Category: SA Economy

 Examining the state of the SA economy at the end of 2019 – and some suggestions for what the authorities can do to turn things around in 2020

South Africa is near the top of the global league – when it comes to the rewards for holding money, that is. You can earn about 3% after inflation on your cash, with only Mexico having higher real short-term interest rates.

However South Africa is close to the bottom of the global growth league (see below). This is no co-incidence, but the result of destructive fiscal and monetary policies.

Q3 GDP relative to the rest of the world

Source: Thompson-Reuters and Investec Wealth and Investment

Such an unnatural state of economic affairs, namely still very expensive money combined with highly depressed economic activity, has clearly not been at all good for SA business. The average real return on invested capital (cash in/cash out) has declined sharply, by about a quarter since 2012. Companies have responded by producing less, investing less, employing fewer workers and paying out more of the cash they generate in dividends.

GDP at current prices is now growing at its slowest rate since the pre-inflationary 1960s, at about 4% a year. This combination of low GDP and inflation below 4% (yet with high interest rates) automatically raises the ratio of national debt to GDP. And it makes it much harder to collect taxes (the collection rates are well explained by these nominal growth rates). Of further interest is that the actual growth in GDP is falling well below the forecasts provided in the Budget Survey (see figures below).

This leads to an economically lethal combination of low inflation and high borrowing costs (for the government and others).

Only actions by the government that clearly indicate it is heading away from a debt trap (ie printing money and so much more inflation in due course) can permanently reduce expectations of higher inflation and thus bring down long-term interest rates. Debt management is a task for the government, not the Reserve Bank.

The investors in those companies that depend on the health of the domestic economy have not been spared the economic damage. The value of these South African economy-facing interest rate plays (banks, retailers and investment trusts for example) have declined significantly and have lagged well behind the JSE All Share Index.  The JSE small cap index has lost 40% of its value of late 2016. Since January 2017, the JSE All Share Index is down by 7%. However an equally weighted index of SA economy plays is down by 22%.

Top 40 and Small Cap Indexes 2014=100

Source; Bloomberg, Investec Wealth and Investment

JSE All Share Index, Precious Metal Index and SA Plays (equally weighted) 2017=100

Source; Bloomberg, Investec Wealth and Investment

It’s against this worrying backdrop that I offer my New Year wish list for South African  business to be able to transform its prospects and with it the prospects of all who depend on the domestic economy. It is after business which is the most important contributor to the economic prospects of all South Africans.

My first wish is that those in government and its agencies should recognise that without a thriving business sector the economy is doomed to permanent stagnation. They should therefore show more respect for the opinions of business and the policy recommendations they make. Most important, they should interfere less in the freedoms of business to act as business sees fit.

Economic growth is transformational and inclusive. Stagnation is just that: nothing much happens, especially for the poor who are stuck in a state of deprivation from which it is difficult to escape. The opportunities that economic growth provides are a powerful spur to upward mobility – of which poor South Africans are so sorely lacking.

My second wish is that government turns over all wastefully managed SOEs to private control (there are no crown jewels) and in this way improve performance and generate cash and additional taxes with which to reduce national debt. Any sense from government that this might happen would bring long-term interest rates sharply lower and immediately reduce the returns required of SA business and in turn lead to more investment.

A third wish (linked to the second) for business success in 2020 is that government cuts its spending and raises revenues from privatisation, rather than raises tax rates next year. There is no scope for raising tax revenues unless there is faster growth. Higher tax rates will depress economic growth and growth in revenues from taxation still further. The wish is therefore that Treasury knows that only cutting government spending can avert the debt trap and has the authority to act accordingly.

Finally, a wish for monetary policy. South African business would benefit from lower short-term interest rates (notably mortgage rates) under Reserve Bank control. Lower interest expenses would help stimulate the spending of households, which could help get business going. It is my wish for business that the Reserve Bank will do what is most obvious and natural for it to do: to act decisively and urgently when both inflation and growth are pointing sharply lower.

Brian Kantor and Loane Sharp

Kantor is Professor Emeritus in Economics UCT and Head of Research Institute Investec Wealth and Investment. Sharp is Director at Prophet Analytics

The most important question in economics – why some countries remain poor while others grow rich – has been definitively answered. According to the United Nations, between 1990 and 2015 the poverty rate in the developing world dropped from 47% to 14%. More than a billion people escaped poverty over the period.

The unequivocal cause of declining poverty has been strong and sustained economic growth. According to the International Monetary Fund, economic growth in developing countries has averaged 4.9% per annum since 1990. At this rate, with population growth in developing countries now 1.2% per annum and steadily falling, real income per person will more than double over the next 20 years. Poverty, in other words, will be substantially eliminated within a generation.

The primary question having been answered, economists have increasingly directed their attention to a secondary question – why some people within a country remain (relatively, sometimes absolutely) poor while others do much better earning and spending their incomes. It is right and good to prefer that the benefits of economic growth be distributed widely rather than narrowly. But in highly competitive markets, this may not be possible – especially in labour markets, where incomes are driven up by competition between employers, held down by competition between workers for work and ultimately settle at a mutually agreed value for the expected productivity of the employee that differs widely according to skill experience and ability. Yet growth, even when unevenly distributed, generates revenues for government that can be used to provide the most vulnerable with extra spending power and valuable benefits in kind (education housing and medical care) that will add to their income generating capacity and mobility.

In contrast to the global experience, SA’s poverty rate has been stubbornly high and recently rising. According to Statistics SA, 55% of the population is defined as poor, living on less than R11,904 per annum. (current rands) Over the period that real per capita income growth in developing countries averaged 3.7% per annum, SA per capita income growth averaged a mere 0.7% per annum.

While poverty remains high, Statistics SA’s latest inequality report, authored by the Southern African Labour and Development Research Unit (SALDRU) at the University of Cape Town, despite its summary view that income distribution in SA is largely and unhappily as unequal as it has been since 1993, shows in fact, that inequality has declined. In 2006, the top 10% of income earners enjoyed 12.5 times the income of the bottom 40%. By 2015, this Palma inequality ratio had declined to 10.2 – significant progress over a short period of time. In 2006, the top 10% incurred 8.6 times the spending of the bottom 40%. By 2015, the ratio had fallen to 7.9 times – also significant progress over a short period of time.

This seems counterintuitive: how can poverty increase and inequality decline? As we explain below, the middle class, not the poor, have been the primary beneficiaries of government policies. We pretend to care for the poor but often act otherwise, no doubt because it makes political sense. Many of the economic policy interventions of the SA authorities would not pass the Rawlsian test.  That is would the intended policy  be helpful to the economic interests of the least well off 20% of the population?

The distribution of spending is significantly more equal than the distribution of income, thanks to taxes, welfare spending, government services and saving (i.e. spending foregone) largely undertaken by the top 10% of income earners. They who are responsible for almost all the wealth accumulated in SA, and without whom the economy would perform even less well and be even more dependent on foreign capital.

The inequality report rightly concludes that lack of economic growth and lack of job creation are the main causes of poverty and inequality. Unfortunately, the report contains much psychosocial nonsense. An example: “High levels of inequality mean that large segments of a society may be excluded from economic opportunities [since] people who receive the best opportunities are the ones who are the richest, and these are not necessarily the same as the ones who are the most talented or who would make the best use of such opportunities.” In other words, rich people cause poverty. Surely it is poverty not inequality that denies opportunity.

To give another example: “Adding a couple of thousand rand to the monthly pocketbooks of the poor could elevate them above the poverty line and set them on a better life trajectory […] but it doesn’t immediately result in greater equality between the outcomes of certain groups” (emphasis added). In other words, eliminating poverty is unacceptable because, in doing so, white people might get better off.

The global economic experience indicates that the self-interest and creative drive of a tiny group of people – a small number of extremely successful business owners and their high-skilled employees – have sharply reduced poverty and will soon eliminate it altogether. They are the crucial agents of economic growth. Respecting their achievements, tolerating their high incomes and protecting their gains becomes the essential social contract. Redistributing these exceptional gains through progressive income tax and well-directed government spending is a further part of the social contract. Successful economies manage to grow and redistribute – in that order.

It hardly seems worth the effort to conduct a comprehensive survey of inequality in SA every few years when the results are so self-evident as to be nearly worthless. The economy hasn’t grown, unemployment has risen and therefore poverty and inequality remain significant problems. No surprise in that. We should like to know, instead, how economic growth and job creation might be achieved or, indeed, is being frustrated.

We know, of course, what causes economic growth and the attendant benefits of investment, employment, innovation, competition and taxes: business profitability. We know what causes job creation and the attendant benefits of economic mobility, childcare, healthcare, retirement savings and workplace safety: economic growth and the profitable employment of labour.

On the economic growth front, it is therefore alarming that SA companies’ return on assets (gross operating surplus / gross fixed capital stock), having peaked at 17.9% in 2004, will this year likely drop below 10% for the first time in 30 years. If business profitability does not recover, economic growth cannot. Analysis of the financial statements of listed companies reveals a similar decline in the return on capital.

On the employment front, it is alarming that, whereas in the 25 years prior to 1994 an additional 1% of economic growth was associated with a 1.3% increase in employment, since 1994 an additional 1% of economic growth was associated with a 0.2% increase in employment. Even if economic growth occurs, job creation cannot occur if the link between economic growth and employment has been severed.

The causes of economic growth and job creation, and therefore the solutions to poverty and inequality, are well understood. Growth will follow business liberalisation, and jobs will follow labour market liberalisation. Yet the report unfathomably frames these as complex and intractable problems. It surely does help to promote an endless agenda for the favoured consultariat and their flow of proposals to tinker further with the economy.

The report usefully observes that inequality in SA is overwhelmingly related to labour market inequalities: inequality between those who have jobs and those who don’t; inequality between public sector and private sector employees; and, within the private sector, inequality between skilled and unskilled employees.

The labour market is clearly central: incomes from work account for three-quarters of all incomes earned and about two-thirds of overall inequality comes from inequality in earnings. Inequality and poverty and the inability of the economy to grow faster are largely attributable to the failure of the economy to provide more employment.

There are serious problems with the survey methodology that is the basis for the report. Some of the problems are true of all surveys. For instance, people are notoriously cagey about their true income and spending patterns, especially when an individual, completing the survey on behalf of others in the household, may fail to disclose the true picture to other individuals in the household, let alone government enumerators. Other problems are specific to this survey. For example, households are asked to report the spending they actually incurred rather than the value of the goods and services received. Heavily subsidised government school fees are a small fraction of the total cost of education, yet only the minimal out-of-pocket fee is reported as expenditure with no adjustment for the full value of the benefit. Likewise subsidies related to healthcare, housing, electricity, water, sanitation and many other government services are not reflected as de facto benefits at their costs of supply, and the costs of administering government programmes are nowhere accounted for in the estimates of expenditure.

As seen in Figure 4.1.4, income from the labour market is the main source of income, increasing from 73.5% in 2006 to 81.3% in 2009 ( after a brief period of strong GDP growth) before declining to 71.0% in 2011 and then remaining constant between 2011 and 2015. The proportion of social grants to overall household income has slightly fluctuated over the years: the proportion decreased from 6.0% in 2006 to 5.4% in 2015. The share of in-kind income gradually rose from 1.2% in 2006 to 2.4% in 2011 before dropping to 1.7% in 2015. Meanwhile, the share of remittances to overall income fluctuated over the years and reached its highest proportion in 2009 contributing 1.2% to overall income. Figures 4.1.5 and 4.1.6 show the distribution of labour market income and social grants, respectively, by income-decile. From these figures, we observe growing dependence on social grants and declining reliance on labour market income in the bottom deciles. By contrast, in the top deciles there was a much greater reliance on labour market income and less reliance on social grants. Therefore, social grants to some extent contributed to the improvement in income inequality.

Unfortunately, the report does not attempt to explain why these differences exist and persist. Except by extensive reference to race. Do richer SA whites (and the rich of other races) harm or serve the economic interest of SA?  Should the objective of economic policy be to retain their valuable services- or to do better without them in the interest of equality? One suspects that many of those who interest themselves in issues of inequality in SA and many others with influence over economic policy find it very difficult to give an unequivocal response to this question. In other words the economic growth that could lift the 33 million poor South Africans out of poverty would be unacceptable because a few white South African might benefit disproportionately from the process.

The truth is that the government has aggravated rather than alleviated inequality. Incomes of high-skilled people have been boosted by immigration restrictions and emigration. Incomes of low-skilled people have been diminished by uncontrolled immigration of low-skilled people from neighbouring countries. Social grants have raised the reservation wage of low-skilled people discouraging their participation in the labour force, particularly in the rural areas. Government education is so poor that a staggering proportion of enrolees drop out of school, eliminating what chances they might have had of finding work. Extensive protections against especially performance-related dismissals have reduced productivity and raised the risk of employing people who prove not worth their hire.

Given all the obstructions to hiring and firing labour – and all the unintended consequences of poverty relief in influencing the willingness to supply labour – it should be no surprise that the distribution of income in SA is what it is. It is well explained by the political interest in “good jobs” rather than in total employment – especially in the highly indulged public sector – and the support for unions and labour regulations that protect those with jobs at the expense of those seeking work. Slow growth in the number of people employed and the inability of the poor to find work should not be regarded as unintended. It is the predictable outcome of policy choices made by the SA government.

Two other important forces on the income distribution should be recognised. Firstly, the expenditure of households headed by men is significantly higher than spending by households headed by women. In 2015 the average expenditure of the households headed by men was twice as high as of those headed by women. (38180/18406) A very similar ratio (2.1) prevailed in 2006 (27058/12965) (2015 prices). This suggests that female-headed households have only one person working whereas male-headed households have two people working with very similar average incomes per worker. It appears that the important gender gap is related to the presence or absence of a working male in the household.

Secondly, average urban incomes are much higher than rural incomes. The urban/rural divide is even more dramatic. In 2015, on average, urban households spent R40,290 in 2015 and rural households R11,658 – a ratio of 3.5 times. In 2006, this ratio was very similar, 3.7. These expenditure gaps are attributable more to employment opportunities than wage differences. Of the total population, 65.3% are urban and 34.7% rural.

The policy implications of these facts of SA economic life seem obvious: more households headed by men, and more of them established in the urban areas. Social assistance and free housing and utilities that do not distinguish between urban and rural areas makes overcoming poverty through employment ever more difficult, because it encourages rural settlement and unemployment especially now that a national minimum wage is the rule.

In 2006, the top 10% spent 57.2% of all expenditure or 8.6 times that of the bottom 40% with a mere 6.6% share. By 2015, this ratio had declined from 8.6 to 7.9 – less inequality. Yet the share of the bottom 40% remained at 6.6%.  In 2006, the middle 50% had a 36.2% share of all expenditure. By 2015, the expenditure share of the top 10% was down to 52.6%, and that of the middle 50% up to 40.8%, of all spending. Thus, a decline in the ratio (top 10%/middle 50%) from 1.81 to 1.32 times, while the ratio of the spending of the middle 50% to that of the poorest 40% rose from 5.5 times to a less equal 6.2 times. The large gains in the share of expenditure have been realised by the 7^th, 8^th and 9^th deciles whose combined share improved by a full four percentage points.

The redistribution of spending power in SA has been to middle-income earners – not the poor. Perhaps especially to the new members of the upper middle class who are employed by government and its enterprises and institutions. If the economy is to grow faster and incomes and spending power are to be more equally spread, the interests of the poor and the rich will have to predominate in policy settings, much more than they have done to date.

Sources:

All charts and statistics are sourced from this study: Statistics South Africa (2019), Inequality Trends in South Africa  A multidimensional diagnostic of inequality, Risenga Maluleke, Statistician-General, Report No. 03-10-19

One of my pleasures is to listen in conference to the accounts of great business enterprises, as told by their CEO’s and CFO’s. They seldom fail to impress with their grasp of the essentials of business success in a complex world. One that always contains the threat of competition from close rivals and even more dangerous the disruption of their business models and their relationship with customers from quarters previously unknown.  They are in it for the long run – not the approval  of the stock market over the next few months. Short termism does not make for business success.

They sense the growing opportunity data collection and analysis offers to produce distribute and market their goods and services more efficiently. To scale the advantages of their intellectual property and culture, they must have global reach that inevitably includes managing successfully in China, with all its opportunities challenges and trade-offs. They are well aware of meeting the demands society and its governments may make on them for them to be able operate legitimately. They know they have to play by rules over which may have little influence.

And one senses from them a new urgency about a more  disciplined approach to the management of shareholders capital. Business success and the performance of managers is increasingly measured by (internal) returns on capital employed, properly calibrated, that adds value for investors by exceeding the returns they could expect from the capital market with similar risks.

The business corporation is the key agency of a modern economy. The success of the developed world in raising output and incomes – improving consistently the standard of living is surely  attributable in large part to the design that accords so much responsibility to businesses large and small. The improvement in the average standard of living, and of those of the least advantaged of the bottom quartile of the income distribution (helped by tax payer provided welfare benefits) in what we define as the developed world has been at a historically unprecedented rate over the last 70 years or so. While the rate of economic improvement may have slowed down in the past twenty or ten years it sustains an impressive clip. Over the past 20 years GDP per capita in constant purchasing power parity terms in the largest seven economies (G7) as calculated by the IMF has grown by a compound average 2.8% p.a. Over the past 10 years this growth rate has slowed only marginally to an average of 2.7% p.a.  A rate rapid enough to double average per capita incomes every 26 years or so.

One might have thought that the proven capabilities and potential of the modern business enterprise would enjoy wide appreciation and respect. That is for its ability to deliver a growing abundance of goods and services that their customers choose, many of which thanks to innovations and inventions sponsored and nurtured by business that were unavailable or inconceivable to earlier generations. In so doing to provide well rewarded employment opportunities to so many and to provide a good return to their providers of capital – both debt and share capital. A large majority of whom, directly and indirectly, are not rich plutocrats but are the many millions of beneficiaries of savings  plans, upon which they rely for a dignified retirement.

But this is not the case at all. Even for the commentators in the leading business publications who present a view of the modern economy and its dependence on the corporation as in deep crisis. A sense of  grave economic crisis that given the much improved state of the global economy and of the role corporations play in it that is very hard to share for the reasons advanced.

For example Martin Wolf in an op-ed in the Financial Times (September 18 2019) Why rigged capitalism is damaging liberal democracy Economies are not delivering for most citizens because of weak competition, feeble productivity growth and tax loopholes

To quote Wolf’s conclusion on the reformed role of the corporation

“……They must, not least, consider their activities in the public arena. What are they doing to ensure better laws governing the structure of the corporation, a fair and effective tax system, a safety net for those afflicted by economic forces beyond their control, a healthy local and global environment and a democracy responsive to the wishes of a broad majority? We need a dynamic capitalist economy that gives everybody a justified belief that they can share in the benefits. What we increasingly seem to have instead is an unstable rentier capitalism, weakened competition, feeble productivity growth, high inequality and, not coincidentally, an increasingly degraded democracy. Fixing this is a challenge for us all, but especially for those who run the world’s most important businesses. The way our economic and political systems work must change, or they will perish.”

However much you might or might not share this view of the corporation, a state of being that is not at all apparent in the accounts of the threats and opportunities provided by business leaders- or in their actions as suggested earlier. Particularly when they are seen as rentiers given some guaranteed source of income provided by a conspiracy of protection against competitive threats. You might agree that he would have the leaders of the large modern corporation accept much greater responsibilities for the (apparently) failing human condition – responsibilities that are surely the essential purview of government. It is to ask corporations to achieve much more than they are at all capable of achieving to the satisfaction of society at large. It is to set them up for failure and to threaten the essential role given to them by society

What inflation adds by way of higher prices, revenues or incomes, weaker exchange rates can be expected to reduce their value abroad. If the move in exchange rates was  equal to the difference in inflation rates between SA and its foreign trading partners, the different fields on which we work or play across the globe would be a level one.

Clearly economic life does not work that way. Our rands almost always have bought us more at home than they do abroad – when exchanged at the prevailing exchange rates. The difference between what our rands can buy at home or abroad can be calculated as the difference between the market rate of exchange and its purchasing power equivalent, as determined by the differences in inflation rates.

Since December 2010, when a US dollar cost R6.61, consumer prices in SA have increased on average by 58%. In the US average prices were up by a mere 16% over the same period. If the USD/ZAR had moved strictly in line with the changing ratio of consumer prices in the two economies (168/116 or 1.36) the dollar would have moved from 6.61 rands to 9 rands for a dollar in August 2019. (9/6.61 =136) A weaker exchange rate of 9 rands to the US dollar would have levelled the playing field. (see chart below)

2010 is a good starting point for such a calculation. The rand then was very close to its PPP equivalent were you to use 1995 as a starting point for the calculation. It was in 1995 that the rand became subject to largely unrestrained capital flows. Until then the (commercial) rand traded consistently close to its purchasing power value

The reality is that exchange rates are determined by forces that may have very little to do with actual price changes in the markets for goods and services. They move in response to global capital flows between economies that can dominate the flows of currency rather than to the flows of exports and imports that are price sensitive to a degree.

As a particular economy becomes more risky capital tends to flow away and exchange rates weaken and interest rates rise to balance supply and demand for the local currency. And if the shocks to the exchange rates are sustained, the inflation rate will respond as the prices paid for imported and exported goods in the local currency, increase or decrease- but with a time lag. This time lag determines the degree to which exchange rates diverge from PPP. The exchange rate leads and inflation follows – not the other way round – as theory might have had it. And convergence to purchasing power equivalent may take a long time.

Converting your SA wealth or incomes from rands into the equivalent purchasing power in the US at August month end would therefore have required the following adjustment. That is to reduce the 6.6 dollars received for R100 at market exchange rates by about 60%. This being the ratio 9/15.2 Having to pay only nine rand for a dollar would have been enough to net out the inflation impact. Rather than the R15.2 you actually had to give up for an extra dollar to spend in New York. (9/15.2*6.6 =3.9)

Thus any R100 of spending power in SA would have provided the equivalent of less than 4 dollars of roughly equivalent spending  power in the US. Or in other words what would be regarded as a substantial fortune of R100m in SA would have provided  a mere 4 million dollars of buying power in the US. Perhaps not enough to live well – or not nearly as well – as you could live in SA off your capital.

Consumer prices in SA and the USA and exchange rates (2010-2019)

Source; IMF World Economic Outlook Data Base.  StatsSA, Federal Reserve Bank of St.Louis and Investec Wealth and Investment

This purchasing power discount (((6.6-3.9))/6.6)*100= 40% at August month end) is a significant deterrent to the relocation of wealthy and skilled South Africans with only rands to support a life style in the developed world. Mobile younger South Africans, with a life of income earning and saving opportunities ahead of them, could undertake a similar calculation. That is multiply the prospective hard currency salaries they might be offered abroad, when measured in current exchange rates, by approximately 6/10’ths to account for their lesser purchasing power. Earning and saving rands at home (and perhaps investing abroad) might yield improved life-time consumption.

We should be relying more on better economic fundamentals than on an undervalued exchange rate to keep capital at home- especially our most valuable human capital. If South Africa would play the economic growth cards more effectively and reduce its risk premium it would retain and attract more capital on better terms.  The nominal rand could then again approach its PPP value and the cost of borrowing rands (and dollars) would come down with less inflation expected. SA Incomes after inflation could grow at a much faster rate – encouraging immigration rather than emigration of capital and skills.

We are well aware that slow economic growth depresses the growth in tax revenues. What is not widely recognised is the influence that tax rates and taxation have on economic growth. The burden of taxation on the SA economy, measured by the ratio of taxes collected to GDP, has been rising as GDP growth has slowed down, so adding to the forces that slow growth in incomes and taxes.

The GDP growth rate picked up in Q2 2019. But GDP is only up 1% on the year before while in current prices, it has increased by only 4.4%. That is slower nominal growth than at any time since the pre-inflationary 1960s, which is not at all helpful in reducing debt to GDP ratios (something of great concern to the credit rating agencies). This 4.4% growth is a mixture of the slow real growth and very low GDP inflation, now only about 3.5% a year.

GDP and CPI inflation

In the first four months of the SA fiscal year (2019-2020) personal income tax collected grew by an imposing 9.7% or an extra R14bn compared to the same period of the previous financial year. Higher revenues from individual taxpayers was the result of effectively higher income tax rates, so-called bracket creeps, on pre-tax incomes that rise with inflation.

Income tax collected from companies, however, stagnated, while very little extra revenue was collected from taxes on expenditure.  Lower disposable incomes resulted in less spending by households and the firms that supply them. The confidence of most households in their prospects for higher (after-tax) incomes in the future has been understandably impaired.

Treasury informs us that total tax revenue this fiscal year, despite higher income tax collected, is up by only 4.8%, compared to the same period a year ago, while government spending has grown up by 10.3%, or over R51bn. The much wider Budget deficit of R33bn (Spending of R156.6bn and revenue of R123.6bn) represents anything but fiscal austerity. It has added to total spending in the economy, up by a welcome over 3% in Q2 2019 – after inflation.

But deficits of this order of magnitude are not sustainable. Nor can they be closed by higher income and other tax rates that would continue to bear down on the growth prospects of the economy and the tax revenues it generates. A sharp slowdown in the growth of spending by government, combined with the sale of loss-making and cash-absorbing government enterprises is urgently called for if a debt trap is to be avoided. Given that the debts SA has issued are mostly repayable in rand, rands that we can print an infinite amount of, a trip to the IMF and the “Ts and Cs” they might impose on our profligacy is unlikely.

More likely is a trip to the printing press of the central bank rather than the capital markets to fund expenditure. Such inflationary prospects are fully reflected in the interest we have to pay to fund our deficits. These interest payments add significantly to government spending. The spread between what the SA government has to offer lenders and those offered by other sovereign borrowers has been widening.

The SA government now has to pay 8.7 percentage points a year more in rands than the average developed market borrower, ex the US (Germany and Japan included) and 7.6 percentage points a year more than the US has to offer for long-term loans. We also have to pay 3.1 percentage points a year more than the average emerging market borrower has to pay to borrow in their own currencies.

The difference between RSA interest rates and other sovereign borrowers. Ten-year bonds in local currencies

It has proved very possible for average incomes and spending power to improve consistently over long periods of time. In the West economic progress has now been sustained for centuries. Over the past 70 years the improvement in global per capita incomes has been especially impressive as the process of economic growth has been extended more widely.

Download PDF with full article here: Kantor – When countries choose freedom

The importance of recognising economic profit or EVA

Owners of businesses could set their managers a straight-forward task. That is to earn a return on their capital they will deploy to exceed the returns shareholders could realistically expect from another firm in the same (risky) line of business. If the managers succeed in this way, that is realise an internal rate of return on the projects they undertake that exceed these required or break even returns, they will be generating an economic profit for their owners. They will have created what is now widely known as Economic Value Added (EVA) in proportion to the amount of capital they put to work. EVA=I*(r-c) where r is the measure of the internal rate of return, c is the required return or as it is sometimes described as the cost of capital and I is the quantum of capital invested.

Continue reading the full paper here: Applying EVA to the holding company

Looking forward to the (paid) Easter holidays? Despite appearances to the contrary, you are paying for it.

The Easter holidays are upon us. Many will be enthusiastically taking time off, believing they will be enjoying a “paid holiday”, in other words, enjoying a holiday paid for by their ever-obliging employers. They are wrong about this – especially if they work in the private sector. They will in fact be sacrificing salary or wages for the time they spend not working.

This is based on the simple assumption that there is a consistent relationship between the value they add for their employers and the hours or days spent working – and that therefore they are paid according to the contribution they are expected to make to the output and profitability of the firm. Wages are not typically charitable contributions.

It makes no sense for some employer, the owner of a business, with a natural concern for the bottom line, to pay you for time spent on holiday, or on weekends off or when sleeping or traveling to or from work. They are unlikely to survive the competition if they did not take into account the accompanying loss of production, revenue and profits incurred when their employees are not working.
Those known costs must mean salaries, wages and employment benefits given up by the worker. There are no paid holidays, any more than there are free lunches in the company canteen.

Those paid on an hourly basis and at the end of every day or week will be under no illusions about having to sacrifice income when not working. Many of them might well be willing to work on the Easter weekend if given the opportunity to do so. They may well prefer to consume goods and services other than leisure.

It is those who are paid on a pre-determined monthly basis who may be inclined to believe that they are being paid to go on holiday. They should appreciate that the more time they are expected to take off, or the larger the contributions the employer may be making to medical insurance or pension contributions, training levies and the like, the less they will inevitably be taking home in their monthly paycheque. They are sacrificing salaries so that their employers can better stay in business and offer them employment.

The same bottom line and hence a sense of sacrificing pay may not apply in anything like the same force in the public sector, where the taxpayer picks up the salary, pension and medical aid bill, regardless of its size; where measuring the output of the public employees is not nearly as easy and where performance measures are often strenuously resisted.

European workers typically take many more days off than their US or South African counterparts. It is a widening trend that has evolved only over the past 30 or so years. We are often surprised at how little time the typical US worker takes off. Why is it so that the average US worker consumes significantly less leisure, takes less time off, therefore sacrifices less pay for holidays and consumes proportionately more other stuff that they prefer to pay for?

Is it a cultural difference, or are US workers naturally more hard working than their European or South African cousins? Maybe, but if that’s the case, why have these differences in working behaviour become so much more pronounced in recent decades? (Incidentally, the average number of hours worked per day in Europe and the US does not differ much). The striking difference is in the average number of days worked.

It may be because US workers and their employers enjoy more freedom to choose pay over leisure. Perhaps the regulations that determine compulsory time off for holidays or festivals are by now less onerous on US than European employers (and on formal South African businesses).

Were maximising output and money income and employment the primary objective of policy, South Africa would be wise to adopt the US rather than the European practice: allow the number of days off to evolve (mostly) out of competition for workers, rather than be regulated for them and their employers. And have fewer “paid holidays”.

The interview is available here: https://iono.fm/c/3504

The 2019-2020 Budget proposals have essentially only one objective.  They all take their cue from the disastrous financial and economic performance of Eskom over the past decade. Averting an Eskom default has required an injection of  equity capital of R23b a year for the next ten years- if necessary – by now even more hard pressed South African taxpayers.

The revenue collected by the central government budget is estimated to increase by 9.2%, having grown by 7.4% in 2018-19. Expenditure on a consolidated all government basis expenditure, including the extra spent on supporting Eskom’s balance sheet will be up by 9.6%

When compared to expected inflation of about 5% these represent large real increases and a growing burden on taxpayers, given that the economy is predicted to grow by a mere 1.5% in 2019.  Personal income tax collections are estimated to increase by R55b or 11% in the next financial year. This increase in collections occurs without an increase in explicit income tax rates but with bracket creep. Given inflation linked increases in employment benefits it is the many income tax payers in the lowest brackets who will be paying more. Presuming they also keep their jobs.

There are nearly 6.937 million registered income tax payers who are expected to earn between R79000 and R500,000 of taxable income in 2019-20 out of a total cohort of 7.643 m income tax payers altogether. These many income taxpayers in the lower brackets  will together be paying R100 billion more income tax this year than if full adjustment of tax rates for inflation of wages been made. Total income tax expected in 2019-20 is R554b. The very few 283,000 income tax payers who earn more than R1m, will be expected to deliver R225.6b of income tax or 41% of the total. But bracket creep is much less significant for them, especially for those already paying a marginal income tax rate of 45% – for incomes over R1.5m per annum.

Clearly the judgment must have been that the higher income earners are being squeezed about a far as is practically possible to do without reducing tax revenues collected from them. There are a further 6.369m individuals registered with SARS who fall below the threshold and pay no income tax. They will however pay more tax on the goods and services they can afford. Taxes collected on all goods and service (VAT, Excise taxes and customs duties) are expected to rise by an inflation beating 9.6% in 2019-20.

These are increases in taxes on a very large majority of the population that are surely unlikely to find favour with an electorate going to the polls in May 2019. But having to save Eskom required nothing less than a very austere budget.  Any thought that the investment programmes of the publicly owned enterprises can lead any revival in economic growth  has surely been disabused. These enterprises provide essential services to the economy must be able to provide them on globally competitive terms and be financially stable if the economy is to prosper.  Any continued failure to do so will demand ever higher and unpopular taxes on a slow growing economy. And higher taxes will impeded growth further – as they have done to date. The burdens of slow growth are widely shared as this Budget reveals.

The failure of the public enterprises and the inability of the highly paid SA income earner and taxpayer to compensate for such failures, must surely lead any government, subject to a popular will, to adopt the obvious solution. That is to privatise the operations of the public enterprises on the best possible financial terms consistently with a competitive economy. Private capital and privately business are more than up to this task. The question raised by the 2019-20 SA Budget is just when will such a fully embraced economic realism save the economy- and all who depend upon it

Exploration for oil or minerals is a very risky activity. And when a significant find is made there is the further risk that the terms allowed to the finder may turn out to be unexpectedly adverse. Indeed the larger the resource proved, the more adverse these terms are likely to be.

Any original successful risk taker is hostage to the government where the discovery was made. With any potentially valuable discovery under the ground or water, what was essentially unknown will have become much more of a valuable known. Accordingly the share of the value added allowed to the discoverer can easily become a matter of ex-post negotiation rather than a rule of previously agreed laws.

Exploring for oil or gas in deep turbulent South African waters is surely a particularly risky endeavour. Rules applying to exploration for oil or gas are still to be re-drafted and voted upon. Yet despite all this inherent uncertainty – all the known unknowns – Total and its partners went ahead and explored off our coast. And have discovered what is clearly a significant quantity of hydro-carbons in their concession area. They will be drilling further wells to determine the fuller potential of the gas and oil available for exploitation.

How then should South Africa respond to this fait accompli this new economic opportunity of great potential significance? Surely to maximise the output of oil and gas? Upon which taxes or royalties can and will be levied. But would have to be of an internationally comparable and competitive scale to fully encourage production and further exploration activity.

Given a natural concern for safety and the environment, the business of bring the oil and gas to market should best be governed by no other  consideration than that of maximising output at minimal cost.  What is in prospect, if all goes well, is construction activity on a very large scale undertaken over many years. Drills will be sunk from platforms to be built, served by helicopters and launches with bases and workers onshore. Pipelines will be laid to bring the oil and gas onshore and to extend the net-work to new refineries and their customers in the urban areas.  Much further capital expenditure in oil and gas intensive industry for export and the local market will become feasible off the newly established grids. The economy could take off.

To make the best of what has become possible, minimal consideration should be given to any other potential interests in the resource, other than the general interest in faster economic growth. Interests that might impose themselves on the project managers and the capital providers should be actively disallowed.

It is the case for letting construction companies and those that are free to hire them, to bid competitively for work. Work that they would be free to organise as best they saw fit.  Meaning they would be subject to minimal interference in the form of patronage, crony capitalism, corruption and extortion that has been so expensively and damagingly characteristic of construction activity in South Africa recently. Think of the huge overruns at Kusile and Medupi and the perils of constructing pipelines and roads in Kwa-Zulu where extortion has become commonplace. Or ask any construction company (a declining number) for details of how they have now to do business in SA

The genuine public interest in redistributing the benefits of the project would then be satisfied by the extra revenue generated for government- not by opportunistic rent seeking. And the extra revenue could be well spent for the benefit of the poor in better funded schools and hospitals or cash grants- maybe even lower tax rates. A case of growth and then redistribution- rather than erratic redistribution at the expense of growth. It would represent a true game changer for the SA economy.

This is a working paper and the final version will replace this after comments have been received. I welcome comment and corrections from readers.

The paper is available here: South African Foreign Investment

JSE dividends (All Share Index dividends per share) have increased significantly faster than earnings over recent years. The payout ratio (dividends/earnings) that averaged about a steady 40% between 1995 and 2016 has increased to about 60% of earnings. If we leave Naspers, now about 18% of the All Share Index, out of the calculation, the payout ratio is now close to 70% of reported headline earnings. This ratio is unusually high by international and emerging market comparisons.

Since 2012 JSE dividends per share in rands have doubled while reported earnings are only 20% higher than they were in 2012. Share prices are about 100% up on 2012 levels and have tracked dividends more closely than depressed earnings. A value gap between dividend flows and the price paid for these dividends has opened up. Our model of the JSE indicates that the JSE may be  about 15% below its ‘fair value” as predicted by reported dividends  and interest rates (see figure below)

Fig.1 JSE All Share Index, earnings and dividends per share (2012=100)

Source; Ires and Investec Wealth and Investment

JSE dividends and earnings are currently growing at about the same rate of about 13% p.a. and are forecast to sustain growth rates of about 10% p.a over the next twelve months. (see chart below)

Fig.2 JSE growth in All Share Index earnings and dividends per share

Source; Ires and Investec Wealth and Investment

Should shareholders welcome or disdain this higher payout ratio? If a company has prospective returns from its investment programme that exceed its cost of capital, it should retain all the cash it is generating and invest it back into the company on behalf of its shareholders. Shareholders can only hope to achieve lower market related, risk adjusted returns with the cash distributed to them. If the company can beat this opportunity cost of capital, it should not pay dividends or buy back its shares. Indeed in such circumstances free cash flow ( cash retained after capital expenditure) will ideally be negative rather than positive. A true growth company would be well justified in raising fresh equity or debt capital to fund its expansion and be revalued accordingly with sustainably faster growth in mind.

That SA companies are paying out more of their earnings is both good news and bad news for shareholders and the economy at large. The good news is that paying out more is better than undertaking capital expenditure, including mergers and acquisitions, that cannot be expected to beat their cost of capital and add value for shareholders .

The attempts SA companies have made seeking growth offshore have often proved value destroying rather than value adding. Such attempts typically add unwanted complexity to SA businesses and reduce their value. While they may diversify away some SA specific risks, shareholders are fully able to undertake their own diversification investing directly in offshore companies. They do not need SA managers to do it for them and venture outside their area of competence.

The bad news implication of higher SA payouts is that it reflects an understandable reluctance to invest more in what has become very slow growth South Africa. Such a reluctance to invest more in capital or people (also called working capital) while good for shareholders, inevitably reinforces the slow economic growth under way.

The solution to the problem of high pay outs in South Africa is to get growth going again. Companies will then invest more in growing markets for their goods and services and retain more cash to the purpose. They would be doing more good for shareholders, their customers, their employees and the wider economy.

It is unrealistic to expect SA firms to invest more unless the markets for what they produce can also be expected to grow. It is the spending of SA households that determines the path of the SA economy. It is the consumption egg that leads the investment chicken.

Without the stimulus of lower interest rates household spending will remain subdued. We can only hope a stronger rand and consequently less inflation will allow the Reserve Bank to help the economy along – rather than stand in its way.

The bond market indicates that inflation is expected to stay below 2% per annum over the next ten years in the US. And the Fed is confidently expected not to raise short term rates this year.

Are such views consistent with a very buoyant labour market? Unemployment rates are below 4% while average earnings are rising at about 3% p.a. Some believe this portends more inflation and higher interest rates that will confound the market consensus.

U.S. Unemployment rate and growth in earnings

Source; Fred- Federal Reserve Bank of St.Louis and Investec Wealth and Investment

Do changes in prices lead or follow changes in wage rates in the US? The economic reality is that they both follow and lead with variable lags. The markets for goods and the markets for labour have the general state of the economy in common. The wages and prices that emerge depend upon how rapidly the demand for and the supply of all goods, services and labour are growing. Higher or lower prices, wages and asset valuations have their causes and in turn will have effects on the willingness to buy or sell. And might not higher real wages in the US soon reduce the demand for labour and employment – as they have done in SA?

The prices of goods and services are not simply determined by adding a constant percentage point to the cost of producing them. The state of the economy (demand) and the competition to supply customers (including from abroad) will determine how much margin over costs finds its way into the prices a firm will charge. It is this mix of demand pull and cost push and pressures on margin that determines prices.

Another force common to both is the increase in prices and wages expected in the future. The faster they are expected to increase the more workers and firms and investors will wish to charge upfront for their services.

The Phillips curve predicts that decreases in the unemployment rate (increases in the demand for labour) will cause wages to rise faster. Keynesian economists invoked this theory in the sixties to argue that more employment could be traded of for more inflation that comes with higher wages. The idea was that workers, unwilling to accept the wage cuts that might have restored full employment, might be fooled into accepting lower real wages by inflation.

The theory has had very poor powers of prediction- particularly in the high inflation and slow growth seventies. It became a case of more inflation and slower growth and still is. Firms and workers and the unions that negotiate for them have every reason to build inflation into their wage and price settings. Therefore only inflation surprises therefore can have real effects on the economy- not inflation itself.

And the market place is not easily surprised. Their inflation forecasts, using very similar methods, are as likely to be accurate or rather as inaccurate as those of the central banks. There is no good reason to believe that any wage plus theory of inflation will beat the market view on inflation today.

Central bankers have long recognized that there was no output or employment benefit to be gained from tolerating more inflation. Only unexpectedly higher inflation might stimulate more output- but the ability of monetary policy to helpfully surprise the market is very limited.  Central bankers now judge it better to avoid inflation surprises in both directions.  Better they  believe to offer the market place a highly predictable and low rate of inflation in the interest of balanced and permanently higher growth rates- as does the SA Reserve Bank.

Yet balanced growth demands more flexibility than the SA Reserve Bank has demonstrated. The flexibility to recognize that powerful and possibly frequent supply side shocks to inflation – exchange rate, oil price and food price shocks – do not call for higher interest rates. Central banks can hope to stabilize aggregate demand – supply management is beyond their compass.  And the market place is fully capable of recognizing the difference. Inflationary expectations are also rational.

December 5, 2018

The global financial markets are reacting to two forces at work. About what Fed Chairman Powell might do to the US economy with interest rates and what President Trump might do to the Chinese economy with tariffs.

Interest rates set by the Fed might or might not prove helpful for the US economy. Given its unknown future path. It is not Potus but market forces that are restraining interest rate increases in the US. The absence of which is helpful to share prices- all else, expectations of earnings growth for example, remaining unchanged.

It is the US bond market itself that has eliminated any rational basis for the Fed to raise short term interest rates. Should the Fed pursue any aggressive intent with its own lending and borrowing rates, interest rates in the US market place, beyond the very shortest rates, are very likely to fall rather than rise.

Hence the cost of funding US corporations that typically borrow at fixed rates for three or more years and the cost of funding a home that is mostly fixed for twenty years or more, would likely fall rather than rise. And so make credit cheaper rather than more expensive.

The term structure of interest rates in the US has become ever flatter over the past few months. The difference between ten-year and two-year interest rates offered by the US Treasury has narrowed sharply. Ten year loans now yield only fractionally more (0.13% p.a) than two year loans. (See figure below)

Fig.1: Interest rates in the US and the spread between ten year and two year Treasury Bond yields

Source; Bloomberg and Investec Wealth and Investmment

This difference in the cost of a short term and long term loan could easily turn negative- that is longer term interest rates falling below short rates should the Fed persist with raising its rates. Which it is unlikely to do beyond the 0.25% increase widely expected in December for term structure reasns.

The US capital market is not expecting interest rates to rise from current levels in the future. Given the opportunity to borrow or lend for shorter or longer periods at pre-determined fixed rates, the longer term rate will be the average of the short rates expected over the longer period. Lending for two years at a fixed rate must be expected to return as much as would a one year loan- renegotiated for a further year at prevailing rates. Otherwise money would move from the longer to the shorter end of the yield curve or vice versa to remove any expected benefit or cost.

By interpolation of the US treasury yield curve, the interest rate expected to be paid or earned in the US for a one year loan in five years time, has stabilized at about 3.2% p.a. or only about 0.5% p.a more than the current one year rate. These modest expectations should be comforting to investors. They are not expectations with which the Fed can easily argue- for fear of sending interest rates lower not higher.

Fig.2; US One year rates expected in five years

The market believes that interest rates will not move much higher because market forces will not act that way. Increased demands for loans at current interest rates – are not expected to materialize. They are considered unlikely because real growth in the US  is not expected to gain further momentum and is more likely to slow down from its recent peak rate of growth. Furthermore, given the outlook for real growth, inflation is unlikely to pick up momentum. For which lenders would demand upfront compensation in the form of higher yields.

The market of course might change its collective mind – redirecting the yield curve steeper or shallower. And in turn giving the Fed more or less reason to intervene helpfully. Interest rate settings should not unsettle the market place. They are very likely to be pro-cyclical

But the more important known unknown for the market will be Donald Trump and his economic relationship with the rest of the world. Perhaps Trump himself can also be helpfully constrained by the market place. The approval of the market place can surely help his re-election prospects.