South Africa has consistently topped the Absa Africa Financial Markets Index in recent years and remains the most attractive financial market for international investors in Africa. One key factor that should be highlighted is the consistent and regular review of the regulatory background to the financial markets that operate in South Africa. In light of international areas of misconduct in a post financial crisis world, the South African authorities are demonstrating that they are vigilant with their own regulation.
The 2018 Financial Market Review jointly published by the South African Reserve Bank (SARB) and Financial Sector Conduct Authority (FSCA) delivered a thorough overview on market regulation and governance. In its executive summary, the Review stated: “South Africa’s financial sector authorities – National Treasury, the South African Reserve Bank (SARB) and the Financial Sector Conduct Authority (FSCA) established the Financial Markets Review Committee (FMRC) to develop recommendations to reinforce conduct standards in wholesale financial markets focusing on (i) specific tools to strengthen the implementation and governance of conduct standards by market participants; and (ii) areas where changes to financial markets legislation and associated subordinate legislation are required to support a new conduct framework for wholesale financial markets.” This ongoing regulatory framework gives significant confidence to both international and domestic investors enabling South Africa to remain attractive as a gateway to African investment.
We should consider some numbers behind the South African economy. The economy has grown since 2010, but so has the population, which has now reached more than 58 million inhabitants. However, the economic growth has been slow and, in terms of USD, the GDP per capita has fallen sharply, partly reflected by a weakening domestic currency.
It is worth noting that the province of Gauteng is by far the largest contributor to the economy (making up over a third), but it is the smallest province in terms of square kilometres. For further background, the region around Johannesburg has had significant development backed by the gold rush of the 1800s. Mining today makes up 8% of the South African economy, with financial services and real estate making up the largest industrial contribution, coming in at 22%.
As the economy has matured and more consumers have emerged, it is important to note that manufacturing output has been declining and is now roughly half the size of South Africa’s total economic output. Its biggest export markets are China (18% and rising), Germany (15%) and the United States (12%). Botswana, Mozambique and Namibia are the top export markets on the African continent. The United Kingdom comes in at 7% of total exports. Regarding imports, China has 28% of the South African market, followed by Germany at 20%.
It is important to note that South Africa’s credit rating is currently hovering close to ‘junk status’. The credit agencies will be taking into account potential political instability, state capture/corruption and its sub-par economic growth trajectory. South African interest rates are sitting towards the low end of their history, dating back to 1998 when they were 22%. They were recently left unchanged at 6.5% after a South African Reserve Bank meeting on 19th September, having been trimmed by 25 bps in the prior meeting in July. Into year end, the South African rand is predicted to fall further against a basket of currencies, with a government budget outlook in October indicating further fiscal slippage to an over 4.5% likely budget deficit in 2020 as well as lingering concerns over a November Moody’s credit agency update on South Africa.
Let us return to the financial market structure within South Africa. Over time, the regulators have successfully addressed the issues of liquidity, transparency and competition. This applies to all the key asset classes from foreign exchange, equities, bond and money markets. The markets in aggregate are seen as both ‘effective’, ‘fair’ and offering ‘market integrity’. It also has a well-established framework of domestically based asset managers with a long history of strong performance and corporate governance.
As a member of the Global Foreign Exchange Committee, South African regulations upholding their domestic foreign exchange market adhere to international standards, namely the FX Global Code. Instruments to trade within foreign exchange are deep in nature, enabling the spot, forwards, FX swaps, currency options and futures that can be found on the Johannesburg Stock Exchange (JSE). The South African foreign exchange market averages around $20bn turnover per day. The foreign exchange swap market enjoys the largest share, whereas the net average daily volume against the South African rand (ZAR) for the spot, forward and swap market is over $3bn, $1bn and $8.3bn, respectively. It is important to note that the current legal framework in South Africa does not provide for the regulation and/or foreign exchange dealers. However, they are subject to a host of requirements as prescribed by the Banks Act and administered by the FSCA.
The money market in South Africa is defined by the issuing, buying and selling of debt instruments ranging from one day to one year – the most common being three months. Banks play a significant role in the money market as financial intermediaries, through which the South African Reserve Bank (SARB) intervenes in the market for purposes of implementing monetary policy. In recent years, the SARB has embarked on a comprehensive review of the monetary implementation framework, and an electronic money market environment has been established that offers same-day settlement, electronic recording and clearing and settlement of money market trades. Short-term interest rate futures and options can be traded on the JSE.
The listed bond market is another liquid instrument for investors in South Africa. It is estimated to be valued as a market at over ZAR 3tn. Currently, bonds are traded bilaterally. After reaching an agreement, the deals are reported to the JSE for matching and settlement. Primary dealers are appointed by the national treasury to make markets in government bonds. There are currently nine primary dealers comprising five local banks and four international banks. The SARB conducts a weekly auction based on a Dutch auction framework. It is worth noting that trade in South African bonds has over the past decade increasingly moved offshore, impacting domestic liquidity and price efficiencies.
With South Africa’s credit rating hovering above ‘junk status’, the activities in the credit market are seen as key to asset performance domestically. The credit market is the marketplace where the trading, structuring and investing in the credit/credit risk of the domestic government, consumers and corporates takes place. Like in the developed markets, the local exchange, the JSE, calculates several benchmarks such as zero-coupon bond and swap curves. Residential mortgage-backed securities are priced off this market and are recorded as trades, but it is not compulsory to do so.
The equity market in South Africa is well established and offers significant liquidity. The Johannesburg Stock Exchange was founded in 1887 to provide a marketplace for the shares of South Africa’s mining and financial companies that were established following the discovery of the Witwatersrand goldfields in 1886. Over 130 years, the equity market has changed from a narrow but booming market to an open, concentrated and cyclical market. It has grown to rank as the 19th largest stock exchange in the world by market capitalisation and the largest in Africa.
It is interesting to note that the South African equity market has around a 7% weighting in the MSCI Equity Markets Index that consists of 24 countries representing just over 10% of world market capitalisation. There are several key trading strategies that have become predominant on the South African equity market, outside of tracking its weighting within emerging markets. One is an offshore-focussed rand currency hedge versus domestic (SA Inc) companies. The offshore/domestic split is 60%/40%, while the rand hedge companies (such as Naspers, Richemont or BHP Billiton) are significantly larger companies and very liquid as they are dual listed on international exchanges. It is worth noting here that Naspers is nearly 20% of the JSE Index. The other strategy is a more generic defensive one against cyclical companies to take advantage of the cyclicality of the South African economy and interest rate expectations – 131 (of 165) companies are more cyclical than defensive, hence the cyclical nature to the equity market.
Globalisation and the convergence of markets has meant that companies have become more international and accessing direct domestic economic growth can be a challenge outside of consumer plays. South Africa is no exception, and with 60% of its revenue generated offshore, the desire to achieve a requisite level of domestic emerging growth through an economic cycle is more difficult. What is interesting is how South Africa is becoming less positively correlated with the other emerging market countries over time, particularly in relation to countries whose currencies are not commodity-linked (metals and oil) or whose economies are commodity-consuming, such as India and China. There is no doubt that if South Africa was to unlock consumer demand domestically via government reform and fiscal policy, then the equity market would become a haven of interest for international investors, and it would feature more prominently within the emerging market stable.
The most important and key representative financial instrument available to investors in South Africa remains the currency itself. The rand reflects the strength of the economy, the political will and the creditworthiness of the country. Uncertainties in global markets around trade and matters at home have left the rand with fewer international friends in 2019. In early October, the rand did breach the R15 to USD1, which marked its worst monthly performance in over three years, before recovering more recently.
The South African government has in part presented a welcome stimulus package this month, although hoped for labour market reforms were not backed. It also did not at this stage back a full-scale privatising of unproductive state-owned entities or agree to sell underperforming coal-fired stations, possibly through auctions. However, what was agreed were the five themes of modernising network industries, lowering barriers to entry for new businesses and increasing competition to address distorted patterns in the ownership of the economy, along with prioritising labour-intensive growth in sectors such as agriculture, implementing flexible industrial and trade policies and promoting export competitiveness and supporting regional growth opportunities. This at least temporarily has brought an end to the slide in the South African currency. However, economic growth remains sub optimal for this important emerging market to Africa. The opportunities for this exciting, still-emerging economy remain within sight and are backed by a strong regulatory and financial framework that allows both domestic and international investors to relatively freely invest.
The key remains the economy, and it is important to recognise that this month, the World Bank has cut South Africa’s growth forecast for 2019 through to 2021, citing weak investor sentiment and lingering policy uncertainty. Growth for 2019 is now projected at 0.8%, half a percentage point lower than April’s forecast and unchanged from 2018. Growth is expected to hit 1% in 2020, 0.7% lower than the previous forecast, and 1.3% in 2021, again half a percentage point below prior estimates. This is at a time when the most recent Absa Manufacturing PMI dipped to 41.6 in September, the second consecutive sharp decline in factory activity and South Africa’s largest in a decade. It also comes after a poor performance in 2018, when the South African economy went into a technical recession after GDP decreased by 0.7% in the second quarter following a decline of 2.2% in the first quarter of that year.
In the end, it is the currency that continues to take the brunt of any disappointment in potential returns emanating from the international investor base. That under performance can only be addressed by a longer period of fiscal and political stability backed by a sensible structural reform programme to unlock a burgeoning consumer opportunity that has as yet to be fulfilled.