South African economy is surging

Africa’s economic powerhouse doesn’t fit the emerging markets mould. South Africa is considered to be a promising emerging market — even though its highly developed economic infrastructure is characterized by first-world attributes and its stock exchange is among the world’s top 20 in terms of market capitalization. As Africa’s economic powerhouse, the South African economy accounts for more than a quarter of the continent’s gross domestic product.

Its economy and stock market are running at full steam, unaffected by shifts in the global commodities cycle, which had been the catalyst of growth in recent years. In fact, the economy is experiencing its longest continuous growth spurt, while the stock market reached its highest level ever at the end of April.

Since the establishment of a democratic administration in 1994, South Africa has enjoyed more than 12 years of robust economic growth, averaging more than 4% annually. This trend represents a big recovery from the troubled 1990-94 period, during which the country endured a painful transition from apartheid.

Last year, the economy grew by 5% and is expected to continue at this pace until at least 2011, according to forecasts by the London-based Economist Intelligence Unit. The EIU says inflation has also been tamed, falling to 4.6% in 2006 from 9.3% in 2002, and the EIU expects GDP to decline steadily in the next five years to 3%.

The economy has benefited from the boom in commodities, stronger consumer spending and lower unemployment rates, which in turn has fuelled the banking sector, says Markus Koebler, vice president of global equities at Natcan Investment Management in Montreal.

Mark Mobius, portfolio manager of Templeton Emerging Markets Fund at Franklin Templeton In-vest-ments Inc. in Singapore, calls South Africa “an interesting investment destination.” The local economy, supported by the export of commodities, is doing well, he says, largely due to opportunities the government created over the past decade by helping local companies expand domestically, regionally and internationally.

Government assistance for existing and new businesses provides access to funds through various measures to support exports, innovation, investment and job creation.

Mobius also likes South Africa’s “well-established legal system and financial framework” and that most of the companies he invests in, he says, are “normally well aware of best practices in terms of corporate governance, which is better than many other emerging-market countries.”

In addition, the black middle class has “grown by leaps and bounds,” fuelling spending as well as growth in the retail, property and financial sectors, says Anthony Ginsberg, managing partner of Beverly Hills, Calif.-based Ginsglobal Index Funds, which has offices in Capetown, South Africa.

Buoyant consumer demand has been enhanced by easily available credit, especially in the retail sector, Ginsberg says: “Store-issued credit cards make it easier for people to acquire goods on credit.” He contends that although the white population previously “controlled spending power,” this is no longer the case.

In an effort to redress the injustices of apartheid, black empowerment became the central focus of the government. While this initiative has been successful to some extent, it has spurred the creation of a small but wealthy black business elite, thus increasing inequality within the population.

Although unemployment has fallen from more than 30% in 2003, it remains high at more than 25%. At the same time, although average wages have risen by about 20% since 1994, poverty continues to be pervasive for almost half of the population.

Accordingly, the government recently implemented the Accelerated and Shared Growth Initiative for South Africa, which will allocate some 370 billion rand (about US$50 million) over the next three years, mainly to infrastructure public works projects, in an effort to boost job creation more equitably. The goal of this program is to increase economic growth and halve unemployment and poverty by 2014.

As part of the government’s budgetary measures, it also expects to spend two trillion rand over the next three years on social services and infrastructure and on establishing a social security system.

Although South Africa has an abundance of investment opportunities, it has not attracted the level of foreign direct investment that is typical of countries at the same stage of development. South Africa has received a fraction of the FDI that comparable emerging-market economies have received — just 1.5% of GDP, vs an average of 2.7% for other countries, states Eric Werker in a November 2006 Harvard Business School’s Research & Ideaspaper. He attributes this to two primary reasons: after apartheid, South African conglomerates had money to invest as well as a large market share within their own industries; and foreign firms and asset managers wanting exposure to the country have the option of investing through the financial markets.

However, some substantial foreign investments have been made. The most notable is Britain-based Barclays Bank PLC’s recent acquisition of a majority stake in Absa Bank Ltd., South Africa’s biggest retail lender. Barclays initially withdrew from the country in 1986 in the wake of anti-apartheid pressures. This is the largest FDI ever made in South Africa.

The booming South African economy has been paralleled by an equally hot stock market.

The MSCI South Africa index reached record highs in both rand and U.S.-dollar terms on April 30. The FTSE/JSE top 40 price index, which has more than doubled over the past two years, also recorded an all-time high at the end of April in rand terms. And over the past one-, three-, five- and 10-year periods ended April 30, the MSCI index had an average annual compound return of 14%, 40%, 31.7%, and 11.7%, respectively, in US$ terms.

According to UBS Ltd. ’s South Africa Strategy report, the non-resources sectors performed strongly in April, with consumer goods, services and financials providing leadership, while technology, materials and energy underperformed. For the year ended April 30, the leading sectors were materials and industrials; the lagging sectors were energy, technology and health care.

Mobius sees value in some commodity stocks, retailers and some financial stocks. In addition to these sectors, Ginsberg likes property and construction. He says that these sectors — and related ones such as infrastructure, civil engineering and transportation — will gain significant ground as South Africa prepares to host the 2010 FIFA World Cup of Soccer. The country plans to build five new stadiums and renovate another five.

Ginsberg likens the South African banking sector to that of Canada. He says that South Africa has four major banking groups, which form an oligopolistic structure that benefits from pricing power and wider margins. Insurance and brokerage companies enjoy similar benefits.

In spite of the positive developments, South Africa presents significant challenges and risks. On the political front, finding a viable candidate to replace outgoing president Thabo Mbeki in 2009 is giving rise to much concern. Crime and corruption are also deep-seated and, in many instances, state institutions face the risk of becoming extensions of the ruling party. In spite of the government’s best intentions, the country suffers from a dearth of professional and technical skills, which could stall development.

The commodity-based rand is also facing increasing pressure, making imports more expensive and creating less attractive conditions for manufacturers who depend on imported inputs.

Mobius and Ginsberg caution about dependency on commodities. If the commodity cycle turns, says Mobius, “We can expect some pressure on the earnings of some South African companies.”

Ginsberg also warns that dependence on foreign investment, combined with a weakening rand, could lead to foreign investors “taking money off the table” — creating unfavourable conditions for both the stock market and the currency. Essentially, there could be an outflow of capital and a run on the rand, causing the stock market to take a breather, he adds.

Clients who wish to participate in the market can invest either in mutual funds — such as Templeton Emerging Markets Fund or Altamira Global Discovery Fund — that have limited exposure to the market, or buy South African ADRs traded on U.S. stock exchanges.

Dwarka Lakhan

Dwarka Lakhan is a pioneer in emerging markets journalism in Canada. His first emerging markets article, “Africa Joins Ranks of the Emerging,” appeared in Investment Executive, Canada’s leading newspaper for financial advisors, in September 1994. Since then he has written hundreds of articles on the full spectrum of emerging markets and has conducted more than two thousand interviews with emerging and frontier markets investment professionals.

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