Flaws in governance keep South Africa in the shadows

“When things tend to be ugly and bad, institutions are weakened. We are at a cross roads in South Africa.”

Former South African deputy finance minister Mcebisi Jonas, 30 March 2017

We have long been concerned about the direction of governance in South Africa. ‘The management and politics’ component of our top-down country allocation process is designed not only to capture the political environment, but also the competency of the central bank, the robustness of other institutions such as the media and legal system, and also governance both at a corporate and a national level.

It is the last of these where South Africa has given us the most concern. Economic policy has tended to be fairly technocratic (although not addressing the country’s painfully low trend rate of GDP growth), the South African Reserve Bank is one of the best central banks in the emerging world, the media and law courts are independent and highly active, and corporate governance is of a high quality. It is our perception of a steady slide into corruption and nepotism in the executive that has caused us to be negative on management and politics for South Africa since 2010.

2010 saw a major, but rapidly-forgotten, scandal in South Africa. Kumba Iron Ore (at the time a US$20bn company) went to re-register the mineral rights of its massive Sishen iron ore mine with the Department of Mineral Resources only to discover that, hours before, a shell company had already made the registration. That shell company, it was to transpire, was 50% owned by Duduzane Zuma, the son of President Jacob Zuma. Three years of court cases subsequently led to the Constitutional Court awarding the mineral rights to Kumba, but we took these events as a seriously negative indicator of the outlook for South African equities.

That view was reinforced in December 2015, when a well-respected finance minister was suddenly replaced by unknown MP David van Rooyen. South African financial markets reacted very badly to the news, leading to the appointment of a third finance minister in five days – Pravin Gordhan. This showed both the vulnerability of South African markets to political events and also a lack of understanding of markets at the highest level in South Africa.

Since then, South Africa’s vulnerability has only increased. Sovereign debt is rated at just above non-investment grade level, and all three major ratings agencies have stressed the importance of fiscal orthodoxy in maintaining those ratings.*

The sacking of Mr Gordhan this month would seem to have accelerated market awareness of political risk in South Africa. The full impact on bond and currency markets may take some time to come out, but risks remain elevated as other investors come round to our view. With real GDP growth having averaged an annual 1.6% over the last ten years, it is not as though the growth story is compelling. We remain neutrally-weighted in South Africa, but hold a company that achieves almost all of its economic value from outside South Africa. There is an outside chance that the current crisis will lead to President Zuma’s removal, which might open up the opportunity for desperately-needed economic reforms, but until then we remain cautious on the outlook for the South African economy and domestically-focused stocks.

* S&P downgraded South Africa’s credit rating to non-investment grade shortly after the time of writing.

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