July 2019 – ZA Economist

Is Libra a bank by another name? Answers, important for a modern economy, are about to be found out.

Is the new block chained backed payments system (LIBRA) to be introduced by Facebook a pure and much lower cost payments system? Or a bank, or equivalently a money market fund, upon which transactions can be drawn conveniently for low or no fees.

The operating costs for a bank that provides a payments facility are largely covered by the difference between the interest paid on deposits (perhaps zero) and the interest earned by the bank/payments provider making loans- of varying degrees of default risk. Unlike a Visa that collects fees to cover its costs –and does not make loans.

The banks have cross-subsided the fees that might otherwise have to charge with the revenue earned from their lending activities. The profitability of banks depends in part on managing their cash reserves, keeping them as small as possible to meet demands for cash back. And holding no more than prudent reserves of equity capital to cover non-performing loans. And provide shareholders with enough of a return to keep them in the banking business.

It is this leverage (banks holding fractional reserves of cash) that exposes the bank shareholders (and the broader economy that depends upon sound banks facilitating transactions) to the danger that non-performing loans may exceed the equity of the bank. However it is not only the deposits (liabilities of the banks and assets of depositors) that may be destroyed by the failure of a banking system. Of greater importance is that the payments system, can go down with the banks, with truly catastrophic effect for any modern, highly specialized economy that depends on its payments system.

Perfect safety for a payments system can only come with deposits fully backed by cash issued by the central bank with its power to create as much extra cash as the system might need. Block chain may well offer enormous savings in protecting the transactions they give effect to, against fraud. Savings that mean low enough fees that would cover the full costs and still provide a profitable return on capital. And avoid the dangers of leverage. SA banks lose as much as R800m a year to credit and debit card fraud. They likely spend even more on trying to prevent fraud.

Leaving banks to make the trade-off between risk and return, has worked well enough for most, but not all the time. The Global Financial Crisis of 2008 (GFC) demonstrated why it is very important to be able to deal with a banking crisis – should banks or more specifically- the payments system delivered by banks, be threatened with failure. The solution to any run on the banking system is for the central bank to supply more than enough cash to the banking system to stop any run on the banks- as the GFC also proved.

Perhaps modern information technology will allow a 100 percent, central bank deposit backed (not private bank backed) fee collecting payment providers, to compete effectively with the deposit taking banks for our transaction balances. If so, deposit taking banks, supplying a bundled service of payments with the aid of leverage, may fade away to be replaced by other forms of financial intermediation. That is by other financial institutions that can provide essential credit and take on leverage profitably, but without accepting responsibility for effecting payments.

This new world (of fully backed transaction accounts) may be the next phase in the evolution of the modern financial system. One that would provide for the separation of the payments system from the dangers of leverage. Wisdom would be to let a profit seeking, competitive financial system to evolve in response to the preferences of lenders and borrowers. And for regulators to stay out of the way so that a pure payments system could possibly evolve. However, if Libra is a bank- dressed up as a money market fund, carrying risks on its balance sheet, it should also be required to play by the same rules as its banking competitors. However these rules applied to vulnerable banks could be relaxed if the payments system were secure.

Dealing with the unpredictable rand–better judgment, not luck called for

The rand (USD/ZAR) has not been a one-way road. Yet SA portfolios are more likely to be adding dollars when they are expensive and not doing so when the rand has recovered.

The rand cost of a dollar doubled between January 2000 and January 2002 – but had recovered these losses by early 2005. The USD/ZAR weakened during the financial crisis, but by mid-2011 was back more or less where it was in early 2000. A period of consistent rand weakness followed between 2012 and 2016 and a dollar cost nearly R17 in early 2016. A sharp rand recovery then ensued and the USD/ZAR was back to R11.6 in early 2018. Further weakness occurred in 2018 and the rand has been trading between R15 and R14 since late 2018. Weaker but still well ahead of its exchange value in 2016. The rand in March 2019, had lost about 20% of its dollar value a year before. It has recovered strongly since and t on July 5^th at R14.05, the rand was a mere 4% weaker Vs the USD than a year before

The USD/ZAR exchange rate; 2000-2019 (Daily Data)

Source; Bloomberg, Investec Wealth and Investment

Two forces can explain the exchange value of the rand. The first the direction of all other emerging market currencies. The USD/ZAR behaves consistently in line with other emerging market (EM) currencies. And they generally weaken against the USD when the dollar is strong, compared to its own developed market currency peers.

When the USD/ZAR weakens or strengthens against other EM currencies, it does so for reasons that are specific to South Africa. Such as the sacking of Finance Ministers Nene in December 2015 and Gordhan in March 2017. These decisions that made SA a riskier economy, can easily be identified by a higher ratio of the exchange value of the rand to that of an EM basket of currencies. The reappointment of Gordhan as Minister of Finance in late December 2015 improved the relative (EM) value of the ZAR by as much as 25% through the course of 2016. His subsequent sacking in March 2017 brought 15% of relative rand underperformance. The early signs of Ramaphoria was worth some 15% of relative rand outperformance – and its subsequent waning can also be noticed in an increase in the ratio ZAR/EM.

The rand compared to a basket of emerging market exchange rates (Daily Data)

Source; Bloomberg, Investec Wealth and Investment

This ratio has remained very stable since late 2018- indicating that SA specific risks are largely unchanged recently. Emerging market credit spreads have also receded recently – as have the spreads on RSA dollar denominated debt. The cost of ensuring an RSA five-year dollar denominated bond against default has fallen recently to 1.62% p.a. from 2.2% earlier in the year. The USD/ZAR exchange rate -currently at R14 – is very close to its value as predicted by other EM exchange rates and the sovereign risk spread. It would appear to have as much chance of strengthening or weakening.

The exchange rate leads consumer prices because of its influence on the rand prices of imports and exports that influence all other prices in SA. A weak rand means more inflation and vice versa. And given the Reserve Bank’s devotion to inflation targets, the exchange rate therefore leads the direction of interest rates. Despite a renewed bout of dollar strength and rand weakness in 2018 import price inflation – about 6% p.a. in early 2019 -has remained subdued.

Import and Headline Inflation in South Africa (Quarterly Data)

Source; SA Reserve Bank, Bloomberg, Investec Wealth and Investment

This has helped to subdue the impact of rand weakness against the US dollar that might have brought higher interest rates and even more depressed domestic spending. The dollar prices of the goods and services imported by South Africans has fallen by 20% since 2010 and by more than 10% since early 2018. This has been a lucky deflationary break for the SA economy.

SA Import Prices (2010=100)

Source; SA Reserve Bank, Bloomberg, Investec Wealth and Investment

Given that the rand is driven by global and political forces largely beyond the influence of interest rates in SA, it would be wise for the Reserve Bank to ignore the exchange value of the rand and its consequences. And set interest rates to prevent domestic demand from adding to or reducing the pressure on prices that comes from the import supply side. The SA economy can do better than merely hope for a weak dollar.

Making the most of the investment holding company

Investment holding companies have long played a large role on the JSE. Two of the more important of them, Naspers and PSG, have provided spectacular returns for their shareholders in recent years. R100 invested in PSG in January 2010 with dividends reinvested in the stock has grown to R1435 by late June 2019. The same R100 invested in Naspers would have almost as well for its shareholders over the same period having increased its rand value by 14 times.

Not all holding companies are equal. A one-time darling of the JSE, Remgro has barely managed to keep pace with the JSE All Share index- R100 invested in Remgro or the JSE in 2010 would have grown to about the same R250.

Total returns; Naspers, PSG, Remgro and the JSE All Share Index (2010=100)

Source; Bloomberg, Investec Wealth and Investment

The advantage enjoyed by the managers of an investment holding company is that the capital made available to them is permanent capital. It cannot be cashed in, as is the case with a mutual fund or unit trust, that may be obliged to redeem capital and may have to sell down their assets to do so.

It therefore can invest in potentially market return beating companies, companies that will return more than their opportunity costs of capital – if only in time. Its often significant shareholdings may give it a useful, active role in improving the performance of the operating companies it invests in.

While shareholders in a listed investment holding company cannot force any liquidation of assets, they can always sell their shares. At a price that would have to be attractively low enough to promise the buyer a return at least as good as is promised elsewhere in the market place – for a similar degree of risk.

This market-clearing price, multiplied by the number of shares issued will determine the market value of the holding company. And this market value, as in the case of Naspers (since 2014) and Remgro (continuously since 2010 )– has been well blow their Net Asset Value (NAV). That is the holding company is likely to be worth than the sum of its parts – were the parts unbundled to its shareholders. No doubt to the chagrin of its managers when their company is judged to be worth more- sometimes much more – dead than alive. And who may well have delivered market beating returns in the past.

The market and net asset value of the holding company will always have much in common. The market value of its listed assets and its net debt would be included in both- as would the value of its unlisted assets- though the market may judge them to be worth less than the director’s estimates included in NAV.

The market value will however be influenced by two other important forces, not reflected in its marked to market, balance sheet, its NAV. Included in market value, but not NAV, will be two unknowns -the expected implicit costs to shareholders of running the head office- and the present value of its ongoing investment programme. Past performance may not be a good guide to expected performance as we are often reminded. The economic value expected to be added by the extra capital to be invested by the holding company may be presumed by the market place, to be insufficiently promising to compensate for the costs of running the head office. Hence reducing market value relative to NAV

The way for the managers of a holding company to close the value gap between NAV and Market Value is clear. That is to adopt a highly disciplined approach to acquisitions and investments. And be as disciplined in the rewards offered managers. A plan to list major unlisted assets to prove their value and to unbundle them when their investment case has been proved, will help add market value. Market value adding – performance related pay – can also be well aligned with the interest of shareholders if made dependent on closing this gap between NAV and market value.