For the past three months I have been presenting to investors in the US and UK and, most recently, at the World Economic Forum in Davos the findings of Goldman Sachs’s report “Two Decades of Freedom – a 20-Year Review of South Africa”.
Seen from abroad, many investors are positively surprised by South Africa’s progress in the fiscal and monetary environment; the associated rise in the size, sophistication and depth of the economy and capital markets; the significant gains made in the cash and non-cash (free services) transfers for the poor; and the rapid rise of the middle class.
They are also encouraged by the government’s adoption of the National Development Plan (NDP) and by the overall respect for the rule of law and the constitution. The promise of a fast-growing neighbourhood of sub-Saharan Africa is also catching attention.
But many are equally concerned by the twin budget and current account deficits, the persistent labour strife exemplified by the platinum sector strike, a low-growth environment with rising inflationary pressures, social service delivery protests, the inefficiencies and corruption in the public administration and instances of anti-competitive behaviour in the private sector.
Many also suspect that the government either lacks the political will to implement the NDP or more likely lacks the skills and institutional capacity to execute it. Some even question South Africa’s position as the best platform for investing in the African growth story.
So, how do the offshore equity investors currently see the country?
Growth/momentum institutional investors are the least persuaded by the South African story. This reflects concerns at the weak and weakening rand on the one hand, and the weak overall economic growth performance projected into a lacklustre corporate earnings outlook on the other. This is not unique to South Africa.
A similar slowdown in other growth markets such as Turkey is forecast as their central banks start to increase interest rates. Ultimately, this is likely to result in an economic slowdown.
Cash flow oriented/value investors continue to approach South African investments with a deep fundamental approach and a constructive outlook. Their concerns have resulted in their applying a higher discount to their investment thesis and ultimately looking for cheaper valuations to increase investments.
Liquid, well-managed companies with well-understood equity stories are at the top of the add-on list.
Among certain mining investors and many specialist mining funds, local mining has become almost “untouchable” as a result of the labour strife. Should the labour issues be resolved, the platinum group metals sector may once again become an appealing investment.
Hedge funds, in particular, continue to believe that local banks are broadly exposed to unsecured lender credit pressures and that these will contaminate loan growth and non-performing loan ratios. This, in turn, will contaminate the earnings and return outlook.
How do the offshore institutions see our currency?
Last year a lot of the outflow that pushed the rand weaker was a combination of speculative interest in the context of a tapering environment, a reduction of overweight offshore bond positions and active “overlay hedging” from real money investors that were long South African equities and bonds.
But so far, this year has been somewhat different: portfolio flows in both bonds and equities have been disappointing. Since the start of the year, there have been only four days of positive inflow into the bond market, totalling R1.5 billion (versus bond outflows of almost R7bn).
The equity market has seen net outflow of around R1bn for the year to date and only six positive days of inflow. In other words, what we are experiencing is the impact of a 6.8 percent current account deficit in the absence of portfolio inflows.
Clearly the US dollar in a tapering environment along with expectations regarding the potential near-term performance of growth markets generally and more specifically concerns over the perpetual labour issues are all combining to producefragile sentiment. This is true in respect of emerging market assets generally and for the country. This means the opportunistic inflows that we would have expected in the past are simply not materialising to support the currency,.
Ultimately, the “shorts” seem to be continuing to focus on countries that maintain significant current account deficits and are overly reliant on portfolio inflows as the primary source of their financing.
The “early adopters” of a more hawkish monetary policy stance (Brazil, India and Indonesia) have seen their currencies stabilise in the past six weeks, whereas those viewed as continuing with real rates that are too low to attract or even retain capital continue to weaken. South Africa’s rate hike last week will have met some, though not all, of those expectations.
Unlike the central banks of other key emerging markets, the SA Reserve Bank established an inflation targeting framework in 2000. The framework has been effective in managing inflationary (and deflationary) pressure, anchoring inflation expectations and supporting growth in the past 14 years. Hence, we expect the Reserve Bank to maintain its measured approach to any further rate action and focus on the inflation and growth outlook consistent with this framework.
So what, overall, is the scorecard from abroad?
We have quality institutions. The trust and confidence from offshore investors, particularly in the Reserve Bank and the Ministry of Finance, is probably greater than for any other emerging market. Investors derive comfort from the transparency and integrity of policymakers, as well as their openness and accessibility.
But it is clear that skills shortages are one of the issues preventing greater levels of foreign direct investment. Likewise, the link between productivity growth, skills and better labour relations is undeniable.
Foreign investors want to see a labour legislation framework that gives workers and unions better representation, but at the same time prevents unions from crippling businesses or even industries. The fact that the same, extremely damaging, stand-off between the unions and the employers continues every year shows that this is an area that still requires attention and new policy initiatives.
The government’s efforts to intervene directly and to mediate are welcome. But sadly they cannot, on their own, address the fundamental structural fault lines in the labour law architecture. This needs to be revamped and redesigned urgently.
With respect to the macroeconomic mix of high and growing twin deficits, high inflation and dependency on portfolio inflows, the perception is that there is little that policymakers are able to do to alleviate the issues in the short term.
Regarding the domestic macro mix: the sustainability of a 7 percent current account deficit and a 5 percent fiscal deficit with unemployment at 25 percent and growth at 3 percent is questioned. At the same time inflation is piercing the upper end of the targeting band in a global environment of rapidly declining portfolio flows into emerging markets. Policymakers at the Treasury and the Reserve Bank are, therefore, limited in the responses they can adopt to turn the tide in the short term.
It is possible for domestic gross domestic product (GDP) to grow at 5 percent for the next 20 years. This would give us a $1 trillion (R11 trillion) economy by 2030, halving unemployment and the debt-to-GDP ratio, while doubling GDP per capita. But the age of easy money has ended. South Africa needs to raise its game to attract the investment needed to achieve its potential.
Colin Coleman is partner managing director at Goldman Sachs. This is an edited extract from a speech given to the Cape Town Press Club on January 29.