After years of corruption and poor management, South Africa faces a deteriorating fiscal balance, ballooning government debt and an inefficient and unreliable power grid. These formidable headwinds are stifling economic growth – just 0.8% in 2018 (Figure 1) – and deterring corporate investment.
The extent to which they can be dealt with depends on the outcome of the forthcoming election. President Ramaphosa is expected to win, but the size of his win will determine whether he has the authority to make crucial reforms, as his main opposition comes from within his own party, the ANC.
The elections are therefore likely to be pivotal for markets, not least because Moody’s, the last of the three major ratings agencies to have an investment grade rating on the sovereign, has decided to suspend its rating review for now. Without a strong commitment to economic and energy reform from the new government, a sovereign downgrade in November or earlier is highly likely, with knock-on implications for South African equities.
Electric Power Struggle
Electoral power and electrical power are closely connected in South Africa. The government is propping up the country’s heavily unionized public electric utility, Eskom, and other state-owned enterprises (SOEs), as well as paying a hugely-inflated public wage bill. This is putting tremendous pressure on the fiscal balance.
Government support for Eskom is expected to push the country’s fiscal deficit to 4.5% of GDP in 2019-20 from 4.2% in 2018-19 (Figure 2). Despite plans to spend R69bn on Eskom over the next three years and R150bn over the next 10 years, this is not enough to cover the R17bn funding gap this year for the ailing utility giant that provides more than 90% of the country’s power needs.
Total debt for Eskom stands at $30bn, more than 60% of which is guaranteed by the state, with debt servicing requirements exceeding EBITDA by 2x. If the government assumes the burden of Eskom’s government guaranteed debt, the country’s debt to GDP ratio could reach 65% (Figure 3).
Eskom employs 48,000 people, around 20% more than similar-sized utilities globally, and is under the influence of several powerful unions.
Mismanagement, lack of maintenance on aging generation assets and poor execution of new power plants have created an imbalance of power resulting in large scale load shedding. Load shedding, along with the 14% tariff hike for 2019, is creating uncertainty and cost pressures for South African corporates. The president’s plans to reform Eskom, which include workforce reductions, have the unions planning to strike just before the upcoming election.
Political Power Struggle
To add to the political stakes, interim President Cyril Ramaphosa must get at least get 60% of the vote in the election on May 8th or investors and ratings agencies will question whether he will have enough power within the ruling ANC party to implement necessary economic and SOE reforms.
Historically, the ANC has captured at least 62% of the vote in elections. Early polls show the ANC winning between 55% and 61%. In the past, ANC has consolidated support within the final six weeks before an election, so early polls may be misleading. However, rolling blackouts do not bode well for the party, as voters blame its lawmakers for the energy crisis.
Even if the ANC wins the 62%+ share needed for Ramaphosa to garner a strong mandate, reforms will be difficult. The most important will take years and substantial capital to achieve. However, there are some easy wins that the government could implement such as faster visa processes for tourists and professionals, upgrading internet infrastructure, reducing the cost of doing business and improving the education system.
If Ramaphosa does win a strong mandate, he will need to move quickly. Election uncertainty, unreliable power generation, water shortages and fear of land expropriation and more onerous regulation under the new Mining Charter have turned both corporates and investors cautious in recent months. Corporates have placed capex and M&A plans on hold and are not expecting a real recovery for at least 12-18 months. Investors are scrutinizing corporate’s capital allocation decisions more closely, seeking divestments of non-core assets and preferring higher dividend payouts and share buybacks over growth.
All of which is weighing on growth and investment. South Africa is one of only a few countries in the world to see no improvement in per capita GDP growth in the past 5 years (Figure 4). While the growth outlook (estimated at 1.3% in 2019 and 1.9% in 2020) may improve, uncertainty will be rife until after the elections and stock and bond market volatility will be heightened. For now, equity investors should consider exposure to offshore plays, rand hedges and domestic companies positioned to gain market share over competitors.
The views expressed in this material are the views of Michelle Middleton and Laura Ostrander through the period ended 04/05/2019 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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