Month: June 2018

The mining charter- its true purpose

Version published in Business Day 23rd June 2018

 

There is much to be gained from a thriving mining sector. Its promise for growing incomes is as great- perhaps greater than any other sector of the SA economy- given the opportunity. There would be extra income to be earned on the mines and rigs and additional taxes paid by many more workers. There would be more jobs gained and increased incomes earned supplying goods and services to additional mining enterprises.

 

Exports would grow and the balance of payments would benefit from inflows of permanent mining capital. The exchange value of the rand would become less vulnerable to outflows of portfolio capital – to the advantage of all businesses and their customers in our economy.

 

The recipe to stimulate rapid growth in mining activity is simple It is to make the rules and regulations applied to the owners of mining companies at least as attractive as anywhere in the world.. Applied to capital that realistically can only be expected from well-established, well-diversified global mining companies with the appetite for taking on mining risks and the balance sheets and borrowing capacity to do so.

 

And wouldn’t it be a game changer for exploration activity were ownership of the rights to the potential value below the surface be transferred from the state to the owner of the land above. Including to communities with traditional rights to graze or plant land that could be far more valuable than they can possibly know before exploration. Rights ceded in exchange for a significant betterment tax should ownership be transferred to a mining company received on transfer from the buyer.

 

However the newly proposed and amended mining charter informs us very clearly that this more competitive landscape for mining is not about to happen. The intention is to put onerous constraints on the powers of owners to manage a mine as best they might. Owners will be required to contract with suppliers, directors and managers and partners with preferred legal status rather than chosen on merit. It imposes further controls on how they have to share the benefits of ownership and the capital they will have put at risk. With partners not necessarily of their own choosing or on terms chosen by them should the mine prove successful.

 

They will be required to pay taxes and royalties and declare dividends based on cash flows, not on normal accounting principles. For fear – not doubt legitimate – that taxable income might be minimised by transfer pricing – reducing revenues and raising costs. Or by exaggerating the interest paid on loans provided by holding companies residing in no tax or low tax jurisdictions. Interest payments (expensed for tax purposes) that are intentionally more like capital repaid.

 

Eliminating tax avoidance and applying the complex regulations will take a costly to taxpayers and owners army of competent officials on both sides of the fence to hopefully ensure compliance.

 

It would be much more sensible if mining companies in SA were not subject to any income taxes at all. This would eliminate all attempts to minimise tax payments and protect the tax base. All income distributed by companies as employment benefits, rents, interest dividends or capital repayments can instead be taxed in the hands of the receivers- reported by the company making the payments. Compliance becomes much less onerous and the case for investing much improved – to the great advantage of mining output.

 

It should be very clear therefore that the intentions of the mining charter are not to stimulate mining output and employment. Its primary purpose is to redistribute its benefits. The mining charter is symptomatic of this approach to economic development in South Africa. Redistribution at the expense of potential growth. The consequential sacrifice of growth, so balefully apparent, should not be regarded as unintended.

Looking at the hard numbers

Our review of the state of the SA economy indicates a modest but welcome pick-up in economic activity. This was driven by lower levels of inflation particularly at retail level where even some lower prices helped spur spending by households.

Unfortunately the suddenly weak rand will reverse inflation trends and slow down spending all over again. As Mike Tyson said, everybody has a plan in the ring until they get hit in the face. Consumers have had to take another punch in the form of a weaker rand that will soon show up at the stores. They will depend on the Reserve Bank rolling with the punch: leaving interest rates unchanged to soften the blow of higher prices. The real danger is that the Bank will do the opposite and raise rates, doing nothing for the rand and only depressing spending further.

We have updated our index of the current state of the SA economy with data released for May 2018. We call it the Hard Number Index (HNI) because it relies on two hard numbers that are provided very close to the month end. The data we rely upon and combine to form our Index are new vehicle sales, provided by the National Association of Vehicle Manufacturers (NAAMSA) and the cash (notes) in circulation issued by the Reserve Bank. The note issue is a liability on the Reserve Bank balance sheet, reported soon after each month end.

These are hard numbers and not the result of sample surveys that inevitably take time to collect and estimate. A further advantage in the May releases is that they are less likely to be influenced by the Easter effect that comes at different times in March or April, and so always makes seasonal adjustments very difficult to claculate accurately for those months. The seasons of the year do make a difference to vehicle sales and even more so on demands for cash that tend to rise as consumers intend to spend more on holidays, especially at Easter and Christmas.

The current state of the economy, according to the HNI, as of the May month end, is shown in the chart below (Figure 1). The HNI is compared with the Reserve Bank Business Cycle Indicator that has only been updated to February 2018 (an especially out of date measure given that disappointing first quarter GDP estimates have already been released). The disappoinment was that in the first quarter GDP, declined at a 2.2% annual rate. the economy will have moved on – hopefully forward.

The HNI may be regarded as a leading indicator of the SA business cycle and has served very well in this regard as may be seen in figures one and two. However the two series parted company to a degree after 2016. The HNI has pointed to lower levels of activity than the Reserve Bank Indicator. However in late 2017 the HNI stabilised and picked up some momentum. These trends, when extrapolated, suggest that the economy will stabilise at its current pedestrian pace for the next 12 months.

We show the second derivative of the business cycle in figure 2, the growth in the economic indicators. As may be seen the growth in the Reserve Bank activity indicator has been slow but persistently slow in 2017 and 2018. The HNI has recently turned from negative to positive growth.

The components of the HNI have shown a different direction. Supply (and demand) for cash, adjusted for prices, has shown a welcome upward direction, and is forecast to be sustained over the next 12 months. However vehicle sales, while they have shown a modest recovery in 2017, are pointing marginally lower: down from their current annual rate of about 546 000 new passenger cars sold, to a marginally lower rate of sales of 535 000 cars forecast to be sold this time next year. See figures 3 and 4.

The pick-up in the real cash cycle was assisted by less inflation in 2017. Figure 5 compares the growth in the value of notes issued (at face value) with the slower inflation adjusted rate of growth.

The increase in prices at retail level has been unusually lower than headline inflation in recent months. In March 2018, retail inflation was running at 1.6% compared to headline inflation that month of 3.8% that increased to 4.5% in April. This pick up in what are spending intentions, hence demands for cash, would be faster if prices were measured at retail rather than headline inflation.

Lower levels of retail inflation in 2017 owed much to the end of the drought, the recovery of the rand and the weakness of spending at retail level that gave retailers very little pricing power. The consequently lower inflation rates at retail level – sometimes deflation – undoubtedly helped stimulate extra spending at retail level in late 2017. The real money cycle is almost always closely linked to the cycle of retail sales volumes as we show in figure 6.

As we show in figure 7, measuring the increases in the real supply of cash using retail prices rather than the CPI accords better with the faster pace of retail sales volumes in recent months.

It may also be seen in figure 8 that the forecast for both is for slower growth over the next 12 months. Both the growth rates in real cash and real retail sales are forecast to slow towards a three per cent per annum pace by early 2019.

The recent weakness in the rand will not be helpful in this regard. It will mean more inflation and so more pressure on the spending power of households. We may hope that the Reserve Bank will not be adding to this depressing effect on spending by raising interest rates and also doing nothing to help the rand while only slowing down economic growth further. 13 June 2018

Keep Cities Connected

A successful city is pro- rich and pro-poor. It budgets for growth to serve all who live there.

Cities bring people together in what becomes very crowded space. They come together to make better connections: helping employees connect with employers and helping customers and clients to connect with the suppliers of important services. The physicians are helped to connect with their essential patients. Lawyers, accountants, consultants of great variety, can connect with their clients who rely on their skills and experience for which they willingly pay and make practice possible. Restaurateurs, with their chefs and waitrons, connect the many who they feed and amuse. And artists of all kinds connect with the audiences they may only find in the large city, to mutual delight.

Cities offer valuable choices to all their citizens, rich and poor and those in between, that are not available outside. We complement each other and we combine together to make as sure as we can that our crowded space can serve our purpose to connect. And so we establish and maintain a grid of one kind or another to deliver essential services – water, energy, roads and other forms of transport – more cost effectively than if we somehow had to do it for ourselves, off grid so to speak.

The essential purpose of local government is to maintain and improve the quality of the vital connections by providing the grid efficiently. Elected civic leaders should compete on this basis for the votes that elect them to office. Successful cities will attract migrants from outside to join in and share in the success. They manage the growth well enough to preserve the advantages of city life for all who choose to live there, including the poor who cannot or will not pay enough to be connected to the grid. Yet it is essential to keep them well connected, for the sake of the city and all including the well-off who live nearby. Making these connections possible is not charity – it is good sense.

And the South African city would surely do better if it were given fuller responsibility for policing, schooling and securing the bulk supplies of water and energy for their grids – that has proved not nearly secure or capable enough when provided by the central government or by proxy provincial governments.

City success will be revealed in the value attached to the buildings of the city, the houses, offices, factories and warehouses that make up the city. More accurately it is revealed in the value of the land under the buildings and the vacant land that can be put to more valuable uses over time. Development and re-development increase the supply of buildings, helping hold down land values and the rentals attached to them. They help keep more people flowing in rather than out of the city.

There is a virtuous civic circle to be sustained. The better the city delivers, the more its land will be worth and the more revenue it can collect to maintain and improve its connections and grid. And failure to deliver soon shows up in deteriorating property values and increasing financial strain, harming all, perhaps especially the poor.

Cape Town has been the success story of SA cities, judged by the flow of migrants to it (rich and poor) and by the growing value of real estate that is so supportive of its balance sheet and income. The city borrows very little and its net interest bill, after investment income, is very small compared to its revenue and expenditure.

Yet the city budget proposes to fund the significant capital expenditure needed to guarantee sufficient water with permanently higher tariffs. Lower tariffs would serve the city much better by helping to preserve on-grid demands. It would also generate enough extra revenue to pay the extra interest and repay the loans. This would be possible with more borrowing that in no way would threaten financial stability. Rather it will help by improving the growth potential of the city that depends upon its grid – especially so when competitively priced.

Making sense of the earnings and dividend cycle

The JSE earnings and dividend cycles – a May 2018 update. What the market may be telling us

The growth in reported JSE All Share Index earnings per share appear to have peaked. The year on year growth in earnings have fallen back from the 30% rate realised in late 2017 to the current rate of 10% realised by the May 2018 month end. Index dividends per JSE share were growing at a 20% annual rate at the May month end. A time series forecast of both earnings and dividends suggests that their growth will slow down to less than 5% in the next 12 months.

 

The resource companies listed on the JSE have grown their earnings and dividends more rapidly than the other sectors over the past year – off a lower base. Resource earnings in January 2017 were 34% down on earnings the year before, while All Share Index earnings were 15% lower in January 2017 than in January 2016.

We show some of the trends in sectoral earnings growth rates in figure 2 below. Industrial Index earnings were trending higher at a 19% a year rate by May 2018, Banks at a 7% rate while the General Retail Index earnings per share were declining at a 3% rate. Resource earnings were trending at a 34% rate in May 2018 – though well down on the peaks of 80% growth realiised in late 2017.

 

When calculating an earnings cycle the base effects- what happened a year before – is important for current growth. It is much easier (more difficult) to realise high (low) rates of growth when growth was subdued (or buoyant) in the same month the year before. Perhaps it is more helpful when interpreting the performance of listed companies and the values attached to them to examine the level of rather reported earnings.

Perhaps even more illuminating about the state of play on the JSE would be to examine the level of earnings or dividends in constant prices, as we do in figure 3 below.

 

 

Real dividends have outpaced real earnings – they are now close to peak real dividends of 2014, while real earnings are still well below real earnings realised before the global financial crisis and recessions of 2009. This is surely a very sobering statistic- it shows that the real earnings front of the JSE have moved backwards since 2006.

The movement of the JSE since 2000 therefore appears to be better explained by dividends than earnings. Were it not for the stellar performance of Naspers, a play on Chinese internet firm Tencent the JSE All Share Index, in which Naspers has comprised an ever more important weight, would have fallen back.

It would appear that JSE-listed companies have performed better than the SA economy. They have accordingly returned relatively more cash to shareholders, presumably for want of investment opportunities. A corollary is that had they invested more of their cash in South Africa, the economy would have performed better. However it is unrealistic to expect capital expenditure of business enterprises to lead household spending (accounting for 60% of all spending in SA) that has remained consistently depressed by the standards of the past.

In figure 3 above we compare real JSE Index earnings and dividends with the real value of the JSE. The All Share Index seems better explained by the upward trend in real dividends than the sideways move in real earnings. We can confirm this by regression analysis. An equation that links the nominal value of the JSE All Share Index with the contemporaneous level of reported dividends and short term interest rates provides a good statistical fit. Indeed the current level of the JSE is almost precisely as would be predicted by this valuation model. When we add the rand value of emerging markets (EM) generally as an additional explanation of the level of the JSE – we get an even better fit. The R squared rises from 94% to 99% with all the explanatory variables attaining highly significant and plausible values.

 

This provides for the conclusion that the JSE may be slightly undervalued by the standards of the past, given the level of the EM benchmark that the JSE has lagged behind. Perhaps giving a degree of safety to the JSE at current levels. Yet as before, the strength of the JSE will depend upon the flow of dividends, interest rates, the value of the rand and the level of the EM benchmark that the JSE always tracks closely.

We could add as a further important influence the value of Information Technology stocks worldwide that Naspers will follow closely. Perhaps it is easier to be confident about the supportive role to be played by the EM benchmarks and the role of IT within them, than the benefits a stronger rand and accompanying lower interest rates could bring to the flow of dividends and earnings from the JSE All Share Index. The strong dollar and therefore the weaker rand and the more inflation that will follow it has become a headwind for the SA economy and the companies dependent on it. 5 June 2018