Author: Brian Kantor

To be grateful for not so small mercies

January 27, 2021

There is some very good news to cheer South Africans up. They are a lot wealthier than they were when the lockdowns were announced in March. And wealthier than they were on January 1st 2020. If their wealth has been diversified through the JSE, the average shareholder will be 70% better off than they were in March. And 13% up on their portfolios of the 1st January 2020. The All Bond Index has returned 31% since March and 9% since January 2020. Those with shares off-shore would also have done well, but not as well. They would be up 59% if they held an MSCI EM benchmark tracker or 46% if they had tracked the S&P 500 March. That foreign holiday plan sadly disrupted in March would now be about 16% cheaper in USD. Since the ZAR/USD bottom of April the mighty ZAR has also done a lot better than the average EM currency.

Screenshot 2021-02-03 194750 Screenshot 2021-02-03 194805

To what should South African wealth owners attribute their much improved financial condition? The usual global suspects can be interrogated. A weaker dollar in a more risk on environment and so buoyant EM stock markets, to which the JSE is umbilically attached, is a large part of the explanation. A rising S&P 500 is a tide that lifts all boats, though some higher than others, as we have seen of the JSE and the ZAR.

But there are more than global risk-on forces at work. SA specific risks, as measured in global bond markets, have declined, notably so since October. They have also have declined relatively, by more than the risks attached to Brazil, Mexico and Russia bonds of the same duration. In April, at the height of market turbulence, the yield on RSA USD denominated 5y bonds had risen to over 7% p.a. And the risk spread, the extra yield over US Treasuries, was about 6.5% p.a. These bonds now offer 3.1% p.a. and an extra 2.7% p.a. over US T Bonds, less than half their levels in March 2020 with much of the improvement also registered after October. Insuring RSA Yankee bonds against default now costs but 1.1% p.a. more than it would cost to insure the average of Brazilian, Mexican and Russian debt. This extra insurance premium to cover SA default SA was 1.5% in October.

Screenshot 2021-02-03 194821 Screenshot 2021-02-03 194838

The reasons for lower SA risks are not at all as obvious as the benefits. By reducing risk and helping to add to the wealth of South Africans they encourage more spending needed to encourage output and employment. Lower risks moreover reduce the returns required of business adding to their capital stock in SA, so much more of which is needed to permanently raise output employment and incomes. And tax revenues rise with income.

Such improved prospects will be completely reversed by an additional wealth tax. It will not be expected to be a once off event. It will mean more SA risk and demand higher returns on the cash firms invest, meaning still less capex. It will reduce the value of SA companies so that they can meet such higher required risk adjusted returns for investors and immediately reduce the rewards for saving and the value of pensions. It will encourage the export of the savings of tax paying wealth owners and the emigration of skilled taxpayers. Tighter controls on capital flows would inevitably have to follow that would undermine the depth of our capital markets. Have those who advise wealth tax increases estimated how much collateral damage will be done to tax revenues over the longer run?

The sensible way to fund an unavoidable increase in government spending is to call further on the R160b of Treasury cash held at the Reserve Bank. And to raise a temporary overdraft from the Reserve Bank to supplement this cash balance, should this become at all necessary.  Adding more money to the wealth portfolios of South Africans, including to their deposits at the banks, created this way, would further stimulate spending, income growth and tax revenues. It would be growth enhancing and therefore risk reducing.

Vaccines and vacuity – the true costs of not securing vaccine supplies

The failure to secure a large supply of vaccines to help South Africa to reach herd immunity quickly, reveals a vacuity in thinking about the cost to the economy.

The fiasco over the supply of vaccines reveals fully the vacuity of South Africa’s approach to Covid-19. The deposit of R283m to secure a supply of vaccines was not budgeted for because we didn’t have the money for it – even though money for much else was found in the adjusted Budget.

In this context, I observe that the Treasury deposits at the Reserve Bank amounted to R160bn in October, boosted by loans from the IMF and other agencies with anti-pandemic action front of their minds. Has anyone in the Treasury or government attempted to calculate how much additional income will be lost for want of the vaccine – and how much tax revenue the Treasury will not be able to collect?

It will be many times more than the R20bn to be spent on the vaccine. Bear in mind too, that R7bn of this is to be funded by members of medical schemes, which in effect makes it a tax increase or expropriation by any other name, unhelpful given the state of the economy.

Yet a supply of additional money could have been made available by the Reserve Bank, in the same way that money is being created on a large scale by central banks all over the world to fund the extra spending that the lockdowns have made imperative. And the Bank could still do so, to help the Treasury fund the vaccine and the money cost of rolling it out. The idea of raising taxes to fund the extra spending when the economy is under such pressure makes little sense. A higher tax rate or taxing specific incomes will slow the economy even further and might lead to lower tax revenues of all kinds.

Moreover, there is little prospect of more inflation to come. Should inflation emerge at some point, a reversion to normal funding arrangements would be called for. The danger then is that central banks like our Reserve Bank might not act soon enough and inflation picks up. But it is a danger that pales into insignificance when compared with the present danger posed by the pandemic.

Governments around the world know enough economics to know that spending more to help employ workers (and machines) who would otherwise be idle was a costless exercise – costless in the true opportunity cost sense. But South Africa seemingly cannot bring itself to think through the problem this way. The upshot is that South Africa lacks the essential self-confidence to do what would be right now.

The monetary and financial market statistics tell us how unready the economy is to sustain any recovery of output and employment. The supply of extra Reserve Bank money in the form of notes and deposits by banks with the Reserve Bank, what is described as the money base or M0, rose by 8% in 2020. There was a flurry of extra such money in March and July 2020, since reversed. In the US, the money base is up by 43% (See figure 1).

Figure 1: Annual growth in central bank money, SA and US

Annual growth in central bank money, SA and US

Source: SA Reserve Bank, Federal Reserve Bank of St. Louis and Investec Wealth & Investment

The SA banking system is hunkering down, not gearing up. Bank deposits have been growing at about an 8% rate, while lending to the private sector is up a mere 3%. The banks are building balance sheet strength, raising deposits and are cautious about lending more. They are relying less on repurchase agreements made with the Reserve Bank and other lenders, reserving more against potential bad debts while not paying dividends and hence adding to their reserves of equity capital. All of these act to depress growth.

Figure 2: SA bank deposits and lending (R million)

SA bank deposits and lending (R million)

Source: SA Reserve Bank and Investec Wealth & Investment

Figure 3: SA banks – adding to equity capital

SA banks – adding to equity capital

Source: SA Reserve Bank and Investec Wealth & Investment

The financial metrics continue to paint a grim picture of the prospects for the SA economy. Long-term interest rates remain above 9%, even as inflation is expected to average 5% over the next 10 years. This makes capital expensive for potential investors who are therefore less likely to add to their plant and equipment. The difference between borrowing long and short remains wide, implying sharp increases in short-term interest rates to come and expensive funding for the government (that is taxpayers) at the long end. The risk of South Africa defaulting on its US dollar debt demands that we pay an extra 2.3% more a year than the US government for dollars over five years.

Figure 4: Key financial metrics in 2020-21

Key financial metrics in 2020-21

Source: Bloomberg and Invested Wealth & Investment

Poorly judged parsimony and monetary conservatism have brought SA great harm in the fight against Covid-19. They have made the prospects for a recovery in GDP and government revenue appear bleak. It is not too late to change course. We should be funding the extra unavoidable spending on the vaccine and its roll out by drawing on the cash reserves of the government or by raising an overdraft form the Reserve Bank.

Hard truths about pandemic spending

The government can call on the central bank to provide money but is not trusted to do the right thing

When or rather if economies return to their pre-shock growth paths, the cost-benefit analysis of the lockdowns is unlikely to bear favourable witness to the responses made to the Covid crisis by SA.

The cost is the difference between GDP on its pre-Covid path (which was on a regrettably moderate incline) and what is likely to be produced and earned before we get back on that path. My own back-of-envelope calculations came to a very large number, equivalent to possibly R1-trillion in money of the day, or equivalent to a quarter of pre-Covid GDP. Certainly, a very large amount of potential income will have been sacrificed. The benefits in the estimate of the value of years of life saved by the lockdowns will be much harder to calculate.

The more precise calculations of costs and benefits dealing with any future pandemic could go as follows. First, estimate the losses of income and output caused by any potential lockdown. These costs in the form of income and output foregone should then be compared with the cost of providing a reserve of medical capacity sufficient to prevent the medical system from being overwhelmed by pandemic demands — which is the case for imposing a lockdown, as we have been reminded.

Hoping to eliminate death is not a realistic option for medical and economic reasons. Minimising the difference between the costs and benefits of any policy should be the objective and is a judgment call. Yet the cost of building and maintaining an adequate medical reserve will be much lower than the sacrifice of income caused by any compulsory lockdown. But this cost will be explicit on any budget that current taxpayers would be liable for. And they and the immediate beneficiaries of alternative government spending clearly attach much present value to lower taxes and other welfare benefits. Future benefits that are uncertain in time and scale are always heavily discounted. But it is a trade-off that is resolved whenever a forward-looking society invests in a reserve to defend itself against any potential invader.

But what happens when war or a pandemic breaks out? The future, after the war, then becomes largely irrelevant compared with the immediate task of winning the war. The task is to spend enough and well enough to immediately increase resistance or medical capacity. Any failure to have built a medical reserve will make it practically difficult to do enough, quickly enough. The crisis, however, becomes too important for money to stand in the way. And where will or can the extra spending money come from?

Raising tax rates will be self-defeating. Less not more tax will be collected. Raising additional government debts may prove very expensive for taxpayers to pay for and repay in the future.

There is another way. A government under great pressure to spend more can call on its own central bank to immediately provide the money to spend. The central bank can create as much money for its government as it chooses to do. It provides extra cash for the government by buying government debt in the market or providing the government with an overdraft to spend on a large enough scale. This is what the developed world is doing on a very large scale: creating much more money to fund extraordinary increases in spending to fight the crisis. The policies are expected to be reversed when or should inflation rear its ugly head.

They have done what SA has been unwilling, not unable, to do. For want perhaps of a full understanding of opportunity costs, we have not spent enough. But more so because our government is not trusted to do right for our society and economy: in the short run spend more and in the long run spend less. Tragically so.

A Holiday post-Covid19 message – Believe in successful (economic) evolution

There is one constant that applies pre- during and post-Covid. Market driven economies adapt continuously to the changing tastes of consumers and the opportunities technology provides to supply them more profitably. Best practice
evolves so that firms can attract their essential business partners, their workers, supervisors, and capital providers on market driven terms.

Businesses and their supply chains including their supplies of labour and skills have sometimes to respond to circumstances that are beyond their control and they could not have anticipated. As with the Covid lockdowns. They
were an extreme form of government interference in the roles economic agents may ordinarily choose to play. With outcomes that few would describe as predictable or fair.

This forced households and businesses to adjust rapidly to dramatically changed circumstances to minimize losses as best they could. The Covid economy offered grave dangers and some opportunity. It accidentally produced a few big
winners and many more losers for whom income or debt relief from their governments, who caused them so much damage, seems only fair. Businesses as usual will be doing all they can, to accurately anticipate our preferences and
actions as consumers, as suppliers of labour and skills, and as providers of capital.

The Covid economy has proved that if your job is to deliver a service and the only machine you need with which to combine your labour and intelligence, is a computer, you can work anywhere, including home. And connectivity to other
computers is bound to improve and become less expensive. Wider choices have therefore presented themselves to both sides of the employment nexus.

Trade-offs of income for other benefits including the quality of the working environment have always to be made. Who indeed pays for the Google campus and how valuable are its benefits? Ask Google. The requirements and solutions for
business success will differ from firm to firm. Yet first mover advances in the right new direction are very valuable. It takes time for the competition to latch on, catch up and compete away the temporarily high returns to owners and the
superior benefits they may provide to attract “best of breed”.

In the post-Covid economy how much of our incomes will be earned from our homes? And how much will we play in or outside, in restaurants, resorts and cruise-liners. (Merely mentioning them makes me salivate in anticipation of happier
times) Will our output, be higher or lower working from home, or higher in face-to-face collaboration with colleagues and fellow workers at a more or less distant work-place? The owner of a business, to survive, is compelled to measure
what employees deliver, wherever they may deliver it or wish to deliver.

Potential and actual employees will also be estimating the extra benefits and extra space costs working from home. Benefits that include more time for leisure or to bring up their children? Clearly very little is produced commuting to
work. Potential income and leisure are sacrificed in the time commuting, or higher actual or owner equivalent and market rentals are incurred reducing the time and costs of getting to the office, factory or warehouse. The savings in
time and money and office or house rentals are open to trade-offs, experimentation and ultimate resolution. The providers of transport, cars, busses, trains above and below ground, aircraft and highways, not to mention office
buildings, will be predicting and observing the outcomes.

Workers would have to accept less pay to work at home should they prove less productive there and prefer to do so. They can expect to earn more if the opposite proves true. Or will employers have to offer them more to get them to

come to the office, to bear the extra costs of commuting? Should they be expected to be more productive and creative in F2F collaboration. Which may well be a lot more fun and even worth sacrificing some income and leisure and time at
home for. We will find out what mix of income and salary and working conditions work best and for whom. There will be no cookie cutter solutions. We should be confident that the process can best be left to work out in the usual, successful,
evolutionary way.

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.

Money matters – also in SA

Central Banks have more to offer a distressed economy than lower interest rates. They can supply their economy with much more of their money in the form of the deposits they supply to their private banks. They can add as much money to the economy as they deem necessary, by lending more to their governments, private banks and businesses.

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 any additional central bank money. The extra money and credit created will then be exchanged for goods and services, the labour to help produce them and exchanged for other assets.  Higher share prices, more valuable long dated debt, and real estate, translates into more private wealth, leading to less income saved and more spent. Helping to relieve distress.

Lockdowns have disrupted output and sacrificed the incomes of businesses and the households and governments on a large scale. Getting back to an economic normal requires a mixture of increasing freedom and willingness to supply goods services and labour. It also needs more spending to encourage firms to wish to produce more and hire more workers and managers. Money creation on a very large and urgent scale is helping to stimulate demand almost everywhere. M2 (that is bank deposits) in the US have grown by nearly 25% over the past twelve months. QE is working very rapidly this time round.

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 by 3 percentage points to 3.5%. It has rejected any 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 weak state of demand.  Go figure as they would say in New York

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 and the supply of Reserve Bank money is up by 12.5% p.a. in September compared to the year before. This represents a marked acceleration. Much less helpfully bank lending to the private sector was up by only 3.9% p.a. in August. 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, of about a net R60b in 2020. That is the cash on their books less all their repurchase agreements with the Reserve Bank and others have become less negative.

The banks have been provisioning against loan defaults on a large scale. These provisions reduce their reported earnings and therefore dividends. It therefore increases their cash and free reserves that are reflected as an increase in equity reserves. A process that is reversed should the bad debts materialize.

The banks invested a further and significant R110b in additional government debt between January and June 2020. Very helpful to a very hard pressed fiscus, but also crowding out lending to the private sector. The currently very steep slope of the yield curve adds to the attraction of borrowing short to lend long to the government. It also implies that short rates are expected to increase very dramatically over the next five years. Unless inflation or real growth picks up very surprisingly, the very much higher short rates implied by the yield curve seem unlikely. Borrowing short to lend long seems like a very good and profitable strategy for SA banks and others. Borrowing short and rolling over short term debt rather than borrowing long, at much higher rates seems like a good idea for the RSA.

This all leads to an undeniable conclusion. Any revival of the SA economy will depend on realizing lower real long-term interest rates and flattening the yield curve. It will bring lower real required returns for any business that might invest more in the SA economy, essential if the economy is to pick up any sustainable momentum.   Only a credible commitment to restraining government spending over the longer run can lead SA out of the stultifying burden of very expensive capital.

A call for realism in economic and monetary policy

What permanent shape will the global economy take after the lock downs are fully relieved? How fast can the global economy grow when something like normality resumes? There are those who argue that the major economies have entered an extended period of economic stagnation.   Some even argue that demand will have difficulty in keeping up with minimal extra supplies of goods services and labour. That monetary policy has shot its bolt because interest rates cannot go much below zero.

We should dismiss such underconsumption theories.  Monetary stimulus comes not only from lower interest rates but also occurs directly as excess supplies of money are converted into demands for other goods or services and for other assets. Higher asset prices and greater wealth also have positive effects on spending. There is no technical limit to the amount of money central banks can create to stimulate more spending. The only limit is their own judgment as to how much extra is necessary to the purpose of getting an economy up and running again.

Stagnation will be for a want of willingness to supply goods services and labour. If demand remains weak we should expect ever more injections of central bank cash until demand increases enough to make inflation rather than growth the problem for central banks.  This is unlikely any time soon and global interest rates will remain low until then. Such policies can be reversed when the time is right to do so.

These low interest rates encourage a flow of capital to those parts of the world where real interest rates are much higher. As in South Africa where the market still rules the determination of long-term interest rates given the clear unwillingness of the SA Reserve Bank to monetize government debt on any significant scale. The SA government has to offer nearly 10% for ten-year money.  Adjusted for expected inflation of around 5% this provides a very attractive expected real return of around 5% per annum over the next ten years.

The average private firm contemplating investing in plant and equipment in SA would have to add a risk premium of another five per cent to establish the returns required to justify such an investment. These  expected returns would therefore have to be of the order of an expected 10% p.a. after inflation.  A requirement that is prohibitively high and explains in large measure the lack of capital expenditure in SA. And reinforces the prospect of a permanently stagnant economy. It also explains the depressed value of SA facing companies on the JSE regarded as without good prospects for growth. For faster growth in capex, interest rates have to come down or, less happily, inflation must go up to reduce required returns on capex.

Improving our growth prospects requires a steely economic realism in response to current very difficult circumstances. It necessitates more central bank intervention to lower long-term interest rates and much more reliance on short term borrowing that will be much less expensive for taxpayers. It calls for still lower interest rates at the short end. It calls for money creation and debt management of the kind practiced almost everywhere else as a temporary, post lock-down stimulus to more spending and growth- but alas not here.

The blow out in the borrowing requirement of the government –because revenue has collapsed with incomes – is a best regarded as unavoidable. Realism means no increases in tax rates on expenditure or incomes. Doing so would further slow-down the economy and revenue collections with it. Higher expenditure taxes and charges would also raise headline inflation, depress spending on other goods and services and raise demands from public sector unions for better pay. These now pressing demands for improved employment benefits for comparatively well paid and protected public sector employees must be strongly resisted. This will help demonstrate that the SA government can spend within its capacity to raise revenue over the longer term. The debt trap is avoidable.

It calls for policy responses that would best serve the economy now in crisis and act as a bridge to permanently sound policies of a market friendly nature. So providing a signal of improving prospects that would justify significant inflows of capital to lower interest rates and required returns. That in turn would lead to much higher levels of capital expenditure necessary for permanently faster growth.

PSG and Capitec – Shareholders’ (un)bundle of joy

By unbundling Capitec, PSG has done the right thing for shareholders – but shareholders remain sceptical about its prospects.
PSG shareholders should be pleased. The decision to unbundle PSG’s stake in Capitec has delivered approximately R7.85bn extra to them. This estimated value add for PSG shareholders is calculated by eliminating the discount previously applied to the value of the Capitec shares held indirectly by PSG.Without the unbundling, the discount applied to the assets of PSG would have been maintained to reduce the value of their Capitec shares. The market value of the 28.1% of all Capitec shares unbundled to PSG shareholders, worth R960 a Capitec share, would have been worth R31.4bn on 16 September. These Capitec shares might have been worth 25% less, or nearly R8bn, to PSG shareholders, had it been kept on the books.

The PSG holding in Capitec had accounted for a very important 70% of the net asset value (NAV) or the sum of parts of PSG. Before the unbundling cautionary was issued in April 2020, the difference between the NAV and market value of PSG, the discount to NAV, had risen to well over 30%. The difference in NAV and market value of PSG was then approximately R20bn in absolute terms. The discount to NAV then narrowed to about 18% when the decision to proceed with the unbundling was confirmed.

Now with the unbundling complete, PSG again trades at a much wider discount of 40% or so to its much-reduced NAV.

Capitec and PSG delivered well above market returns after 2010. By the end of 2019, the Capitec share price was up over 18 times compared to its 2010 value. By comparison, the PSG share price was then 10 times its 2010 value, and the JSE 2.1 times.  The Capitec share price strongly outpaced that of PSG only after 2017.

The Capitec and PSG share prices, compared to the JSE All Share Index (2010 = 100)
The Capitec and PSG share prices, compared to the JSE All Share Index chart
Source: Iress and Investec Wealth & Investment

The better the established assets of a holding company perform, as in the case of a Capitec held by PSG or a Tencent held by Naspers, the more valuable will be the holding company. Its NAV and market value will rise together but the gap between them may remain wide. Investors will do more than count the value of the listed and unlisted assets reported by the holding company. They will estimate the future cost of running the head office, including the cost of share options and other benefits provided to managers of the holding company.  They will deduct any negative estimate of the present value of head office from its market value. They may attach a lower value to unlisted assets than that reported by the company and included in its NAV.

Investors will also attempt to value the potential pipeline of investments the holding company is expected to undertake. These investments may well be expected to earn less than their cost of capital, in other words, deliver lower returns than shareholders could expect from the wider market. These investments would therefore be expected to diminish the value of the company rather than add to it. They are thus expected to be worth less than the cash allocated to them.

To illustrate this point, assume a company is expected to invest R100 of its cash in a new venture (it may even borrow the cash to be invested or sell shares in its holdings to do so). But the prospects for the investments or acquisitions are not regarded as promising at all. Assume further that the investment programme is expected to realise a rate of return only half of that expected from the market place for similarly risky companies. In that case, an investment that costs R100 can only be worth half as much to its shareholders. Hence half of the cash allocated to the investment programme or R50 would have to be deducted from its current market value.
 
All that value that is expected to be lost in holding company activity will then be offset by a lower share price and market value for the holding company – low enough to provide competitive returns with the market. This leads to a market value for the company that is less than its NAV. This value loss, the difference between what the holding company is worth to its shareholders and what it would be worth if the company would be unwound, calls for action from the holding company of the sort taken by PSG. It calls for more disciplined allocations of shareholder capital and a much less ambitious investment programme. The company should rather shrink, through share buy backs and dividends, and unbundling its listed assets, rather than attempt to grow. It calls for unbundling and a lean head office and incentives for managers linked directly to adding value for shareholders by narrowing the absolute difference between NAV and market value. Management incentives, for that matter, should not be related to the performance of the shares in successful companies owned by the holding company, to which little or no management contribution is made.

On that score, a final point directed towards Naspers and its management: the gap between your NAV and market value runs into not billions, but trillions of rands. This gap represents an extremely negative judgment by investors. It reflects the likelihood of value-destroying capital allocations that are expected to continue on a gargantuan scale. It also reflects the cost of what is expected to remain an indulgent and expensive head office.

The case for funding with equity, not debt

Two recent cases of JSE-listed companies reveal the advantages of equity funding over debt funding.
While issuing debt can be more dangerous than issuing equity, it receives more encouragement from shareholders and the regulators. Debt has more upside potential: if a borrower can return more than the costs of funding the debt (return on equity improves) and there is less to be shared with fellow shareholders.

But this upside comes with the extra risk that shareholders will bear should the transactions funded with debt turn out poorly. Any increase in the risk of default will reduce the value of the equity in the firm – perhaps significantly so.

The accounting model of the firm regards equity finance as incurring no charge against earnings. You might think it would help the argument for raising permanent equity capital rather than temporary debt capital. But this is clearly not the case, with the rules and regulations and laws that govern the capital structure of companies. It is also represented in the attitude of shareholders to the issuing of additional equity. They have come to grant ever less discretion to company boards to issue equity. Less so with risky debt.

(Note: I am grateful to Paul Theodosiou for the following explanation of the different treatment of debt and equity capital raising. Paul was until recently non-executive chairman of JSE-listed REIT, Self Storage (SSS), and previously MD of the now de-listed Accucap of which I was the non-executive chairman).

Typically at the AGM, a company will seek two approvals in respect of shares – a general approval to issue shares for cash (which these days is very limited – 5% of shares in issue is the norm) and an approval to place unissued shares under the control of directors (to be utilised for specific transactions that will require shareholder approval). These need 75% approval. So shareholders keep a fairly tight rein on the issue of shares.

Taking on or issuing debt, on the other hand, leaves management with far more discretion. Debt instruments can be listed on the JSE without shareholder approval, and bank debt can be taken on at management’s discretion. The checks and balances are more broad and general when it comes to debt. Firstly, the memorandum of incorporation will normally have a limit of some kind (for REITs, the loan to value ratio limits the amount of debt relative to the value of the assets). If the company is nominally within its self-imposed limits, shareholders have no say. Secondly, the JSE rules provide for transactions to be categorised, and above a certain size relative to market cap, shareholders must be given the right to approve by way of a circular issued and a meeting called. The circular will spell out how much debt and equity will be used to finance the transaction, and here the shareholders will have discretion to vote for or against the deal. If they don’t approve of the company taking on debt, they can vote at this stage. Thirdly, shareholders can reward or punish management for the way they manage the company’s capital structure – but this is a weak control that involves engaging with management in the first instance to try and persuade, and disinvesting if there isn’t a satisfactory response.)
Perhaps the implicit value of the debt shield – taxes saved by expensing interest payments – without regard to the increase in default risk, confuses the issues for investors and regulators. It is better practice however to separate the investment and financing decisions to be made by a firm. The first step is to establish that an investment can be expected to beat its cost of capital, whatever the source of capital, including internally generated cash that could be given back to shareholders for want of profitable opportunities. When this condition is satisfied, the best (risk adjusted) method of funding the investment can be given attention.

The apparent aversion to issuing equity capital to fund potentially profitable investments seems therefore illogical. Or maybe it represents risk-loving rather than risk-averse behaviour. Debt provides potentially more upside for established shareholders and especially managers, who may benefit most from incentives linked to the upside.

Raising additional equity capital from external sources to supplement internal sources of equity capital is what the true growth companies are able to do. And true growth companies do not pay cash dividends, they reinvest them, earning economic value added (EVA) for their shareholders. A smaller share of a larger cake is clearly worth more to all shareholders.

There are two recent JSE cases worthy of notice.  Foschini shareholders approved the subscription of an extra R3.95bn of capital on 16 July to add about 20% to the number of shares in issue. By 19 August, the company was worth R25.8bn, or R10.5bn more than its market value on 16 July, or R6.5bn more than the extra capital raised. The higher share price therefore has already more than compensated for the additional shares in issue.

The Foschini Group – market value to 19 August 2020

The Foschini Group - market value to 19 August 2020 chart

Source: Bloomberg, Investec Wealth & Investment

The other example is Sasol, now with a market value of about R87bn, heavily depressed by about R110bn of outstanding debt. The extra debt was mostly incurred funding the Lake Charles refinery that ran far over its planned cost and called for extra debt. Sasol was worth over R400bn in early 2014, with debts then of a mere R28bn. The recent market value, now less than the value of its debts, is clearly being supported by the prospect of asset sales and a potential capital raise.

The company would surely be much stronger had the original investment in Lake Charles been covered more fully by additional equity capital, capital they might have been able to raise with much less dilution. It might also have prevented the new management team from having to sell off what might yet prove to be valuable family silver – assets capable of earning a return above their cost of capital. In this case, a large rights issue could still be justified to bring down the debt to a manageable level and, as with the Foschini increase, the value of its shares by more (proportionately) than the number of extra shares issued.

Sasol – market value and total debt, 2012 to July 2020

Sasol - market value and total debt, 2012 to July 2020 chart

Foresight not only hindsight may well justify equity over debt

While issuing debt is more dangerous than issuing equity it receives more encouragement from shareholders and the regulators [1]. Clearly debt has more upside potential. If a borrower can return more than the costs of funding the debt- return on equity improves- and there is less to be shared with fellow shareholders. But clearly the upside comes with extra risks that shareholders will bear should the transactions funded with debt turn out poorly. Any increase in the risks of default will reduce the value of the equity in the firm – perhaps very significantly so.

The accounting model of the firm regards equity finance as incurring no charge against earnings. Hence you might think would help the argument for raising permanent equity capital rather than temporary debt capital. But this is clearly not the case with the rules and regulations and laws that govern the capital structure of companies. It is also represented in the attitude of shareholders to the issuing of additional equity. They have come to grant ever less discretion to the company boards and their managers to issue equity. Less so with risky debt.

Perhaps the implicit value of the debt shield – taxes saved expensing interest payments – without regard to the increase in default risk- confuses the issues for investors and regulators. It is better practice to separate the investment and financing decisions to be made by a firm. First establish that an investment can be expected to beat its cost of capital,-. Cost of capital being the required risk adjusted return on capital invested whatever itsthe source including investing the cash generated by the company itself. Somethingof capital, including internally generated cash that could be given back to shareholders for want of profitable opportunities. When this condition is satisfied the best (risk adjusted) method of funding the investment can be given attention.

The apparent aversion to issuing equity capital to fund potentially profitable capes or acquisitions seems therefore illogical. Or maybe it represents risk loving rather than risk averse behaviour. Debt provides potentially more upside for established shareholders and especially managers who may benefit most from incentives linked to the upside.

Raising additional equity capital from external sources to supplement internal sources of equity capital is what the true growth companies are able to do. And true growth companies do not pay cash dividends, they reinvest them earning Economic Value Added (EVA) for their shareholders. A smaller share of a larger cake is clearly worth more to all shareholders

There are two recent JSE cases worth notice. TFG shareholders approved the subscription of an extra R3.95b of capital on July 16th to add about 20% to the number of shares in issue. The company on August 19th was worth R25.8b or R10.5b more than its market value of the 16th July. Or worth some R6.5b more than the extra capital raised. The higher share price therefore has already more than compensated for the additional shares in issue. ( see below)

The Foschini Group (TFG) Market Value R millions (Daily Data to August 19th 2020)

f1
Source; Bloomberg, Investec Wealth and Investment

The other example is Sasol (SOL) now with a market value of about R80 billion so heavily depressed by about R110b of outstanding debt. The extra debt was mostly incurred funding the Lake Charles refinery that ran so far over its planned cost and called for extra debt. SOL was worth over R400b in early 2014 with debts then of a mere R28b. The market value of SOL (R86b) now less than the value of its debts, is clearly being supported by the prospect of asset sales and a potential capital raise. The company would surely be much stronger had the original investment in Lake Charles been covered more fully by additional equity capital. Capital they might have been able to raise with much less dilution. It might also have prevented the new management team from having to sell off what might yet prove to be valuable family silver that they intend to do. That is assets capable of earning a return above their cost of capital. If so a very large rights issue could still be justified to bring down the debt to a manageable level and as with TFG increase the value of its shares by more (proportionately) than the number of extra shares issued. (see chart below)

f2
Source; Bloomberg, Investec Wealth and Investment

 

 

 

[1] Paul Theodosiou until recently non-executive chairman of JSE listed Reit Self Storage (SSS) and previously MD of now de-listed Acucap (ACP) of which I was the non-executive chairman repoded to my enquiry about the differential treatment of debt and equity capital raising as follows

Typically at the AGM a company will seek two approvals in respect of shares – a general approval to issue shares for cash (which these days is very limited – 5% of shares in issue is the norm) and an approval to place unissued shares under the control of directors (to be utilized for specific transactions that will require shareholder approval). These need 75% approval. So shareholders keep a fairly tight rein on the issue of shares.

Taking on or issuing debt, on the other hand, leaves management with far more discretion. Debt instruments can be listed in the JSE without shareholder approval, and bank debt can be taken on at managements discretion. The checks and balances are more broad and general when it comes to debt. Firstly, the MOI will normally have a limit of some kind (for Reits, the loan to value ratio limits the amount of debt relative to the value of the assets). If the company is nominally within its self-imposed limits, shareholders have no say. Secondly, the JSE rules provide for transactions to be categorised, and above a certain size relative to market cap, shareholders must be given the right to approve by way of a circular issued and a meeting called. The circular will spell out how much debt and equity will be used to finance the transaction, and here the shareholders will have discretion to vote for or against the deal. If they don’t approve of the company taking on debt, they can vote at this stage. Thirdly, shareholders can reward or punish management for the way they manage the company’s capital structure – but this is a weak control that involves engaging with management in the first instance to try and persuade, and disinvesting if there isn’t a satisfactory response.

How to build the confidence needed to borrow and lend

An economic recovery programme for South Africa demands the kind of business and political leadership that now appears to be lacking.

These are truly unprecedented economic times. Never before have large sectors of our own and most other economies been told to stop working. Large numbers of potential participants in the economy are being forced to stay at home. The impact on the supply of goods and services, the demand for them and the incomes normally earned producing and distributing them, has been devastating. Perhaps up to 20% of potential output, or GDP in a normal year, will have been sacrificed globally to the cause. We will know how much has been sacrificed only when we look back and are able to do the calculations.

In South Africa’s case this one fifth of GDP would amount to about R1 trillion of income permanently lost. These are extraordinary declines in output and income. Ordinary recessions, when GDP declines by 2% or 3% in a quarter or a year, are much less severe than this.

Compensation however can be paid to the households and business owners who, through no fault of their own, have lost income and wealth. It is being provided on different scales of generosity across the globe. The richer countries are noticeably more generous than their poorer cousins. South Africa, alas, is among the more parsimonious, at least to date in practice.

There is however no way to recover what has been lost in production. All that can be hoped for is a speedy recovery of the economy when businesses and their employees are allowed to get back to normal. But getting back to producing as much as before the lockdowns means not only more output and jobs becoming available. Any recovery in output will have to be accompanied by more demand for the goods and services that the surviving business enterprises can supply. Without additional spending during the recovery process, there will not be additional supplies of goods, services, jobs and incomes.

Providing unemployment benefits and other benefits paid in cash to the victims of the lockdowns will help to stimulate spending. In the US, every household received a cheque in the post of over $1000 and temporary unemployment benefits of $600 per week were more than many would have earned. The average US household will come out of the crisis with more cash than they had before. And more may be on the way. Spending the cash will help the pace of recovery.

The US and many other countries will be doing what it takes to get back to normal. They will also be learning along the way just how much spending by governments it will take before they can take their feet off the accelerators. They are not being constrained by the monetary cost of such spending programmes. The cheapest way for a government to fund spending is by printing money and redeeming the money issued with more money.

The central banks of developed economies are supplying large extra amounts of cash to their economies in a process of money creation also known as quantitative easing or bond purchasing programmes. The supply of central bank cash in the largest economies has grown 30% this year. Central banks have been buying financial securities, mostly issued by their governments in exchange for their cash that is so willingly accepted in exchange. By so doing, they have helped force down the interest rates their governments pay lenders to very low levels – sometimes even below zero for all government debt, short and long dated. This is an outcome that has made issuing government debt even for 10 years or more even cheaper than issuing money.

These governments have also arranged on an even larger scale (relative to GDP) loan guarantee schemes for their banks to encourage bank lending that will enable businesses that have bled cash during the lockdowns to recapitalise, on favourable terms. Central banks, secured by funds committed by their governments, are covering up to 95% of any losses the banks might suffer if the loans are not repaid. The take-up of such loans by businesses in the US has been very brisk.

South Africa, as mentioned, has not adopted any do-what-it-takes approach to our crisis of perhaps larger relative dimensions. I have argued that we should practise the same logic as the developed economies and rely in the same way on our central bank to create money to hold down the interest cost of funding higher government spending and the accompanying debt. This would be a similarly temporary exercise in economic relief – one well-explained and understood as such – for only as long as it takes.

South Africa has moreover introduced a potentially significant loan guarantee scheme for our banks, with a potential value of up to R200bn. Sadly, little use of the credit lines has so far been made: only R14bn appears as taken up. Every effort should be made to encourage businesses to demand more credit and for the banks to lend more, since they are exposed potentially to only 6% of the loans they make. Working capital, which is necessary to restart SA businesses, is therefore available. The confidence to re-tool seems to be lacking, as is the determination of the banks to find customers willing to invest in the future, from which they will benefit permanently, should they succeed.

The recovery programme demands a business and political leadership that now appears to be lacking. Leadership should want large and small businesses to believe in their prospects after the lockdown and to act accordingly. Economic recovery – getting back to normal as quickly as possible – demands no less.

The Reserve Bank can put its reputation for inflation fighting to good use – reviving our economy after lock-down.

How much income will be sacrificed for the lock downs will depend upon how quickly production (supply) and spending (demand) can be resumed. As always supply and demand will depend on each other and respond together. The more an economy is stimulated by way of government spending on relief and by monetary policy – lower interest rates and more money and credit supplied – the more demand will be exercised and be expected from the customers of businesses. And the greater will be their willingness to tool up and hire workers and managers to satisfy demands.

So much is almost common cause globally. Learning about how well the recovery is going and when the foot can best be taken off the accelerator will be necessary. But surely not until it becomes very clear that an economy is back to normal. That is producing as much output and income as it is capable of- without inflation. When and if inflation comes back, stimulus should and can be reversed.
And the steeper the path back to normal the less the lockdown will have cost in real terms- in income sacrificed. And the cheaper the government can borrow to fund its growing deficits, the less will the future interest bill on much increased issues of government debt.
Hence massive reliance has been placed on central banks in the developed world to print more money. Cash created by central banks in the form of the note issue and bank deposits with the central bank is government debt that does not ordinarily bear interest. Hence extra money issued by central banks has been used on a vast scale to buy government and corporate debt in the market-place in order to hold down all interest rates and to fund government spending directly. Now called politely quantitative easing – but money creation by another name. And to supply their banks with additional cash reserves so that they might provide additional credit on favourable terms to the private and government sectors.
Extra central bank purchases of government debt in the developed have even exceeded this year the vastly increased issues of government debt by the major economies. Hence we observe low even negative interest rates across the entire term structure of interest rates. Making issuing debt for some governments even cheaper than money. The future tax-payer in the developed world has not been made not hostage to a spending and borrowing surge of unprecedented proportions, outside of war time.

The self-same approach is called for in SA and for any economy with its own currency and central bank and for the same very good reasons. And with the same recognition that stimulus can be reversed when the time is right. Unfortunately, the SA Reserve Bank does not agree. It has consistently argued against the case for buying government bonds on an aggressive scale to hold down interest rates. Most recently it has suggested that QE is not only undesirable but impractical, until interest rates are at zero and deflation beckons.
The argument made is that bond purchases (or for that matter increases in Foreign Assets held by the Reserve Bank or declines in their government deposits liabilities) adds to the supply of cash in the system and would have to be fully sterilized by equivalent sales of securities by the Reserve Bank.

However there is never any compulsion to sterilize all such purchases nor any logic in doing so. The object of any bond buying would be to add to the money base by some well-designed amount to encourage the private banks to lend more. The banks might prefer to hold more cash supplied to them in reserve and if so would not have to borrow from the Reserve Bank making the repo rate possibly irrelevant. But this might call for still more cash to be injected and for interest rates to go to zero -helpfully in the circumstances of depressed demand.
Ideally the extra cash supplied to the banks would better be used to fund additional lending to the private and public sectors to encourage spending. The much fuller adoption of the loan guarantee scheme (potentially R200bn of extra bank lending) would reduce any potential demand from our banks for excess cash reserves. The scheme should provide the extra capital and as important the confidence to reboot the SA economy. It urgently needs a champion in the Reserve Bank.
Should the economy recover enough to threaten inflation targets the Governor could be providing good reasons why the monetary taps can be tightened as easily as they were loosened. Given his hard-won inflation fighting credentials these could be used to save the economy from avoidable distress – without prejudicing long term stability.

War and peace – Making sense of the biggest spending splurge in peacetime

Only the arrival of inflation is likely to put an end to the biggest round of government spending seen in in times of peace.

The extent of the surge in government spending and borrowing and money creation currently under way, especially in the richer nations, has no precedent in peacetime. Perhaps that’s because we are not really at peace. We are at war with a virus and, as in most wars, this is accompanied by warlike amounts of impenetrable fog, multiple chaotic situations and much wealth destruction.

Yet there is no sign of any taxpayer revolt to the spending propensities of governments. The current spat between Republicans and Democrats over additional spending is by no means asymptomatic. As I write these words, Congress and the President have already approved extra spending of US$3.2 trillion. The Democrats have now proposed an extra US$3.4 trillion of relief divided up their way. The Republican offer is of an extra US$1.1 trillion spent very differently. For a US$20 trillion economy, either set of spending proposals is formidable.

The global outlook for government debt is truly astonishing. The US fiscal deficit is predicted to approach 25% of GDP shortly, much larger than it has ever been, but for World War 2. In the UK, the debt/GDP ratio was below 60% in 2015 and forecast by the Office for Responsible Budget to fall marginally by 2050. The latest forecast is for a debt/GDP ratio, currently at 100%, to double by 2030. Managing government debt with the aid of central banks and their power to create money, usually the cheapest non-interest bearing form of government debt, is characteristic of all funding arrangements in and after wartime. But if this is war, then it is one without more inflation, either now or expected in the future. 90% of all developed market debt now yields less than 1% a year, of which 10% offers negative returns. It is therefore an inexpensive war for taxpayers to fund.

The recent growth in the size of developed market central banks is equally and consistently awesome. Or is it awful? It could not have happened without them. And there is every prospect of further growth in their assets to come. The balance sheets of four of the largest economies (US, Japan, the European Union and the UK) have increased by the equivalent of US$5.7 trillion (16% of GDP) since February, in other words, by about 30% in five months. Further purchases of securities, mostly issued by their governments, combined with support for extra private bank lending, can be expected to take their balance sheets to about US$27 trillion by 2021, the equivalent of 67% of GDP.

They have similarly increased their liabilities, in the form of extra deposits held by private sector banks at the central bank. These and other central banks have been exchanging their cash for government and other debt on a scale that has made them completely dominant in the market for government debt. They dominate over all maturities that are the benchmarks for all other yields, including earnings and dividend yields in the share market.

The US Fed will soon own 25% of US debt. The number was 10% in 2009. The Bank of Japan has grown its share of government debt from 5% in 2012 to over 40%. The European Central Bank held no European government debt in 2015. It now holds 25% of such debt. The Bank of England now holds 27% of UK government debt. Thus it would be incorrect to describe the low rates of interest on debt as market determined. The flat slope of the yield curve is under central bank control and they are likely to want to keep it that way, because there is no inflation or higher interest rates in sight. Economic revival is their priority.

When will the splurge of (always popular) spending end, while it can still be financed so cheaply? Only when and if inflation rears its ugly head again. And politicians and central banks may then do what their electorates have demanded in the past from post-war regimes: bring inflation down by raising interest rates and reducing money and credit growth (especially by governments) to better balance supply and demand in the economy. Inflation therefore will have to rise, surprisingly and sustainably so, before interest rates do, as the Fed has clearly indicated this week. Asset price inflation in such circumstances should not come as a surprise.

Relative and real – the price of goods, services and the rand

In goods and services as well as in currencies, it’s the relative price that matters

When it comes to prices, what matters is whether a good or service has become relatively more or less expensive, rather than the absolute price. Relative prices can change a great deal even as prices in general rise consistently or remain largely unchanged.

For example, the prices of food and non-alcoholic beverages in SA have risen much faster than the price of clothing. Since 1980, the prices of the goods and services bought by consumers have risen on average (weighted by their importance to household budget) by 31 times. Clothing and footwear prices are up a mere 8 times over the same 40 years. And food prices have increased 43 times since 1980, making food about 5.4 times more expensive than clothes.

Consumption of goods and services
LHS: Deflators for different categories (1980 = 100)
RHS: Multiple increases (1980 – 2019)
Consumption of goods and services graph

Source: SA Reserve Bank Quarterly Bulletin, Investec Wealth & Investment
Inflation rates: All consumption goods and services, food and beverages, clothing and footwear (2010 – 2019)
Inflation rates: All consumption goods and services, food and beverages, clothing and footwear (2010 – 2019)
Source: SA Reserve Bank Quarterly Bulletin, Investec Wealth & Investment
Other relative price movements are worth noting. Over the 10 years 2010 to 2019, furnishings and household equipment became 20% cheaper in a relative sense, while education has become 25% more expensive. Utilities consumed by households (water, electricity) have increased by only 6% more than the average consumer good. Health services (surprisingly perhaps) have only become 3% more costly in a relative sense. More powerful pharmaceuticals and less invasive surgical procedures may well have compensated for these above average charges. Communication services have become about 37% cheaper in a relative sense, helped of course by the price of many a phone call falling to zero.

Relative prices (individual price deflators / consumption goods deflator) (2010 = 1)
Relative prices (individual price deflators / consumption goods deflator)

Source: SA Reserve Bank Quarterly Bulletin, Investec Wealth & Investment

Businesses that serve consumers (retailers and service providers) are likely to flourish when passing on declining real prices. Producers are likely to suffer declining profitability as the prices they are able to charge decline, relative to the costs they incur.

It will be the changing supply side forces that will dominate real price trends. Temporary surges of demand in response to changes in tastes that force real prices higher will tend to be competed away. Constantly improving intellectual property or technology can give producers the opportunity to consistently offer competitive real prices, yet sustain profit margins and returns on capital to fund their growth.

The dominance of China in manufacturing has been an important supply side force acting on real prices, for example on the real prices of clothing, household furnishings, equipment and communication hardware. Having to compete with lower real prices has decimated established manufacturers everywhere, including in SA though often to the benefit of consumers.

Predictably low inflation makes for more easily detected real price signals that consumers and producers should respond to. Unpredictable inflation rates make it harder for businesses to separate the real forces acting on prices from what is merely more inflation, common to all buyers and sellers.

There is however one important real price that shows no sign of stabilising. That is real value of the rand, in other words the rand after it has been adjusted for differences in SA inflation and inflation of our trading partners. The real, trade-weighted rand is now about 30% below its purchasing power parity level. SA producers exporting or competing with imports must hope that it stays as competitive, but there would be no reason to expect it to stay so. It is an important real price given that imports and exports are equivalent to 60% of SA GDP.

The real value of the rand moves in almost perfect synch with the market rates of exchange, which tend to be highly variable. The real and the nominal rand exchange rates have been almost equally variable. The average three month move in the real exchange rate calculated each month since 2010 has been 2.03% with a wide standard deviation of 19.8%.

For an economy open to foreign trade, this real exchange rate volatility adds great uncertainty to business decisions. It disturbs the price signals to which businesses must react. Until SA gets a higher degree of exchange rate stability, the price signals will remain highly disturbed, regardless of the inflation rate.
Quarterly percentage movements in the nominal and real traded-weighted rand exchange rate
Quarterly percentage movements in the nominal and real traded-weighted rand exchange rate chart
Source: SA Reserve Bank and Investec Wealth & Investment