Month: November 2020

How to solve SA’s unemployment woes

Many South Africans are condemned to a lifetime of inactivity for want of experience and the good habits acquired by having jobs. What are some of the practical steps that can be taken to solve SA’s unemployment problems?

In a well-functioning labour market, the number of employees who quit their jobs for something better will match those who are fired. The unemployed will then be a small proportion of the labour force. And it will not be a stagnant pool of work seekers. The number of new hires will roughly match the new work seekers, slightly more or less, depending on the state of the business cycle. Most importantly, the labour market will be reassigning workers to enterprises that are growing faster, from those that are growing slower or going out of business. It is a dynamic process that makes for a more efficient use of labour, and leads to faster growth in output and higher incomes from work over time.

To state the obvious, the above scenario does not describe the current state of the SA labour market. The unemployment rate since 2008 (the first year the current employment survey of households was released) and up to the just released for Q3 2020 survey, has averaged well above 20%. It was 23% in 2008 and 30.1% before the Covid-19 lockdowns. The army of the unemployed grew from 4.4 million in 2008 to 7.1 million in Q1 2020, compounding the problem at an average rate of 4% a year.

The numbers employed grew from 14.4 million to 16.4 million over the same period, at a 1.1% annual average rate, but therein lies the rub. The numbers of South Africans of working age who are neither working nor seeking work, nor are economically active, and therefore not counted as part of the labour force, numbered 15.4 million in Q1 2020. This is up from 12.74 million in 2008, having grown by 1.6% a year on average over the period.

The ability of the economy to absorb a growing potential labour force, defined as numbers employed divided by the working age population, now 39 million, declined from a low 45.8% in 2008 to 42.1% in early 2020. Even more concerning is the inability of the economy to absorb young people into employment. Of the 10.3 million between the ages of 15 and 24 years, 31.9%, or only 3.2 million, were working or seeking work. The economically inactive numbered 7.5 million. The absorption rate for the cohort fell from 17% in 2008 to 11% in early 2020. The economically inactive part of this group numbered 8.2 million in September. Of the cohort aged 15 to 34, the proportion who were not economically active was 40.4%.

A lifetime of inactivity
There is thus a large number of South Africans condemned to a lifetime of inactivity for want of experience and the good habits acquired on the job. What is going so very wrong in the SA labour market? We observe how vitally important it is for those with jobs to retain them. The struggle to hold onto well-paid jobs at state-owned enterprises (SOEs) such as SAA and the SABC is an understandably bitter one with so much at stake. And the sympathies of the politicians are with the threatened workers rather than with the attempts to sustain the economic viability of these SOEs in the face of an ever more padded payroll.

Being unemployed, especially for those retrenched form the public sector, is not part of a temporary journey to re-employment on similar terms. It is almost bound to be destructive of lifetime earnings. Even the competition authorities, who you might expect to focus on efficiency rather than job retention, make retaining jobs a condition for approving a merger or acquisition. Yet despite the large numbers of the unemployed and the economically inactive, the real earnings of those with jobs in the public sector have grown significantly and much faster than outside of it – by an average 2.2% a year after inflation compared with 1.52% for the privately employed. This perhaps explains why the SOEs have had such difficulty in balancing their books.

A system in SA has evolved that reinforces the better treatment of the insiders – those with jobs that are entrenched by law and practice – when compared with the outsiders who struggle. Many therefore give up the struggle to find “decent work”. A National Minimum Wage (NMW) is set at a level – R3500 per month – that regrettably few South Africans earn or are capable of earning. This is a major discouragement to hiring unskilled and inexperienced workers, particularly outside of the major cities. You would have to go well into the seventh decile of all income earners to find families with per capita incomes above this prescribed minimum wage.

It is possible to dismiss or retrench workers or managers in SA. But in addition to any regulated retrenchment package, it is not a low cost exercise to fire underperforming workers of all grades. Employers have to satisfy the Commission for Conciliation, Mediation and Arbitration (CCMA) to do so. Funding a human resources department, with skilled specialists well versed in employment and unemployment procedures, to whom dealing with the CCMA can be delegated, is one of the economies of scale available to big business. The small business owner-manager attempting to navigate the system is at a severe disadvantage that will surely discourage job offers.

The impact of Covid-19

It is not just the regulations and practices that inhibit the willingness of employers to take on more labour. Post-Covid-19 reactions reported by the latest survey of households give some important clues to the forces at work. During lockdowns, numbers employed fell from 16.3 million in Q1 to 14.15 million in Q2, and recovered slightly to 14.7 million in Q3. The numbers counted as unemployed fell sharply from 7.1 million in Q1 to 4.3 million in Q2 and then rose to 6.5 million in Q3, after the lockdown. The numbers of those who were not economically active rose dramatically in Q2 from 15.4 million in Q1 to 21 million in Q2, when it made little sense to actively seek work. The numbers of the economically inactive then fell dramatically by over 2 million in Q3, as more people sought work and were physically allowed to do so.

The numbers employed in Q3 rose, but were not as many as those additional work seekers and so the unemployment rate picked up. It was a development highlighted in the survey. It made sense for more people to look for work because it was more likely to be found, and also presumably because the declining economic circumstances of the family, perhaps the extended family on which many depend, made the search for work and additional income imperative.

South Africans understandably have a reservation wage, below which working does not make good sense. It has to pay to work. And the economically inactive in SA who are overwhelmingly low or no income earners are presumably able to survive without work by drawing on the resources of the wider family. They will not have accumulated much by way of savings to draw upon. The family resources, on which they rely, are likely to be augmented by cash grants from government and from subsistence agriculture or occasional informal employment. Covid-19 may well have damaged the ability of the extended family to provide support for those not working or intending not to work, hence the fewer inactive members of the workforce.

The failure of SA’s mix of economic policies is revealed by what is still for many a reservation wage that remains higher than the wage employers are able and willing to pay them. Hence the discouraged employment seekers who are among the economically inactive. It seems clear that South Africans choose to some extent to supply or not to supply their labour, depending on their circumstances including their skills and earning capacity as well as the state of the economy. They have a sense of when it seems sensible to work or to seek work at the wages they are likely to earn.

Practical solutions

What can be done about this essentially structural issue for our economy? Businesses surviving Covid-19 have increasingly learned to manage with fewer workers and managers. Abandoning the NMW or the CCMA or reducing the legal powers of trade unions and collective bargaining would help increase the demand for labour, but this course of action is unlikely. Meaningfully improving the quality of education and training (on the job as lower-paid interns and apprentices) to raise the potential earnings of many more over their lifetimes of work, also seems wishful thinking. Reducing the value of the cash grants paid, so reducing the reservation wage to force more of the population to seek and obtain work, would be cruel and is as unlikely. Some form of welfare payments for work seems to be on offer in the form of the internship scheme announced recently by President Cyril Ramaphosa.

The Employment Incentive Scheme allows employers to deduct up to R500 off the minimum wage paid to workers under 29 and for all workers in the special economic zones. Employers simply deduct the subsidy from their PAYE transfers. It takes very little extra administration by either the firms or the SA Revenue Service. In 2015/16, 31,000 employers claimed the subsidy for 1.1 million workers and the scheme cost R4.3bn in 2017-18. The subsidy may well have to be raised to keep pace with higher minimum wages imposed on employers.

Raising taxes to subsidise the employment of young South Africans may be the only practical and politically possible way to provide more opportunities for them, especially if the market is not allowed more freedom to address the employment issue, by offering wages and other employment benefits that workers are willing to accept. Abandoning the NMW, the CCMA and nationwide collective bargaining agreements, all so protective of the insiders, would increase the willingness to hire and raise real wages for the least well paid in time. But it would be unrealisitic to expect the unemployment rate in SA to rapidly decline to developed market norms. It will take faster economic growth, which leads to higher rewards for the lowest paid and least skilled, to make work the better option for many more. And it will take many more workers to raise our growth potential.

The Vaccine and the SA economy – Urgency demanded

The prospect of an effective vaccine for Covid19 has been particularly good news for investors in SA. The ZAR has recovered all of the ground it had lost to other EM currencies through much of 2020 and is now only about 10% weaker against the dollar this year. In March, when the uncertainty surrounding Covid19 was most pronounced, the ZAR had lost 30% of its USD value of January 2020(see below) The ZAR has gained about 4% on both the EM basket and the USD this month. (see below)

Exchange Rates; The ZAR and the EM basket Vs the US dollar and the ratio ZAR/EM; Higher values indicate dollar strength (Daily Data Jan 1st 2020=100)

 

 

Screenshot 2021-01-04 145036

 

 

Source; Bloomberg and Investec Wealth and Investment
The JSE equity and bond markets consistently also responded very well to the good global news led by the companies that are highly dependent on the SA economy. The JSE All Share Index since October has gained 14% in USD and the JSE All Bond Index has appreciated by a similar 14% in USD. The emerging market index was up by 9.1% over the same period while the US benchmark the S&P 500 gained 5.4% over the same period. The JSE has been a distinct outperformer recently (see below)

The JSE Equity and Bond Indexes Daily Data (October 1st=100)

Screenshot 2021-01-04 145053

Source; Bloomberg and Investec Wealth and Investment

The JSE, The S&P 500 and the MSCI EM Indexes USD Values (Daily Data January 1st 2020=100)

Screenshot 2021-01-04 145106

Source; Bloomberg and Investec Wealth and Investment

These developments should not have come as a complete surprise. Such favourable reactions in the SA financial markets to a reduction in global uncertainties, usually accompanied by a weaker USD are predictable. What South Africans lose in the currency and financial markets when the world economy appears less certain, we regain when risk tolerance improves. SA unfortunately is amongst the riskiest of destinations for capital and investors who always demand higher returns as compensation for the risks they estimate. As taxpayers we pay out more interest and our companies have to offer higher prospective returns than almost anywhere else where capital flows freely, as it does to and from Johannesburg.
Recent developments in the markets do provide some relief for our beleaguered economy. The yield on long dated RSA bonds has declined by more than a half a per cent this month. With an unchanged outlook for profits such a reduction in the discount rate applied to expected income could add 10% to the present value of a SA business or roughly 10% its price to earnings ratio. (market reactions confirm this) A further reduction in these very high required returns – now equivalent to about 9% p.a after expected inflation – is much needed to encourage SA businesses to invest more. Essential if our economy is to grow faster.
Yet if the economy were expected to grow sustainably faster the discount rate would come down much further and businesses would be very willing to invest more in SA. And foreign investors would willingly supply us with their savings to do so. And the SA government would be much more confidently expected to raise enough revenue to avoid the danger of a debt trap and avoid a much weaker rand- expectations that are fully reflected in our high bond yields.
We can hope for the stars to align but should not expect them to do so. We can help ourselves by making the right policy choices. Opportunity presents itself. The terms at which we engage in foreign trade have improved consistently in recent years, by 20% since 2015. Think metal prices over oil prices. These relative price trends are even more favourable than they were in the seventies when the gold price took off. These developments should spur output and investment by business government policy permitting.
There is a further related large opportunity presented by the discovery of a major energy resource off our southern coast. Bringing the gas ashore can accelerate infrastructure and export led growth, funded by foreign capital not domestic taxpayers and led by business not government. It demands the kind of urgency that has brought us a vaccine.

South Africa. Terms of Foreign Trade. Export Prices/Import Prices (2010=100 Quarterly Data 1970-20200)

Screenshot 2021-01-04 145119

Reputation at stake

Doing what is right for the depressed economy while hoping to regain a reputation for fiscal responsibility over the long run is no simple task. The adjustments made to the Budget last Wednesday (28th October) were made in these highly adverse circumstances. Tax revenues have collapsed along with incomes and output inevitably increasing the borrowing requirements of government- indeed more than doubling them as a per cent of GDP. The sacrifice of incomes in the lockdown however calls urgently for more government spending not less and lower, not higher tax rates.

Economic theory tells us that spending more on resources that will otherwise remain idle makes good sense.  Extra income or benefits in kind provided by governments for households and firms brings more spending in its wake and results in more output, incomes and employment. The normal trade-off of schools for hospitals or cleaner air for more expensive electricity or spending less today to spend more tomorrow, does not apply when an economy operates well below potential and can be expected to continue to do so. More can be spent now so that more will be produced. The extra spending has no economic cost. It is the proverbial free lunch now being consumed generously, sensibly and widely across the globe in response to lockdowns.

We learned from the Minister that the SA economy is not expected to recover to 2019 levels until 2024-25. A much slower process of recovery than is expected elsewhere, for want presumably of enough stimulus, and a reason for spending more now. It will nevertheless take strict control over government spending, especially on the employment benefits provided for its own employees to regain a much better fiscal balance over time. And limiting such highly attractive employment benefits has to start now, as the Minister emphasized . Stabilizing the debt to GDP ratio to limit spending on interest should take a good deal longer. The very limited reactions in the Bond and currency markets to the revised Budget indicate that the jury is still very much out. Unproven is the interim judgment.

While the Treasury is constrained by want of reputation, the Reserve Bank is not so.  It could be helping to hold down the costs of funding long dated government debt. And lending more freely to the banks so that they could fund much more, lower cost short term debt issued by the government. It should lower interest rates further and encourage the banks to lend more freely and make use of the loan guarantee scheme. Which is much the largest part of the Treasury’s stimulus package, regrettably still largely unused. Creating money as the cheapest form of funding government debt is as right now for SA as it is everywhere else. And the Reserve Bank has the anti-inflation credentials to be expected to reverse its monetary course when the time and the recovery calls for it.

Last Wednesday, a vital opportunity to enhance SA’s growth prospects and hence its ability to raise revenue and greatly relieve its Budget constraints was revealed outside Parliament. In the confirmation of a major energy resource in South African waters. Total and partners have speculated heavily on and in South Africa and have triumphed. Good for them and for all of us. The Intergrated Resource Plan (IRP 2019) sees very little scope for natural gas in SA as part of the energy mix. The plan predictably will have to be rewritten. And much better replaced by not another plan but a process well known to balance supply and demand. That is a market led process. One that would leave Total to develop its discovery as it sees best unencumbered by unhelpful regulation or crony capitalism or retrospective expropriation. The potentially favourable consequences of the right approach are hard to overestimate.

The construction of pipelines and urban gas grids and an infrastructure led growth beckon.  Municipalities seeking electricity are likely partners as is Eskom. The people of SA will benefit from additional royalties, income and VAT and taxable income earning opportunities of all kinds. And from cheaper energy. The financial and structural constraints on our economy can be relieved. More immediately can be expected to be relieved with the right business friendly approach.  Our fiscal and investment reputation depends upon it.

Thinking and acting long term comes with a price – the discount rate

An analysis of discount rates shows the extent to which a high risk premium encourages short-term thinking.

In making economic or social choices today, how far ahead do you look? You may blow your Friday wage packet on hedonistic pursuits without any regard to how little food will be on the family table the following week. Or you may run up the mortgage bond to fund the next holiday abroad. We might ascribe such myopic actions as reflecting high personal discount rates. In such cases, future benefits clearly command very little competition with immediate pleasures.

When a business contemplates an investment decision, how far ahead should it calculate its expected benefits? How many years of future cash flow would your business estimate as necessary to justify an acquisition or an addition to plant and equipment? The longer the estimated pay-back period, the greater will tend to be the present value of the investment decision.

Expecting to get back capital risked in 10 or 20 years, rather than in five years, encourages investment by reducing required returns. It means the application of a lower discount rate to future incomes or expected cash flows. It brings higher present values that are more likely to exceed the current costs of the plant, equipment or acquisition. Future-conscious economic and social actors, with longer time horizons, benefit themselves by saving and investing more. They also benefit their broader communities, by helping to contribute to a larger stock of capital and so more productive workers capable of earning higher incomes.

South African investors are exposed to high discount rates. They are as high as they have been in recent times and are high when compared to discount rates in the developed world. The long-term promises of interest and capital repayments by the SA government are discounted at about 9% a year. Adjusted for expected inflation of 5%, this provides savers with a real return of about 4% a year, with which every risky SA business contemplating capex has to compete for capital.

A risk premium of at least 5% for a well-established and listed SA company would have to be added to this 4% and so the discount rate applied to any prospective cash flow. A required return of more than 10% a year after inflation makes for short pay back periods and so limited capex and limited growth opportunities generally. It also means much lower present values attached to established SA business so that they can satisfy such demanding expectations. Higher discount rates destroy wealth.

For example, assume you have an investment that earns income, initially worth 100, that is expected to grow at 5% a year over the next 20 years. Assume a developed world discount rate of 6% – made up of 1%, which is all that is available from government bonds, plus an assumed 5% extra for risky equity. The present value of this expected income or cash flow stream will be 320. Moreover 81% of its current market value can be attributed to the income expected after five years.

The same business, with the same prospects in SA, and with the same risk premium, but competing with government bonds offering 9%, would have future income discounted at 14%. This is more than double the discount rate applied to an averagely risky investment in the developed world. It would have a present market value of 116, about a third lower. Of this, only 54.9% of its present market value will be attributed to income to be expected after five years. This forces such a business to adopt a much shorter focus, with fewer viable investment opportunities.

The direction of economic policy reforms in SA should be evaluated through the prism of the discount rate. The purpose of reform must be to build confidence in the future growth and stability of the economy to lower the damagingly high discount rate. Only this can make businesses more valuable, by encouraging their managers to think more about the long term than the short, and to invest more and thus improve the economic prospects for all South Africans.

The importance of lower long-term interest rates

An SA economic revival will depend on lower real long-term interest rates. Only a credible commitment to restraining government spending over the longer run can therefore relieve SA of the burden of expensive debt.

Central Banks have more to offer a distressed economy than just lower interest rates. Interest rates cannot or will not be allowed to fall much below zero, however central banks can supply their economies with more of their own money, in the form of the deposits they supply to their private banks, if necessary. They can add money by lending more of their cash to their governments, private banks and even businesses. They may choose to buy back assets from banks or buy the debt or even the equity of private businesses.

Central bankers will hope that the banks will lend out more of the extra cash they will be receiving automatically from the central bank. If the banks and their borrowers respond favourably to these monetary injections, the supply of private bank deposits and of bank credit will increase by some multiple of the additional central bank money. The extra money (deposits) supplied will then not be hoarded by the public but exchanged for goods and services and for other assets. Higher share prices, more valuable long-dated debt and real estate will translate into more private wealth, leading to less saved and more spent (asset price deflation has the opposite, depressing impact on an economy).

An economy that delivers less income and output than it is capable of, is distressed. Lockdowns have disrupted output and sacrificed the incomes of businesses, households and governments in a serious way. Getting back to an economically normal state requires a mixture of increasing freedom and willingness to supply goods, services and labour. It also needs more spending to encourage firms to produce more and hire more people.

Money creation on a large and urgent scale is helping to stimulate demand almost everywhere. M2 in the US has grown by nearly 25% over the past 12 months. It has led to a more helpful response from US banks than occurred after the Global Financial Crisis (GFC), as the monetary statistics in figure 1 show.

Figure 1: Money supply growth in the US (M2)
Money supply growth in the US (M2) graph
Source: Federal Reserve Bank of St.Louis and Investec Wealth & Investment

The SA Reserve Bank has adopted a very different strategy and rhetoric. It has decided that it has done all it can for the economy by cutting its repo rate associated lending rates by three percentage points, to 3.5%. It has rejected any quantitative easing (QE) that might have reduced pressure on interest rates at the long end of the yield curve. It argues that a structural inability to supply (over which it has limited influence), is the cause of our economic distress, not the state of demand, which it could influence if it chose to do so – with still lower repo rates and money creation. It is an argument that can be challenged.

Yet perhaps all is not lost on the SA monetary front. The deposit liabilities of the banks (M3) had grown by about 11% by August, compared to a year before, while the money base is up by 12.5%. This is a welcome acceleration, as figure 2 shows. Less helpfully, bank lending to the private sector was up by only 3.9%.

Figure 2: Growth in monetary aggregates

Growth in monetary aggregates graph

Source: SA Reserve Bank and Investec Wealth & Investment

It is possible to reconcile the faster growth in the deposit liabilities of the banks with the slower growth in the credit they have provided. The difference between the growth in bank deposit liabilities (up 11%) and assets (up by about 4%) is accounted for by a large increase in the free cash reserves of the banks. The negative difference between cash and repos narrowed by about a net R60bn in 2020. The banks have been provisioning against loan defaults on a large scale. These provisions reduce their reported earnings and therefore dividends, but it increases their cash and free reserves – represented as an increase in equity reserves. As figures 3 and 4 below show, the equity reserves and their provisions rise during times of stress, as they are doing now and did during the GFC, which led to a sharp recession in SA.

 

Figure 3: SA banks’ free reserves – cash less repurchase agreements with the Reserve Bank and others

SA banks’ free reserves – cash less repurchase agreements with the Reserve Bank and others graph

Source: SA Reserve Bank and Investec Wealth & Investment

Figure 4: SA banks’ capital and reserves (R millions)

SA banks’ capital and reserves (R millions) graph

Source: SA Reserve Bank and Investec Wealth & Investment

The banks however have an attractive alternative to providing credit for the private sector. They borrow short (raise deposits) and can lend to the government at higher rates without risks of default. The currently very steep slope of the yield curve adds to this attraction as well as to the profitability of borrowing short and lending long. If long rates are the average of expected shorter term rates over the same period, the currently steep slope of the yield curve implies that short rates are expected to increase dramatically over the next five years. A one-year RSA bill is now offering 3.2%. A three-year bond currently offers 5.06% and a five-year bond 6.72% (all annual rates). The one-year rate would have to rise to more than 8.3% in three years’ time and to 11.3% in five years, to justify the current slope of the yield curve. Unless inflation or real growth surprise significantly on the upside, these higher short rates, as implied by the yield curve, make such outcomes unlikely. Borrowing short to lend long to the SA government looks like a good profitable strategy for SA banks, for now. Similarly, for the government, it favours a strategy of issuing short-term debt and then rolling it over, rather than raising long-term debt at much higher rates.

Figure 5: The spread between RSA 10-year bond yields and money market rates

The spread between RSA 10-year bond yields and money market rates graph

Source: Bloomberg, Iress and Investec Wealth & Investment

Figure 6: The RSA yield curve and the implicit one-year forward rates

The RSA yield curve and the implicit one-year forward rates graph

Source: Thompson-Reuters and Investec Wealth & Investment

The banks have been holding significantly more government paper over recent years in response to presumably weak demand for credit from private borrowers and the availability of relatively attractive interest rates on low-risk government paper. Government debt as a share of all bank assets is now 13%, a share that has doubled since 2010. The banks invested a further (and significant) R110bn in additional government debt between January and June 2020.

Figure 7: Bank lending to the government

Bank lending to the government graph

Source: SA Reserve Bank and Investec Wealth & Investment

Figure 8: Composition of bank lending to the SA government

 

Source: SA Reserve Bank aComposition of bank lending to the SA government graphnd Investec Wealth & Investment

Such extra investment in government bills and bonds by the banks is helpful to the government, given the ballooning deficit it has to fund one way or another. The growing deficits are the result more of a collapse in revenue than a surge in spending as the chart below shows. But for the banks to prefer government over private debt would effectively crowd out the lending to the private sector that could contribute to economic growth.

Figure 9: National government expenditure and revenue (monthly, seasonally adjusted and smoothed)

National government expenditure and revenue graph

Source: SA Reserve Bank and Investec Wealth & Investment

Figure 10: Annual growth in government revenue and expenditure (smoothd)

Annual growth in government revenue and expenditure graph

Source: SA Reserve Bank and Investec Wealth & Investment

Viewing all these forces at work leads to one important conclusion: any revival of the SA economy will depend on lower real long-term interest rates and less expensive debt for the government and taxpayers. It will also mean lower real required returns for any business. These required returns are currently extremely high, given high nominal bond yields, low inflation and the additional equity risk premium. The returns required to justify an investment in the SA economy are thus of the order of a prohibitive 10% or more after inflation. The Reserve Bank can help in the short run by managing long rates lower. However only a credible commitment to restraining government spending over the longer run can lead SA out of the burden of expensive debt.