South Africa's Great Challenges, and Greater Opportunities

 

MARCH 22, 2016 [SOUTH AFRICA, FISCAL RISK, HIV]
Pablo Echavarria, CFA


South Africa faces a myriad of challenges. Government missteps slow the pace of progress, which nonetheless is being made, setting the stage for growing investment opportunities.

After a fruitful week of corporate and macroeconomic policy meetings, I leave South Africa with a sense of hope for the future but recognition that challenges ahead need to be dealt with for the country to continue its development. Twenty-two years have passed since the end of apartheid, which marked a regressive time in this country's history given institutionalized racism and marginalization of the non-white population. The wounds left by this regime are still being felt throughout society, which is not surprising. But the progress that has been made is encouraging in what remains a young and growing democracy in Africa's second-largest economy.

Over its young history as a democracy, South Africa has been recognized by investors for its strong institutions. The South African Reserve Bank is widely recognized for its independence and prudent management of monetary policy, while the Treasury has maintained its commitment to a framework of fiscal discipline. However, slow economic growth in recent years combined with more challenging external factors brought by a slowdown in global growth have pressured the country's internal and external accounts, with concerns mounting over a potential sovereign debt downgrade below investment grade. This would be a step back for South Africa, as it would likely signify higher borrowing costs, lower amounts of foreign direct investment and loss of credibility with international investors.

Fiscal Risk is Trajectory, Not Level of Budget Deficit

South Africa's fiscal deficit currently stands at 3.9% of gross domestic product (GDP). The size of the deficit is not as alarming as in other developing economies, but it is nonetheless wide. Public debt as a percentage of GDP stands at 49%. Readers familiar with developed market debt statistics might find the debt burden to be quite low, especially compared to countries such as Japan, where debt-to-GDP stands at 226%. However, it is not the size of the government's debt burden that is concerning investors and rating agencies, but the trajectory of the debt build up. To put it in context, South Africa's debt-to-GDP stood at a mere 25% as recently as 2008. Over time, governments, like households, need to balance their budgets to remain viable, and South Africa is not the exception. As a result, debt sustainability will require a clear plan by government to reign in the fiscal deficit to a level that is sustainable over the medium to long term. When one dissects the fiscal deficit drivers, it is evident that both disappointing growth and elevated government expenses are to blame for the fiscal deterioration. As recent as 2007, South Africa's economy was growing GDP at a rate in excess of 6%. Private and public forecasters expect growth to fall below 1% this year and to recover to around 1.5% next year. Most economists we spoke to in the country admit that the risks to growth are to the downside. With lower economic growth comes lower tax collections, as corporate profits suffer, wage growth slows and employment trends deteriorate. This ultimately places a burden on government revenues. So what has driven growth lower? Clearly a slower global economy is partly to blame, but issues specific to South Africa are also impacting the country's economy. Both Treasury and the Reserve Bank estimate that power shortages, a result of under investments by Eskom, the state-controlled electricity producer, are dragging potential GDP growth lower by about 1%. Lack of business confidence has also been a drag on potential economic growth, and here President Jacob Zuma is partly to blame. In early December, he replaced Finance Minister Nhlanhla Nene with relatively unknown lawmaker David van Rooyen. This led to a significant spike in the volatility of the South African rand and a retreat in domestic stock prices. These internal issues, amongst others, have added an element of uncertainty to economic forecasting, and consequently to corporate investments. This ultimately has a negative effect on the potential growth rate of the economy.

Backtracking, Re-opening Lines of Communication to Restore Business Confidence

Thankfully, this young but buoyant democracy seems to have responded with a sense of urgency to this moment of crisis. Just four days after his decision to remove Nene, Zuma and other members of the governing African National Congress (ANC) backtracked on this decision by naming Pravin Gordhan, a former finance minister, as the replacement to Nene. Mr. Gordhan is well respected by investors and has a reputation for fiscal conservatism. More importantly, several chief executive officers I met during the trip mentioned that after years of broken communications between the government and business leaders, conversations have resumed and the outcome of those communications seems to be quite constructive. It appears the brief moment of political crisis experienced in early December acted as a spark to bring South Africans together and work toward a common goal. More importantly, meetings with Treasury suggest that there is a credible plan in place to bring expenditures down, with freezes being instituted on hirings of non-essential government employees. This should help bring down the amount of government spending over time. A more constructive system of communication between businesses and government should act as a starting place for better business confidence, which over time will result in business leaders feeling a greater level of conviction to build new factories, expand production and hire additional workers. This would in turn restore South Africa's growth potential toward a level more commensurate with the long-term potential of this country.

HIV Epidemic

Additionally, South Africa has made great strides toward combating the HIV epidemic. AVERT, a charity organization focused on heightening AIDS awareness, estimates that 6.3 million of South Africa's 54 million people are living with the HIV virus. Sadly, this accounts for more than 19% of the adult population in the country. However, after years of denying the epidemic, the government has taken a much more proactive approach towards the disease, which AVERT estimates that South Africa now invests more than $1 billion annually on antiretroviral therapy (ART), making it the largest treatment program globally. Age expectancy for South Africans remains pitifully low, with South Africans born in 2013 expected to live on average to 56.7 years. This number is down from 62 in the early 1990s, quite the opposite of the trend seen in developed economies, where average age expectancy is rising. However, the progress made over the last few years has driven the age expectancy up from a low of 51.6 in 2006. Many economists argue that the high rate of AIDS mortality has caused efficiency in the economy to decline, as the disease creates a disincentive to affected workers looking to educate and prepare themselves for more productive jobs. Containment of the HIV epidemic is crucial to South Africa's future, as it is likely to result in more skilled, better prepared and educated workers, who can drive greater efficiencies in the economy. Indeed, according to a joint-study by Boston University, Brown University, and the University of Witwatersrand in Johannesburg, "South African patients who remain on ART experience large and sustained benefits in their general well-being, ability to go about their normal lives, and employment for up to at least the first five years after treatment initiation. Through their effect on productivity and employment, the gains to individual patients will translate into social and economic development gains for societies as a whole."

Putting It All Together

Overall, South Africa remains a country of great challenges but greater opportunities. Having met with a plethora of South African corporates over the last week, it is evident that South Africa's management teams are world class, and far superior to the quality of managements we encounter in many other emerging markets. South Africa remains a natural hub to the rest of Africa, and is ideally positioned to participate in the long-term development of the continent (even if the near-term outlook for the region is challenged by lower commodity prices). South African companies are expanding into the region in a measured but consistent fashion and are likely to reap the benefits over the medium to long term. In a world where negative sentiment has become the norm it is quite easy to get caught up in the near-term challenges faced by several of the economies in which we invest. However, the long-term promise for many of these emerging economies remains quite robust, and long-term investors are likely to benefit from significant growth opportunities available for companies in these markets.

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