Transforming South Africa’s Monetary Architecture — recommendations by the National Planning Commission (Part 2)

Household wealth, including offshore wealth, accounts for around 20% of total assets, but the top 10% of the population owns the large bulk of that wealth (see below).

Shadow banks, the intermediaries that move money around on behalf of large institutional investors, have mushroomed since 1994 to manage large amounts of capital that investors and non-financial corporations are reluctant to invest in fixed assets.

They are the de facto liquidity merchants of the South African economy. Surprisingly, the development finance institutions (DFIs) are tiny — the largest 14 DFIs have a collective balance sheet that is only a fraction of the size of bank balance sheets (the two largest being the DBSA and IDC).

South Africa’s wealth as a percentage of total assets consists of currency (0.6%), business assets (3.6%), housing (28.8%), pension and life insurance policies (32.5%), and stocks and bonds (34.6%).

The top 10% of the population owns 99.8% of all stocks and bonds, 63.8% of all pension and life policies, 58.8% of all housing, 59.6% of all business assets and 62.7% of all currency. Even more concerning, in 2017, 35,400 adults representing 0.1% of the population accounted for 29.8% of South Africa’s wealth, which was twice the total wealth of the bottom 90%. The wealth of the richest 3,540 individuals (0.001%) was equal to the wealth of the bottom 90% compared to the bottom 50% who are getting poorer.

(Source: Chatterjee 2020, quoted in the NPC finance report.)

The savings in South African pension funds have mushroomed since 1994. We now have one of the largest pools of pension savings in the world, larger than India, France, Spain and Chile. However, only around 10% of those funds are reinvested back into the real economy (and less than that into infrastructure), while 45% is allowed to leave the country (as per Regulation 28 of the Pensions Act).

If all this money is not being invested in Gross Fixed Capital Formation (GFCF) and the amount that can leave the country has maxed out, then where is it going? The short answer is that it spins around the financial system at ever-increasing velocities. Asset managers, who earn fees from every deal they facilitate, have an interest in short-tenor deal flow rather than long-term investments in fixed assets.

The shadow banks and asset managers are the enablers of this flow of money that is invested in money to make more money. Drawing on research done by Dr Mashimbye for his Stellenbosch PhD, by 2021, there were four clusters of shadow banks: multiasset funds (R1.2-trillion under management), funds-of-funds (just over R500-billion), fixed income funds (just over R400-billion), and money market funds (just under R400-billion).

There are limits to how much they can keep moving through financial markets and still make a profit, and the 45% limit on what goes offshore has been maxed out. As a result, many asset managers now say that there is surplus cash looking for investments.

Obviously, this cash could be absorbed by large-scale fixed asset investments with secure long-term returns – this, of course, is what infrastructure investments can provide if there were a big enough pipeline of projects. At the moment, this is not the case despite the obvious needs as spelt out in the Medium-Term Budget Policy Statement (MTBPS).

The main reason why there are limited infrastructure opportunities despite huge needs is because of the weakening of the State-Owned Enterprises (SOEs) during the state capture years. Although there are signs of recovery, there is a long way to go.

The consolidated cash flows of the SOEs for the period 2018/19 to 2022/23 were reflected in the 2024 Budget Review as follows:

It is clear that net cash flows after interest, debt service and capex remain below the break-even line despite successive bailouts. The Eskom turnaround helps, but the surpluses declared in its latest financial statements would not exist without the R254-billion bailout that Eskom received over the medium term in the 2023 Budget.

The main consequence of the hollowing out of SOEs during the 2012-2022 period is that they could no longer raise debt from the private sector, which is, in turn, partly why so little of the growing pile of private cash cannot get absorbed by infrastructure projects. The Infrastructure Fund set up by the DBSA in 2020 is aimed at resolving this problem.

As far as banks are concerned, as the Banking Inquiry published by the Competition Commission made clear in 2008, South Africa’s banks have been some of the most profitable in the world.

Their Return on Equity (RoE) has averaged above the global average at around 25%, dropping only slightly to an average 20% after the Basel III guidelines were adopted after the Global Financial Crisis of 2007/9.

They have also been better capitalised than most banks around the world. The equity-to-asset ratio has consistently hovered around 15% since 1994, which is higher than, for example, the same ratio for US banks, which peaked in 2019 at 11.4%.

As the Banking Inquiry reported, profitability of SA banks has much to do with the risk-averse regulatory regime imposed by the SARB. However, it also has to do with the changing nature of their counter-parties. By 1993, (mainly white) households accounted for 49% of all deposits, while businesses accounted for 23%.

By 2023, that was reversed: as households moved their money into pension funds and shadow banks (eg Allan Gray’s unit trusts), they accounted for only 31% of all bank deposits by 2023.

Businesses, in turn, accounted for 47% because of their reluctance to reinvest a higher proportion of their profits into fixed assets for expansion. In February 2024, the two biggest non-household depositors in banks were non-financial corporations (over R1.2-trillion) and fund managers (R800-billion). This is why one often hears asset managers argue that they indirectly fund government via the banks.

As far as bank lending is concerned, the most concerning trend is that over the period 2008-2022, bank lending as a percentage of GDP to the private sector has levelled out (from 70% to 60% of GDP), while bank lending to government (not SOEs, and therefore not fixed assets) has steadily increased over the same period (from below 5% to over 10% of GDP).

This is worrying, because if the levelling out of lending to the private sector reflects limited demand for capital for expansion during times of low growth, this means government cannot rely on increased tax returns to service debt. As the Governor of the SARB recently pointed out (in order to justify his low inflation-constrained borrowing regime within a low growth economy), this could lead to a debt trap that then undermines the economic growth that somehow will materialise.

So, if state institutions (departments, SOEs, local governments) have been reducing investment in GFCF since 2008, has this been counteracted by large, mainly listed corporations? The answer, in general, is no.

Drawing on the work of Nimrod Zalk, former Deputy Director-General of the Department of Trade, Industry and Competition, we show that despite high net markup levels, non-financial South African companies have not, in general, reinvested a significant proportion of their profits for expansion.

As Zalk argues: “Internally generated revenues and reinvested profits are the primary source of funding for firm-level investment … A virtuous ‘profit-investment’ nexus – where firms make profitable investments, funded through retained earnings, which underpin further investment – is thus especially important for industrial growth in these regions.”

Because this only happened during the brief 2002-2010 period, Zalk argues we have had “structural change” without “structural transformation”.

The data support Zalk’s view. Average net markup (ie operating surplus as a percentage of the sum of intermediate inputs, wages and capital depreciation) for the period 1994-2019 ranged from 30%-40% (for sectors such as communications, mining and quarrying, wholesale and retail, transport and storage, finance and insurance, business services, agriculture/forestry/fishing), 10%-20% (for construction, electricity and gas, community/social/personal, catering/accommodation), and below 10% (diversified manufacturing, heavy industry).

The compound annual growth of investments in GFCF ranged from:

• 11.5%-6% (in order from the highest – communications, construction, transport and storage, electricity and gas),
• 5.9%-4.7% (community/social/personal, wholesale and retail, mining and quarrying), and
• 2.8%-0.6% (finance and insurance, heavy industry, business services, catering and accommodation, diversified manufacturing, agriculture).

Agriculture is all about extraction – it has a high net markup (33%) and the lowest level of reinvestment in GFCF (0.6%).

Communications is more balanced: it has the highest net markup (42.6%) and the highest level of reinvestment in GFCF (11.5%).

Heavy industry and diversified manufacturing – the big job creators – both have low net markups (8% & 7%) and low reinvestment levels (2.6% & 1.9%).

Drawing on research by University of Johannesburg researchers, we show that the top 50 listed companies were investing between R150-billion to R200-billion per annum in GFCF during the period 2011-2016. This equates to an annual growth of 10% per annum at 2015 prices, which is what is required for replacement, not expansion. This is way below what is required to achieve Zalk’s “virtuous profit-investment nexus”. There is no evidence that this has changed in recent years.

Instead of reinvesting in GFCF, non-financial corporations substantially increased their holdings of financial assets from R1.6-trillion in 2010 to R4.7-trillion in 2021. Furthermore, their holdings of domestic and foreign equities rose from 23% to 46% of GDP over the same period. The externalisation of South African capital has been enabled by dual listings on the JSE, ie listing on other exchanges as well as the JSE.

This, in turn, has resulted in the growth of companies that have no South African operations, or alternatively only a small proportion of their investments are domestic operations. These companies, therefore, source capital locally for investing elsewhere. If the dual-listed companies and those companies with no operations in South Africa are excluded from the top 50 companies listed on the JSE, the remainder accounts for only 20% of the JSE’s total market capitalisation.

By 2022, there were 2.45 million small businesses in South Africa. Of this, 1.75 million were small informal businesses, most of which were owned and run by women, with a limited number of employees. In addition, there were 700,000 small formal businesses, most of which were registered for VAT and had tax numbers. Employing anything between 10 and 300 people, these mainly family-owned businesses with assets equal to 20% of the assets of large corporations, employed more people and accounted for more value add than these large corporations.

However, every survey of them reveals they lack access to credit to expand their businesses. In short, while there is surplus cash, South Africa’s financial system lacks the mechanisms to direct capital into the small formal business sector.

In short, the NPC finance report brings into focus the architecture of South Africa’s financial ecosystem. A vast array of balance sheet configurations has evolved in ways that have constrained investment in GFCF (in particular since 2010) and enabled the upward flow of wealth to the benefit of an increasingly wealthy elite.

Economic growth is unlikely if both persist. Unfortunately, prevailing economic orthodoxy obscures these flows and, by so doing, economic prescriptions are offered that are detached from these realities. To address this, the report recommends 14 balance sheet reconfigurations that could result in a redirection of capital flows.

The National Planning Commission recommendations

In summary, the fourteen recommended balance sheet recommendations include the following:

1. Let the SARB become the prudential authority for the DFIs, thus improving their access to South Africa’s deep capital markets.
2. Enable pension funds to increase their investments in infrastructure.
3. Create new guarantee mechanisms for unlocking domestic capital, similar to the Credit Guarantee Vehicle referred to in the MTBPS.
4. Strengthen the DBSA’s Infrastructure Fund so that it can blend funds from the fiscus with private funds to increase investments in public infrastructure.
5. Strengthen and expand the SOE balance sheets so that they can return to the role they once played as the key coordinators of investments in public infrastructures.
6. Change the risk-reward profile of the bank sector in ways that result in much higher levels of funding for small businesses, poorer households and a wide range of infrastructure projects (not just large ones).
7. Follow the German example by creating a new regulatory and tax regime for incentivizing the reinvestment of profits by non-financial corporations.
8. Strengthen existing and create new mechanisms for enabling small business to access much larger quantities of finance.
9. Harness the skills and agility of the shadow banks by creating incentives that result in the redirection of finance into the real economy.
10. Exploit the potential of blended finance solutions via public-private partnerships, but under the leadership of government agencies in order to avoid the mistaken assumption that the private sector on its own can do what is needed.
11. Build a stable and expanding middle through a range of interventions that reverse the declining wealth of the bottom 50%, including supporting small businesses and favouring South African rather than international companies when it comes to procuring large-scale infrastructures.
12. Given that 42% of households are headed by women, reduce gender-based inequalities via a range of gender-sensitive interventions that enable improved access to finance by women-led businesses.
13. Reinforce the SARB’s role in climate proofing the financial system, including initiatives that are already under way and need to be strengthened.
14. Realign the mandate of the GEPF so that it plays a lead role in achieving the NDP target of increasing the levels of investment in GFCF to 30%. DM

Read Part 1 here.