May 2013 – ZA Economist

How important is mining to the SA Economy. It depends on how you measure it.

A crisis of poor returns on capital invested and declining employment opportunities

SA mining is in crisis. And the travails of SA mining, more particularly those of gold and platinum mining are having a very negative impact on GDP and expected GDP growth and on the value of the rand. To survive as viable businesses able to cover their costs of capital the mines have to plan for lower costs of operations and that means to plan for lower levels of production and employment, that is plan the closing rather than the opening of mining shafts. Investors in the industry and in the South African economy are not at all sanguine about the prospects for the industry and this lack of confidence is well reflected in the market value of the mining companies and in the exchange value of the ZAR.

The market fears further disruption of mining output by uncooperative trade unions. Union leaders do not appear to share the same sense as have shareholders and potential investors have of an industry in crisis. The Unions are expected to further resist retrenchment of their members and to continue to demand what shareholders and also the government regard as hopelessly unrealistic demands for improved employment benefits.

The future of deep level mining in South Africa may well lie in much higher levels of automation. This is a course of action not suited to an economy with so many unemployed or employed on far inferior terms outside the mining sector.

The mining sector contributes much to exports and to the outlook for the rand and interest rates

Lower levels of mining production, particularly if they are the result of strike action, threaten the trade account of the balance of payments and justify a weaker rand. The weaker rand then implies more inflation that makes it harder for the Reserve Bank to offer relief to the economy in the form of lower interest rates, relief, absent a widening trade deficit, that would make every economic sense.

Growth in Domestic Expenditure (GDE) has held up significantly better than growth in domestic output (GDP) meaning stronger growth in imports than in exports. The failures of the mining sector to produce more and to take advantage of what has been until recently, highly favourable price trends ( as we will show below) are a large part of the explanation of current rand weakness and slow economic growth generally.

The share market doesn’t expect growth in output or even growth in earnings and dividends from the mining houses and their subsidiaries. It is rather demanding that the mining houses pay much closer attention to cost control and operational excellence. These low market expectations should act as a warning to managers, workers and the government responsible for mining policy. The lower profits and reduced growth expected is not in synch with demands for higher wages, electricity prices and government interference with mining rights and the taxation of mining profits. The potential upside for shareholders is that if these low expectations can be countered by sober management and better relations with labour and government then these mining companies stand a stronger chance of recovering their status with investors. Merely sustaining the output of gold, platinum even at lower planned levels, would be surprisingly good news and likely to be well received in the share and currency markets.

How dependent then is the SA economy on the mining sector? It all depends on how the share is measured

The SA economy remains highly dependent on the export of minerals and metals. Directly exported minerals and metals account for as much as 60% of all export revenue. Hence the sensitivity of the foreign exchange value of the rand to mineral and metal prices and their production.

Mining’s share of the Gross Value Added (GVA) by all sectors of the SA economy in 2012 was no more than 5.5% when measured in constant 2005 prices. When both mining output and GVA, including mining output, is measured in current prices, mining’s share rises to 9.3% of GVA. As we show below, when measured in constant 2005 prices, the contribution of mining to GVA and GDP has been steadily declining over many years from a large 23% share in 1960 to the current less than 6% share , regardless of the direction of global metal and mineral prices and so mining revenues.

As we also show that when the share of mining is measured in current money of the day prices the share of mining in the economy takes on a very different complexion. The share of mining in the SA economy, so measured as a ratio in current money of the day prices, was less than 12% in 1960, compared to over 23% in constant price terms that year. In 1970 the share of mining in GVA was 8.8% if measured in current prices, or a much higher share, 20% of the economy, if measured in constant 2005 prices. Thereafter the mining share measured in current prices rises significantly rises in response to the very significant increases in the gold price in the seventies. When the gold price peaked in 1980 the share of mining in GVA in current price terms was as much as 21%- but then only about 12% if recorded in constant 2005 prices. Thereafter, as the gold price fell away and the prices of mining output were subject to a long period of deflation and a further decline in the output of gold, the share of mining in current price terms fell further to a much less important 7% by the year 2000. Thereafter when measured in current prices Mining gained a marginally larger share of the economy to the 9% share measured in 2012. The increased output of and higher prices coal and iron ore were significant contributors to thei increase in economy share. The share of mining in the economy in constant price terms by strong contrast declines continuously after 1960 and appears completely unaffected by relative prices or industry trends as we show below.

The share of Mining in Gross Value Added using constant 2005 prices or current prices

Source; SA Reserve Bank Data Bank, Investec Wealth and Investment.

Real prices matter a great deal to producers

A key to the role of any sector of the economy, with an improving or deteriorating share of the economy, is surely relative price trends. When a sector enjoys what may be called pricing power, that is to say the sector can price increases ahead of the average rate of inflation , then one would expect improved profit margins to follow and extra output to be encouraged. In the figure below we show how the SA Mining Sector Price Index, that is the mining sector deflator, has compared over the years with all prices, including the prices of metals and minerals, as reflected by the Gross Value Added Deflator.

As may be seen between 1960 and 1970 Mining Sector selling prices lagged well behind the selling prices of all SA production or value Added. In the seventies, helped especially by a rising gold price, prices realised by the SA mines, rose significantly faster than prices in general. A long period of metal and mineral price deflation then followed until approximately 1999 when commodity prices picked up strongly in absolute and relative terms. These favourable trends or terms of mining trade were then disrupted by the Global Financial Crisis of 2008-09

The Mining Sector Deflator compared to the Gross value Added Deflator (2005=100) Logarithmic Scale

Source; SA Reserve Bank Data Bank, Investec Wealth and Investment.

If we divide the Mining Sector deflator by the GVA deflator we get the relative price of mining output. For producers in any sector the higher the relative price the better and the more encouragement offered to increase otput.[1] In the figure below we compare these relative prices with the share of Mining in GVA, measured in current prices. As may be seen the share of mining grows and declines very consistently with improvements in or a deterioration of the relative prices of mining output. Such responses make every economic sense. That the share of mining, when measured in constant price terms, declines consistently and independently of these relative prices makes very little intuitive sense. Relative prices appear to make no positive impact on the mining sector at all when the mining share is measured in constant prices. The share of mining in the economy, when measured in constant prices, simply declines continuously as may be seen.

The reason for this highly counterintuitive result is simply in the arithmetic of National Income Accounting conventions. If sector prices – for example mining sector prices – rise faster than prices in general then the share of that sector in the economy, when measured in constant prices, automatically declines and vice versa when sector prices rise more slowly than prices in general the share of that sector will rise automatically. [i]

The presumption of such a result is that it is the supply side of the economy, rather than demand forces that drive relative prices and so relative shares in national income methods of calculation. That is it is an increase in supply that results in a lower relative price and so a larger share of the economy. Rather, that as in the case of mining output, where prices are set globally and the mines are price takers, to presume that it is an increase in global demand that leads to higher prices and in turn to more profitable production and so increases in output and in the share of the economy realized by a sector.

Applying the standard convention to the share of Mining and also Exports in SA subject to similar price trends becomes seriously misleading. Measuring sectoral shares using current prices makes much more economic sense.

It should be noticed in the figure below that SA miners benefitted from an extraordinary increases in the prices for their output compared to prices in general in the seventies and after 2000. Relative prices have moved further to the advantage of the mining sector over the past twelve years as may also be seen. That Mining’s share of the economy did not rise anything like as significantly in the past decade and more reflects the wasted opportunity to benefit from the commodity super cycle. The mining boom in terms of volume of output produced regrettably largely passed South African production by. The costs of mining gold and platinum rise as rapidly as did prices. Uncertainties about government policies towards mining and the failure to invest in additional transport infrastructure to export more coal and iron ore also contributed significantly to the modest supply side responses to much more favourable relative price trends.

Mining share of GVA and Relative Mining Prices

Source; SA Reserve Bank Data Bank, Investec Wealth and Investment.

Another very good reason to question the use of constant prices to calculate sectoral shares of the economy is that these shares can change meaningfully with changes in the base year used to measure constant prices. Using exactly the same price series, the same deflators, measured in constant 2005 prices or constant 2000 or constant 1970 prices can make a large difference to the share of a sector measured in constant prices as we show below. Using a deflator with 1970 prices =100 for both Mining and GVA, to one using much lower 2000 prices or 2005 prices as the base equal to 100 shifts the share of mining in constant prices in 2012 from 2.4% using 1970 prices to 4.8% using 2000 prices to 5.5% using 2005 prices. [ii]

Share of Mining In the SA economy using different base years

Source; SA Reserve Bank Data Bank, Investec Wealth and Investment.

That changing the base year can have such a meaningful effect on the sector share makes the use of constant prices as the basis for calculating the share of different sectors in the economy highly unsatisfactory. While the trends in the sector share, measured in constant prices using different base years, remains exactly the same the numerical values can turn out to be very different. Every change in the base year results in once and all constant shift in the trend giving a different impression of the importance of the sector to the economy. This is why in our judgment the most consistent measure of mining’s contribution is the ratio of mining output to Gross Value Added ( GVA)when both mining output and that of all sectors including mining GVA, is measured in money of the day prices. By this calculation the share of mining in the SA economy peaked in 1980 at over 20% and currently contributes about 9% of all value added as we show above.

The contribution of manufacturing to the SA economy is exaggerated using constant price calculations

The same approach to measuring the share of Manufacturing in SA production can be taken. In the figure below we show Manufacturing’s share in GVA as well as the relative price of manufacturing Output. As may be seen the share of Manufacturing measured in current prices was approximately 24% in the eighties. It has since declined markedly to a 12.4% share in 2012. This declining share has been accompanied consistently by an almost continuous decline in relative prices. This downward price pressure has clearly accelerated in recent years. Manufacturing in SA has become increasingly exposed to competition, especially from abroad. Consumers and retailers and their employees have benefited from the competition.

Manufacturing Sector; Share of Output and Relative Prices

Source; SA Reserve Bank Data Bank, Investec Wealth and Investment.

Conclusion

Economic statistics should accurately reflect economic realities and hopefully lead to appropriate economic policy and policy changes. Measuring sector shares in SA in constant price terms as is the National Income Accounting Convention is very misleading about the role of mining in South Africa and therefore also about the role of other sectors, including Manufacturing as we have argued. A irony is that if shares in the economy were measured in current rather than constant price terms this past quarter the disappointing and currency moving Q1 GDP numbers would have looked rather different. Manufacturing, with a lower share of the economy when measured in current prices, 12.3% share in current prices in 2012 compared to 17.2% in constant prices, with a close to 8% decline in output on a seasonally adjusted and annualized basis, would have been less of a drag on economic growth. And mining output that increased in Q1 given a larger share of GVA (5.6% in constant prices, 9.3% in current prices) would have added more to the growth rate.

[1] The case of Gold Mining in South Africa is somewhat different to the norm. In the seventies and eighties the higher gold price offered a choice to the mines. They could choose to mine shafts with lower grade, that is ore with lower gold content and in this way extend the life of the mines by extracting more gold bearing ore so leaving less gold behind. They typically elected, where possible, to extract more gold bearing ore from underground with lower average gold content. As a result the output of gold fell from 1000 metric tons in 1970 to 670 tons in 1985 while the tones of ore extracted and milled by the mines grew by about 30% from 75m tons in 1970 to 105m tons over this period 1970 – 1985. Capital expenditure by the gold mines was R106m in 1970 and R1911m in 1985. Working profit per ton of ore milled was a marginal R3.9 in 1970 and a hugely profitable R70.46 in 1985. 416,846 workers were employed by the gold mines in 1970 and 513,832 in 1985. If productivity was measured as output of gold per worker employed then it declined sharply over this period, from 2.3 kg of gold per worker in 1970 to 1.3kg in 1985. If productivity was however more realistically measured as tones of ore extracted per worker, then it would have improved from 178 tonnes of ore milled d per worker in 1970 to 203.5 tonnes in 1985. These tradeoffs of lower grade for a longer mining life seem no longer available to the gold mining industry. The better grades of ore appear as largely exhausted and the industry is forced to mine lower grade ore at ever deeper more costly levels. The volume of ore extracted has declined consistently over the past ten years while the annual output of gold from SA mines is now below 200 tonnes. (See Table Below) Source; Annual Reports of Chamber of Mines of South Africa.

[i] The mathematical proof of this and other propositions made here are to be found in a paper written in 1987 with Iraj Abedian, Relative Price Changes and their Effects on Sectoral Contributions to National Income , that can be found in my blog www.zaeconomist.com

[ii] Reducing or increasing the absolute value attached to the price series reduces or increases the sectoral share by a constant value. The 1970 deflator rises from a very low absolute base of 100 in 1970 to a level of close to 50000 in 2012- a 500 times increase in average prices over the 42 years. The deflator for 1970 using 2005 prices as the basis would have an absolute value of 0.869 compared to the value of 100 if 1970 was chosen as the base year. Clearly such absolute numbers with excatly the same underlying trend should not have a real effect.

Equity markets and retirement: Back to the future

By Brian Kantor

It is retirement plans for the future that should concern us, not those of the past that have done so well in South Africa.

The weekend newspapers were full of exhortations for South Africans to save more than they appear inclined to do for a comfortable retirement. Personal Finance, in a caption (Weekend Argus 18 May 2013) reports: “You need to save more than you planned to do if you want to have a financially secure retirement, because of interest rates and investment market expectations.”

Given the decline in long term interest rates (and so expected market returns), it will take a larger capital sum to purchase a highly predictable flow of monthly annuity income from a life insurance company. Or, in other words, for any given life expectancy, a million rand of accumulated savings will now buy you significantly less monthly income from an annuity supplier than it would have 10 years ago, when long term interest rates and so expected returns were much higher than they now are.

The article in Personal Finance is accompanied by a figure describing the monthly “inflation-related” pension that could be purchased “by a 65 year old man with provision for spouses annuity and a 10 year guarantee” with R1m. The figure shows the contracted monthly pension as having declined from over R3 700 per month in December 2007 to about R3 000 per month today. A vanilla annuity without any inflation protection would provide about a fixed R60 000- R70 000 per annum for the same retiree.

Interest rates on an RSA bond with 10 years to maturity have declined markedly since 2002 from over 12% for a generic 10 year bond, to their current levels of about 6.3% while inflation linked real yields offered by the RSA government have declined even further, from 4.93% in early January 2002 to their current levels of about 0.6% (see below).

The expected return on a bond is its yield. The expected return on an (on average) risky equity is the bond yield plus an equity risk premium of an extra four or five per cent per annum. If realised returns approximate expected returns – a very large presumption – the lower the market interest rate and the lower the expected returns from bonds or equities, the more you will have to save to secure a given monthly income.

It is these largely certain income streams, a certain nominal 6.3% per annum or so from a 10 year RSA, or a real 0.6% (that is 0.6% plus actual inflation from an inflation-linked 10 year RSA), that form the basis on which a guaranteed annuity of either the inflation exposed or inflation protected variety will be offered by a life insurance company (the R36 000 or R70 000 annuity per annum referred to).

Realised and expected returns may however turn out to be very different. In the US for example, on 31 January 2002 very long dated US Treasury Bonds offered a yield of about 5.43%. Total annual returns from these long dated bonds, calculated each month end between January 2002 and April 2013, averaged approximately 8.75%. Total returns are the sum of interest yield, interest/capital values plus the annual change in the market value of the bond.

As long term interest rates in the US trended significantly lower over the period, long bond prices went proportionately higher, so providing unexpectedly good returns from US bond portfolios – on average 3.3% per annum above the expected returns of 5.43% offered by a 30 year US Treasury Bond on 31 January 2002. By contrast the average US equity investor realised well below expected returns. Equity returns would have been expected to realise about 9% a year in January 2002. Actual returns on the S&P 500, including dividends and capital gains and losses, averaged a mere 2.8% per annum. over the 11 year period. US inflation averaged 2.44% over the period, well ahead of short term interest rates that were an average 2%. Unexpectedly low inflation a brought down long term interest rates and pushed up bond prices to the advantage of bond holders. They did very little for equity investors who would have expected to have earned a premium return over bonds given their greater volatility.

Contributors to a reasonably well managed defined contribution SA pension fund since 2002, that would sensibly have included a good weighting in equities, have realised excellent real returns on their pension funds, than might have been reasonably expected early in 2002. The returns realised in the RSA bond and equity markets over the past 10 years have been well ahead of inflation.

And the actual inflation expected by bond and equity investors and implicit in long dated bond yields in 2002 proved to be greatly overestimated. The fact that interest rates fell over the period, so increasing the market value of any bonds held by a pension fund, added meaningfully to these bond market returns. Very long term interest rates in SA in January 2002 were 14.16%. They have more than halved since then. Actual returns on these bonds since then have averaged over 12% per annum. The return on the All Bond Index (with an average term to maturity of six years) was an average 10.13% per annum. The JSE, represented by the All Share Index, returned an average 15.5% a year while short term interest rates averaged about 8.6%. These returns were especially impressive when compared to inflation that averaged an unexpectedly low 5.9%. A balanced SA pension plan over these 11 years and four months was thus adding real purchasing power to savings at a most impressive rate – a most helpful outcome to those contributors to pension funds intending to retire today.

High real returns from the RSA bond market, combined presumably with excellent real returns from the share market, in which even a conservatively managed pension fund would have benefitted, plus good real returns from the money market, meant that the capital value of any SA pension fund should have grown rapidly enough since 2002 (after management fees) to overcome the reality of lower expected returns in 2013.

Some simulation exercises can help make the point about just how well the current cohort of those facing retirement today have been served by the exceptionally good returns provided by the SA capital markets since 2002.

For example, consider an intended retiree of 65 years today, who had a defined contribution balance of R5m in 2002 and earned a salary then of R500 000. Let us say that his salary grew at 8% a year over the period and he continued to contribute 10% of his growing salary to his pension plan. If the pension plan had a modest 50% weight in equities, 40% in bonds and 10% in cash based on realised returns since 2002, his nest egg would have grown to over R22m by April 2013. Had he not added to his savings, his wealth would have mounted to about R20m. His salary by 2013 would have grown to over R1.1m and his R22m would have bought him an inflation protected retirement income of about R792 000 a year. If he were prepared to take on inflation risk he might be able to secure an annual constant nominal income of about R1.5m for as long as he lived. His post retirement income would thus seem to bear a highly satisfactory relationship to his pre retirement income. It would not make a great deal of difference to these outcomes if part of his 2002 nest egg of R5m was in the form of equity in his own home. The return on homes in the form of implicit rental yield plus capital gains (especially until 2008) would have compared well with alternative investments.

What about the future?

It is therefore not so much the savers of the past that we should be worrying about, but the savers of the future who now have to face lower expected real returns in the market place. Their ability to build up an adequate store of purchasing power for old age is being compromised by low expected real returns. These low expected returns may well turn out to be low realised real returns, in which case a higher rate of real savings is urgently called for by all those intending to retire in 10 or more years.

The danger to investors in long dated fixed interest securities is unexpectedly higher, not unexpectedly lower interest rates. It is not lower nominal interest rates but higher rates that make it more difficult to build savings for the future, as we have shown. Lower inflation can compensate fully for lower nominal interest rates when a fixed annuity is purchased.

Lower expected real returns, all other things equal, demand a higher rate of real savings to sustain a desired rate of post retirement real purchasing power. A higher rate of real saving can be expressed as a larger percentage of nominal income contracted to a pension or retirement savings scheme. But the danger to current savers is that these real and nominal interest rates will rise over time, reducing the value of any bond portfolio. This is the opposite of the benign winds of lower interest rates that have blown over capital markets over the past 20 years.

It should therefore be appreciated that the current level of real interest rates expressed explicitly as the real return on long dated inflation linkers issued by governments is exceptionally low. Real interest rates close to zero are well below long term averages that have been of the order of two or three per cent. In normal times real interest rates can surely be expected to regress back to long term averages. If they do, does it make sense for those retiring today to commit their capital permanently to such low returns? Furthermore, those planning to retire in the next 10 or 20 years might well judge it appropriate to accept more risk in their retirement portfolios – that is the risk that real interest rates will rise as the economy grows and so the demand to invest more capital in real assets raises the competition for savings. Proportionately more equity (that promises higher returns in exchange for more risk) seems to us to be a sensible response to what may be a short lived world of very low interest rates.

Expectations of Platinum Mining in South Africa – Anchored in the False Bay

As printed in Business Day 14 May 2013

by David Holland and Brian Kantor[1]

Behavioral studies have shown that humans exhibit a strong anchoring tendency. When the world changes, they remain anchored to the one they know instead of adapting to the new order. Evidence for this behavior is ubiquitous when parsing through government and labour comments about the ability of mining companies to pay more or hire increased numbers of workers. This is undoubtedly a reason for delay and lack of resolution in discussions between government, organized labour and Anglo American Platinum about the company’s need to reduce costs and investment.

We would like to take a step back and assess how profitable platinum miners are, and calculate the expectations embedded in their market prices. Once we understand those expectations, we can focus on the best way forward for the business and its stakeholders.

The platinum industry has been one of great hope and now disillusionment. We aggregated the historical financial statements of the 5 largest South African platinum miners (Anglo American Platinum, Impala, Lonmin, Northam and Royal Bafokeng) and calculated the inflation-adjusted cash flow return on operating assets, CFROI, which is the real return on capital for the industry. From 1992 to 1997, platinum miners were generating an unattractive return on capital, which slumbered below the cost of capital. The years 1999 to 2002 provided the first wave of extraordinary fortune for platinum miners. The real return on capital exceeded 20%, making it one of the most profitable industries in the world at that time (the average CFROI for global industrial and service companies is 6%). The rush to mine platinum and build company strategies around this effort was on, e.g., Lonmin bet its future on platinum.

The 2^nd wave of fortune occurred during the global commodities “super cycle” from 2006 to 2008. Again, platinum mining became one of the most profitable businesses in the world. The good times ended abruptly with the onset of the Great Recession in 2009, and platinum miners saw their real return on capital drop to 1% – well below the cost of capital, i.e., the return required to justify committing further capital to the industry.

Unfortunately, operating returns have not improved much and have remained below the cost of capital throughout the global slowdown due to increasing labour, electricity and excavation costs, and lower platinum prices. By cost of capital, we mean the minimum return required of an investment in an industry with proper regard to the risks involved in its operations and financial constraints. The greater the risks, the greater the return required to sustain or expand the industry. Firms or sectors of the economy that prove unable to satisfy their cost of capital decline while firms that beat their cost of capital are strongly encouraged by shareholders and other capital providers to expand and to raise the finances necessary to do so.

The 2012 CFROI in the platinum sector of the SA economy was a miserable minus 0.6%, which is the lowest return on capital since 1992 when our calculations on realized returns in the sector begin. Suffice to say, platinum miners aren’t producing sufficient returns to satisfy shareholders or the market place to support their operations. This has resulted in unavoidable cost-cutting, lay-offs and deep cuts to capital expenditure plans. These are natural economic consequences when a business is destroying economic value by not meeting its cost of capital.

And what does the future hold? We’ve taken analyst expectations for 2013 and 2014 and estimated the real return on capital. It remains very poor at a value destructive level of 0% for 2013 and a depressed 3.4% until 2017. There is no hint of a return to superior profitability in the share prices of platinum miners. The market has them valued to continue to realize a real return on capital of less than 6%, which is the average real return on capital for industrial and service firms throughout the world. As an aside, despite high gold prices, profitability for SA gold miners is no better. Their aggregate CFROI is expected to remain around a value destructive 3% for the next 5 years.

In a nutshell, South African platinum and gold miners are destroying value and are expected to continue to do so. They are in a dire economic state. To survive they have to reduce costs. Demands for wage increases that far exceed inflation are now totally unrealistic and cannot be fulfilled. These demands are anchored to a past that no longer exists. The tragedy is that for the workers who are bound to lose their jobs mining platinum, there are no forms of alternative employment that will provide them with anything like the same rewards.

All parties should focus on what is realistically possible and economically feasible. A wage freeze, reduced hours or some form of deferred pay are called for to minimize the pain. The workers and the unions already subject to retrenchment and very poor job prospects would surely be wise to focus on job retention rather than further gains in real employment benefits for those still fortunate enough to retain their jobs. Any improved employment benefits that may be extracted will go to even fewer surviving workers. There is however another way that makes much more economic sense for all stakeholders not least the government and SARS that shares fully in profits and also wages earned. Cooperation – yes, call it co-option if you like – is urgently called for.

In normal economic circumstances it is sensible for employees of a failing firm not to sacrifice current benefits to keep their employers going. Ordinarily, they can expect to find equally well-paid work with another firm in an industry willing and able to employ them. After all, skilled or even less skilled but experienced workers are a valuable scarce resource in a well functioning economy that sustains close to full employment conditions. Unfortunately, this does not describe the SA labour market with its relatively few insiders employed formally and the many others, particularly young potential workers so anxious to join them but unable to do so.

Moreover most workers prefer fixed predictable rewards to variable income. The risks of variable incomes are borne by shareholders and to a degree, managers with bonuses linked to the company’s operating performance. If a failing firm is unable to offer market related benefits to its employees or indeed its owners, then it deserves to fail and the scarce resources it was employing and in effect wasting could be transferred to other firms capable of employing resources more productively.

In the case of platinum and gold miners in South Africa, the prospect of alternative employment with anything like the same benefits is very bleak. Workers would be well advised to settle for less especially now and hope to make it up at a later stage should the prospects of the industry and its productivity improve. Deferred pay offers an inventive compromise where current pay sacrificed is exchanged for shares or even options on shares to be realized at some point in the future. It would then be in all parties’ best interest for productivity and return on capital to improve. If these cost savings were made or even expected to be realized, the shares the workers owned in the industry, exchanged for lower take home pay, would appreciate significantly. Sacrifices made now to hold on to jobs could be more than made up in the share market. And more valuable platinum and mining companies would be able to much more easily fund growth in output and employment rather than manage as best they can declining output and employment.

Unless the industry can come to deliver a cost of capital beating return, its value to all stakeholders will surely decline further and its prospects deteriorate. Perhaps even to the point where nationalizing the industry with full compensation might seem a realistic proposition. It may cost relatively little to take over a failed industry. Nationalization however will not solve the problem of poor labour relations and the decline in the productivity of both labour and capital in the industry. It would simply mean that taxpayers, rather than shareholders who will have lost so much, carry the can for the failures of management and unions that must share the blame. The government and its agencies have many alternative and much better uses for tax revenues than to subsidise the already well-paid workers in a difficult, capital-intensive industry that is likely to realize poor returns.

The unions might think correctly that management subject to the discipline of taxpayers rather than shareholders would be a softer touch. Government and its taxpayers should be very wary of signing a blank cheque. All parties need to focus on what is realistically possible and economically feasible. By taking stock of the poor economic performance of the platinum mining industry and its depressed expectations, all parties can negotiate from a shared set of financial and economic facts. These are difficult times and creative approaches are needed. All parties need to be anchored in the right bay signaled by today’s reality and expectations.

[1] David Holland is an independent consultant and senior advisor to Credit Suisse. Brian Kantor is Chief Strategist and Economist with Investec Wealth and Investment.

Listed JSE property continues to surprise. Can it continue do so?

Exceptional returns all over again.

Property stocks listed on the JSE have again confounded the market place. From the beginning of the year to 8 May 2013, the Property Loan Stock (PLS) Index returned nearly 20% compared to 5% from the All Bond Index and 4% from the JSE All Share Index.

Since 30 April 2012 the returns provided by the PLS Index in capital appreciation and dividends have been even more spectacular. The PLS Index returned over 47%, over a period when the All Share and All Bond Indexes also provided still very good total returns of 21% and 18% respectively. Between January 2000 and May 2013 The PLS Index provided average annual returns, calculated monthly, of 23.4%, compared to an average 15.5% for the All Share Index, 11.9% average from the All Bond Index and about 8.8% average returns from the money market. Annual inflation averaged about 5.8% over the period.

What has the market missed when valuing JSE listed property? Interest rates and / or property fundamentals?

The extra value attached to listed property could have come from unexpectedly good rental income and / or unexpected declines in the rates at which those rental flows are discounted. Listed property valuations have very clearly had the benefit of unexpected declines in interest rates. Less obvious may have been unexpectedly good or perhaps also unexpectedly consistent growth in rental incomes after costs. Expected dividends are not made explcit like interest rates and interest rate expectations. At best they can only be inferred from market movements themselves.

In the figure below we show how the dividends distributed by the companies represented in the PLS Index, weighted by company size, have grown over the years. Over the extended period the dividends paid have fully kept up with the Consumer Price Index (CPI). Having lagged behind the CPI between 2002 and 2004, the PLS Index’s dividends per share had caught up with inflation by 2006. Since then they have matched inflation almost perfectly. Such consistent growth in distributions, despite the global financial crisis of 2008 that had a particularly severe impact on listed property elsewhere, might well have taken investors by surprise and justified something of a rerating for the sector. However no such re-rating has occurred.

The benefits of lower interest rates for property valuations

The value of JSE listed property companies has been very clearly assisted by unexpected declines in SA interest rates. As interest rates come down, property companies benefit in two ways. Firstly, their bottom lines benefit from less interest expensed. Secondly, the discount or capitalisation rate attached to expected rental income goes down and values go up with lower interest rates.

As we show in the figure below, long term interest rates and the PLS dividend yield have declined in more or less lock step. We also show the difference between long RSA bond yields and the initial PLS dividend yield. This yield spread represents the rating of the PLS. A widening spread indicates less market approval (a de-rating) and a narrowing spread indicates a more favourable rating (a re-rating). This spread widened to the disadvantage of the property sector in 2002-03. It then narrowed significantly from a +5% spread to a -2% by 2007. Thereafter the spread widened as interest rates rose in 2008 and narrowed again in 2009. This risk spread has remained highly stable since then.

It may be concluded therefore that the sector has not improved its rating relative to long term bonds since 2009. The improved property returns since then can be attributed to interest rate movements rather than to any sense of improved property market fundamentals.

Given that PLS dividends have kept pace with inflation (and may be expected to maintain this pace), the PLS dividend yield could then be regarded as a real inflation protected yield. Thus a comparison can be made with the real, fully inflation protected yield offered by RSA inflation linkers. The yield on the R197, an inflation-linked 10 year bond, has fallen dramatically over the past 12 months. Yet the spread between the PLS dividend yield and the inflation-linked R197 has remained largely unchanged as may be seen in the figure below. This “real” spread, the extra rewards for holding listed property, has not declined in recent years. This provides further proof that higher PLS values have been driven by interest rates rather than improved sentiment. No re-rating of the PLS sector has taken place according to these metrics.

Making the case for the PLS sector at current levels and yields.

The listed property sector is highly sensitive to interest rate movements. We calculate that for every 1% move in the All Bond Index, the PLS Index can be expected to move in the order of 1.5%. We have shown that the major force acting on the PLS Index in recent years have been lower interest rates. As we have indicated, there is little sign in the market place that expectations of the property sector have become more demanding. It is lower interest rates rather than faster growth in expected rental income (and the dividends associated with better underlying economic performance) that have driven the PLS Index higher.

What then are the required returns that will drive property valuations and development activity in SA over the long run? Our sense is that that the normal risk premium for a well diversified, listed and well traded SA property portfolio should be of the order of extra 2-3% per annum over long term interest rates on RSA bonds.

If that is the case, the expected risk-adjusted return on listed property would now be of the order of 9-10% per annum, that is about 3% above the current 10 year RSA bond yield of 6.13%. The current PLS Index dividend yield is 5.2%. Expected inflation implicit in the RSA bond market is 5.56% – being the difference in the nominal yield on a generic RSA 10 year bond of 6.13% and the equivalently dated inflation-linked RSA197 that currently yields 0.57%.

Adding inflation equaling growth in PLS dividends of 5.57% to the initial PLS dividend yield of 5.2% gives us an expected return of 10.77% per annum, or a PLS risk premium of 4.64% per annum. This is a risk premium significantly higher than our estimate of a required risk premium of 2-3%. It suggests that if we are right about a normal risk premium there is still some upside for the PLS Index at current interest rates.

Subtracting the RSA inflation linked yield of 0.6% from the 5% PLS dividend yield gives us real risk premium of the same magnitude, of about 4% plus. Again this seems too generous a reward for the risks in well diversified real estate.

The fundamental case for investing in JSE listed property today is that the current risk premiums available in the market place are larger than necessary for attracting funds to the sector. Yet it should be appreciated that regardless of the long term case for investing in JSE listed real estate (that may or may not prove compelling), the short term movements in the PLS Index will be dominated by movements in interest rates. In the short, if not the long run, the property sector remains a play on the direction of interest rates, regardless of the investment fundamentals. Brian Kantor

Why a great variety of new cars on the road is good economic policy

A lead article in BD by Alexander Parker, (Friday 5 April) was introduced with the headline State-Aided car exports ‘almost 40% of trade gap’.

The article quoted Roger Pitot of the National Association of Automotive Components and Allied Manufacturers, that the motor industry’s trade deficit was R49bn “or more than 40% of the national trade deficit … by far the highest we’ve ever had”. Presumably this trade deficit is the difference between the imports of motor vehicles (fully built) and also of components of motor vehicles (to be assembled in SA) and the exports of motor vehicles and components from SA.

Fair enough – but then the article goes on to quote Gavin Maile from KPMG “… local production of vehicles for export also contributed to the trade deficit …” an observation given prominence in the headline.

(This last statement is a non sequitur. Any exports of motor vehicles from SA would reduce the trade deficit provided, which seems reasonable enough to assume, that the prices received for the the exported vehicles covered at least some of the labour, transport and rental cost etc incurred in SA assembling and/or shipping out the vehicles. This would be true even if all the components of the vehicles exported were imported. Indeed, if the fully built up vehicles were shipped to SA and then re-shipped to neighbouring countries, outside the customs union, provided there were extra rands to be earned in these operations, the SA trade deficit would decline.) Imports might go up in rand terms importing the vehicles and or their components, but if some of the imports were then re-exported exports measured in rands would go up by more than the rand cost of the imported vehicles or the components previously imported.

But these logical quibbles aside, the more important point is that there is no logical reason to expect or plan for a balance of imports and and exports in any one sector of the economy as perhaps the component producers are suggesting and would prefer. There will always be sectors of the economy that profitably export far more than they import: for example mining or farming and other sectors, such as the motor industry where the opposite applies.

We and the firms we own and work for strive to profitably produce a surplus of the services or goods that we specialise in to supply the world of consumers and users, both domestic and foreign. We then turn these sales into money for salaries and wages and rents and taxes and profits for owners who then exchange this income for all the other goods and services that are cheaper to buy in than produce ourselves. As Adam Smith explained many years ago, division of labour and the productivity gained through specilaisation is limited by the extent of the market. These benefits of trade are widened by opportunities to sell to and buy from foreign firms and households.

An economy protected against foreign competition will not only import less but also export less because it denies itself the advantages of specialisation in goods and services in which it has comparative advantages (in both the domestic and foreign markets). The notion that trading partners will willingly buy from SA firms without an equal opportunity for their firms to also sell to SA customers is clearly false. Trade is a two-way street where the traffic is best kept flowing freely in both directions.

It is possibly a moot point whether SA would have much of a domestic motor assembly, let alone a domestic motor manufacturing industry, were it not for a long history of protection offered to the domestic manufacturer and component producer. The effective protection against imports may have declined to a degree – hence the greater volume of imported vehicles. The one great advantage of the current system of incentivising exports by giving license to import, is an SA market with a great variety of vehicles (though how well prices paid on the local showroom floors compare with prices abroad is a subject of much debate).

This variety of new vehicles on offer in the domestic market – from luxury to utility – not only encourages demand for vehicles but also employment in the distribution and maintenance of these vehicles. One wonders how the numbers employed in distributing and servicing the vehicle stock compare with those employed in manufacturing vehicles and components. Less variety on offer would mean reduced demand for new vehicles and a smaller slower growing vehicle park to service and trade.

But aside from employment gains made in distributing and servicing an enhanced vehicle park, there is another very valuable benefit from having a great variety of new motor vehicles for customers to choose from. The quality of motoring experiences for many highly paid and highly skilled participants in our economy – the indispensable rain makers so to speak – ranks for them (in lifestyle) not far behind, in importance and relevance, to the quality of their homes, children’s education and medical services. Force them all to drive the equivalent of the East German Trabant or a limited selection of cars that might be produced cheaply in relatively large numbers in SA, would mean a less attractive life style for them and so effectively a still higher tax rate imposed on their incomes.

With all taxes or exactions on their standard of living, these key personnel with artificially diminished choices in vehicles or in any other goods and services they wished to spend their own incomes on, would have to be compensated with higher pre- tax incomes to help keep them in SA. Being able to exercise consumer sovereignty not only makes you free: it also makes your economy more competitive in the market for skills and so in all markets for goods and services that domestic suppliers enter.

Freedom to enjoy the full variety of goods and services on offer in the global village, especially educational, medical and motoring services (at competitive prices that only openness to imports can bring), helps hold down the cost of attracting essential skills without which no industry or economy can hope to be competitive. Adopting free trade helps supply a better quality of life, including importantly a better quality of motoring. This is sensible economic policy that pays off for all sectors of the economy, especially for those that have a comparative advantage in exporting their surplus production. Protecting the market against imported goods or services inevitably will bring lower levels of exports and a lower standard of living for all- rich and poor.

Brian Kantor

Platinum mining in SA: Anchored in the False Bay

By David Holland and Brian Kantor

Behavioural studies have shown that humans exhibit a strong anchoring tendency. When the world changes, they remain anchored to the one they know instead of adapting to the new order. Evidence for this behaviour is ubiquitous when parsing through government and labour comments about the ability of mining companies to pay more or hire increased numbers of workers. This is undoubtedly a reason for delay and lack of resolution in discussions between government, organised labour and Anglo American Platinum about the company’s need to reduce costs and investment.

The platinum industry has been one of great hope and now disillusionment. We aggregated the historical financial statements of the five largest South African platinum miners (Anglo American Platinum, Impala, Lonmin, Northam and Royal Bafokeng) and calculated the inflation-adjusted cash flow return on operating assets, CFROI, which is the real return on capital for the industry. From 1992 to 1997, platinum miners were generating an unattractive return on capital, which slumbered below the cost of capital. The years 1999 to 2002 provided the first wave of extraordinary fortune for platinum miners. The real return on capital exceeded 20%, making it one of the most profitable industries in the world at that time (the average CFROI for global industrial and service companies is 6%). The rush to mine platinum and build company strategies around this effort was on, e.g., Lonmin bet its future on platinum.

The second wave of fortune occurred during the global commodities “super cycle” from 2006 to 2008. Again, platinum mining became one of the most profitable businesses in the world. The good times ended abruptly with the onset of the Great Recession in 2009, and platinum miners saw their real return on capital drop to 1% – well below the cost of capital, i.e., the return required to justify committing further capital to the industry.

The 2012 CFROI in the platinum sector of the SA economy was a miserable minus 0.6%, which is the lowest return on capital since 1992 when our calculations on realised returns in the sector begin. Suffice to say, platinum miners aren’t producing sufficient returns to satisfy shareholders or the market place to support their operations. This has resulted in unavoidable cost-cutting, lay-offs and deep cuts to capital expenditure plans. These are natural economic consequences when a business is destroying economic value by not meeting its cost of capital.

And what does the future hold? We’ve taken analyst expectations for 2013 and 2014 and estimated the real return on capital. It remains very poor at a value destructive level of 0% for 2013 and a depressed 3.4% until 2017. There is no hint of a return to superior profitability in the share prices of platinum miners. The market has them valued to continue to realise a real return on capital of less than 6%, which is the average real return on capital for industrial and service firms throughout the world.

In a nutshell, South African platinum miners are destroying value and are expected to continue to do so. They are in a very dire economic state. To survive they have to reduce costs. Demands for wage increases that far exceed inflation are now totally unrealistic and cannot be fulfilled. These demands are anchored to a past that no longer exists. The tragedy is that for the workers who are bound to lose their jobs mining platinum, there are no forms of alternative employment that will provide them with anything like the same rewards.

All parties should focus on what is realistically possible and economically feasible. A wage freeze, reduced hours or some form of deferred pay are called for to minimise the pain. The workers and the unions already subject to retrenchment and very poor job prospects would surely be wise to focus on job retention rather than further gains in real employment benefits. Deferred pay offers the potential for an inventive compromise where pay is exchanged for share options. It would be in all parties’ best interest for productivity to improve and for the shares to appreciate.

Unless the industry can come to deliver a cost of capital beating return, its value to all stakeholders will surely decline further and its prospects deteriorate, perhaps even to the point where nationalising the industry with full compensation might seem a realistic proposition. It may cost relatively little to take over a failed industry. Nationalisation however will not solve the problem of poor labour relations and the decline in the productivity of both labour and capital in the industry. It would simply mean that taxpayers, rather than shareholders who will have lost so much, carry the can for the failures of management and unions that must share the blame. The government and its agencies have many alternative and much better uses for tax revenues than to subsidise the already well-paid workers in a difficult, capital-intensive industry that is likely to realise poor returns.

The unions might think (correctly) that management subject to the discipline of taxpayers rather than shareholders would be a softer touch. Government and its taxpayers should be very wary of signing a blank cheque. All parties need to focus on what is realistically possible and economically feasible. By taking stock of the poor economic performance of the platinum mining industry and its depressed expectations, all parties can negotiate from a shared set of financial and economic facts. These are difficult times and creative approaches are needed. All parties need to be anchored in the right bay, signaled by today’s reality and expectations.

David Holland is an independent consultant and senior advisor to Credit Suisse. Brian Kantor is Chief Strategist and Economist with Investec Wealth and Investment.

Vehicle sales: Combined impact

April proved to be a good month for SA motor plants and showrooms. 50 920 units were sold with all sales categories – from new cars sold to households to very expensive heavy vehicles sold to business (and exports too) – well up on March and on sales recorded a year before. The early Easter holidays had reduced trading days in March compared to a year before, increasing trading opportunities in April.

On a seasonally adjusted basis, unit sales were up by a solid 7 644 units in April compared to March and were nearly 20% up on April sales a year before. If we combine March and April sales, sales this year of 105 866 units were 6.7% higher than the equivalent two months in 2012. This growth in domestic sales will surely be very encouraging to the industry, especially to its manufacturing and assembly arm, accompanied as it was by very good export volumes of 22 907 units – equal to a solid 45% of domestic sales volumes.

When sales are smoothed and extrapolated using a time series forecast, sales appear to be on track for close to 700 000 units on an annual basis by this time next year. This would leave unit sales close to their record pace of late 2007.

As we show below, the industry marked time between 1990 and 2003. Sales then took off very strongly only to be much depressed in the aftermath of the global financial crisis.

This financial crisis was accompanied by a much weaker rand and significantly higher interest rates. Money market rates were over 12% in mid 2008, with overdraft and mortgage rates of the order of 15% p.a. They have come down steadily and significantly since then. As we show below, vehicle sales in SA appear highly sensitive to the level of interest rates and the associated finance costs. The money market is expecting interest rates at worst to remain at current levels for an extended period of time. Our own view is that the next move in SA interest rates will be down, not up, due to sub-par growth rates. These vehicle sales do however confirm that the economy is performing somewhat better on the demand side than the supply side.

The recent strength in the rand and the lower inflation rate this implies improves the chance of an interest rate cut. The sensitivity of vehicle sales to interest rates makes the argument for lower interest rates a still stronger one. The motor manufacturers are the the largest contributors to manufacturing activity generally. They and the economy deserve all the predictable help they can get form lower interest rates. Brian Kantor

The cash conundrum

There is far more cash out there than can be explained by National Income Estimates of Expenditure and Output. This is as true of the US as it is of SA.

A modern economy laden with old fashioned cash

A peculiar feature of the modern economy is just how much cash lies around. The demand for cash appears largely unaffected by the growing use of highly convenient alternatives to cash to pay a bill, or check out of a hotel restaurant or shop. The value of transactions processed by the banks has grown very significantly with the use of credit and debit cards. A still more important development is the use of an online transaction that transfers ownership of a bank deposit from one party to another with a few clicks on a computer.

The extraordinary demand for dollars circulating outside the US banking system has attracted renewed interest following a revised estimate of the greenbacks held outside the US. (See James Surowieki, “The Underground Recovery” in the New Yorker, 25 April and referred to by John Mauldin in his free weekly investment and economic newsletter, “Thoughts from the Frontline”, 27 April, John Mauldin. The revised estimates of off shore holdings came from Edgar Feige of the University of Wisconsin, a pioneer in the analysis of the demand for cash.)

After allowing for the 27% held offshore, this leaves about US$750bn of cash in US wallets, purses, under mattresses and in safety vaults. This is equivalent to over $2000 cash stored by every person in the US. The average American family that is hard pressed for cash at the end of every month will be surprised to know how cash flush they are presumed to be. But as with many other metrics, such averages tell us very little about the financial condition of the average family. The distribution of these extraordinary cash holdings is no doubt highly skewed to the right, with relatively few holders holding the bulk of the cash for their own good reasons.

The demand for cash and other transactions in SA

In SA a similarly extraordinary growth in the demand for cash outside the banking system has been recorded. The rapid growth in demands for cash has taken place despite the impressive advances made in the availability and use of alternatives to cash in SA, as in the US and elsewhere, with the adoption by banks of new technologies. The notes in circulation outside the banking system grew from nearly R23bn at the end of 1999 to over R81b by the end of 2012. That is at an average compound growth rate of 11.3% p.a. Adjusted for inflation the average compound rate of growth was 4.4% p.a. (See below)

According to the 2011 census there are some 15 milion households in SA. Dividing R8.1bn of cash in circulation by these 15 million households would mean that the average household in SA held on average as much as R5 400 in cash at the end of 2012. A small, fairly constant proportion of this cash will be held in neighbouring countries, especially Zimbabwe, but these demands are unlikely to account for more than 4% of the rand notes and coin currently in circulation.

In the figures below we show the strong growth in the value of electronic transactions effected by the SA Banks. Not surprisingly, given their convenience, the use of electronic fund transfers (EFTs) has grown significantly while the use of cheques has fallen away. The use of credit cards, while still relatively small, has more or less kept pace with the other forms of exchange since 2002, as we show below.

The value of purely electronic transactions facilitated by the banks grew from R155.2bn in January 2003 to R603.5bn in December 2012, that is at an average compound growth rate of approximately 13.6% p.a. This growth, while impressive, is only about 2% p.a faster than the growth in cash, despite the switch from cheques to EFTs. The average EFT processed by the banks is now about R8 583 per transaction and the average credit card transaction is of the order of R545. These average sized transactions are lower than they were in 2003 when adjusted for inflation.

The average low income SA household is too poor to hold this much cash at the expense of the inadequate food, clothes, energy or educational services they consume. And so we should conclude that the heavy lifting of cash in SA is probably not being done by the road side hawker or marginal retailer, but by more significant business enterprises and their owners.

How can we explain the demand for cash? Using cash escapes surveillance.

The question then is what is all this cash on hand being used for? Cash very obviously serves the interests of those who wish to hide their income from the tax authorities or the officials responsible for means testing welfare benefits. Using cash helps escape surveillance by government and the financial system generally. Honestly declaring extra income earned that takes welfare recipients beyond the income thresholds or tax payers into higher tax brackets can make for what are effectively very high rates of taxation of income at the margin. An extra $100 or rands of extra income earned and declared may well mean more than a hundred of sacrificed benefits or as much in taxes levied.

The currency approach to measuring informal activity

Clearly there is a lot more cash out there in use in SA and the US and in many other economies than can be explained by officially estimated incomes or expenditure, especially given the growth in the use of the alternatives to cash. The question then is just how much income and economic activity goes unrecorded when cash is exchanged for labour and goods and services? Just how much income or expenditure is going unrecorded because the transactions and the value they add are made in cash and are not reported in any reliable consistent way?

An estimate of how much activity is not recorded can be found by observation of the demand for cash itself. The essence of the approach is to attempt to explain and predict the demand for cash using incomes, prices and improvements in payments technology, measured as the value of electronic transactions processed by the banks, as explanations of the demand for cash. The observed higher demands for cash, the demands for cash that cannot be explained in this economically sensible way, then becomes a proxy for estimating the unrecorded levels of economic activity.

How much economic activity is not recorded?

The New Yorker article suggested that as much as $2 trillion worth of economic activity in the US may be going unrecorded. Given that the US GDP is officially estimated at just over $16 trillion, this would make unrecorded activity or the informal economy in the US equivalent to about 12% of the official US economy. Such an estimate is on the low side of estimates made for a number of developed economies, using a variety of methods to supplement national income estimates, including the currency demand models.

Many years ago I attempted to replicate the studies of Feige and others using SA data. In those days the SA economy and its labour market was severely infected by apartheid. In particular, the pass laws and other racially inspired laws and regulations prevented employers providing work and employees from offering their labour. These controls would have encouraged “illegal” activity and employment and the use of cash to avoid detection. My ball park estimates of unrecorded activity were equivalent to over 15% of the official economy. Or, in other words, the SA economy was then perhaps 15% larger than indicated by estimated GDP.

This approach did not find favour. The official estimates of unrecorded activity in SA to this day, officially assumed to be very largely informal retail activity, are estimated to be only about five per cent of recorded activity. This estimate is extraordinarily, perhaps unbelievably low, by international comparisons.

The incentives to use cash in the US and South Africa

For the US the major incentive to use cash may well be, as the New Yorker suggests, to avoid losing welfare benefits. In South Africa a further more important reason for using cash may be to escape not only tax or avoid the loss of welfare benefits but also and more importantly to escape the burdens of a highly regulated labour market. The incentive to use cash, rather than banks, to side step the regulations of the labour market and also by so doing to escape the supervision of the Receiver of Revenue, is surely a powerful motive for using cash.

More unrecorded activity means more unrecorded employment. If so this does not weaken the argument for a less regulated economy

If we are underestimating income and expenditure we are also underestimating actual employment. The only employment numbers we can be reasonably be sure of are the jobs offered by the formal sector. Unrecorded economic activity and unrecorded employment are therefore also matters of conjecture.

If SA has less of an employment problem than the official estimates indicate, given the unrecorded economic activity and associated employment, it still has as much of a poverty problem. The solution to SA poverty is faster growth, especially in faster growth of formal employment. But such growth in employment will not be realized or recorded unless the incentives for all businesses, especially small businesses, to operate formally are much improved.

Conclusion: Greater economic freedom for South Africa will add to incomes and employment and reduce the demands for cash and increase rather than reduce tax collected.

Encouraging formal employment and less evasion of taxation requires freer labour markets, less complicated income taxation, lower business income tax rates and much more sympathetic regulation of small businesses and their owners. Such steps might well raise more rather than reduce tax revenues as small businesses elect to operate above rather than below the radar screen. If they did so one of their attendant benefits would be access to a much more convenient payments system.

Progress in this regard may well be recognised by slower growth in the demand for and supply of cash. Unfortunately SA, with new licensing demands on all businesses that would seem to be in the interest only of the officials attempting to enforce new licensing laws, seems to be moving in the other direction. Brian Kantor