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This story first appeared in Finweek.



SA’s persistently weak growth and the stench of failure in its state-owned enterprises (SOEs) has dragged the country to the brink of junk status.

Last week Moody’s issued a credit note warning that a credit downgrade was on the cards unless government embraced reforms needed to put the country back on the growth path, and placed five SOEs on downgrade watch. Moody’s warning merely restates facts already on the ground: bond investors are increasingly steering clear of SOEs such as SA National Roads Agency (Sanral), Eskom and Transnet. In other words, a downgrade is already priced into SOE credit instruments.

In June, Fitch and S&P held their SA credit ratings at BBB-, just a notch above junk. Bond yields started to strengthen in the belief that SA had perhaps dodged a downgrade to junk. But with the relentless news drip-feed of dodgy tenders at several SOEs, including Eskom, South African Airways (SAA) and Passenger Rail Agency of SA (Prasa), and the Hawks’ campaign against Gordhan over alleged irregularities while he was head of SA Revenue Services, the whiff of downgrade would not go away.

Also in June, Moody’s said it was concerned over tensions between finance minister Pravin Gordhan and other elements in government, which “raised questions about the commitment of the government to sustained fiscal consolidation and prudent governance of state-owned enterprises.”

The whiff of downgrade would not go away. Moody’s cut its SA growth forecast for 2016 from 0,5% to 0.2%, projecting a tepid recovery to 1.1% in 2017. It placed five SOEs on review for downgrade – Eskom, Sanral, the Land Bank, Industrial Development Corporation (IDC) and Development Bank of SA (DBSA). Adding a glimmer of hope, Moody’s added that reform of the labour market and SOEs might change this outlook.

President Jacob Zuma appeared on the same platform as Gordhan, as if to reassure investors that all was well between the two. Zuma also announced the formation of a high-level council charged with overseeing the troubled SOEs and restoring them to health.

“Far from being positive for the nation, some see this as Zuma’s attempt to exercise greater control over these SOEs than Treasury might normally have over the heads of these lucrative entities that hold large sway in the direction and appointment of many capital expenditure projects and tenders,” says Wayne Duvenage, chairman at Organisation Undoing Tax Abuse (Outa).

Last month Futuregrowth Asset Management, a subsidiary of Old Mutual, announced it would halt any further investment in some of the larger SOEs “without having deeper sight of, and comfort around, their governance, decision-making and independence.”

This was quickly followed by a similar decision by Denmark’s Jyske Bank, which said it would cease lending to Eskom, citing concerns over governance. The trickle became a flood: Aluwani Capital Partners and Abax Investmensts, based in Cape Town, were both reported to have soft-peddled on investing in SOEs due to perceived political and economic risks.  SA-based fund managers such as Aeon Investment Management and Sasfin Asset Management came out in support of Futuregrowth. Other investors have been less vocal, but are also understood to have made similar calls.

Following the Moody’s announcement, Anglogold Ashanti chairman Sipho Pityana couldn’t stomach it anymore and called for President Jacob Zuma to stand down before it is too late. “Zuma made commitments to the international investor community earlier this year to stabilise SOEs and to project policy certainty. He has failed to do this, and in fact maintains that there is nothing wrong with our SOEs or with policy direction.

“We can now see the consequences. Because of Zuma, SA is now one step closer to a sovereign downgrade, which will have disastrous implications; already, Eskom faces the prospect of having to pay higher interest on new debt, which means further electricity price increases,” said Pityana in a statement.

What has alarmed bond investors is the ongoing tussle between finance minister Pravin Gordhan and the Hawks, who want to question him over alleged irregularities while he has head of SA Revenue Services. Gordhan has so far refused to cooperate with the Hawks, a move broadly supported by business and opposition leaders, who see this as an attempt by elements within the ANC to unseat a highly respected finance minister who is investigating irregularities at SAA, Eskom and arms manufacturer, Denel, all of which are mired in suspicions of corruption and governance lapses.

Gordhan seems to be prevailing. He replaced the board at SAA earlier this month as part of a wide-ranging plan to restore the company to health and ensure corporate governance guidelines are followed. He made this a precondition for the release of R5bn in guarantees that allows SAA to continue operating as a going concern. This also allowed it to finalise its long-overdue financial statements.

Moody’s analysis of the SA economy and the state of its SOEs merely gave voice to facts already on the ground. Sanral was forced to cancel several bond auctions in the last year due to lack of interest. There were 11 bidders in 2014 when investors still held out hope that Sanral would persuade delinquent Gauteng motorists to support its e-tolls plan. But by May this year the number of bidders for its bonds had fallen to two.

The ratings agency warned that SA faced a downgrade unless there was a recovery in growth, and wants to see fundamental structural reforms.

In a statement explaining its decision to put Sanral on downgrade watch, Moody’s says public resistance to open road tolling remains strong, as measured by monthly average decline in e-tolls collections from the R86m in the 2015 financial year to R76m in 2016. This is well below revenues needed to entice investors to support its bond issues. According to research by the Organisation Undoing Tax Abuse (Outa), nine out of 10 Gauteng motorists do not pay e-tolls. The only way out of this mess for Sanral is to bring legal action against defaulters, but even this is unlikely to have the desired effect.

“While Sanral issued summonses to defaulting road users some are preparing to defend their cases in court further delaying debt collection. Therefore Moody’s expects Sanral’s cash flow pressures to persist in 2017,” says the ratings agency.

Sanral has served more than 6,000 summonses to motorists for non-payment of e-tolls, but this legal battle may take years to resolve, which means its e-tolls revenue is unlikely to improve any time soon.

For Futuregrowth, the harbinger of bad news for SOEs, retribution was swift and severe. It later issued a statement regretting the fact that it had not engaged with SOEs prior to making its announcement, but its decision not to invest in these companies would not change. Yields on SOE bonds spiked following the Futuregrowth announcement, effectively raising their costs of borrowing.

Investors are concerned that Eskom’s debt will overwhelm its liquidity. In March the North Gauteng High Court ordered the National Energy Regulator of South Africa (Nersa), which approves electricity tariff adjustments, to review its latest tariff increase. “Notwithstanding an ongoing appeal process, future tariffs might be affected, which could in turn further exacerbate the funding needs of Eskom against a backdrop of rising costs, notably due to the ongoing growth in power purchase agreements with independent power producers, and a very significant capex programme to upgrade and expand the country’s electricity infrastructure,” said Moody’s last week.

Eskom is able to raise debt on the back of a R350bn Guarantee Framework Agreement with government, but this guarantee may be stretched to capacity as tariff increases become more difficult to implement and the power producer’s capex programme moves into its next phase. Governance is another concern to Moody’s, particularly the ongoing investigation by National Treasury into coal contracts, notably to Tegeta Exploration, majority owned by the Gupta family and President Zuma’s son, Duduzane. Eskom awarded the contract in 2015 and then extended it this year, awarding Tegeta an up-front payment of R586m. amaBhungane reported earlier this month that National Treasury had blocked a further R855m extension of this contract, and has asked Eskom for details on its coal contracts. Had the latest coal contract been extended, Tegeta would hgave received R1.7bn without open tender.

Duvenage says many SOEs have changed accounting policies to boost asset values. “While this in itself is not unfounded by International Financial Reporting Standards (IFRS) standards, it could be frowned upon when applied by SOEs that should not be treating their citizens’ assets at trading tools with which to improve balance sheet ratios. This allows them to further borrow at relatively high interest rates, and spend on capital projects that often run over budget by as much as 300%, and more. Many of these projects which are shrouded in tender irregularities and corrupt activities.”


What the CEOs of state-owned companies earn

The hunt is on for new CEOs at Sanral, Prasa and SAA. The pay is pretty good (see below) but if history is any guide, taking on these posts could be a career-ending move for the new incumbents, who will have to sort through unimaginable financial and governance messes.

Sanral’s 2015 annual report says CEO Nazir Alli earned R4,032m in pay and benefits that year. Alli has been attempting to retire from the company, but has been re-appointed as the hunt for a new CEO continues. We are not surprised, given the e-tolls fiasco the new incumbent will have to sort out. Directors and management remuneration came to R197m in 2015.

Eskom’s chief executive Brian Molefe earned a total package of R9.5m, about R800,000 a month. This does not count shares awarded but not yet vested to Molefe, amounting to several millions of rands more. Directors and executives were paid a total of R75m over the last year, up from R51m the previous year.

Dudu Myeni is listed as receiving directors’ fees of R828,000 in SAA’s 2014 annual report, though this is almost certainly a fraction of her total package. The 2015 annual report is about to be tabled. Former CEO Monwabisi Kalawe is listed as receiving a salary of R3,8m in 2014. Kalawe was charged in May with using forged documents in an attempt to force Dudu Myeni to resign. Kalawe is accused of procuring false overseas bank statements, allegedly to smear Myeni. These were publicised after being handed over to forensic investigator, Paul O’Sullivan. O’Sullivan withdrew the statements and apologised once the forgery became known.

Passenger Rail Agency of SA’s (Prasa) fired CEO, Lucky Montana, was listed in the annual report for 2015 as earning a salary of R5.6m with a performance bonus of close to R2m. His replacement as acting CEO, Nathi Khena, earned R2.6m according to the 2015 annual report. The hunt is on for a permanent CEO, with transport minister Dipuo Peters reportedly at war with Prasa chairman Popo Molefe over the appointment of a suitable successor. It’s a tough job with a high casualty rate. Montana was mired in controversy, having presided over Prasa’s massive fleet renewal programme. According to news reports, 13 locomotives ordered from a Spanish firm at a cost of R600m are the wrong size for our rail infrastructures, and the company failed to adequately hedge its foreign currency exposure, which means it will purchase fewer trains than planned.

Industrial Development Corporation’s CEO Geoffrey Qhena earned a total package of R7,9m according to the IDC’s 2014 annual report. This was made up of emoluments of R3,94m, a performance bonus of R2,9m and retirement and other benefits of R1m.

Development Bank of Southern Africa’s CEO Patrick Dlamini earned a total package of R9.5m in 2015, up from R7.2m 2014. This was made up of a salary of R4.4m, a bonus of R4.45m and other benefits of about R650,000.

According to Land Bank’s annual report for 2015/6, the top earner in the company was chief financial officer Lebogang Serithi with a total package of R4m. Former CEO Phakamani Hadebe earned a performance bonus of R1.8m, while his replacement Tshokolo Petrus Nchocho is listed as earning just R653,000 for the year, though he was only appointed in February 2015.

Denel’s CEO Riaz Saloojee reportedly earned R4.7m for the 2016 financial year and R3.9m the previous year. Saloojee was fired as CEO last year and re-hired fired and re-hired in April this year. According to the Sunday Times, he was bulleted for renegotiating a R455m Nedbank loan for five years to six months, causing a cash crunch at the arms producer. Saloojee also appeared to be at odds with the company’s decision to establish Denel Asia through the acquisition of a company linked to the Gupta family, VR Laser Asia, which National Treasury says was illegal. Denel’s board of directors dispute this, saying it was in conformity with the Public Finance Management Act.


What a downgrade means for SA

Pieter Hugo, head of retail at Prudential Investment Managers, says in the event of a ratings downgrade, investors would demand higher interest rates on SA government bonds to compensate them for the higher risk involved, so the SA government’s cost of borrowing would rise by way of an increasing yield on government bonds. Current bond investors would experience a fall in capital values (to the extent that this hasn’t been priced into the values already).

“Over the medium term, higher borrowing costs would force the government either to raise more revenue via higher taxes or to cut spending in order to avoid widening the budget deficit. Consequently, ordinary South Africans could end up with somewhat lower disposable income, giving them less to save and invest – also also spend, which would then again have a knock-on impact on reducing the growth rate.

“SA government bonds would also be automatically excluded from certain global government bond indices. Such indices have become popular benchmarks for index tracking funds, helping to grow the global demand for SA government bonds. So index-tracking investors and any other investors precluded from investing in non-investment grade assets (like many pension funds) would no longer invest in our bonds, adding further pressure on yields to rise. There would be less foreign (and local) demand for our bonds and money would leave South Africa, causing further rand weakness and ultimately impacting inflation and investors’ pockets,” says Hugo.

The cost of borrowing for state-owned enterprises and private companies would also increase, which would likely dent corporate balance sheets, particularly those of companies that are highly geared or rely on borrowing, like property companies. This would in turn impact negatively on profits and investor dividends, trimming equity returns.

Also in the bond market, fewer corporate bond issues are likely in what is already a much smaller market following the collapse of African Bank. This also would mean fewer higher-yielding investment options for asset managers and reduced liquidity.