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 – and deterring corporate investment.
The extent to which they can be dealt with depends on the outcome of the election on 8 May. President Cyril Ramaphosa is expected to win, but the size of his victory will determine whether he has the authority to make crucial reforms, as his main opposition comes from within his own party, the African National Congress.
The elections will be pivotal for markets, not least because Moody’s, the last of the three major rating agencies to have an investment grade rating on the sovereign, has decided to suspend its rating review. Without a strong commitment to economic and energy reform from the government, a sovereign downgrade in November or earlier is highly probable, with implications for South African equities.
Electoral power and electrical power are closely connected in South Africa. The government is propping up the country’s heavily unionised public electric utility, Eskom, and other state-owned enterprises, 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. Despite plans to spend Zar69bn ($5bn) on Eskom over the following three years and Zar150bn over the next 10, this is not enough to cover the Zar17bn funding gap this year for the ailing utility giant that provides more than 90% of the country’s power.
Total debt for Eskom stands at $30bn, more than 60% of which is guaranteed by the state, with debt servicing requirements twice exceeding earnings. If the government assumes the burden of Eskom’s government guaranteed debt, South Africa’s debt to GDP ratio could reach 65%.
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 assets and poor execution of new power plants have created an imbalance of power resulting in large-scale load shedding. This, along with the 14% tariff increase for 2019, is creating uncertainty and cost pressures for South African corporates. Ramaphosa’s plans to reform Eskom, which include workforce reductions, have the unions planning to strike just before the election.
To add to the political stakes, Ramaphosa must win at least get 60% of the vote in the election or investors and rating agencies will question whether he will have enough power within the ANC to implement necessary economic and SOE reforms.
Historically, the ANC has captured at least 62% of the vote in elections. Early polls show the party winning between 55%-61%. In the past, it 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 law-makers for the energy crisis.
Even if the ANC wins the more than 62% share needed for Ramaphosa to garner a strong mandate, reforms will be difficult. The most important will take substantial capital and many years to achieve. However, there are some steps that the government could already implement, including 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 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 made corporates and investors cautious in recent months. Corporates have placed capital expenditure plans and mergers and acquisitions on hold, and are not expecting a real recovery for at least 12-18 months. Investors are scrutinising businesses’ capital allocation decisions more closely, seeking divestments of non-core assets and preferring higher dividend pay-outs and share buy-backs over growth.
This 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 five years. 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.
Michelle Lynn Middleton is Senior Equity Research Analyst and Laura Ann Ostrander is Emerging Markets Macro Strategist at State Street Global Advisors. This is an abridged version of a blog post first published on the State Street Global Advisors website.