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Investing in South Africa: The road to 2025

November 2017

South Africa

Without Prejudice
Since the downgrade of South Africa's credit rating to "junk" status by Standard & Poor's and Fitch Ratings earlier this year, investors have been wary of Africa's second largest economy. Many reputable institutions, including UBS, claim to prefer Russia or even Brazil, in spite of political scandal and corruption in those jurisdictions. This may be due to a perception that the worst is behind these economies, while the worst may be yet to come for South Africa.

The average time for an economy's credit rating to spring back to investment grade is seven to eight years, taking us to 2025. We argue that although political risk remains a concern in South Africa, there are positive signs that could hasten recovery.

The downgrade in context

On 3 April 2017, credit rating agency Standard & Poor's downgraded South Africa's credit rating to BB+, its highest non-investment grade mark (commonly known as "junk" status). This was a direct result of concerns over political risk and policy shifts, following President Jacob Zuma's midnight cabinet reshuffle on 31 March 2017. Zuma removed five ministers including the then Finance Minister Pravin Gordhan in an abrupt and unexpected move. Days later, on 7 April 2017, credit rating agency Fitch Ratings followed S&P, downgrading South Africa to "junk" status. Moody's downgraded South Africa to its lowest investment grade rating on 9 June 2017. In addition to political uncertainty, the credit rating agencies highlighted the slowing economy, weakening institutional frameworks and erosion of fiscal strength as key drivers of the downgrade.

 

The sting of political uncertainty

Until very recently, Kenya was considered to be rising as a shining hope of the continent. In mid-2016, Ernst & Young forecast Kenya's GDP growth at seven percent, making it one of the most attractive investment destinations. However, Kenya has since been subject to political change.  On 1 September 2017, the Kenyan election results were overturned when the Supreme Court of Kenya invalidated the president's win and called for a new vote. Kenya's credit rating is marked below investment grade by Fitch Ratings, Moody's and Standard & Poor's, although each considers the rating stable. Credit rating agencies have held their breath for Kenya's future, while they look on at the election re-run. Kenya's predicament is a mixed picture for investors, while there is uncertainty with the government, the strength of the rule of law is clear. The fact that the independent judiciary stood up to scrutinise the executive can be taken as a positive sign. 

Like Kenya, South Africa also has an independent judiciary and freedom of press. The independent Reserve Bank, which has control over monetary policy, also indicates a strong and stable institutional framework. Although South Africa's political narrative differs markedly from Kenya's, investors are watching the South African government closely for an indication of its path. The outcome of the ANC's elective conference in December 2017 will be a litmus test for investors as they will form their own opinions from the results. South Africa's general election in 2019 will also be a key driver of investor opinion and the opportunity for the government to restore stability and confidence. 

South Africa's step-up to an investment grade rating in the early 2000s was accompanied by political stability. There was a clear consensus between the Mandela and Mbeki governments as to what needed to be achieved in respect of economic policy and structural reform. Stable leadership creates strong institutions over time and this legacy is key to maintaining investor confidence.

Infrastructure: a case study

The impact of policy decisions on investment is demonstrated by regulatory hurdles in the infrastructure sector. There are concerns in respect of the renewable independent power producer purchase programme, as the South African Energy Minister Mmamoloko Kubayi

announced in early September that the private power industry must re-negotiate their previously agreed tariffs down to 77c/kilowatt-hour. This price cap affects approximately 26 projects (representing ZAR60 billion in investment), which have been on hold since 2015, creating a stumbling block to the flagship public-private partnership initiative along with its substantial financial backers. The viability of projects at this price cap is under question. Following the minister's announcement, news providers claimed that the minister left for the BRICs summit in China and then promptly took annual leave, leaving no room for negotiation or voicing of grievances. 

There may be legal recourse for preferred bidders, if they sue to enforce their previously negotiated power purchase agreements. 

However, this may lead to a protracted and expensive process and it is unclear to what extent the private power industry will be prepared to take this route. One thing is clear, which is that such abrupt policy moves, especially in the context of the recent change in energy minister, undermines political credibility. This is likely to negatively impact the attractiveness of South Africa to foreign green energy investors. Already Windlab Africa and LM Wind Power, two leaders in the wind farm industry, have diverted projects away from South Africa. 

Economic positives

Even though investors are gauging political uncertainty in their decision-making, there are promising signs in South Africa's economic outlook. South Africa slipped into recession in June 2016 led by weaknesses in manufacturing and trade. The recession was short-lived; results from the second quarter of 2017 indicated that South Africa moved into positive GDP growth of 2.5%. Historically South Africa's economic prosperity was built on strength in commodities, which remain important today; gems and precious metals made up 16% of South African exports in 2016. 

However, there is also strength in the manufacturing and financial sectors, which have benefitted from globalisation. This has made the economy more resilient to volatile commodity prices. Due in part to this diversification, when the oil price fell in 2015, the South African economy recovered more quickly than might have been expected twenty-five years ago. While both inflation and exchange rates increased when oil prices fell, the effects were neither deep nor did they endure for any length of time. The OECD projects that South African economic growth will continue throughout 2017, picking up moderately in 2018, due to a rise in private consumption and export growth as commodity prices recover.

As Africa's most industrialised economy, there are many positives to South Africa's development trajectory. One example is the expansion of 4G and even 5G telecommunications, where in many instances connectivity has moved straight to LTE and LTE-A, without ever having 2G or 3G. This "leapfrogging" in technology speeds up the pace of development and allows for accelerated growth. A similar concept is at work in the infrastructure space with the growth of standardised projects, which slash design and development costs by copying and pasting the plans from one project, to another. These developments still come with their challenges as even with ready-made design plans, human capital, regulatory hurdles and strong productivity are key to implementing a project. Further, as data connectivity expands, the South African parliament is debating how to manage the high costs of mobile data which currently restrict the access of many South Africans to these advances. 

In conclusion, South Africa's development path is unique to its circumstances and, therefore, the course of its political future is difficult for an investor to quantify. On balance, there are signs of promise in South Africa's economic outlook and a great deal of potential. The real test will be the direction of the government and whether the confidence of investors can be restored by a move to political stability. 

Policy decisions that encourage investment, particularly in the infrastructure sector, have the potential to accelerate a return to an investment grade credit rating. Whether this momentum can gather before 2025, remains to be seen.

Article by Chloe Honeyborne, trainee solicitor, London office

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