The economy is like a garden, DIG IT?

By Marcus Rautenbach, Principal Investment Consultant

To paraphrase the character from the 2001 film Joe Dirt, the economy is like a garden. DIG IT?

After the second wave of the COVID-19 pandemic struck South Africa, and with much of the detail about South Africa’s intended vaccination programme still unclear, some South Africans are asking if the country is facing yet another lost decade. An economy that performs poorly compared to peers and global standards only encourages such questions.

The purpose of the following paragraphs is to create a perspective of the economic challenges facing South Africa, and not to propose solutions or advise Government, corporates or household sectors. The growth of South Africa’s economic output lags that of the global total, the other BRICS countries and many appropriate peers in Eastern Europe, Central Asia and South America.

Why?

While considering the question of obstacles facing the South African economy, it is appropriate to consider measures that could improve South Africa’s economic outlook. It is helpful to think of an economy as a garden. For a garden to grow, it requires fertile soil, sunshine and enough water. As the garden grows, a gardener is required to weed and prune the garden for it to achieve its full potential. However, it is important to understand too that no amount of weeding and pruning will make the garden grow in the absence of fertile soil, sunshine and enough water.

The garden that is the South African economy appears to be drab and mediocre compared to peers.

This is evident from the projections for South Africa’s gross domestic product (GDP) growth rate for 2021, which ranges between 3% and 3.5%, moving closer to 2% for 2022[1] South Africa’s GDP growth is only at approximately two-thirds of global levels, meaning that South Africa falls further behind global peers every year. In the period from 1992 to 2007, South Africa’s GDP growth accelerated faster than global growth, but since 2007, local GDP growth has slowed compared to global growth. This corresponds with the global commodity super cycle that ended in 2007.

South Africa’s garden has fallen into a state of neglect, perhaps because of a drought (commodity super cycle that ended) with no provision for alternative sources of water during the drought (negligence), and excessive harvesting (post 2010). The neglect could in part also have resulted from overpruning or even ineffective pruning (the overmanagement or ineffective management of the economy).

A low or slow GDP growth rate is an impediment to realising objective to achieve a better life for all.

How does the neglect and poor condition of South Africa’s economic garden manifest itself? Some obstacles which appear in the garden that is the South African economy are:

Government finances

Challenges besiege South Africa’s government finances. Government revenue is under pressure and expenditure remains at elevated levels. The Minister of Finance reported a consolidated budget deficit of 14.0% on GDP for 2020/21 in his 2021/22 Budget Speech in February 2021. The Minister expected the gross government debt-to-GDP ratio to stabilise at 88.9% by 2025. A fragile economy with modest GDP growth expectations cannot be afforded due to the budget deficit, debt-to-GDP ratio and debt servicing cost at present levels. To further burden a National Budget that is under severe pressure already, some state-owned enterprises (e.g. Eskom, SAA and Landbank) continue to rely on fiscal support from Government.

Unemployment

At the same time, unemployment in South Africa remains a concern. Roughly 6.5 million South Africans (30.8%) out of a work force of 21.2 million persons were unemployed by the third quarter of 2020[2]. Even though the method of calculating unemployment corresponds with global practice for such a calculation, it does not take account of the 2.7 million discouraged job seekers or the 15.2 million economically inactive South Africans of working age. Including discouraged job seekers, 9.2 million South Africans of working age are unemployed, and the expanded unemployment rate is 38.6%.

Load shedding

Rolling blackouts, euphemistically referred to as “load shedding”, are projected to prevail throughout 2021. Allowing for a consistent unplanned outage of 12 000 MW and an operational reserve of 2 200 MW (Eskom seems to know what they are talking about), Eskom’s demand modelling shows a shortfall of electricity that reaches 1 500 MW at some points during the next three months[3]. The shortfall raises the possibility of either Stage 1 or Stage 2 load shedding during 2021. It is possible that the status will get worse during the winter of 2021. Government activated a 2 000 MW emergency electricity procurement programme, but this is only expected to come on stream towards the end of 2022. A further tranche of new capacity of 12 000 MW is expected to be available later in 2023.

COVID-19 pandemic

The spread of the COVID-19 pandemic is a disaster and strategies to contain the spread of the virus are a national priority. The South African experience of the COVID-19 pandemic is devastating, with most people being acquainted with individuals who succumbed to the infection. By 30 January 2021, 1 out of every 542 South Africans had an active, confirmed case of COVID-19 infection (total infections less recoveries less fatalities) and 1 out of every 1 350 South Africans had perished from

COVID-19 infections[4] (compared to 1 out of 303 active infections in the world and 1 out of 3 518 COVID-19 fatalities in the world[5]).

The COVID-19 pandemic has long-term economic consequences in addition to the human tragedy it has caused. It is not clear how global economic growth will be affected in the long term, and it is not clear which countries will be affected worse than others. It is evident that some economic sectors benefit while others suffer because of the COVID-19 pandemic. It further appears that the pandemic is worse for those individuals who are economically more vulnerable.

It is useful to understand some of the factors that contributed to the deterioration of South Africa’s economic garden:

1. Inequality

The Lorenz Curve reflects the inequality that prevails in a society. The Lorenz Curve for consumption expenditure in South Africa in 2020 is estimated from data obtained from Stats SA. It shows the bottom 50% of the population by income to be responsible for only 12.2% of consumption expenditure while the bottom 90% of the population by income are responsible for 53.3% of consumption expenditure. This means the top 10% of the population by income are responsible for 46.7% of consumption expenditure.

To ensure a better life for all its citizens, it is crucial that South Africa accelerate its economic growth and, likewise, it is crucial that it address the inequality that prevails in society.

However, without accelerating economic growth, there is not much point in addressing the inequality in society, as the average person in society may become poorer. Without growing the economy and expanding the tax base, South Africa could experience higher unemployment, which means the reliance on social grants could increase.

No country ever has legislated itself out of poverty. No gardener’s pruning or weeding has ever broken a drought.

2. Global economic growth

It will be difficult for a middle-income country like South Africa to grow its economy in the absence of global economic expansion.

One of the factors that drives global economic expansion is globalisation, where production and services migrate to lower-cost territories from higher-cost territories. Consumption, however, remains rooted in traditional territories. Among other things, the effect of globalisation is lower prices on durable, semi-durable and consumer goods. This makes the goods more accessible and leads to a higher quality of life for the average person. However, globalisation often leads to higher unemployment in the high-cost territories. It is important to consider the impact of South Africa’s labour policy on the country’s ability to participate in the globalisation of economic opportunities.

In an ideal economy, labour will be mobile to migrate along with job opportunities, or the unskilled and semi-skilled workers will be retrained to be absorbed into a growing economy. In practice, this is not easily achieved.

Unskilled and semi-skilled workers endure the worst of the high unemployment numbers and look for political solutions to assist them. However, the political solutions (e.g. minimum wages and trade protection etc.) often impede economic growth.

3. Labour and capital

Free movement of capital and labour across international boundaries to environments where both attract a higher reward generates economic growth.

Of all the production resources, capital remains the resource that moves freely to be employed in territories where it attracts a higher reward. Technology and entrepreneurship are both mobile factors of product that could relocate easily. For example, many consider one such entrepreneur, Elon Musk, who is often associated with the application of new technology (electric motor vehicle Tesla and space transporter SpaceX) to be South African, despite the fact that he left South Africa in the late 1980s. Labour is usually subject to immigration restrictions and, in practice, it is expensive for labour to migrate. Labour is therefore less mobile than capital.

Gross Fixed Capital Formation (GFCF) measures the capital available for investment in an economy. As investment opportunities decline, GFCF also declines in an economy. A lower GFCF number can result from structural shifts or weaknesses in an economy, but it can also result from economic policy errors in a country.

GFCF in South Africa has declined steadily since the end of the commodity super cycle in 2007, i.e. capital moved away from South Africa. Some policy decisions in South Africa may have contributed to this trend.

When facing the challenge of disappearing economic opportunities because of lower gross fixed capital formation, the first response is usually protectionist in nature, as measures are put in place to prevent capital from relocating and minimum wages are introduced. As minimum wages are implemented, it is necessary to close the borders to curb the inflow of more workers (increased supply of labour).

The protectionist measures seldom have the desired effect and often accelerate the economic decline being experienced.

Some argue that the best way to invigorate economic growth is to free both capital and labour from restrictions. In practice, this means the removal of minimum wages and the opening of borders to allow the inflow of more labour. These steps result in lower wages, which in turn create opportunity, which eventually attracts capital. There are those who believe this to be a failure of the capitalist system, as low wages often drive many into greater poverty and increase the inequality in a country.

In an environment where low wages cannot be relied on to create economic opportunities, one should look to productivity gains, disruptions from new technology or new resource deposits to attract new investments. As South Africa may be ideally positioned to benefit from significant productivity gains, disruptions from new technology or discovering new resource deposits, it is likely that Gross Fixed Capital formation will continue to decline.

4. Free and secure movement of goods and services

Trade quotas, tariffs, import duties and levies are an impediment to higher economic output. These measures effectively increase the price of services and goods without the value derived from the particular goods or service increasing. They are used to raise revenue for governments and are used by governments to protect their (national) interests – for example, steps taken by South Africa’s government to protect its domestic food producers. The result of these protectionist measures is to raise the price of durable, semi-durable and consumer goods, which is indirectly paid by consumers. Over-reliance on protective trade policies is kept in check by possible retaliatory measures taken by other countries. It has happened in the past that protectionist measures followed upon each other and spiralled out of control, as was the case with the Banana Wars between the United States (US) and European Union (EU) circa 1997[6]. A trade dispute about the EU’s import of bananas from the Caribbean soon resulted in 100% duties being place on Scottish cashmere and French cheese imported into the US.

Since 2016, both the US and the People Republic of China resorted to taking protectionist measures aimed at each other, but in reality affecting third-party producers and manufacturers around the world.

In addition to free trade being more desirable than protectionist measures, it is necessary for producers and manufacturers to be able to move their goods around the world and around countries in relative safety. In this regard, piracy on the open seas and highway robbery sound like tales from the 16th century, but they do affect free trade in the 21st century as well.

Producers and manufacturers require some level of certainty that they will be able to transport their products, in which they have invested their working capital, to markets where these products can be sold. The absence of law and order in some seas and territories constricts global economic growth and in South Africa, highway robbery constricts free trade to the same extent.

The free and secure movement of goods and services is conducive to economic expansion.

5. Government policy

In 1975, Milton Friedman said, “One of the great mistakes is to judge policies by their intentions rather than their results.”[7]

Governments implement policies because they believe the policies to be necessary and for the good of their nation. The post-implementation assessment of these policies occur less frequently. As a result, one often finds failed policies and unaddressed policy failures. South Africa is no different from the rest of the world in this regard.

Several policy issues are on the agenda in South Africa. Two of these policies are perhaps more pressing at the moment:

• Land reform; and
• National Health Insurance (NHI).

These policies are crucial to South Africa’s future economic development and it is necessary to get the policies right first time.

Successful land reform is necessary not only to address South Africa’s history of colonialism and apartheid, but also to transfer some of the means of production to those previously excluded by law from economic opportunities. Land reform is therefore as much about the economy as it is about justice and the emotive aspect of addressing the legacy of colonialism and apartheid.

The freehold ownership of land is a cornerstone of economic activity in developed economies around the world. Owners of property can add improvements to their property to increase the value of their property, they can sell their property to raise capital, and they can raise loans against the security of their property. The key to the economic aspect of land reform is that such reform should result in the freehold transfer of property to beneficiaries, rather than trusts holding property on behalf of the population.

Land reform is often a controversial matter. It requires wisdom and prudence to address the issue to the satisfaction of most of the population, and it can provide an economic boost to South Africa.

Universal access to affordable healthcare contributes to human dignity. The objective is laudable and must be supported by all. The importance of national healthcare has become clearer in the COVID-19 pandemic. In a thriving economy it is not possible for one part of the population to have access to quality healthcare while another part of the population suffers the ravages of ill health and disease.

Whether the proposed NHI can be afforded by South Africa, or be achieved in isolation of sound fundamental economic management, remains open to question.

The NHI initiative is based on two principles. The first principle is that, through the NHI, the state will be the single payer for health services and will receive the entire healthcare funding nationally and then make payment for procurement of all services nationally. The second principle is that the NHI will be used to correct the imbalance of medical expenditure.

While 83% of the population depend on medical services provided by the Department of Health, at a budget of R226 billion per annum, 17% of the population depend on privately funded medical services (R200 billion per annum[8]). Broadly speaking, this means R4 500 per person per annum is spent on more than 50 million people who depend on the Department of Health for healthcare while more than R20 000 per person per annum is spent in the private sector on healthcare for 9.5 million persons.

The original White Paper in 2017 estimated the cost for NHI at R256 billion per annum (at 2010 prices). A more recent estimate runs to R458 billion per annum and a harder hitting estimate comes to R700 billion per year[9]. These amounts should be considered relative to South Africa’s revenue from personal income tax that amounted to R529 billion in 2019/20 (39% of total tax revenue) and total tax revenue of R1 355.8 billion in 2019/20[10]. South Africa’s GDP for the four quarters to September 2020, unadjusted and in current prices, amounted to R4 939 billion[11]. The implication is that the NHI will require R1 out of every R7 of the total economy every year.

Government has indicated that it will fund the NHI from existing resources rather than from new or higher taxes. It is uncertain whether a project as large and encompassing as this one can be funded from existing resources, or even what exactly existing resources mean.

Due to the sheer size of the NHI initiative, the risk is that it could have a negative impact on the South African economy if not implemented prudently.

A third policy issue that requires consideration is South Africa’s labour policy, with specific reference to the National Minimum Wage policy.

Government’s labour policy to maintain a national minimum wage is well intentioned, but heavily influenced by demands from the trade union movement. This, in itself, is not a bad thing, but when it leads to economic imprudence it is. The objective of a decent or living wage is laudable and must be supported by all. Again, whether it can be achieved in isolation of sound fundamental economic management remains open to question (refer to Milton Friedman on policy intentions).

It is an essential truth that no one has ever been able to legislate a population out of poverty.

The policy of maintaining a national minimum wage is restrictive and excludes many from the job market. Arguably, it is more important to gain a toehold in the job market than it is to remain dependent on social grants. The impact of the minimum wage policy is to put pressure on the numbers of those employed and to increase the numbers of those who depend on social grants.

To complicate the matter further, the “pay gap” in South Africa remains significant when measured by the difference in the remuneration of executive management and the remuneration on the shop floor. It is difficult to abolish or reduce the National Minimum Wage policy in the face of reports of generous executive remuneration. In the event that executive remuneration is constrained (by whichever means), many talented South African business leaders may choose to emigrate. PwC’s Executive Directors Report 2020 quotes Peter Drucker that the ideal chief executive officer (CEO) to average worker remuneration ratio is 20:1 (or even 25:1). Using the minimum wage of R3 500 per month, the ratio for the remuneration of CEOs to minimum wages in South Africa is 66:1[12], implying that the average CEO in South Africa receives monthly remuneration of R231 000. The ratio for CEO remuneration compared to the unskilled median wage is 24:1, well within Drucker’s ideal range, making it more difficult to argue in favour of a National Minimum Wage policy. At a ratio of 24:1 to CEO remuneration, the median wage amounts to R9 631 per month.

It is evident that some of South Africa’s national policies should be assessed to ascertain if the policy outcomes are in line with the policy objectives, and future policies (e.g. the NHI) will benefit from more stringent cost assessments.

6. The fight against corruption

The perception (and experience) of corruption deters investment. The absence of corruption does not necessarily translate into economic growth, but the presence of corruption deters investments, resulting in lower economic growth. It is therefore necessary for any country to deal convincingly with corruption.

Corruption is widely perceived to prevail in South Africa. Failing to deal with corruption results in an unwillingness to invest capital in South Africa, or to lend money to Government. To address the perception of corruption, there has to be accountability by those accused of corruption and there has to be public prosecutions.

The perception is that corruption is entrenched in South African society and that it is likely to become a long-term feature of society, despite the current efforts to reverse the trend. The steps already taken by South Africa’s National Prosecution Authority (NPA) should be supported. The NPA should be encouraged to sharpen its focus on the successful prosecution of the corrupt and, importantly, there should be consequences for those found guilty of corruption.

From an economic perspective, it is a matter of trust.

7. Quality education outcomes

One of the key requirements for sustained economic growth is access to a well-schooled labour pool. It is easy to find negative comparisons or inflammatory survey results about the quality of South African education outcomes. Without engaging in the technical aspects of these comparisons or surveys, most will agree that the proportion of educated individuals in South Africa is low compared to many other countries, and the proportion of South Africans with higher education in mathematics or science is even lower. Some also question the quality of the average public education when compared to global peers. It should be acknowledged that the reasons for the current position of South Africa’s education system are complex and stem from the inequality that is part of South Africa’s history.

Access to an educated corps of workers at fair wages will attract investment in an economy. Even if the outcomes of an education system can be improved in a short time, the impact thereof on economic growth takes many years to manifest in economic growth. Without improving the outcomes of South Africa’s education system now, many of South Africa’s inhabitants will be doomed to lives of continuous economic struggle and South Africa to a lower economic growth rate.

The economy is like a garden. DIG IT?

Some factors that contributed to the neglect of South Africa’s economic garden are outside its control. For example, South Africa cannot control global forces of globalisation, nor can it secure the movement of goods on the high seas or accelerate global economic growth by itself.

Some factors contributing to the neglect can be changed, but it will take a long time for the effect of these changes to become evident. These factors should be addressed now and should include improving education outcomes and addressing the prevailing inequality in South African society.

There are also contributing factors that can be changed with an immediate impact on South Africa’s economic growth. These factors should be addressed with a sense of urgency and include fiscal austerity, electricity supply certainty, thoughtful government policies on land reform, the NHI and critical assessment of the National Wage policy, policy certainty and the fight against corruption.

What creates an even bigger challenge is that steps taken to address one issue (e.g. abolishing the National Minimum Wage policy to enhance South Africa’s global competitive position) could result in challenges in other areas (e.g. addressing inequality). It is unlikely that a single, simple solution will be found to address all of the challenges at the same time. It would require setting priorities to address the challenges and to realise when the list of priorities should be reviewed.

One should acknowledge that some of the required steps have been initiated already. The NPA has made a start with the prosecution of those accused of corruption, but needs to follow through with successful prosecutions. Eskom has addressed some the issues troubling its generation capacity, but these efforts need to be continued, more independent power producers need to be admitted to the national grid and Eskom’s corporate woes (debt) need to be addressed.

In the short term, the next steps required to deal with the structural challenges that face South Africa’s economy are:

1. Instil confidence – Tackle corruption and hold the guilty accountable.
2. Government consumption expenditure – Manage the civil service wage bill specifically.
3. Infrastructure – Invest in water and sanitation, telecommunications (fibre/5G), roads etc.
4. Electricity – Get the independent power producers online sooner rather than later (same said for the next round of procurement from IPPs).
5. State Owned Enterprises (SOEs) – Stop the downward spiral.

Disclaimer.

[1] OECD Economic Outlook, December 2020: Turning hope into reality

[2] Stats SA Quarterly Labour Force Survey Q3 2020

[3] Eskom’s Weekly System Status Report

[4] www.sacoronavirus.co.za on 31 January 2021 and Stats SA Mid-year population estimates July 2020

[5] www.worldometers.info/coronavirus/

[6] www.theguardian.com/world/1999/mar/05/eu.wto3

[7]  Interview with Richard Heffner on The Open Mind (7 December 1975)

[8] Michael Settas at www.freemarketfoundation.com/article-view/why-the-nhi-is-bad-medice-for-south-africa

[9] www.irr.org.za/media/government-must-tell-us-what-the-nhi-will-cost-and-where-the-money-will-come-from-2013-irr

[10] SARS 2020 Tax Statistics

[11] P0441 Gross Domestic Product (Quarterly) (2020Q3) accessed at www.statssa.gov.za

[12] www.pwc.co.za/en/press-room/pwc-executive-directors-report-2020