With inflation and currency volatility in check, South Africa's economy has provided fertile ground for greater prosperity and a boom in consumer finance. The government harbours ambitious investment plans over the next eight years, but with sovereign bond issuance falling below GDP growth, the domestic and international debt markets — and particularly securitisation — will have to pick up the slack. Darius Sokolov reports.
In 1994 the African National Congress formed South Africa's first democratic government, and found itself confronting an economy in tatters. The new regime soon made its economic position clear: disappointing many of its allies on the left and in the trade union movement, it would push a programme of market liberalisation. Finance minister Trevor Manuel — still in the post twelve years on — announced the Growth, Employment and Redistribution (GEAR) strategy that set out to reach 6% annual GDP growth by 2000 and create over 400,000 new jobs each year.
The reality fell rather short of these targets. Annual per capita growth rates between 1994 and 1999 averaged 0.8%. It also became apparent that the new regime was failing to address the deep structural faults underlying the country's economy: high unemployment, gross income inequality, and a rift between formal and informal sectors that shows little sign of closing.
But since 2000 the economy has been healthier, with GDP per capita growth averaging 2.7% in the last six years. The economy's growth reached 4.9% in 2005. In this year the government focused its sights on curbing inflation. The currency devaluation crisis of 2001 (the rand dropped 24% against the dollar) pushed inflation up to 9.3% in 2002. But the rate is now within its 3%-6% target band, with an average of 4.3% in 2005.
With inflation under control, the government was able to hold interest rates at a low of 7% for more than a year from April 2005. A sequence of 50bp rises in June, August and October have now brought the South African Reserve Bank's repurchase rate to 8.5%.
The recent prosperity has fed a consumer boom, as a growing middle class enjoys its new found wealth. Along with spending comes increased household debt (40% of GDP at the end of 2005), of which 85% is mortgage debt during a time of rapid house price inflation that peaked at 35% in the second half of 2004. There has also been spectacular growth in the equity market, which at the end of 2005 had a market capitalisation of R3.6tr. The FTSE/JSE All Share index has almost doubled in value over two years, with average monthly growth rates of 2.8% over the last 24 months.
But growth does not seem to be reaching the parts of the economy, and the population, that need it most. A particularly stark indicator is unemployment, now at 26%. IMF figures show that while unemployment dropped immediately after 1994, it has been creeping gradually back up and now stands at a similar level. There are more jobs, but they are not keeping up with growth in the labour force. Moreover, says the IMF, all of the employment increase is in the informal sector, which is growing relative to formal business.
The government's latest economic push is called the Accelerated and Shared Growth Initiative for South Africa (ASGISA), which again targets 6% growth, and to halve unemployment by 2014. The government identifies six main factors hampering an improvement in the economy, which the policy hopes to address: the exchange rate and its stability; weak infrastructure (particularly transport and telecommunications); skills shortages; competition barriers in some sectors; the regulatory burden on smaller businesses; and shortcomings in government organisation and strategic leadership.
The government has sought to encourage cross-border investment, both into and out of the country, by relaxing exchange controls for businesses. Controls were scrapped for non-residents in 1995. Limits on foreign direct investment by South African firms were scrapped in October 2004, and companies were allowed to retain foreign dividends abroad. Limits on foreign investments by South African investment funds were increased a year later to 15% for pension funds and long term insurers, and 25% for unit trusts. These ceilings are likely to be raised further.
Volatility of the South African rand is a continuing concern. The rand was severely devalued in 1998 (28% against the US dollar) and 2001 (24% against the dollar in the year's last three months). The currency seemed to have settled by the end of 2005, but volatility returned this year: in the second quarter of 2006 the rand devalued to 16.2% against the dollar, the biggest fall since 2001.
The IMF's Staff Report for 2006, Article IV Consultation with South Africa, blames the recent currency troubles mainly on increased risk aversion in global financial markets, which it says hit stock prices and sovereign spreads. While most emerging markets suffered, South Africa was hit harder than most. A widening current account deficit increased vulnerability, important commodity prices weakened, and reportedly there was short selling of the rand by investors covering their exposures to less liquid emerging economy currencies.
Overall, South Africa's external economy remains exposed to the vagaries of global market sentiment, and the IMF maintains that the country's main short term risks come from without.
For all its shortcomings, the South African economy is by far the strongest in the region. It makes up a quarter of total GDP in the African continent. The international consensus on the economy is positive — South Africa is widely seen as a well-managed economy that should continue to prosper.
A prudent sovereign
One success of the post-apartheid government's GEAR policy was to bring its fiscal deficit down to a level that could be the envy of many developed nations. From 5.1% of GDP in 1994, high tax revenues helped South Africa approach a balanced budget in 2005–2006 with a deficit of 0.3%. Outstanding government debt stood at 30% of GDP.
Such fiscal prudence has had a damping effect on the domestic bond market, which is dominated by sovereign issuance. At the end of fiscal year 2005/2006, R418bn of marketable domestic government bonds had been issued, constituting 78.3% of total government debt and 23.2% of GDP. This compares with R332bn in 1999/2000, 37% of GDP at the time.
This year's South African treasury budget forecasts suggest that trend will continue. It forecasts that sovereign bonds will only amount to 18.5% of GDP by the end of 2008/2009 — despite plans for a big spending programme in the run up to the 2010 Fifa World Cup.
The government's 2006 medium term budget policy statement, published on October 26, outlines a national infrastructure spending programme growing on average 14% per year, from R87bn in 2006/2007 to an estimated R129.5bn in 2009–2010. Most of this money will be spent on transport and communication infrastructure.
While debt reduction has slowed supply in the sovereign market, it helped rating agencies to recognise that South Africa was due for an upgrade. In January Moody's lifted the sovereign long term foreign currency debt rating one notch to Baa1. Its A2 local currency rating is on a par with Israel, Poland and Saudi Arabia. Fitch had already upgraded the foreign currency rating to BBB+, and A for local currency, in August 2005. Standard & Poor's has South Africa at BBB+/A+.
Corporates with frontiers
The pattern of growth in South African industry shows the extent of the consumer boom. Construction is the most dynamic sector: growing 10% in 2004, and another 10% in just the first nine months of 2005. Finance and real estate services, retail and wholesale trade, then manufacturing — consumer goods rather than basic materials — come next.
South Africa is now predominantly a service economy, while the mining industries for which South Africa is widely known are becoming less important to the domestic economy. Though they are still big factors in foreign trade: precious stones alone are a quarter of exports.
If growth is to meet the government's ambitious targets, businesses must overcome a number of obstacles. The World Bank's leading Investment Climate Survey published in May asked 800 companies, from leading corporations to small firms, to identify the main barriers to their growth. The four concerns that stood out (identified by around 30% of businesses in each case) were skill shortages, macroeconomic instability, labour regulation, and crime. The firms most concerned with macroeconomic instability were exporters, suggesting that the turbulent exchange rate was at the heart of their worries.
Larger companies in particular see a lack of opportunities for diversification as a problem. South Africa's geographical position, bordered by countries that are some way behind it in terms of economic development, is a particular issue. The African economy is growing: the continent as a whole increased GDP by 4.5% in 2005, and estimates are higher for this year. But economies outside South Africa are generally much more focused on basic commodities, with fewer opportunities for expansion in services and manufacturing.
Banks — SA's 'Big Five'
South Africa has 34 banks registered with the Reserve Bank's bank supervision department, which regulates the industry. But for many purposes there are only five.
The biggest, Standard Bank of South Africa, had assets of R436bn at the end of 2005. The other three super-sized banks, all with assets of over R300bn, are Absa Bank, First Rand, and NedBank. Investec is a good deal smaller, with R97bn, but four times larger than the next on the list, Imperial Bank.
The banks are well capitalised, with capital holdings averaging 12.6% in March 2006, safely above the Reserve Bank's minimum of 10%. The five biggest banks are all planning to implement the advanced internal ratings-based (IRB) approach under Basle II for their retail assets, and the foundation IRB approach for corporate assets. The accord will be implemented in South Africa on January 1, 2008.
Growth has been kind to the big banks, with consumer spending boosting their retail books in particular. The assets of the five big banks grew on average by 17% in 2005. Even in a lower interest environment profits have remained healthy, with an average after-tax return on equity (net qualifying capital and reserves) of 14.5% in 2005.
The domestic investors
Middle class households channelling their growing incomes into consumption are good for supply in the bond markets, as banks look to refinance their retail lending. But a low marginal propensity to save is not so good for demand.
In fact the decline in the savings rate in South Africa started as far back as the early 1980s. By 2001 private and corporate savings had reached a low of roughly 13% of gross national disposable income (GNDI) each. This does not compare well, for example, with the high saving rates of Asian economies which have boosted that region's rapid growth. Malaysia, Thailand and Korea all have gross national saving rates of over 30% of GNDI.
South Africa may not be up there with the Asian tigers, but investment is increasing at a decent pace. The total assets of South African institutional investors stood at R2.84bn at the end of 2005, according to figures compiled by Rand Merchant Bank. This amount was triple what it had been at the end of 1996, and growth in institutional investment reached a six year high with a 20% increase from 2004 to 2005.
Long term insurers are the biggest investors overall in South Africa's capital markets, holding 40% of the total financial assets of institutional funds. After them come official pension funds with 16%, unit trusts with 14% and private pension funds with 14%.
Another important presence in the South African marketplace is that of the Public Investment Commissioners (PIC), with 15% of institutional assets, or R420bn. The PIC is a non-bank financial intermediary charged with making investments on behalf of government departments and other public sector bodies, including social security funds and government employee pension funds.
But the insurers are only the third biggest presence in the bond markets: the majority of their capital is held in shares. Official pension funds make up 32% of institutional funds in the bond markets, followed by the PIC (29%), which has been reducing the proportion of its debt holdings, once the large majority of its assets.
Indeed the proportion of overall funds invested in fixed income instruments has been on a gentle decline across the board — from 34.4% of institutional funds in 1996 to 26.1% in 2005. Institutional bond investment grew by 234% from 1996 to 2005, with growth rates staying fairly constant between 8% and 14% over the last six years. But the equity boom has directed further growth elsewhere.
Although, says Simon Howie, credit portfolio manager at Investec Asset Management in Cape Town, equity profits have not hurt the overall level of capital going into the bond market.
"Equity growth is causing an overall boost to funds under management," he says, "and as funds rebalance across asset classes some of that feeds back into fixed income."
Apart from the focus on equity, concentration risk is a big major issue for South African bond investors. There are barely a handful of corporate and government-backed issuers in the bond market (see Corporate and public sector bonds chapter on page 12). Thus the inevitable vicious cycle: investors are loath to become too exposed to the same small group of names, but low demand deters potential new issuers.
The rapid development of the securitisation market has helped provide more options for investors. According to Andrew Canter, head of fixed interest investment at Futuregrowth Asset Management in Cape Town, interest rate volatility in the past has been a particular barrier to investing in the securitisation market, as many funds operate with fixed rate benchmarks. But the development of a more accessible interest rate swap market is breaking this down.
"Funds are developing the ability to manage interest rates both on the systems side and the mandate side," says Canter. "In theory, it is an ideal arbitrage opportunity — if you look at pricing on equivalent rated fixed bonds and floaters, the securitisation market offers a very good risk/return profile."