RealFin Capital Partners Follow the Money Occam’s Razor in the South African Context Occam’s Razor The common interpretation of “Occam’s Razor” is that when assessing or solving a problem, the simplest explanation is usually the most correct. If we apply that logic to the recent “turmoil” in South Africa, we may uncover a motivation behind the politically audacious decisions taken by President Zuma in recent weeks. We argue that in this case, the simplest explanation to understanding the underlying reasoning behind recent actions is to “follow the money”.
Political Manoeuvring 15 months ago, President Zuma attempted to take control of the National Treasury by firing then Finance Minister Nhlanhla Nene and appointing the short-tenured Des van Rooyen. There was immediate outrage and Zuma lost that battle. Pravin Gordhan was ushered in and tasked with controlling the budget in the wake of the crisis – a tumultuous December in the financial markets that has subsequently been dubbed “Nene-gate”. While Gordhan certainly had no magic wand to fix South Africa’s economic woes (and arguably has somewhat socialist leanings in his policy approach), he was considered a “safe pair of hands” and one that the credit rating agencies approved of. From the perspective of South Africans, he, together with his deputy Mcebisi Jonas, were “in-corruptible” – a euphemism for “not-in-the-Gupta’s-pocket”, a good attribute when holding the keys to the South African financial kingdom. The keys have now changed hands and it is the close Zuma ally Malusi Gigagba at the Finance Ministry helm – previously Minister of Home Affairs (remember the unabridged birth certificate visa debacle that dented SA tourism – a taste of what’s to come?) Gigaba is supported by Sfiso Buthelezi in the role as deputy, a position that carries with it the role of Chairman of the Public Investment Corp (PIC).
Rand-Dollar Exchange Rate - A Timeline of Manoeuvring R 17.00
Zuma announces Gordhan’s reappointment
R 16.00
S&P downgrades SA to junk; Moodys places SA on review for downgrade
Zuma fires Nene, replaces him with Van Rooyen
R 15.00
Fitch downgrades SA to junk
S&P and Fitch downgrade SA credit rating to one notch above junk
R 14.00
Gordahn refuses to sign-off nuclear deal
R 13.00
Gordhan “Shifted” from Finance Ministry; Nene appointed
R 12.00
Zuma fires Gordhan & Jonas; appoints Gigaba & Buthelezi Nene refuses to sign off on the nuclear deal
R 11.00
-2 01 4 M ay -2 01 4 Ju l-2 0 Se 14 p20 14 N ov -2 01 4 Ja n20 15 M ar -2 01 5 M ay -2 01 5 Ju l-2 0 Se 15 p20 15 N ov -2 01 5 Ja n20 16 M ar -2 01 6 M ay -2 01 6 Ju l-2 0 Se 16 p20 16 N ov -2 01 6 Ja n20 17 M ar -2 01 7
M ar
Ja
n-
20 14
R 10.00
The Size of the Honeypot The PIC pot is enormous and is a wholly state-owned treasure. PIC assets are in the region of R1.9 trillion which is roughly 45% of South Africa’s GDP! The PIC is the most accessible and flexible tool for the implementation of a developmental policy that can quite happily take stakes in unlisted “investments”. At the end of March 2016, the size of the unlisted portfolio ran to R44.6 billion with a further R38.5 billion earmarked for approved projects. Given the sheer scale of the PIC portfolio, there are untold opportunities for the syphoning off of assets into pet projects where the “dealmakers” will undoubtedly be rewarded. The one measure of accountability is the Government Employees Pension Fund (GEPF) which accounts for 90% of PIC assets. The GEPF is a defined-benefit plan where the employer (the government, or rather the taxpayer) underwrites the plan obligations. The GEPF has a trustee board to ensure that the plan is managed with the beneficiary’s best interests in mind – these trustees now have an ever more important duty to hold the PIC investment decision makers to account. Of course, the other honeypot is National Treasury itself. The National Treasury has the power to “sign off” on state spending and it was this power that really put Zuma and Gordhan at such loggerheads. Gordhan refused, as did his predecessor Nene, to agree to a nuclear power plant build which he deemed totally unnecessary for the South African economy. That decision now sits with Gigaba. The other signature that Gordhan refused to provide was a sign-off of what has been dubbed “Gupta Bank”. With South Africa’s mainstream banks refusing to do business with the Gupta-owned entities, what better way to ensure your operation runs than to simply create your own financial institution? However, to operate as a bank requires a banking licence and it would seem clear that Gigaba will be tasked with prioritising the approval of a banking licence for Habib Bank (aka Gupta Bank).
Does SA need Nuclear Power? Both Nene and Gordhan refused to authorise the “nuclear deal” and for good reason. South Africa does not need a nuclear power plant. By 2022, when the Eskom Medupi and Kusile plants are (eventually) completed, South Africa will have a generating capacity of 55GW. When we compare this capacity to the actual electricity demand, which has shrunk with the reduced economic output (and is likely to further reduce with economic contraction), we see peak demand has fallen from around 34GW to 27GW. If we include energy efficiency and the introduction of rooftop solar panels to new developments, electricity demand is forecasted to be at about 23GW by 2022. As the demand for Eskom electricity decreases, they will, in defiance of economic logic, have to increase prices in order to stay afloat! So, there is certainly no need for nuclear power, and given the other dire budgetary holes, it makes little sense to devote the estimated $50 billion to building an additional 9.6GW of capacity. However, applying Occam’s Razor to this decision makes it very easy to see how a $50 billion project (and let’s be honest, it’s unlikely to come in under budget) generates massive opportunities to award turnkey tenders to friends, family and other “interested” parties.
Expected Electricity Output and Demand (2022 - GW)
}
70 60 50
Capacity not required
40 30 20 10 0 Current expected generating capacity by 2022
Current including nuclear build by 2022
Estimated electricity demand by 2022
The Impact of Credit Ratings The ability to control the PIC and National Treasury’s decision-making authority which unlocks bank licences and nuclear deals and the “patronage” which flows from that power is fairly easy to understand. What seems to be far less understood, particularly by many of our politicians, is the impact that credit rating agencies will have on South Africa’s economy. Rating agencies, S&P and Fitch have downgraded South Africa to junk status and Moody’s is likely to follow suit. South Africa plugs into global capital markets, it does not operate in isolation. A credit downgrade to junk status means the rating agencies have assessed that South African debt is “higher risk”. Higher risk in a debt sense means that the potential for default on either the interest or capital portion of the debt has increased. For investors in SA debt to be compensated for this increased risk, they require an increased yield on the debt. Increasing yields from a government perspective means that debt financing costs just became significantly more expensive. The portion of the budget that will now need to be allocated to “interest expense”, will eat into allocations for other budgetary allocations that South Africa desperately needs – primary healthcare, water and sanitation, social grants, housing – the list goes on. So, to claim that the poor are unaffected by credit ratings is completely disingenuous. The holders of South African debt are a mix of domestic and foreign investors. As can be seen in the chart below, 35% of South African Government debt is held by non-residents – foreign pension funds, index trackers and other investment vehicles. Many of these vehicles, pension funds, in particular, will have an “investment grade” mandate which will require the sale of non-investment grade (i.e. junk) rated bonds. We can, therefore, expect an outflow of foreign investment capital which will further exacerbate currency weakness. Currency weakness will make imports more expensive, Holders of South African Government Bonds 2016 petroleum products in particular, for which we have no substitute. In economic terms, we are price inelastic. Higher Other Financial Other import prices will “force” producers to pass these costs Institutions 1% 10% onto consumers, raising prices and triggering inflation. Again, it will not be the well-paid political elite who feel the impact of rising prices, but instead, it will be the poor Pension funds Non-residents of South Africa who are extremely financially vulnerable. 29% 35% Higher inflation will lead the Reserve Bank to increase interest rates to both try and dampen inflation and defend the currency. Higher rates will further reduce consumer and business spending, choking off any hope of economic Insurers Banks growth. A lack of economic growth will increase financial 8% 17% desperation, the social impacts of which will be dire. It is not a positive picture. Source: RealCap
What Comes Next? Unfortunately, there does not appear to be a current silver lining. A motion of no-confidence in the president has been tabled for the 18th of April. For this to carry, it will require ANC MPs to vote with the opposition parties. Already there have been reports in the press of threats and intimidation – how many MPs are going to be prepared to at best sacrifice their MP pay cheques (which start at R100k + benefits per month for lower-level members) and at worst, put their lives at risk to remove Zuma? In order for President Zuma to have carried off the manoeuvring he has done, it is clear that the rot does not stop at the top, but permeates the organisation. The vested interest in maintaining the status quo is strong and deep. South Africa is not going to recover from this economic and political predicament for many years. A currency at under R14 to the US Dollar, despite having lost 10% of its value in just a few short weeks, may still prove an excellent entry point for maximising offshore discretionary allowances and other mechanisms of foreign or Rand-hedged investing. As The Economist wrote on the almost incredible current economic collapse of Venezuela, “Those in power always have a greater incentive to buy off political threats than to invest in projects that will only bear fruit over time, possibly after they have gone.” Returning to the Razor – the money in the political trough is far too tempting to have any hope that our politicians will work for the good of the people. That ship has sailed.