
But there is more than roll over risk to be considered. The Treasury preference for borrowing long- when inflationary expectations are elevated (over six per cent per annum as they have been for much of the period since 2010) – indicates little confidence in the ability of monetary policy to meet its inflation target of between 3 and 6 per cent p.a.
Borrowing long – extending the maturity structure of national debt -adds to the temptation to inflate away the real value of debt incurred. Investors are surely aware of their vulnerability to the consequences of a debt trap- the danger that a country will print money to retire expensive debt that will then lead to inflation and much reduce the real value of their loans.
Such reliance on borrowing long that brings with it inflationary temptation must show up in higher long term interest rates – relative to shorter rates- to compensate for the extra risks incurred in lending long. Having to roll over short term debt at market related interest rates that will rise with inflation makes lenders less hostage to the danger of unexpectedly high inflation. It may even act to discipline government spending and borrowing because inflating away the debt burden is not an option. Accordingly it reduces the danger of inflation and by doing so may improve a credit rating. Borrowing long is an opportunity that a government treasury should best resist- as proof of its anti-inflationary credentials.
The employment effects of National Minimum Wages – the evidence will mount
Over the next few years we will learn much more about the sensitivity of employment in South Africa to large changes in the minimum wages employers are able to offer. What were 124 minimum wage determinations that varied from sector to sector and region to region has been replaced this year by a National Minimum Wage (NMW) of R3500 per month or the equivalent of R20 per hour.
The first evidence of the brave new world of a much improved NMW is now to hand with the Quarterly Labour Force Survey for the first quarter 2019 published by Stas SA. The survey provides no consolation at all for the proponents of the NMW. The number of potential workers increased by 149,000 in the latest quarter while the numbers employed declined by a further 237,000. The unemployment rate (narrowly defined to include only those actively seeking work) increased by 0.9% to 27.6% and when broadly defined to include discouraged workers, the unemployment rate has increased by a further 1% to 38%.
These regulated minimums were initially proposed by a panel of experts appointed to the task in 2016 by then Deputy -President Ramaphosa. The panel recommended the NMW to be set well above what many workers were earning. The poorest quintile of earners (some 16.3m souls) earned an average wage of a mere R1017 per month in 2016. Only 15.9% of these poorest South Africans were employed (mostly part time presumably) and their unemployment rate was 65.8%
Thus most poor South Africans are not employed – despite –rather because of low wages. Given social grants and the extended families it may make very little sense to seek or accept very low paid work- all regrettably that may be available to those without skills and strength. The newly prescribed NMW will not affect many of them – except perhaps to largely eliminate their opportunities to work part-time.
The next poorest 20% (12.9m of them) when employed had average wages of R1707 per month of whom 35.9% were employed and 37.9% unemployed. The somewhat better off third 20% (52% of a cohort of 9m who worked) earned on average only R2651 per month – with an unemployment rate of 21.7%
It is only when you enter the ranks of the remaining 40% of households defined as “non-poor” by the panel, is the average monthly wage of R4751 well ahead of the NMW of R3500. And the broad unemployment rate is a less mind blowing 14.1%. The top 20% of households (6.483m people) are reported to earn an average R13,458 per month and were fully employed with an unemployment rate of 4.8%.
It would seem that the benefits of a higher NMW would be mostly confined to those in quintile 3 (provided they keep their jobs – big if) And the damage in the form of fewer jobs and less part time work would be concentrated in the same group now earning well below the NMW, yet very much part of the labour market.
The panel admitted that they had very little knowledge of the impact on employment. They estimated job losses in a very wide range of 100,000 and 900,000 job losses. They promised to examine the evidence as it presented itself and adjust their recommendations accordingly. One might regard this cavalier approach as irresponsible social engineering.
For a better idea of just how sensitive employment can be to the cost of hiring workers, the panel might have studied the impact of the employment tax incentive – designed to lower the cost of employing young South Africans (under 28 years ) introduced in 2014. And now extended to all workers in the special economic zones. For the details about how very simply to claim the benefits, see SARS’ own resources here and here.
The 2019 Budget Review proudly pointed to how highly effective offering employers a subsidy of up to R1000 per worker has been for employment. In 2015-16, 31,000 employers (disproportionately employers with fewer than 50 workers) claimed the incentives for 1.1m workers with R4.3 billion of tax revenues sacrificed in 2017/18. That is a tax expenditure of a mere R275 per extra worker and over a million of them.
It is a case of the SA government taking away with the one hand- discouraging low wage employment- and then encouraging it with the other- providing significant wage subsidies to reduce the minimums actually paid by employers. Given the wishful thinking about the benefits of “decent jobs” political more than economic- while conveniently ignoring the costs to the many workers not employed- this sleight of hand – is regrettably as much as we should expect from economic policy.
What matters for shareholders is return on capital. Managers should be rewarded accordingly
The best managers can do for their shareholders is to realise returns that exceed the opportunity cost of the capital entrusted to them. That is to generate returns that exceed the returns their shareholders could realistically expect from alternative, equivalently risky investments.
This difference between the returns a firm is able to earn on its projects and the charge it needs to make for that capital, is widely known as Economic Value Added (EVA).
This economic profit margin is sometimes described as a moat that protects a truly profitable firm from its competitors. But more than intellectual property or valuable brands that keep out the competition and preserve pricing power, a truly valuable firm will have a long runway of opportunities to invest more in cost of capital beating investments. It is the margin between the internal rate of return of the company and the required risk adjusted return, multiplied by the volume of investment undertaken that makes for EVA and potentially more wealthy owners- not margin alone.
The task for managers is to maximise neither margin nor scale – but their combination – EVA. For investments today in SA in rands an averagely risky project, given long term RSA interest rates of about 9% p.a. would have to promise a return of more than 14% p.a on average to hope to be EVA accretive.
The leading advisor on corporate governance in the US now agrees with the all importance of EVA when evaluating managers. Fortune Magazine of the 29th March reported that
“On Wednesday, ISS, the U.S.’s leading adviser on corporate governance, announced that it’s starting to measure corporate pay-for-performance plans using a metric that prevents CEOs from gaming the system by gunning short-term profits, piling on debt, or bloating up via pricey acquisitions to swell their long-term comp. ISS’s stance is a potential game-changer: No tool is better suited to holding management accountable for what really drives outsized returns to investors, generating hordes of new cash from dollops of fresh capital……”.
Positive EVA’s or improvements in EVA do not translate automatically into share market beating returns. The share market will always search for companies capable of realizing EVA. And who reward their managers accordingly in ways that align their interest with those of their shareholders. Such remuneration practice provide investors with useful clues about prospective EVA. It will help them follow the money. Managers after all will do what they are incentivized to do.
When EVA is positive, realizing as much of it as may be possible, calls for raising cash rather than paying it out- negative rather than positive cash flow – after spending to sustain the established capital stock. Not only retaining cash – not paying dividends but raising fresh capital- equity or debt- can make every sense if EVA enhancing.
Paying up for prospective EVA will raise share prices and reduce realized market returns. And investment activity that is expected to waste capital will reduce share prices to improve prospective returns. Investors may change their minds about how sustainable EVA will be. Investors, by adding or reducing the period of time before margins inevitably fade away in the face of predictable competition, can make large differences to the market value of a company- and can do so overnight.
These expectations as well as changes in the climate for doing business, as in interest rates that help determine the cost of capital, are often well beyond the control of managers. Managers should be encouraged by shareholders and investors to maximise EVA – not their share prices or total shareholder returns over which they can have little immediate influence, given all the other value creating or destroying forces always at work. They should neither be indulged, when by luck more than their good judgment, the market takes all share prices higher. Nor should they be penalized when the market turns sour.
Shareholders and their managers with EVA linked rewards- should hope that positive EVA surprises – when sustained – will be appreciated by investors willing to pay up for their shares. It may take time to convince investors of the superior capabilities of a management team and their business models. But superiority can only be demonstrated by consistently adding economic value beating the cost of capital.
The paradox of paid holidays
Looking forward to the (paid) Easter holidays? Despite appearances to the contrary, you are paying for it.
The Easter holidays are upon us. Many will be enthusiastically taking time off, believing they will be enjoying a “paid holiday”, in other words, enjoying a holiday paid for by their ever-obliging employers. They are wrong about this – especially if they work in the private sector. They will in fact be sacrificing salary or wages for the time they spend not working.
This is based on the simple assumption that there is a consistent relationship between the value they add for their employers and the hours or days spent working – and that therefore they are paid according to the contribution they are expected to make to the output and profitability of the firm. Wages are not typically charitable contributions.
It makes no sense for some employer, the owner of a business, with a natural concern for the bottom line, to pay you for time spent on holiday, or on weekends off or when sleeping or traveling to or from work. They are unlikely to survive the competition if they did not take into account the accompanying loss of production, revenue and profits incurred when their employees are not working.
Those known costs must mean salaries, wages and employment benefits given up by the worker. There are no paid holidays, any more than there are free lunches in the company canteen.
Those paid on an hourly basis and at the end of every day or week will be under no illusions about having to sacrifice income when not working. Many of them might well be willing to work on the Easter weekend if given the opportunity to do so. They may well prefer to consume goods and services other than leisure.
It is those who are paid on a pre-determined monthly basis who may be inclined to believe that they are being paid to go on holiday. They should appreciate that the more time they are expected to take off, or the larger the contributions the employer may be making to medical insurance or pension contributions, training levies and the like, the less they will inevitably be taking home in their monthly paycheque. They are sacrificing salaries so that their employers can better stay in business and offer them employment.
The same bottom line and hence a sense of sacrificing pay may not apply in anything like the same force in the public sector, where the taxpayer picks up the salary, pension and medical aid bill, regardless of its size; where measuring the output of the public employees is not nearly as easy and where performance measures are often strenuously resisted.
European workers typically take many more days off than their US or South African counterparts. It is a widening trend that has evolved only over the past 30 or so years. We are often surprised at how little time the typical US worker takes off. Why is it so that the average US worker consumes significantly less leisure, takes less time off, therefore sacrifices less pay for holidays and consumes proportionately more other stuff that they prefer to pay for?
Is it a cultural difference, or are US workers naturally more hard working than their European or South African cousins? Maybe, but if that’s the case, why have these differences in working behaviour become so much more pronounced in recent decades? (Incidentally, the average number of hours worked per day in Europe and the US does not differ much). The striking difference is in the average number of days worked.
It may be because US workers and their employers enjoy more freedom to choose pay over leisure. Perhaps the regulations that determine compulsory time off for holidays or festivals are by now less onerous on US than European employers (and on formal South African businesses).
Were maximising output and money income and employment the primary objective of policy, South Africa would be wise to adopt the US rather than the European practice: allow the number of days off to evolve (mostly) out of competition for workers, rather than be regulated for them and their employers. And have fewer “paid holidays”.
The market and the economy – not a certain relationship
Brian Kantor 3rd April 2019
The state of the US economy gets very close attention from investors in the stock market. The market moved sharply lower in late December on fears of a US slowdown. More recently it has bounced back strongly as the outlook became less threatening as the Fed came to share some of the market anxieties and indicated it would not now be raising short term interest rates.
This raises a question. Could you make a fortune buying or selling shares accurately forecasting US GDP growth rates over the next few years? The answer is a highly qualified yes. It would take very surprising – to others – very fast growth to deliver well above average returns in the stock market or, as surprising to all but yourself, very slow growth to deliver unusually poor returns.
Such phases of very fast or very slow growth, that presumably could confound the forecasters and investors, have in fact been very rare events. Since 1967 there have only been seven recessions in the US. There have been about the same number of so-called technical recessions – defined as two or more consecutive quarters when the real GDP declined.
I count 20 quarters since 1967 when growth in the US was less than 1% per annum. Average annual returns on the S&P over these low growth quarters was a negative 11.8%. The worst quarter for shareholders was Q1 2009 when the market was down 47% on the same quarter a year before. However slow growth was not always bad news for investors. In Q2 1981, when growth fell at a 2.9% rate, the S&P 500 Index was up by 19.4% on a year before. Yet the statistical relationship between growth and returns over these low growth quarters was a generally very weak one with a simple positive correlation of only 0.07- not nearly enough regularity to rely upon as an investment policy.
Slow growth quarters in the US; Scatter plot of Quarterly Growth and Annual Returns
Source; Federal Reserve Bank of St. Louis, Bloomberg and Investec Wealth and Investment
I have also identified 98 quarters when growth in the US was a strong over 3% p.a. On average over these quarters the annual returns averaged an impressive 14.7% p.a. But this high average came with a great deal of variability around this average. The best annual return of 46.7% came in Q3 1982 and the worst -17.7% in Q4 1973. The statistical relationship between strong quarterly growth and annual returns is also very weak with a correlation close to zero.
Fast growth quarters in the US; Scatter plot of Quarterly Growth and Annual Returns
Source; Federal Reserve Bank of St. Louis, Bloomberg and Investec Wealth and Investment
The statistical relationship between quarterly growth and returns over the entire period 1967-2018 is altogether a very weak one. Linear regression equations that explain annual index returns with quarterly growth rates have very little explanatory power. Using smoother annual GDP growth rates in the equation do little better. R squares of no more than 0.16 indicate that there is much more than growth determining annual or even more variable quarterly returns. Generally accurate forecasts of GDP growth are simply not going to cut the returns mustard.
The problem for any reliance on patterns of past performance is that the markets are always forward looking. The well-considered, forecasts of the economy and of the companies dependent on it, will already have helped determine the current value of any company and of any Index average of them. Hence only economic surprises- indeed only large surprises in the GDP numbers can move the market. But anticipating these surprises is largely beyond the capabilities of the collective of forecasters – who will employ similar methods evaluating the widely available data that anticipates and makes up the GDP itself. Any surprises are going to surprise the forecasters as much as the market
However as recent developments on the share market indicate- down and up with not so much the GDP itself – but with expectations of it- what matters over any short period of time in the markets is not so much the forecasts themselves, but the confidence held in such forecasts. These will never be in a constant state. Any additional uncertainty about the state of the economy (less confidence in the forecasts) adds volatility to the market. That is wider daily moves in the market up and down. And when the market moves through a wider daily range share prices will move in the opposite direction in a statistically very consistent way.
The impact of risk (changes in the VIX) on S&P returns 2016-2019; Daily Data. Correlation (-0.74)
Source; Federal Reserve Bank of St. Louis, Bloomberg and Investec Wealth and Investment
Such changes in sentiment are not easily forecast. If they could be reliably anticipated this would undoubtedly be wealth enhancing to the forecaster or rather the sage. They are however best ignored by long term investors in favour of as good a forecast of the economy over the long run, as you can hope to make or receive.
Radio interview on Classic FM
The interview is available here: https://iono.fm/c/3504
Finding our way out of the debt trap demands more than monetary policy can offer
The interest payable on the national debt is surely a burden on taxpayers. But it is also as clearly a benefit to those who receive the interest.
Foreign investors owned 37% of all rand-denominated debt, R923bn worth of the R2.49 trillion issued in 2018-19. They also owned all the foreign currency debt issued by the government in 2018, valued at R320bn. Thus, foreigners own about 50% of all government debt issued (see figure below, taken form the Budget Review 2019 as is the further table that provides detail on the composition of RSA national debt).
As the table above shows, there is a heavy load for South Africans to have to carry, especially when there is little to show for the debts incurred. This includes productive infrastructure that would add to GDP and incomes to be taxed and would make borrowing worthwhile, should the returns on the capital raised exceed the interest cost of the debt incurred, which has not been the case. Much of the debt incurred by the government has been used, given insufficient tax revenue, to fund the employment benefits of public-sector employees and other goods and services consumed by government agencies. In essence, it has been raising expensive debt to fund consumption rather than capital accumulation.
More sadly, some of the national debt that has been incurred and used to fund state-owned companies, mostly Eskom, has not even covered its interest rate costs. The Treasury calculates that the difference between the book value of assets of these companies (over R1.2 trillion) and their debts (over R800bn) means their equity capital earned a negative amount in 2017/18. In other words this investment by taxpayers (assets minus liabilities) is now worth nothing at all. Selling off their assets for what they could fetch in the market place would, at worst, reduce the current and future national debt burden. At best, they would provide a superior service to users of these essential services. These private companies, if profitable, could then provide an additional source of tax revenue.
What was paid for the assets is economically irrelevant. The only relevance is their market value that may or may not exceed the value of the debt incurred. Still, less national debt is better than more.
So, what can be done to reduce the burden of SA’s national debt and the dangers of a debt trap that SA has entered? One obvious answer would be for the government to borrow at lower interest rates. However, it is not lower inflation that would necessarily reduce the interest paid on conventional government debt.; only lower expected inflation could do this. Lenders demand compensation in the form of higher interest rates for taking on the risk that inflation poses to the purchasing power of their interest income and the market value of their debt. The more inflation that is expected, the higher interest rates will be.
The Governor of the Reserve Bank believes that lower inflation – the result of realising the Bank’s inflation target – will lead to lower inflation expectations and bring down interest rates with it. But the link between realised inflation and expected inflation is not nearly as direct or obvious as the recent behaviour of the bond market and interest rates confirms. In recent years, inflation compensation in the bond market, the difference in yields offered by a conventional bond exposed to the danger of unexpectedly high inflation, and an inflation-proofed bond of the same duration that offers a real yield, has remained stubbornly high. It has been at about 6%, a number that has not declined in line with lower inflation, which is currently at 4%.
Long-term interest rates, inflation compensation and inflation in SA
The problem for the Governor is that the Reserve Bank is only partially able to control the inflation rate, which is dominated by forces beyond its influence.
The exchange value of the rand, which has a large influence on inflation in SA, follows a course that is independent of Reserve Bank reactions. It is influenced by the sayings and actions of SA politicians. The rand also responds directly to global capital flows that drive the US dollar and emerging market currencies. Prices in SA respond directly to the price of imported oil and the taxes levied on it. The weather, food prices and the Eskom tariff are among other forces that always act on prices, to which the Bank can only react but not influence.
The interest rate reactions of the bank can only influence the demand side of the price equation. Reducing demand with higher interest rates, in the hope of countering the supply side shocks to prices, can depress demand in the economy.
The trouble with slow growth is that it raises the risk that SA may abandon its fiscal conservatism and elect to inflate its way out of its debt, which becomes ever more burdensome with slower growth. Paradoxically perhaps, it’s a burden that also rises with lower inflation. When nominal GDP growth (real growth plus inflation) falls below interest rates, the burden of debt (debt/GDP) increases.
Long-term interest rates and growth in nominal GDP
SA can only hope to reduce the costs of funding its debt and escape the threatening debt trap by convincing the market place that it will not abandon fiscal conservatism. It will take even more than raising taxes or reducing the trajectory of government expenditure to reduce long-term interest rates meaningfully, which are both austere actions that in themselves hold back growth in the short run.
A commitment to the privatisation, rather than the reform, of our failed public enterprises is called for. This will reduce risks to lenders, bring down interest rates and permanently raise the growth rate. It will support the rand and reduce inflation by attracting additional foreign investment and capital.
Without such a change of mind and actions to back them up, the risks of us, sooner or later, inflating our way out of the debt trap will remain. Absent such reforms, our problems will continue to be exacerbated by permanently slow growth, for which the failed public enterprises will bear a large responsibility. Any failure to take this obvious action will keep up the high cost of funding borrowings.