South Africa’s Economic Woes

Frank Charnas is CEO of AfriQue Consulting Group. He tweets @frankcharnas

South Africa boasts the most advanced marketplace in Africa. However the contraction of the Chinese economy, over-reliance on commodities, a failure to deliver structural change, and political mismanagement have caused the economy to stutter and led to a sharp devaluation of the local currency. On June 3 Standard and Poor’s will review South Africa’s sovereign rating, and it is widely expected to downgrade it to “junk” status. This bodes poorly for the country, and would signal a major degradation in South Africa’s ability to deliver much needed economic development.

Ultimately, South Africa is in dire need of gross structural reform

In light of this the current pricing levels on South African credit default Swaps Swaps Swaps can be defined as a derivate contact composed of two parties that exchange to cash flow between two separate financial instruments.They are generally divided into two categories. This includes contingent claims (options) and forward claims, where forward contracts, swaps, and exchange-traded funds (ETFs) are exchanged. Commodity price, equity price, interest rate, and foreign exchange rate are common variables used as one of the cash flows in swaps upon initiation. Different Types of Swaps Swaps can be defined as a derivate contact composed of two parties that exchange to cash flow between two separate financial instruments.They are generally divided into two categories. This includes contingent claims (options) and forward claims, where forward contracts, swaps, and exchange-traded funds (ETFs) are exchanged. Commodity price, equity price, interest rate, and foreign exchange rate are common variables used as one of the cash flows in swaps upon initiation. Different Types of Swaps Read this Term has made the cost of insuring government bonds as expensive as countries with “junk” credit status. This is a possible indication that the market is already pre-positioning itself for a downgrade by at least one of the credit rating agencies over the coming year. But how did the most developed economy in Africa fall to these levels and what does the future hold for South Africa?

China has sneezed but South Africa is the one with the cold.

Firstly, the contraction of the Chinese economy has had a negative effect throughout Africa with the two economies most exposed to the Chinese market being South Africa and Zambia. China is the largest consumer of South African raw materials, and a degradation in Chinese demand has challenged the profitability of production and commodities extraction in South Africa. The devaluation of the yuan has cheapened the price of Chinese exports into the country, hurting South Africa’s balance of trade. This has enhanced the downward spiral of the local currency, the rand (ZAR), which has dropped 30% against the USD since the start of last year. Additionally, China is a major investor in infrastructure and large projects throughout Africa, including in South Africa, and the slowdown in the Chinese economy will likely see this investment diminished over the coming months.

Internal problems

However, it would be unfair to blame the entirety of South Africa’s economic woes on China. The South African economy remains overly reliant on commodities extraction and has not evolved sufficiently in the democratic era. There exists only a very small middle and upper class population, providing a narrow tax base with extreme inequality continuing to be a pervasive societal weakness. The country has experienced severe electricity shortages and now faces water restrictions, largely caused by inefficient maintenance as well as a failure to upgrade infrastructure to accommodate the incorporation of millions of disadvantaged citizens. The local government identifies this inequality as a remnant of Apartheid and an inhibition to development, whereas its critics believe that the government has fundamentally failed at delivering the structural reform required to remedy the situation.

Apartheid, unions, commodities

The majority of mining and large industry are remnants from the Apartheid regime, and are based on a supply of readily available cheap labor. Conversely, the labor force in South Africa today is politically powerful, aided by an alliance of the Congress of South African Trade Unions (COSATU) with the ruling African National Congress (ANC). This has meant that contemporary South African production is less attractive in the face of cheaper mechanized alternatives in competing economies. Thus, should a ratings agency choose to downgrade the economy, it will be as a result of structural shortcomings and not the cyclical downgrade resulting from Chinese contraction and low commodity prices. Additionally, as the demand for commodities decreases and foreign investment exits the country, the South African mining sector may be further decimated, decreasing the mineral production in the country.

Road to reform

The situation thus appears dire for South Africa, with slowing growth, an increasing expenditure bill, an unfavorable balance of trade, and unattractive conditions for foreign direct investment which could damage the crucial mineral extraction sector. Moreover, the situation is likely to damage the country's mineral extraction sector. Despite this, there remain well experienced and respected economic leaders in the country, capable of steering the economy away from the abyss.

Finance Minister Pravin Gordhan has a respectable track record and is known for prudent macroeconomic policies. His budget presentation will take place in February, and will serve to set out the recovery path. Ultimately, South Africa is in dire need of gross structural reform to fundamentally alter the economy and lessen its exposure to commodity prices and Chinese expansion. It is unlikely that South Africa can implement the required reform needed to change the economic structure in the country in the near term. However, it is possible that a well balanced and well designed budget can potentially delay the downgrading of the economy to “junk” status. Failure to do so may indicate further troubling times for South Africa.