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Mar 1, 2023

Polina Kurdyavko hits the road, reflecting on her observations from around the world while tying in fresh investment perspectives related to emerging markets. For investors that are both armchair travelers and road warriors, these insights will open your eyes to the opportunities abroad. Subscribe to receive her latest note.

Do you remember your first business trip? Mine was a visit to South Africa over twenty years ago. I remember being shocked by the poverty and crime rate in local townships, and urban areas reserved for non-whites until the end of apartheid in the early 1990s.

Key points

  • South Africa is again in a state of national disaster as the country continues to struggle with its largest energy crisis ever.
  • While the current Government largely inherited the problem, they have been proactive in creating the Project Management Office to focus on restructuring the electricity sector.
  • Investors have reacted to the crises and spreads have widened. While valuations on South African debt are attractive, we are cautious.
  • In the short term, we believe investors will be rewarded for being patient and waiting for the right opportunity.

How could a country with First World institutions have deep Third World problems related to crime and unemployment? Last week I landed in the dark city of Johannesburg – literally, with no working traffic or street lights. South Africa is again in a state of national disaster, this time caused by severe load shedding, as the state-owned utility cannot supply nearly half of its potential generation capacity to consumers.

I found myself asking once again, how can a country with First World institutions have Third World problems related to electricity and transportation? How did this happen, who is responsible, how can it be fixed and what is the cost to the nation? Unfortunately, not all problems can be quickly solved. South Africa is the case in point.

Markets have also taken note of the precarious position that South Africa is in, with sovereign spreads for hard currency and yields for local currency debt being close to twenty-year highs. While the government has accumulated USD30bn in foreign exchange (FX) reserves during this period, its total debt to GDP and external debt to GDP has doubled as well. We, therefore, see the spread moves as justified. While valuations appear attractive, we maintain a cautious overall stance on South Africa’s debt. In the corporate sector, some companies are better positioned, given their export-oriented nature, but we have taken a tactical approach to the local currency sovereign debt. Although we believe the recent sell-off is overdone both in local rates and FX, we expect current challenges are likely to put more strain on local businesses over the coming months and could weigh negatively on local currency sovereign debt.

How did the state-owned utility end up in this situation? During the last five years under Cyril Ramaphosa’s leadership, the government has continued to deliver prudent and orthodox fiscal and monetary policy that should, in theory, have provided a positive backdrop for investments. Yet, the country lost its investment grade status four years ago. Structural problems caused by almost ten years of deep routed corruption under the previous president Jacob Zuma, as well as 34% unemployment rate -the highest in the world - started to show deeper cracks in the system. Both the national electricity and transportation sectors are in a state of crisis after over fourteen years of load shedding.

Indeed, one can quickly become an expert in load shedding levels having spent only a few hours in South Africa. When the country operates up to level four of load shedding, customers don’t have electricity for two to four hours a day. Once this level goes to six, businesses experience power cuts for eight hours a day. Since September 2022 South Africa has been operating at level six or above. For businesses, the difference can be critical. Most can cope with level four but are forced to reduce capacity at level six. For example, some restaurant owners might be forced to shut down their venues as the cost of a diesel generator could erase their already thin margins (if they are unable to pass the costs to the consumer). Likewise, earlier in the year 10 million chicks had to be culled in a period of six weeks due to load shedding, as electricity accounts for 75% of egg production costs, causing KFC to close seventy of their restaurants. Other sectors are also facing pressure. One of the mining companies told us that they might have to close up to 25% of their production if load shedding continues at current levels over the next six to eight months. Public safety concerns have also risen with the country now facing a problem with sewage and increased water pollution risk that, in turn, leads to water shedding.

The cause of the problem is multifaceted. Structurally high unemployment has led to crime and corruption, while the poor design has contributed to power outages. With the unofficial unemployment rate sitting at 42%, the incentives to deploy tactics to circumvent the systems remain in place: some have even resorted to stealing coal and replacing it with stones that block electricity generators. There are also a multitude of examples of engrained corruption, such as maintenance contractors who deliberately break parts of the generator during the maintenance process to repair it yet again. Poor design of some of the recently built plants has meant that they were not well adapted to the South African climate. As a result, out of twelve units, only five are currently operating, resulting in a 4 GWH shortage in electricity across the country.

While most businesses can adapt to the current crisis by building their own renewable electricity supply, this process is likely to take a while. It is estimated that on average a company requires three to five years to reduce reliance on state-owned electricity generation and ten to fifteen years to become fully self-sufficient. In the meantime, efforts to increase supply over the next eight to ten months are mainly focused on increasing its diesel purchases funded through the state budget. For the time being, the current situation is likely to continue putting pressure on local businesses, especially as we enter the winter period of June to August. As times get more challenging, tail risks rise. Estimates of the impact of load shedding on GDP growth in 2023 vary dramatically. The South African Reserve Bank (SARB) estimates a two-percentage point loss of GDP this year will be attributable to load shedding and targets a modest 0.3% GDP growth number for the year, while the South African Treasury forecasts are more optimistic at close to 1% GDP growth. With that said, third-party consultants, such as PWC, estimate that the country could lose up to 3% of its GDP due to its electricity crisis.

Tail risk scenarios go beyond the growth impact. We are approaching the South African general elections in 2024. Given the disappointment with the government’s handling of the energy crisis, the ANC party could lose its majority for the first time in 27 years. There is also a risk that the current president, Cyril Ramaphosa, might not be re-elected. This opens the country to more uncertainty, with risks of a coalition government under a different leader.

One could argue that Cyril has inherited the problem rather than created it, especially given the corruption legacy under the Zuma administration between 2009 and 2018. In fact, the structural challenges of high unemployment go back to the apartheid era. Despite Tito Mboweni putting in place a comprehensive labour reform in the late 90s, structural changes in the economy resulted in the tertiary sector growing to over two-thirds of the economy requiring a higher skill set than that available within the labour market. Yet, regardless of the root cause of the problem, both the population and investors are likely to vote with their feet. We have seen this trend already on the investment side as local asset managers have increased their offshore allocation by five percentage points last year, as the offshore regulatory limit was raised to 45% this year from the previous 30% cap. Moreover, anecdotal evidence suggests that local pension funds are witnessing outflows this year, suggesting that the allocation to fixed income portfolios that grew strongly during the 2019/2020 period might not provide supportive technicals going forward.

What's the good news? Dire circumstances require drastic measures to help come out of the crisis. The government has been proactive in creating a Project Management Office (PMO) under Rudi Dicks’ leadership to focus on restructuring the electricity and transportation sectors. We believe that the PMO unit has made good progress, as witnessed by the proposed state-owned electricity utility’s financing plan during the budget announcement this week. We would expect further announcements related to the separation of transmission and generation in the coming months. The focus remains on connecting the private electricity players to the grid and opening generation to private competition. The national state of disaster has created a sense of urgency that has allowed the government to move at a relatively fast pace circumventing legal roadblocks. It has also helped moderate the ANC’s historical resistance to private competition.

If the PMO can pull off its plans, over the next ten years we could see South Africa emerging from this crisis as one of the greenest economies with most of its new electricity supply coming from solar energy, potentially accounting for a third of the country’s total electricity generation. In the short term, however, we believe investors will be rewarded for being patient and waiting for the right opportunity. Despite our confidence in the strength and integrity of local institutions, periods of transition are often accompanied by increased volatility. The hope is that the leadership will come through stronger, and the transition will be benign, similar to the experience we witnessed thirty years ago when Nelson Mandela came to power, avoiding the risk of a civil war breakout. However, in practice, very few countries have successfully handled similar energy crises. India, for example, has endured over 20 years of crisis in its electricity supply and the problems are still ongoing, despite companies adjusting over the years by building alternative sources of electricity supply. Even if the PMO manages to deliver, such transitions take time and, in the interim, South Africa's Third World electricity problem will no doubt weigh on its First World institutions and, by extension, fixed income valuations in the market.

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