China – Rebalancing, Debt and the Stock Market

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Macro Letter – No 58 – 08-07-2016

China – Rebalancing, Debt and the Stock Market

  • Chinese growth has been slowing since 2007
  • Total debt to GDP has risen from 148% in 2007 to 237% today
  • Oversupply in real-estate is still a concern but lower interest rates are helping
  • Infrastructure spending may help and Chinese stocks are cheap

I was prompted to write this rather longer letter by the recent weakness of the Chinese currency. The chart below tracks the progress of the USDCNY over the last three years, compared with many emerging markets the devaluation is minimal:-

china-currency 2yr

Source: Trading Economics

A longer term chart shows how far the currency has travelled over the last 12 years:-

china-currency 12 yr

Source: Trading Economics

It was at the National People’s Congress of March 2013 that the policy of “rebalancing” was introduced, however, the CNY continued to strengthen. This gradual appreciation against the US$ had created large imbalances within the Chinese economy. The economic-policy adjustment of “rebalancing” had one objective: shifting China from a production-oriented economy to one focused on household consumption. If, in the process, it could alleviate international pressure on the Chinese administration to allow the CNY to float freely, so much the better. Now it looks as if the outcome of allowing the CNY to float freely would see it sink like a stone.

A Review of Rebalancing

A detailed analysis of the rebalancing challenge is contained in this February 2013 paper from the ECB – China’s Economic Growth and Rebalancing it highlights international concerns:-

China’s leadership is well aware of the limitations of the producer-biased and export-led model. Interestingly, there is no major disagreement between the Chinese and the international community about the need for rebalancing policies to ensure China’s smooth transition to a more sustainable model. The disagreement is more about how fast the reform measures should be implemented.

It has been argued that intertwined economic and political interests make China’s rebalancing more difficult and cause the reform process to advance slowly. Political resistance to the reforms stems from various sources. First, in a system where political success at the local level has been historically dependent on quantitative growth, reforms that emphasise the quality of growth are bound to meet some resistance. Second, the current growth model required to keep some strategic sectors of the economy closed and under state control (e.g. financial markets, services, heavy industry). The planned opening up of these sectors to competition does not only meet resistance from SOEs and banks, but is also questioned in government circles owing to worries about exhausting the “privilege” of direct macroeconomic policy management. Not surprisingly, major resistance is observed in the export lobby, which is one of the most influential in China and the one which reforms affect most directly.

Reviewing the policy initiative in June 2014 – shortly after the, once in a decade, handover of power from President Hu Jintao and Premier Wen Jiabao to Xi Jinping and Li Keqiang – McKinsey – China’s great rebalancing: Promise and peril concluded:-

Of course, there is no guarantee that rebalancing will succeed. Part of the problem is that the politics associated with it—boosting the income of Chinese households at the expense of state-owned companies and other large investment-oriented entities—is actually more complicated than the economics. But one thing is certain. China is rapidly reaching the point of diminishing economic and political returns from its investment-driven model, which is headed for change one way or another: either through a proactive rebalancing, with reforms and policy adjustments, or a forced rebalancing precipitated by rising stresses in and beyond the financial system. So far, the signs are encouraging that the new leadership is serious about changing China’s growth model, and this is reason enough for global firms that have benefited from China’s investment boom to rethink their strategies for the years ahead.

Three years on the challenges of rebalancing an $11trln economy of 1.4bln people are becoming evident. McKinsey – China’s Choice – Capturing the $5 Trillion Productivity Opportunity, published last month, makes the case for continued reform based on boosting productivity:-

…Government can do a great deal to improve the odds of success by transforming institutions in six priority areas:

I. Open more sectors up to competition. SOEs still account for 43 percent of service sector fixed-asset investment, compared with 8 percent in manufacturing

.…In telecommunications, for instance, an effort to introduce mobile virtual network operators to target underserved segments has not yet had a substantial impact because the big three players in the sector still have considerable clout in negotiations and strong influence on pricing. In health care, fixing the economics model to make hospitals less dependent on drug sales and encourage more qualified doctors to work at private hospitals could help improve the quality of service.

II. Improve the breadth and quality of capital markets. China would benefit from a financial system where market forces allocate capital efficiently; that means well functioning bond and equity markets that attract a diverse set of investors, including institutional and overseas players. The municipal bond market could lower financing costs for local government while bringing market discipline to managing investment projects. To facilitate this shift, China needs to strengthen the foundations of an effective financial system, such as strong, independent credit-rating agencies, more transparent public data on the economy, and more effective communication about government monetary policy. Inviting new players (such as internet banks) to supply capital and helping banks build capabilities to undertake more lending for underserved segments such as small and medium-sized enterprises and rural consumers will be important.

III. Enable corporate restructuring. Shifting successfully to a productivity-led growth model will mean a sea change—letting inefficient companies fail rather than protecting and propping them up and rationalizing excess capacity.

…enforcing bankruptcy law and improving the bankruptcy process. Strengthening capabilities of asset-management companies tasked with handling restructuring could help to turn around companies in default. China will need to expand the securitization of non-performing loans to be prepared for any larger-scale bad debt situation and to ensure that banks put effective risk management in place.

IV. Invest in talent and enhance labor mobility. China has made great strides in educating its people, but more is needed. Among the measures that the government could now take are providing more funding for education, designing programs that rotate effective teachers to places they are most needed, and engaging the private sector to define job-ready skills, build those into curricula, and establish an education to-employment pipeline. On top of this, the government could enhance labor mobility to optimize employment across different regions of the country. Expansion of unemployment insurance and training can help smooth the transition for displaced workers and help them back into jobs. Ensuring gender equality in opportunities in education and in the labor market, while supporting women as well as men as they develop their careers, can further strengthen China’s talent base.

V. Boost aggregate demand. As inequality grows, the government can revise fiscal and tax policies to give households more spending power. For families in need, it could consider conditional cash transfers. Improving social safety net programs by raising health-care and retirement benefits, for example, can reduce the need for precautionary saving for out-of-pocket medical expenses, facilitate consumption, and reduce income inequality. Broadening affordable-housing programs to include migrant workers, with market-based subsidies on both the supply and demand side, can also help low-income families to consume more.

VI. Improve public-sector effectiveness. Ensuring that government raises its own productivity is an important part of any transition to a productivity-led model. Such an effort can start by using household income and productivity indicators to evaluate officials and departments rather than rewarding them largely for the GDP growth their cities or regions achieve. Digitizing government operations and service delivery is an important part of the mix. Government also needs to develop better conflict-resolution capabilities to mediate between different stakeholders so that restructuring and reforms can proceed.

Another aspect of President Xi’s reform is in foreign policy, it has been dubbed the “One Belt, One Road” (OBOR). Last week the Economist – Our bulldozers, our rules discussed the potential of the initiative:-

…Asia needs new infrastructure—about $770 billion a year of it until 2020, according to the Asian Development Bank. This demand should eventually ease today’s worries about a lack of projects. Bert Hofman, the World Bank’s chief in Beijing, adds that individual countries will benefit more if they align their plans with one another and with China. It does not pay to plan and build separately.

Next, China needs OBOR. At home, its businesses are being squeezed by rising costs and growing demands that they pay more attention to protecting the environment. It makes sense for them to shift some manufacturing overseas—as long as the infrastructure is there.

Lastly, Xi Jinping needs it. He has made OBOR such a central part of his foreign policy and has gone to such lengths to swing the bureaucracy behind the project that it is too late to step back now.

None of this means the new Silk Road will be efficient, nor does it mean China’s plans will always be welcome in countries suspicious of its expanding reach. But the building blocks are in place. The first projects are up and running. OBOR is already beginning to challenge the notion of Europe and Asia existing side by side as different trading blocs.

This is reminiscent of the economic development of Japan during the 1970’s and 1980’s.

Despite these policy initiatives, the Chinese economy has been slowing for the past six years. An excellent overview of the current situation was provided last month by the China-United States Exchange Foundation – China’s Incomplete Growth Strategy, in which they highlighted the policies for and challenges to achieve growth, both in the long and short run. Most of the problems are associated with the oversupply evident in the real-estate market and the economic drag from the debt associated with this over-supply. Their solution, as McKinsey suggested above, is infrastructure development:-

…last November, they officially placed the blame on long-term supply-side shortcomings, which they pledged to address with far-reaching structural reforms.

…the supply-side focus largely ignores the present. China faces two separate challenges: the long-term issue of a declining potential growth rate and the immediate problem of below-potential actual growth.

Among the long-term factors undermining potential growth are diminishing returns to scale, a widening income gap, and a narrowing scope for technological catch-up through imitation. Moreover, even as the country’s demographic dividend dissolves, its carrying capacity (the size of the population the environment can sustain) is being exhausted – a situation that high levels of pollution are certainly not helping. Finally, and most important, the country is suffering from inadequate progress on market-orientated reform.

While some of these factors are irreversible, others can be addressed effectively. And, indeed, the government’s supply-side reform strategy will go a long way toward doing just that, ultimately stabilizing and even raising China’s growth potential. But, contrary to popular belief, they will not boost China’s actual growth rate today.

Why are so many economists convinced that a long-term reform strategy is all China needs? One reason is the widely held notion that today’s overcapacity reflects supply-side problems, not insufficient demand. According to this view, China should implement policies like tax cuts to encourage companies to produce products for which there is genuine demand. That way, the government would not inadvertently sustain “zombie enterprises” that cannot survive without bank loans and support from local governments.

But only some of China’s overcapacity can be attributed to bad investment decisions. A large share has emerged because of a lack of effective demand. And that is, at least partly, a result of the government’s effort to moderate real-estate investment, which has caused the sector’s annual growth to tank, plunging from 38% in 2010 to 1% at the end of 2015.

With real-estate investment still accounting for more than 14% of GDP last year, plummeting growth in the sector has put considerable downward pressure on the economy as a whole, helping to push China into a debt-deflation spiral. As overcapacity drives down the producer price index – which has now been falling for 51 consecutive months – real debt rises. This is undermining corporate profitability, spurring companies to deleverage and reduce investment, and fuelling further declines in PPI.

The enduring importance of real-estate investment to China’s economic growth is reflected in trends from the first quarter of this year. Annual GDP growth of 6.7%, despite being the slowest rate for any quarter in seven years, exceeded market expectations. And it was driven partly by an unforeseen increase in real-estate investment growth, to 6%.

This is not to say that what China needs is more real-estate investment. According to the National Bureau of Statistics, China had 718 million square meters of unsold commercial and residential floor space at the end of 2015; when space under construction is factored in, inventory expands to more than five billion square meters. With an average of only 1.2 billion square meters of housing being sold each year, the best way to reduce this supply glut is clear: limit future construction. One of the most important reasons for the recent investment surge was abundant liquidity driving speculative demand – and that is hardly sustainable.

…Infrastructure investment, in particular, may well be the key to tackling China’s economic woes. After all, such investment, which grew at 19.6% in the first quarter of 2016, has already proved to be a critical driver of economic growth – and, unlike real-estate investment, it has not worsened China’s resource allocation or set the stage for major imbalances.

When there is slack in the economy, the only way to escape the debt-deflation trap is to grow strongly. Given that China is saddled with large local-government and corporate debts, but also enjoys large domestic savings and a strong fiscal position, this message could not be more pertinent. In an ideal world, domestic consumption would serve as the main engine of growth; under current circumstances, infrastructure investment is the most reliable option.

In the short term, when overcapacity and deflation are the main obstacles, infrastructure investment boosts growth through the economy’s demand side. In the long run, it operates through the supply side to boost productivity and thus raise growth potential. China can fund such investment with fiscal deficits, given strong demand for government bonds. And, with China’s major banks still state-owned, and capital controls still in place, the risk of an imminent financial crisis is very low.

Of course, China’s government must uphold its commitment to implement structural reforms. But infrastructure investment is also badly needed, not just to prevent the economy from sliding further, but also to enable China to generate the sustained long-term growth that it requires to achieve developed-country status.

The slowdown in Chinese growth has finally prompted concerns around the world. In their May Economic Letter, the Dallas Fed – Impact of Chinese Slowdown on U.S. No Longer Negligible noted that the knock on effect of slowing Chinese growth had taken 20% off US GDP. The chart below shows Chinese and US annual GDP growth over the last 10 years, China is the left hand scale, the negative impact of Chinese growth on US GDP since 2010 has been roughly 0.4%:-

China vs US GDP 10 yr

Source: Trading Economics

The Problem of Debt

The current environment in China – as it is in much of the rest of the world – is dominated by the incessant increase in debt. In May, in what many observers regard to be a reversal of their opinion on the dangers of China’s debt mountain, the Economist – The coming debt bust attempted to quantify the magnitude of the problem facing the Chinese financial system:-

China was right to turn on the credit taps to prop up growth after the global financial crisis. It was wrong not to turn them off again. The country’s debt has increased just as quickly over the past two years as in the two years after the 2008 crunch. Its debt-to-GDP ratio has soared from 150% to nearly 260% over a decade, the kind of surge that is usually followed by a financial bust or an abrupt slowdown.

China will not be an exception to that rule. Problem loans have doubled in two years and, officially, are already 5.5% of banks’ total lending. The reality is grimmer. Roughly two-fifths of new debt is swallowed by interest on existing loans; in 2014, 16% of the 1,000 biggest Chinese firms owed more in interest than they earned before tax. China requires more and more credit to generate less and less growth: it now takes nearly four yuan of new borrowing to generate one yuan of additional GDP, up from just over one yuan of credit before the financial crisis. With the government’s connivance, debt levels can probably keep climbing for a while, perhaps even for a few more years. But not for ever.

When the debt cycle turns, both asset prices and the real economy will be in for a shock. That won’t be fun for anyone. It is true that China has been fastidious in capping its external liabilities (it is a net creditor). Its dangers are home-made. But the damage from a big Chinese credit blow-up would still be immense. China is the world’s second-biggest economy; its banking sector is the biggest, with assets equivalent to 40% of global GDP. Its stockmarkets, even after last year’s crash, are together worth $6 trillion, second only to America’s. And its bond market, at $7.5 trillion, is the world’s third-biggest and growing fast. A mere 2% devaluation of the yuan last summer sent global stockmarkets crashing; a bigger bust would do far worse. A mild economic slowdown caused trouble for commodity exporters around the world; a hard landing would be painful for all those who benefit from Chinese demand.

Brace, brace

Optimists have drawn comfort from two ideas. First, over three-plus decades of reform, China’s officials have consistently shown that once they identified problems, they had the will and skill to fix them. Second, control of the financial system—the state owns the major banks and most of their biggest debtors—gave them time to clean things up.

Both these sources of comfort are fading away. This is a government not so much guiding events as struggling to keep up with them. In the past year alone, China has spent nearly $200 billion to prop up the stockmarket; $65 billion of bank loans have gone bad; financial frauds have cost investors at least $20 billion; and $600 billion of capital has left the country. To help pump up growth, officials have inflated a property bubble. Debt is still expanding twice as fast as the economy.

…“shadow assets” have increased by more than 30% annually over the past three years. In theory, shadow banks diversify sources of credit and spread risk away from the regular banks. In practice, the lines between the shadow and formal banking systems are badly blurred.

That creates two risks. The first is higher-than-expected losses for the banks. Hungry for profits in a slowing economy, plenty of Chinese banks have mis-categorised risky loans as investments to dodge scrutiny and lessen capital requirements. These shadow loans were worth roughly 16% of standard loans in mid-2015, up from just 4% in 2012. The second risk is liquidity. The banks have become ever more reliant on “wealth management products”, whereby they pay higher rates for what are, in effect, short-term deposits and put them into longer-term assets. For years China restricted bank loans to less than 75% of their deposit base, ensuring that they had plenty of cash in reserve. Now the real level is nearing 100%, a threshold where a sudden shortage in funding—the classic precursor to banking crises—is well within the realm of possibility. Midsized banks have been the most active in expanding; they are the place to look for sudden trouble.

Pandamonium

The end to China’s debt build-up would not look exactly like past financial blow-ups. China’s shadow-banking system is big, but it has not spawned any products nearly as complex or international in reach as America’s bundles of subprime mortgages in 2008. Its relatively insulated financial system means that parallels with the 1997-98 Asian crisis, in which countries from Thailand to South Korea borrowed too much from abroad, are thin. Some worry that China will look like Japan in the 1990s, slowly grinding towards stagnation. But its financial system is more chaotic, with more pressure for capital outflows, than was Japan’s; a Chinese crisis is likely to be sharper and more sudden than Japan’s chronic malaise.

One thing is certain. The longer China delays a reckoning with its problems, the more severe the eventual consequences will be. For a start, it should plan for turmoil. Policy co-ordination was appalling during last year’s stockmarket crash; regulators must work out in advance who monitors what and prepare emergency responses. Rather than deploying both fiscal and monetary stimulus to keep growth above the official target of at least 6.5% this year (which is, in any event, unnecessarily fast), the government should save its firepower for a real calamity. The central bank should also put on ice its plans to internationalise the yuan; a premature opening of the capital account would lead only to big outflows and bigger trouble, when the financial system is already on shaky ground.

Most important, China must start to curb the relentless rise of debt. The assumption that the government of Xi Jinping will keep bailing out its banks, borrowers and depositors is pervasive—and not just in China itself. It must tolerate more defaults, close failed companies and let growth sag. This will be tough, but it is too late for China to avoid pain. The task now is to avert something far worse.

An article in Bruegal – Chinese banks: the way forward, which was published in April, looks in greater detail at the expansion of Chinese bank credit:-

The extensive credit expansion in January and February, especially from the banking sector, has several implications. First, it masks the growth of the non-performing loan ratio as the denominator has experienced such a big increase. Second, such surge in credit granted must have had a surge in demand as well. Whether that new demand reflects an improvement in the economy or simply more financing needs is a key question. If it is the latter then it reflects an increasing demand for new funds to repay outstanding loans.

Having said that, China had a bad-loan coverage ratio of 150%, which is considered high for international standards. However, there is rumor that this will be lowered to 120%. In any event, credit risk is rapidly rising in China as the economy slows down and financial conditions are lax enough for corporates to continue to leverage. The question, thus, is how weak are Chinese banks in the current circumstances.

No review of the financial position of China would be complete without a comment from Michael Pettis; last month he wrote Rebalancing, wealth transfers, and the growth of Chinese debt, this is a long research paper so I have only included extracts below:-

There is no way Beijing can address the debt without a sharp drop in GDP growth, but as unwilling as Beijing may be to see much lower growth, it doesn’t have any other option. It must choose either much lower but manageable growth today or a chaotic decline in growth tomorrow. The debt burden cannot stop rising, in other words, until Beijing adjusts its growth expectations sharply downwards and forcefully implements the kinds of reforms that the XI administration has talked about implementing, albeit against powerful political opposition, since the Third Plenum of October 2013.

Pettis then produces a set of scenarios, firstly with growth remaining at current levels:-

Growth remains at 6-7% 2016 -2019 2020-2023
No government transfers

 

 

 

 

 

 

·    Debt growth is steady at 12-14%

·    Investment growth is steady at current levels

·    Consumption growth is steady at current levels

·    Growth in household income is steady and household share of GDP is unchanged

·    No rebalancing

 

·    Period begins with 25% higher debt-to-GDP ratio, and consumption and investment account for roughly equal shares of GDP

·    Debt growth rises to 15-18%

·    Investment growth is steady at current levels

·    Consumption growth is steady at current levels

·    Growth in household income is steady and household share of GDP is unchanged

·    No rebalancing

 

Growth remains at 6-7% 2016 -2019 2020-2023
Annual government transfers of 1-2% of GDP

 

 

 

 

 

 

·   Debt growth drops to 9-10%

·   Investment growth declines by 2-3 percentage points

·   Consumption growth rises by 2-3 percentage points

·   Growth in household income rises by 2-3 percentage points and household share of GDP rises slightly

·   Minimal rebalancing

 

·   Period begins with 10-15% higher debt-to-GDP ratio, and consumption exceeds investment as a source of growth

·   Debt growth rises to 11-13%

·   Investment growth declines by another percentage point

·   Consumption growth is steady

·   Growth in household income is steady and household share of GDP rises

·   Gradual rebalancing

 

Growth remains at 6-7% 2016 -2019 2020-2023    
Annual government transfers of 3-4% of GDP

 

 

 

 

 

 

 

·    Debt growth drops to 8-10%

·    Investment growth declines by 6-7 percentage points

·    Consumption growth rises by 6-7 percentage points

·    Growth in household income rises by 6-7 percentage points and household share of GDP is materially higher

·    Material rebalancing

 

·    Period begins with 5-10% higher debt-to-GDP ratio, and consumption significantly exceeds investment as a source of growth

·    Debt growth rises to 6-8%

·    Consumption growth declines by 1-2 percentage points

·    Growth in household income declines by 1-2 percentage points and household share of GDP is materially higher

·    Material rebalancing

 

 

Next, Pettis looks at the same scenarios adjusting growth lower:-

Growth drops to 3-4% 2016 -2019 2020-2023
No government transfers

 

 

 

 

 

 

 

 

·    Debt growth drops to 6-8%

·    Investment growth declines by 4-6 percentage points

·    Consumption growth declines by 2-4 percentage points

·    Growth in household income declines by 2-4 percentage points and household share of GDP is slightly higher

·    Material rebalancing

 

 

·    Period begins with 10-15% higher debt-to-GDP ratio, and consumption exceeds investment as a source of growth

·    Debt growth is steady at 6-8%

·    Investment growth is steady at current levels

·    Consumption growth is steady at current levels

·    Growth in household income is steady at current levels and household share of GDP is materially higher

·    Material rebalancing

 

Growth drops to 3-4% 2016 -2019 2020-2023
Annual government transfers of 1-2% of GDP

 

 

 

 

 

 

 

 

 

·   Debt growth drops to 5-6%

·   Investment growth declines by 7-9 percentage points

·   Consumption growth is flat

·   Growth in household income is flat and household share of GDP is higher

·   Material rebalancing

 

 

 

·   Period begins with slightly higher debt-to-GDP ratio, and consumption significantly exceeds investment as a source of growth

·   Debt growth is steady at 5-6%

·   Investment growth is steady at current levels

·   Consumption growth is steady at current levels

·   Growth in household income is steady at current levels and household share of GDP is materially higher

·   Material rebalancing

 

 

 

Growth drops to 3-4% 2016 -2019 2020-2023
Annual government transfers of 3-4% of GDP

 

 

 

 

 

 

 

·   Debt growth drops to close to zero

·   Investment growth is zero

·   Consumption growth rises from current levels

·   Growth in household income rises from current levels and household share of GDP is materially higher

·   Substantial rebalancing

 

·   Period begins with lower debt-to-GDP ratio, and consumption significantly exceeds investment as a source of growth

·   Debt growth drops to well below GDP growth

·   Investment growth is steady at current levels

·   Consumption growth is steady at current levels

·   Growth in household income is steady at current levels and household share of GDP is substantially higher

·   Substantial rebalancing

 

Pettis concludes:-

A massive debt burden significantly reduces the options available to policy-makers and a severely unbalanced structure of demand forces policy-makers to choose between rising unemployment, rising debt, or rising wealth transfers. Economists who do not understand how this fairly simply trade-off dominates all policymaking simply will not be able to provide useful policy advice.

Conclusion and Investment Opportunities

China, like many other countries has a problem with debt. The FT recently published an estimate that the Chinese debt to GDP ratio was only 237% (lower than the Economist’s 260%) and government debt to GDP is only 43.9%, whilst household debt to GDP is 39.5%. The Heritage Foundation – Index of Economic Freedom 2016 – estimates China’s government spending to GDP at 29.3%, below that of many developed nations. The Rahn curve below shows how government spending can help to accelerate growth but the diminishing return once it rises above 15% of GDP:-

1DFA0969D85ED690F4E4B05858404992

Source: The Heritage Foundation, Peter Brimelow

Nonetheless, China compares favourably with Japan where government spending is 40.2%.

Stocks, Bonds and the Currency

The Shanghai Composite, shown below, has turned higher since the middle of May. A break above 3,075 could see it retest the highs of 2015 but this is unlikely to be the policy of the Xi administration:-

china-stock-market 10 yr

Source: Trading Economics, Shanghai Stock Exchange

 

10 year Chinese Government bonds have declined in yield as a result of the international turmoil created by Brexit, but, unlike many of major, international government bonds, they have not made new lows so far:-

china-government-bond-yield 1 yr

Source: Trading Economics, Chinese Ministry of Finance

I believe the recent rally in stocks is a function of the lower yield on bonds. The Chinese government has the whip hand. During the rally and subsequent collapse in the stock market during 2015, the government did not respond in a coordinated manner. Amongst a plethora of initiatives, and I may well have missed some, they relaxed margin requirements, fuelling the speculative bubble,  then, as the shake out gathered momentum, suspended the trading in shares listed on multiple markets. As liquidity conditions became more severe they froze 38 individual trading accounts – including certain algorithmic liquidity providers. The regulators also banned short selling and margin loans enabling investors to sell short on T=) settlement. They forced certain brokers to execute buy orders; one broker was bailed out with a CNY 260bln cash injection.

The rules on insurance companies purchasing stock were relaxed, certain shareholders (specifically SOE’s) were prohibited from selling and, under Announcement 18, senior managers and major shareholder (ones holding a stake of 5 % or more) were threatened with “severe punishment” if they sold shares of any listed company during a period of six months. IPO issuance was also suspended – a recent article from the  FRBSF – China’s IPO Activity and Equity Market Volatility looks at possible reforms of the IPO market. The authorities will not want to make the same mistakes a second time.

Margin lending has, so far, remained subdued. The chart below has data up to March 2016. Chinese investors were wounded last year but 10 year bond yields have fallen 80bp since June 2015:-

BN-NE269_CMARGI_G_20160321002958

Source: Wind Information Co, WSJ

Returning to the first chart, tracing the fortunes of the CNY, China appears to be exporting its way out of trouble at the expense of its trading partners. Its largest export market is the EU, US followed by Japan and South Korea.  Here is the US census bureau data for US-China trade since 2008:-

Month Exports Imports Balance
Jan-16 8212 37146 -28934
Feb-16 8049 36161 -28112
Mar-16 8952 29853 -20901
Apr-16 8667 32973 -24306
May-16 8518 37535 -29017
Month Exports Imports Balance
Jan-15 9482 38588 -29107
Feb-15 8759 31574 -22814
Mar-15 9882 41139 -31257
Apr-15 9307 36116 -26809
May-15 8763 39073 -30310
Jun-15 9622 41455 -31833
Jul-15 9514 41216 -31703
Aug-15 9169 44142 -34973
Sep-15 9424 45718 -36294
Oct-15 11410 44319 -32908
Nov-15 10618 41908 -31290
Dec-15 10122 37996 -27874
Year
2015 116072 483245 -367173
2014 123621 468484 -344863
2013 121746 440430 -318684
2012 110517 425619 -315103
2011 104122 399371 -295250
2010 91911 364953 -273042
2009 69497 296374 -226877
2008 69733 337773 -268040

 

Source: US Census Bureau

To help stem the decline in Chinese growth the National Bureau of Statistics has revised the way it calculates GDP. Zero Hedge – China To Boost “Economic Growth” By Changing Definition Of GDP quotes Yu Song of Goldman Sachs:-

Under the new method, the size of the economy is larger than previously estimated2015 GDP was revised up by 1.3% to 11tn USD, the Real growth rate was also revised up (rates vary from year to year and averaged 0.06% (6 bps) over the past 5 years). The upward revision is because China’s R&D expenditure growth has been consistently faster than that of overall GDP–though the difference the change makes to the GDP growth rate is small as R&D is a small part of the economy. The NBS announced 1Q real growth was revised up by 0.04% (4bps), but it did not specify whether the growth rate is now 6.8% yoy or remains at 6.7% yoy. We believe the latter case is slightly more likely as an upward revision would have been highlighted. A higher trend level would mean 2Q GDP growth should be higher as well. As a result, we revise our Q2 real GDP growth forecast to 6.7% yoy from 6.6% yoy previously with slight upside risk to our full-year forecast of 6.6% yoy.

Whether the markets are taken in by this sleight of hand remains to be seen, but, when statisticians are making comparisons in a couple of years from now, the higher growth rate will most likely be taken as gospel.

State Owned Enterprises are investing even as the private sector continues to withdraw – Reuters – China needs the private sector to step up. Residential and commercial construction continues to grow despite 718 M2 of vacant floor space. It is worth remembering that 75% of Chinese individual net worth is tied up in Real-Estate – in the US the figure is 28%. Lagarde’s second in command, David Lipton, of the IMF said China had made only “limited progress” in reducing its debt load but government bonds are near historic lows, making non-performing loans easier to extend. Back in the summer of 2014 I wrote about the importance of the housing market – Macro Letter – No 18 – 29-08-2014The second arrow of Likonomics and the Chinese property market, the stock market subsequently rallied but then collapsed. Now the policy of “rebalancing” seems to be taking a breather.

Chinese stocks, meanwhile, are cheap relative to many other markets. As at the end of June the CAPE was 12.4, PE 6.1 – the lowest of any major stock market globally, PC 3.2, PB 0.8, PS 0.6 and the dividend yield was 4.7%. Only the differential between the dividend yield and the 10 year bond yield (1.93%) looks unremarkable.

Chinese Q2 GDP data is released next week, an unnamed official suggested the PBoC might still have room to cut interest rates, although any further loosening of bank reserve requirements appears unlikely. As we head into the summer lull, Chinese stocks, especially those with an exposure to infrastructure, may offer an excellent buying opportunity.

Nigeria and South Africa – what are their prospects for growth and investment?

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Macro Letter – No 37 – 06-06-2015

Nigeria and South Africa – what are their prospects for growth and investment?

  • The IMF forecast South Africa to grow by only 2% in 2015 and 2.1% in 2016
  • Whilst Nigeria is forecast to grow by 4.8% in 2015 and 5% in 2016
  • Both countries are succeeding in diversifying away from resources
  • Corruption remains the greatest political challenge to their prosperity

To begin my analysis of the two largest economies in Africa here is a table of statistics:-

Indicator Nigeria South Africa
GDP 523 USD Billion – Dec 13 351 USD Billion – Dec 13
GDP y/y 3.96 percent – Feb 15 2.1 percent – Feb 15
GDP per capita 1098 USD – Dec 13 5916 USD – Dec 13
GDP per capita PPP 5676 USD – Dec13 12106 USD – Dec 13
Unemployment Rate 23.9 percent – Dec 11 26.4 percent – Feb 15
Population 174 Million – Dec 13 54 Million – Dec 14
Inflation Rate 8.7 percent – Apr 15 4.5 percent – Apr 15
Food Inflation 9.48 percent – Apr 15 5 percent – Apr 15
Interest Rate 13 percent – May 15 5.75 percent – May 15
Foreign Exchange Reserves 4118713 NGN Million – May 15 470400 ZAR THO Million – Apr 15
Balance of Trade 1145749 NGN Millions – Dec 14 (2513) ZAR Million – Apr 15
Current Account ($158 USD Million) – Nov14 (198000) ZAR Million – Nov 14
Gold Reserves 21.37 Tonnes – Nov 14 125 Tonnes – Nov 14
Crude Oil Production 2520 BBL/D/1K – Jan 14 3 BBL/D/1K – Dec 14
Foreign Direct Investment 1030 USD Million – Nov14 1684 ZAR Billion – Nov 14
Government Budget (1.8) percent of GDP – Dec 13 (3.8) percent of GDP – Dec 14
Government Debt to GDP 11 percent – Dec 13 46.1 percent – Dec 13
Capacity Utilization 60.3 percent – Nov 14 81.5 percent – Nov 14
Corporate Tax Rate 30 percent – Jan14 28 percent – Jan 14
Personal Income Tax Rate 24 percent -Jan14 41 percent – Apr 15
Sales Tax Rate 5 percent – Jan 14 14 percent – Jan 15
Population below poverty line 33.1% (2013 est.) 26.2% (2011 est.)
Labour force 48.57 million (2011 est.) 17.89 million (2012 est.)
Labour force by occupation services: 32%; agriculture: 30%; manufacturing: 11% agriculture: 9%, industry: 26%, services: 65% (2007 est.)
Main industries crude oil, coal, tin, columbite, uranium; palm oil, peanuts, cotton, rubber, wood; hides and skins, textiles, cement and other construction materials, food products, footwear, chemicals, fertilizer, printing, ceramics, steel, small commercial ship construction and repair, entertainment, machinery, car assembly mining (world’s largest producer of platinum), gold, chromium, automobile assembly, metalworking, machinery, textiles, iron and steel, chemicals, fertiliser, foodstuffs, commercial ship repair
Ease-of-doing-business rank 131st 39th
Exports $97.46 billion (2012 est.) $101.2 billion (2012 est.)
Export goods petroleum and petroleum products 95%, cocoa, rubber, machinery, processed foods, entertainment gold, diamonds, platinum, other metals and minerals, machinery and equipment
Main Export Partners  India 12.8%  China 14.5%
   United States 11.1%  United States 7.9%
   Brazil 10%  Japan 5.7%
   Spain 7.1%  Germany 5.5%
   Netherlands 7%  India 4.5%
   Germany 5.1%  United Kingdom 4.1% (2012 est.)
   France 4.7%
   United Kingdom 4.5%
   South Africa 4.2% (2013 est.)
Imports $70.58 billion (2012 est.) $106.8 billion (2012 est.)
Import goods machinery and equipment, chemicals, transport equipement, manufactured goods, foodstuffs machinery and equipment, chemicals, petroleum products, scientific instruments, foodstuffs
Main import partners  China 20.8%  China 14.9%
   United States 11.2%  Germany 10.1%
   India 4.5% (2013 est.)  United States 7.3%
   Saudi Arabia 7.2%
   India 4.6%
   Japan 4.5% (2012 est.)
Gross external debt $10.1 billion (2012 est.) $47.66 billion (31 December 2011 est.)
Public debt 18.8% of GDP (2012 est.) 43.3% of GDP (2012 est.)
Credit Rating (S&P) B+ (Domestic) BBB+ (Domestic)
  B+ (Foreign) BBB- (Foreign)
  B+ (T&C Assessment) BBB+ (T&C Assessment)
  Outlook: Stable Outlook: Stable
Foreign reserves $42.8 billion (2012 est.) $54.98 billion (31 December 2012 est.)

Source: Trading Economics, CIA Factbook, IMF, World Bank, S&P

One additional factor to mention from the outset is the importance of China, and not just as an import partner, although South Africa also exports more to China than it does to any other country. Chinese companies have been aggressively bidding for infrastructure projects across the continent, partly in response to over-investment at home. These companies have also been acquisitive, especially in the resource sector, for several years. Across the continent China now accounts for 20% of infrastructure investment. This has grown from next to nothing in 2002. It has been concentrated in transportation – railways, roads and airports – and, to a lesser degree, in energy; although the decline in commodities prices since 2009/2010 has reduced China’ resource security concerns.

Looking ahead, Chinese investment in Africa has the potential to dramatically improve the prospects for large swathes of the continent. Brookings –   Are Chinese Companies Retooling in Africa? elaborates.

Another major investment trend across Africa has been the growth of private participation in infrastructure (PPI) which now accounts for around 50% of the $30bln per annum – up from $5bln in 2003. This investment is concentrated in telecommunications – 64%, electricity – 18.6% and seaports – 9.8%. Nonetheless, the estimated infrastructure investment gap – $93bln – remains a significant impediment to productivity growth.

Nigeria

Nigeria has just emerged from a general election, the most credible since its return to constitutional government in 1999. The new president, Buhari and his APC party, secured a substantial victory on an anti-terrorist and anti-corruption mandate; it’s worth noting that Muhammadu Buhari is a devout Muslim, his campaign slogan was “new broom”.

The country has overcome some challenges but, as this article from Brookings – Nigeria’s Renewed Hope for Democratic Development – makes clear, there is much still to be done:-

…there is an extensive list of challenges awaiting Buhari and the APC government. They include: ending the Boko Haram insurgency; promoting the socio-economic advance of the largely Muslim and impoverished northern region; overhauling the criminalized petroleum sector; improving the core infrastructures of electricity, water supply, and public transport; drastically reducing corruption in state institutions; and rapidly increasing jobs in agriculture, agro-processing, and light industry.

Chatham House – Nigeria’s New President Pits Hope Against Harsh Realities, takes up the theme:-

This would-be economic powerhouse and Africa’s biggest crude oil producer is running low on fuel. While Nigeria exported around 2.08 million barrels of oil a day in the first quarter of 2015, its three refineries operate at 20 per cent capacity at most. So Nigeria imports its petrol to run cars and diesel to power private generators for homes and businesses. National grid power generation is negligible relative to demand. 

The traders that import refined products are paid by government in cash or crude oil via the byzantine Nigerian National Petroleum Corporation (NNPC). Most foreign suppliers had long stopped supplying on credit as they are owed $1.5 billion in arrears dating back to 2011. Local traders and wholesalers claim to be owed N200 billion in subsidies and are withholding supplies pending some form of settlement.

…In a country that remains dependent on crude exports for fiscal revenue and product imports to function, the cabal-controlled opaque deals that keep the economy running are perhaps at the heart of the corruption that makes people’s lives unnecessarily harsh every day in Nigeria.

But given the parlous state of the economy after crude oil prices halved in six months in 2014, the depreciation of the national currency, the erosion of foreign reserves to under $30 billion, (perhaps four months of external payments), and the political and popular sensitivities around fuel importation and the fuel subsidy, the new government may not have chosen the fuel traders and how to reform the NNPC as the first challenge to tackle. But the traders have forced the issue.

…With ambitions including economic diversification, institutional reform and improving welfare to millions of Nigeria’s poorest, President Buhari and the APC will see their efforts stymied in 2015 by empty state coffers.

Yet it is not the availability of money but the management of it that may effect change in Nigeria. Years of high oil prices and strong GDP growth have not translated into the development, job creation and poverty reduction that they should have. Instead Nigeria is one of the fastest-growing markets for luxury aircraft and champagne, while it ranks 152 out of 187 countries in the Human Development Index.

Back in April 2014 the Nigerian Statistics Office rebased GDP for the first time in 20 years, the result was a near doubling of the size of their economy, as this article from the Atlanitic – How Nigeria Became Africa’s Largest Economy Overnight, expalins:-

In computing its GDP all these years, Nigeria, incredibly, wasn’t factoring in booming sectors like film and telecommunications. The Nigerian movie industry, Nollywood, generates nearly $600 million a year and employs more than a million people, making it the country’s second-largest employer after agriculture. As for the telecom industry, consider that there are now some 120 million mobile-phone subscribers in Nigeria, out of a population of 170 million. Nigeria and South Africa are the largest mobile markets in sub-Saharan Africa, and cell-phone use has been exploding in the country:

Nigeria mobile subsribers

Nigerian Communications Commission (Datawrapper)

Incorporating the film and telecom industries into Nigeria’s GDP made a huge difference in the services sector, rendering the country’s economy not just bigger but more diversified:

Nigeria GDP estimate

 National Bureau of Statistics (Datawrapper)

This is not the first time an African country’s GDP has risen after rebasing, Ghana saw a 60% increase in 2010. The World Bank and IMF estimates for growth in many frontier markets may prove self-fulfilling prophesies if other frontier economies rebase in a similar manner. Nonetheless, these countries are growing rapidly and present a plethora of investment opportunities in the process.

Between 2000 and 2008 African GDP growth averaged 4.9%, twice the pace of the previous decade. Last August, ahead of the US-Africa Summit, saw the publication of the Cato Institute – Sustaining the Economic Rise of Africa – they gave an excellent summation of the state of the region:-

 …between 1990 and 2010, the share of Africans living at $1.25 per day or less fell from 56 percent to 48 percent, while the continent’s population almost doubled in size. If the current trends continue, Africa’s poverty rate will fall to 24 percent by 2030. Since 1990 the per-capita caloric intake in Africa increased from 2,150 kcal to 2,430 kcal in 2013. Between 1990 and 2012, the proportion of the population of African countries with access to clean drinking water increased from 48 percent to 64 percent. Many African countries have also seen dramatic falls in infant and child mortality. Since 2005, some African countries, such as Senegal, Rwanda, Uganda, Ghana, and Kenya, have seen child mortality decline by an annual rate exceeding 6 percent.

Nonetheless, the continent still lags significantly behind the rest of the world in its income levels and also in many indicators of human well-being. For example, Africa scored a mere 0.502 on the United Nation’s 2014 Human Development Index, measured on a scale from 0 to 1, with higher values denoting higher standards of living. By comparison, the United States scored 0.914, Latin America 0.74, and China 0.719.

The extent of trade protectionism, for example, is large, especially when compared with other regions in the world. Average applied tariffs in Africa remain comparatively high, and the extent of trade liberalization on the continent has not matched that experienced in the rest of the world. While between 1988 and 2010, the average applied tariff in high-income countries in the Organization for Economic Cooperation and Development fell from 9.5 percent to 2.8 percent, Africa saw a reduction from 26.6 percent to 11 percent. That is not a negligible decrease but it still leaves the continent with unnecessarily high tariff protection, which hinders trade.

Cato went on to highlight what Africa needs:-

Needs Examples
The Rule of law Land title, commercial contact enforcement
Improvement in governance Oversight of government contracts
Reduction of red tape Regulatory reforms
Infrastructure investment Electricity generation, transportation
Regional Economic integration Free-trade agreements

Here are the IMF – Selected Issues papersDecember 2014 – South Africa and April 2015 – Nigeria  – which look in more detail at several of these issues.

Whilst Nigeria is not exactly a paragon of virtue when it comes to corruption – ranking 136th out of 175 countries on Transparency International’s Corruption Perceptions Index – this 2011 article from the Economist – Africa’s hopeful economiespoints to real signs of progress, both in Nigeria and across the continent as a whole:-

Her $3 billion fortune makes Oprah Winfrey the wealthiest black person in America, a position she has held for years. But she is no longer the richest black person in the world. That honour now goes to Aliko Dangote, the Nigerian cement king. Critics grumble that he is too close to the country’s soiled political class. Nonetheless his $10 billion fortune is money earned, not expropriated. The Dangote Group started as a small trading outfit in 1977. It has become a pan-African conglomerate with interests in sugar and logistics, as well as construction, and it is a real business, not a kleptocratic sham.

…Severe income disparities persist through much of the continent; but a genuine middle class is emerging. According to Standard Bank, which operates throughout Africa, 60m African households have annual incomes greater than $3,000 at market exchange rates. By 2015, that number is expected to reach 100m—almost the same as in India now.

…Since The Economist regrettably labelled Africa “the hopeless continent” a decade ago, a profound change has taken hold. Labour productivity has been rising. It is now growing by, on average, 2.7% a year. Trade between Africa and the rest of the world has increased by 200% since 2000. Inflation dropped from 22% in the 1990s to 8% in the past decade. Foreign debts declined by a quarter, budget deficits by two-thirds.

…Africa’s population is set to double, from 1 billion to 2 billion, over the next 40 years. As Africa’s population grows in size, it will also alter in shape. The median age is now 20, compared with 30 in Asia and 40 in Europe. With fertility rates dropping, that median will rise as today’s mass of young people moves into its most productive years. The ratio of people of working age to those younger and older—the dependency ratio—will improve. This “demographic dividend” was crucial to the growth of East Asian economies a generation ago. It offers a huge opportunity to Africa today.

Dangote Group may not be a “kleptocratic sham” but it is protected from foreign competition by import tariffs which enable it to make a 62% margin on domestic sales. The Economist article goes on to apply a string of caveats – after all, every silver-lining must have its dark cloud, especially for those trained in the “dismal science”- the authors conclude:-

Africa is not the next China. It provides only a tiny fraction of world output—2.5% at purchasing-power parity. It is as yet not even a good bet for retail investors, given the dearth of stockmarkets. Mr Dangote’s $10 billion undeniably makes him a big fish, but the Dangote Group accounts for a quarter of Nigeria’s stockmarket by value: it is a small and rather illiquid pond.

For corporations wishing to succeed in Africa, Nigeria remains a key market. With roughly 20% of Sub-Saharan Africa’s 930 mln people and population growth of 2-3% per annum, this is a market one can’t ignore. The Economist – Business in Nigeria – takes up the story:-

In 2001 MTN, a fledgling telecoms company from South Africa, paid $285m for one of four mobile licences sold at auction by the government of Nigeria. Observers thought its board was bonkers. Nigeria had spent most of the previous four decades under military rule. The country was rich in oil reserves but otherwise desperately poor. Its infrastructure was crumbling. The state phone company had taken a century to amass a few hundred thousand customers from a population of 120m. The business climate was scarcely stable.

MTN took a punt anyway. The firm’s boss called up colleagues from his old days in pay-television and found they had 10m Nigerian customers. He reasoned that if they could afford pay-TV they could stump up for a mobile phone. Within five years MTN had 32m customers. The company now operates across Africa and the Middle East. But Nigeria was its making and remains its biggest single source of profits.

In the 1980’s, after an oil price collapse threatened to under-mine government finances, I ended up doing business in Nigeria with a subsidiary of Unilever (ULVR). Outside of the Oil and Mining sector, it was one of a very few multi-nationals still operating in the country, however, there had been an, almost catastrophic, deterioration in the operations of the division with which I dealt. This decline had taken place over the two decades since Nigerian independence: it reflected the endemic problems of doing business in the country. Managers privately told me, the principal reason they had not closed down was because this was the only practical way to recoup losses sustained in lending the government money.

Finally Unilever, along with a handful of other firms, are reaping the benefit of their long term investment. According to UN forecasts the population of Nigeria will overtake the population of the US by 2045, as soon as 2020, according to research from Oxford Economics, the population will have topped 200mln making Nigeria the fifth largest country in the world, overtaking Pakistan and Brazil – they should have a very bright future.

Near-term growth has slowed as a result of weaker GDP – 3.96% in Q1 2015 vs Q4 2014 at 5.94%, Q3 2014, 6.23% and Q2 2014 of 6.54%. The marginal effect of a falling oil price is still substantial – especially for the export market 95% of which is in petroleum and petroleum products.

The construction sector has remained robust, growing at around 10% – lower than in 2013 but still impressive. Information and Communications has also shown stability, growing at 8% per annum.

South Africa

South Africa has triple Nigeria’s per capita GDP, it is also endowed with better developed institutions. This does not, however, guarantee prosperity. This article from last week’s South African Independent on Sunday – South Africa’s triple challengemakes that clear:-

We are frequently reminded by the political establishment of South Africa’s triple challenge of poverty, inequality and unemployment. This weighs heavily on the social, political and economic fabric of the country.

This is why the unemployment and economic growth data just released points to South Africa sinking into crisis. Official unemployment, at 26.4 percent, rose to a 12-year high. Growth slumped to 1.3 percent for the first quarter this year, below expectation.

The official unemployment rate is one of the highest in the world. The measure masks a low economic participation rate and excludes discouraged work-seekers. In other words, people who want work but have stopped looking for work due to being discouraged are not counted among the unemployed. If a higher participation rate was factored in and discouraged work-seekers were included in the data, the unemployment rate would be nudging towards 50 percent.

…The economy is not big enough to absorb everyone into it. The solution is a bigger economy. For that, the economy needs growth. Not difficult. But growth has ground down to 1.3 percent and looks set to slow further. At the recent Monetary Policy Committee meeting, the SA Reserve Bank warned the inflation risks were to the downside but the risks to economic growth were on the downside.

The combination of weak economic prospects, along with higher inflation, means unemployment is set to rise even further.

… The underperformance of South Africa has been self-inflicted. It struggles under its triple triple.

First Triple: poverty, inequality and unemployment.

…if South Africa had full employment, then poverty and unemployment would be dramatically diminished as issues. However, by not emphasising this perspective, policy is focused on inequality and poverty but is not resolving unemployment.

The national budget is a case in point where the “rich” (success) are penalised through a very “progressive” tax take. Inequality is reduced by pulling down the top end of earners (in reality right down to the working class).

Poverty is tackled through a very aggressive redistribution spending policy. Through this whole process, unemployment is neglected and perpetuated. Policy focus on poverty alleviation has the effect of transferring economic resources to consumption, which is in complete contrast to poverty reduction that transfers resources to investment.

…This shift of resources to consumption has resulted in the second triple, which has become a major constraint and stumbling block to resolving the first triple.

Second Triple: the triple deficit.

The budget deficit in recent years has led to a multiple downgrade of the credit rating. On the face of it, the government “needs” more taxes to balance its books. Yet households, the core of the tax base, are also in deficit. The cost pressures in recent years and availability of credit has led to households spending more than they have earned. The ability to meet a higher tax bill is simply not there. The tax base is both narrow and shallow.

The high unemployment rate also places pressure in a higher dependency ratio on each salary and wage earner. And the government has very ambitious spending plans and faces at least four expenditure threats where each one can take South Africa to a solvency crisis. These are: the public sector wage bill; National Health Insurance; State Owned Enterprises’ need for capital; and the nuclear deal. So far, indications are that the government is going to commit to all four.

The third deficit is the current account deficit. This has been widening to record levels, especially since 2008. Of particular concern is that the current account deficit has been widening while the economy has been slowing and the currency has been weakening. This is a major concern as it means the country is losing competitiveness at an alarming rate.

Part of the reason for the loss of competitiveness comes down to the third triple:

Third Triple: the triple mistake.

The first mistake is labour unrest. No one invests in labour unrest, and investment is essential to grow the economy. South Africa must find a way to resolve labour disputes without unrest. Labour relations is where South Africa languishes near the bottom of the World Economic Forum’s Global Competitiveness survey. The unemployment crisis needs attraction of investment into labour, not away from it.

The second major mistake is the regulatory tsunami that has hit the business sector. The economy is being attacked by policymakers not nurtured. Companies trying to contain costs in a low growth environment have resources diverted to compliance, leaving less to grow their businesses. The biggest problem is that the regulatory burden requires economies of scale in order to be compliant. This is manageable by big business but debilitating for the SME sector. And it is the SME sector that is the engine of job creation. South Africa should be seeking to make South Africa an easier place to invest and do business not more difficult.

…The third mistake South Africa is making is in taxes. Economic expansion cannot happen without investment. Investment cannot be sustained without savings. The investment rate is currently 19 percent of GDP. This will buy a long-term growth rate of 2 to 3 percent.

Excessive debt, both public and private, a low savings rate and a low investment to GDP ratio – it sounds remarkably like the problems of many developed economies. Before dismissing the above article as a little localised hyperbole it’s worth considering this leader from last week’s Economist – Africa’s second-largest economy is in a huge mess:-

There is little in the way of bright news about South Africa’s economy—and not just because power cuts are plunging neighbourhoods into darkness several times a week. According to figures released on May 26th, annual GDP grew by a mere 1.3% in the first three months of this year, a crawl compared with the 4.1% achieved in the fourth quarter of 2014. Unemployment is soaring. Even using a narrow definition, it stands at 26.4%, the highest since 2003.

“The numbers are saying ‘something has to be done, and done quickly’,” says Pali Lehohla, South Africa’s statistician-general. But where to begin? Power shortages under Eskom, the failing state utility, have dampened manufacturing, drought has hit agriculture and tourism, a rare boon, has been hampered by much-criticised new visa requirements. Rating agencies have warned that South Africa is dancing dangerously close to junk status, though no immediate downgrade is likely.

…Strikes are hurting mining. Talks between unions and gold-mine bosses are due to begin in early June. But with unions opening the bargaining by demanding that basic pay for unskilled mineworkers be doubled, prospects of an early settlement seem poor. Last year similar demands at platinum mines sparked five months of labour unrest. A strike by 1.3m public-sector employees has been averted, but only at the cost of a 7% wage increase, with the money coming from emergency funds.

The weak economy is stoking social unrest and public violence. Foreigners, seen as competition for scarce jobs, were targeted in a recent spate of xenophobic attacks that left at least seven people dead. The IRR, a think-tank in Johannesburg, says that protests have nearly doubled since 2010. Many relate to the provision of basic services such as water and electricity. Inequality remains high. A report by the Boston Consulting Group, a consultancy, placed South Africa 138th of 149 countries for its ability to turn the country’s wealth into well-being for its people.

So far the government of President Jacob Zuma has shown little sign of being able to improve matters. The African National Congress, the ruling party, is bogged down in internal political battles, not least over whether to pursue capitalist or socialist economics. The government’s much-touted National Development Plan, a market-friendly strategy to encourage investment and growth, is largely ignored. Even by the ANC’s own standards, it is failing: only 2% growth is expected in 2015 when the economy needs to expand by at least 5% a year to reduce unemployment.

The country doesn’t score that well on corruption either, ranking 67th out of 175 countries on the Corruption Preceptions Index.

Likewise the Deliotte’s CFO Survey is less than encouraging. Many South African CFO’s expressed anxiety about the future. New investment is overwhelmingly directed towards expanding into other, higher-growth, parts of the continent. Of those companies with no presence elsewhere in Africa, 80% said they wanted to build such a presence within the next year – West and east Africa were their favoured destinations.

Capital Markets and Investment Opportunities

Africa is largely dependent on private capital flows as this May 2015 article explains – Brookings – Private Capital Flows, Official Development Assistance, and Remittances to Africa: Who Gets What?:-

The data also show that private capital flows to sub-Saharan Africa over the period of 2001-2012 have mostly benefited two countries—South Africa and Nigeria—which accounted for 45 percent and 13 percent of total private flows to sub-Saharan Africa, respectively. These two countries have attracted the most flows in part because they are the largest in sub-Saharan Africa, together making up more than half of the region’s GDP.

…Portfolio flows have also been increasing recently, though they remain concentrated in South Africa: That country received 96 percent of the portfolio flows to the region in 1990-2000. However, in 2001-2012, the issuance of sovereign bonds by a number of countries and increased interest by investors has led to a more diversified recipient base for portfolio flows. South Africa’s share of the total fell to 59 percent, whereas Nigeria’s increased to 24 percent, and other countries like Mauritius (14 percent) emerged on the scene.

…From 1990 to 2000, half of total FDI to sub-Saharan Africa went to South Africa (29 percent) and Nigeria (21 percent). This trend has not changed: Between 2001 and 2012, the top 10 recipient countries received 85 percent of the total FDI inflows to the region.

…In terms of volume, Nigeria was the largest recipient of remittances in the region from 1990 to 2012.

I want to turn my attention to more liquid opportunities.

Bonds – South Africa

The SARB – Quarterly Bulletin – March 2015 – sums up the recent price action in South African government bonds:-

South African bond yields moved generally lower from early 2014, in line with US bond yields. Local yields receded further in January 2015, supported by an improved inflation outlook and abundant international liquidity following the announcement of an expanded asset-purchase programme by the ECB and continued quantitative easing out of Japan. Bond yields edged higher in early March 2015 as a reversal in the oil price, the announcement of higher levies on fuel and rand depreciation impacted on inflation expectations. Most money-market interest rates have displayed little movement since the middle of 2014, remaining well-aligned with the repurchase rate of the South African Reserve Bank (the Bank) that had been held steady over this period.

The SARB has left base rates unchanged at 5.75% since July 2014 as a result of the stabilisation of the Rand and falling oil prices. Inflation expectations had been on the downside but as SARB Governor Lesetja Kganyago stated in the 21st May MPC statement:-

The challenges facing monetary policy have persisted, and, as expected, the downward trend in inflation which was mainly attributable to the impact of lower oil prices, has reversed. Headline inflation is expected to breach temporarily the upper end of the target range early next year, and thereafter remains uncomfortably close to the upper end of the target band for most of the forecast period. The upside risks have increased, mainly due to further possible electricity price increases. The exchange rate also continues to impart an upside risk to inflation as uncertainty regarding impending US monetary policy continues. Domestic demand, however, remains subdued while electricity constraints continue to weigh on output growth and general consumer and business confidence.

As the chart below suggests, 10yr Bond yields have risen from their January lows. The upward trend appears to be established, the current 10yr yield is 8.51% which is not far from the January 2014 high of 8.8%. I suspect this level will be breached but not to a substantial extent because the rising interest rate environment will undermine, already weak, growth expectations. If yields approach 9.25% I think this offers a buying opportunity. For the present, remain short. For most retail investors this means using South African bond index futures, but remember, only your P&L will be exposed to currency fluctuations.

Bonds – Nigeria

Nigerian 10yr Government bonds have behaved in a very different manner to South Africa over the last seven years, as the chart below reveals:-

south-africa-nigeria government-bond-yield

Source: Trading Economics, Central Bank of Nigeria and South African Treasury

A portfolio of these two bonds would offer an attractive Sharpe ratio. Short South Africa and Long Nigeria 10yr might be another strategy to consider, you may get positive carry, but Nigerian inflation has been substantially higher over this period. Here is a chart:-

south-africa-nigeria inflation-cpi

Source: Trading Economics, National Bureau of Statistics Nigeria and Statistics South Africa

The Central Bank of Nigeria – MPC May 2015 Communique 101 – provides a wealth of information, here are some highlights:-

The Committee expressed concern about the weakening economic momentum but recognized the relative similarity in the condition to the evolving economic environment in virtually all oil exporting economies, suggesting the need for acceleration of various ongoing initiatives to diversify the economic base of the country.

The Committee noted that the uptick in inflationary pressures, year-to-date, was largely traceable to transient factors such as high demand for transportation, food and energy, especially in the period around the general elections as well as the Easter festivities. It also noted the roles played by system liquidity and the pass-through effects of the recent depreciation of the naira exchange rate. When the transient causes are isolated, the Committee observed the decline in month-on-month inflation across all the measures in April as headline inflation moderated to 0.8% from 0.9% in March; core inflation moderated to 0.6% from 0.8% and food inflation moderated to 0.9% from 1.0%.

The Committee reiterated its commitment to price stability noting that given the already tight stance of monetary policy and the transient nature of the incubators of the current inflationary trend, which are outside the direct control of monetary policy, the space for maneuver remains constrained, necessitating the intervention of fiscal and structural policies to stimulate output growth.

…the Committee stressed the need for proactive measures to protect the reserve buffer to safeguard the value of the domestic currency and engender overall stability of the banking system. It was, however, noted that monetary policy is gradually approaching the limits of tightening and would, therefore, require complementary fiscal and structural policies.

…Consequently, the MPC voted to:

(i) Retain the MPR at 13 per cent with a corridor of +/- 200 basis points around the midpoint;

(ii) Retain the Liquidity Ratio at 30 per cent; and

(iii) Harmonize the CRR on public and private sector deposits at 31.0 per cent.

10yr Bond yields have fallen from more than 17% in mid-February to 13.7% today. I believe that the hawkish policy of the Central Bank of Nigeria will insure that inflation falls further. Now the election is over, bond yields will continue to decline as foreign capital flows into the country. As recently as July 2014 yields were at 12% – I think they will go lower even than this despite yield curve inversion. The one major risk to this otherwise promising scenario is a rating agency downgrade. S&P downgraded Niara bonds to +B as recently as March, the election result helps but the new government need to deliver on their promises of reform.

To access the Nigerian bond market you need to contact one of the primary dealers – here is the link to the Nigerian Debt Management Office. You will have to deal with the issues of exchange controls, an alternative would be to be a fixed rate receiver through a Niara interest rate swap. The list of dealers may be a place to start but I suspect this is a strictly institutional option.

Stocks – South Africa

The SARB – Quarterly Bulletin – March 2015 – describes recent developments in South African equities:-

Despite the subdued growth in the economy over the past year, domestic share price entered 2015 on a positive note, recovering from the losses incurred in the second half of 2014 to reach all-time-high levels in March 2015. The domestic share market benefited from sustained accommodative monetary policies in the advanced economies, while lower international oil prices and the depreciation of the rand also boosted some share prices. Corporate funding through the issuance of shares in the primary share market rose considerably in 2014, consistent with the high level of share prices and rising number of companies listed on the JSE Limited.

…The performance of equity funding on the JSE was strong in 2014. Equity capital raised in the domestic and international primary share markets by companies listed on the JSE amounted to R153 billion in 2014, which was 65 per cent higher than the amount raised in 2013. Equity capital raising activity was concentrated in companies listed in the financial and industrial sectors, which dominated equity funding in 2014 with shares of 35 and 41 per cent respectively. Dividing the industrial sector further, as shown in the accompanying graph, more than half of the industrial sector’s equity funding in 2014 was accounted for by companies in the consumer goods subsector. Proceeds were utilised mostly for acquisitions, both abroad and domestically.

Robust funding in the primary share market was consistent with the high level of share prices and rising number of companies listed on the JSE, as new listings exceeded delistings in 2014 for the first time since 2008. The number of company listings came to 329 on the main board at the end of February 2015, while 60 were listed on the Alternative Exchange (AltX) and 3 on the development and venture capital boards. The most prominent method of raising capital was the waiver of pre-emptive rights where shares were issued for cash to the general market or specific investors. Equity financing amounted to R43 billion in the first two months of 2015.

Secondary market trading has remained stable but the P/E ratio, at around 18 times, is above its long term average (1990-2015) of 14.4. The P/E ratio has only broken above 20 once, back in 2010, during the rebound from the global recession – though it came close to these levels in 1993.

The Johannesburg (JSE) and the Nigerian Stock Exchange (NSE) are currently working towards developing a partnership that would benefit both exchanges. In this collaboration, among other things, South African companies would be able to list on the NSE and Nigerian companies on the JSE.

South Africa has the most sophisticated financial markets in Africa, it also acts as a conduit for foreign investment to the rest of the continent. The main stock index – the FTSE/JSE 40 – has traded steadily higher since 2009:-

south-africa-stock-market

Source: Trading Economics and JSE

However, this does not take account of the currency risk of investing in the Rand. An alternative is the iShares MSCI South Africa ETF – EZA. Here are the top 10 components:-

Company Symbol % Assets
Naspers Ltd Class N NAPRF.JO 19.44
Mtn Group Ltd MTNOF.JO 9.83
Sasol Ltd SASOF.JO 6.51
Standard Bank Group Ltd SBGOF.JO 5.27
Firstrand Ltd FSR.JO 4.81
Steinhoff International Holdings Ltd SNHFF.JO 4.41
Sanlam Ltd SLMAF.JO 3.46
Aspen Pharmacare Holdings Ltd APNHF.JO 3.43
Remgro Ltd RMGOF.JO 3.28
Bidvest Group Ltd BDVSF.JO 2.63

Source: Yahoo Finance

iShares MSCI South Africa

Source: Yahoo Finance

It is clear from the chart above that South Africa’s main stocks are struggling due to the difficult domestic economic situation, which has led to continuous bouts of currency weakness and bond rating agency downgrades.

For domestic or hedged investors the market trend remains positive, but for international investors the carry costs of hedging undermines the attraction of this market.

Stocks – Nigeria

Nigerian stocks have recovered from weakness earlier this year. The Central Bank put most of the recent performance down to improvements in earnings, sentiment and the successful conclusion of the election.

nigeria-stock-market 2010 - 2015

Source: Trading Economics and NSE

Given the heavy weighting to Dangote in this index (25%) perhaps a more diversified investment would be the Global X MSCI Nigeria ETF (NGE) here are the top 10 constituents:-

Nigerian Breweries PLC 16.41
Guaranty Trust Bank PLC 11.54
Zenith Bank PLC 8.93
Nestle Nigeria PLC 7.06
Ecobank Transnational Inc 4.72
Lafarge Africa PLC 4.66
First Bank Of Nigeria PLC 4.64
Dangote Cement PLC 4.63
Guinness Nigeria PLC 4.48
Stanbic IBTC Holdings PLC 4.37

Source: Yahoo Finance and MSCI

The advantage of the ETF is that you don’t have to deal with the problem of Nigerian exchange controls, however you should keep a close eye on the currency which continues to depreciate against the US$. The technical picture is unclear, I have no direct exposure to Nigeria but it remains on my list of stock markets with significant long-term potential. The current P/E ratio is around 16 times, not cheap like China last year, but worth watching.

NGE 2 yr chart

Source: Yahoo Finance

Currency

The South African Rand (ZAR) is a freely traded international currency. Daily turnover is roughly 1.1% of the global total – mostly traded in London. The Nigerian Niara (NGN) is subject to exchange controls. It is possible to trade non-deliverable forwards, but liquidity reflects the relative lack of tradability. The chart below compares the two currencies against the US$ since 2007:-

ZAR and NGN vs USD - 2007-2015

Source: Trading Economics

Since H2 2011 the ZAR/USD rate has been weakening. This trend looks set to continue. This is how its recent movements are described in the SARB – Quarterly Bulletin – March 2015 – they highlight the developments during 2014:-

The nominal effective exchange rate of the rand declined, on balance, by 2,8 per cent in 2014, compared with a decline of 18,6 per cent in 2013. The trade-weighted exchange rate of the rand increased, on balance, by 0,3 per cent in the fourth quarter of 2014 following a decline of 2 per cent in the third quarter. The rand did, however, regain some momentum, rebounding by 4,0 per cent in October 2014 supported by a positive Medium Term Budget Policy Statement and portfolio investment inflows. The domestic currency weakened by 0,3 per cent in November 2014 amid South Africa’s credit rating downgrade from Baa1 to Baa2 by Moody’s rating agency as electricity challenges became more acute. In December 2014, the trade-weighted exchange rate of the rand weakened further along with other emerging-market currencies and declined by 3,2 per cent. Sentiment towards emerging-market currencies, including the rand, was generally weighed down by the persistent weakness of the euro area, a slowing Chinese economy and an unexpected Japanese recession.

The USD/NGN has been declining by steps as the Central Bank of Nigeria, in a futile attempt to halt the depreciation, depletes its gross reserves. These have fallen to $28bln from more than $50bln in less than two years. Now that the elections are behind them the currency should be less vulnerable. During mid-April overnight rates hit 90% but have since returned to a more normal range – still a volatile series. It’s unlikely they will drop below 9% with the current hawkish MPC. This makes Long NGN Short ZAR an attractive trade – carry will be around 300bp. However, this should be viewed as a trading position. The Central Bank of Nigeria will probably have to defend the NGN again, when they fail the USD/NGN rate will rapidly head for 230.