South African fixed investment slow for now, faster later
By Cees Bruggemans, Chief Economist of FNB.
Participating in the FNB Fixed Investment Round Table for 4Q2011 were:
Cees Bruggemans: An interesting week lies behind us, with 3Q GDP growth in the US coming in at 2.5%, China still offering promising growth data and Europe coming through with an insurance-leveraged €1 trillion lifeboat, a ‘voluntary’ 50% haircut for private holders of Greek debt, €106bn of extra capital demanded from EU banks to reach 9% tier 1 capital by mid-2012, and Italy requested to undertake more serious reforms shortly. Also, reported corporate earnings continue performing well globally.
This news has been well received by global markets. Even though the EU actions are unlikely to offer the final solution to all our ills, this news flow is another serious down payment on restoring lost confidence to global markets.
Though growth in the US next year will experience strong headwinds from fiscal austerity and weak housing market, a double-dip is not expected. Europe may experience a mild recession in coming quarters, austerity and credit-led, but its GDP should be lifting by 2H2012. Global growth should continue moderately.
Hugo Pienaar: Given slow global growth and our export exposure to the US (8% share), Japan (8%), China (12%), Africa (15%) and Europe (23%), and domestic adjustments underway (considering the lower levels of business and consumer confidence as reported by BER opinion surveys), we expect only modest South African GDP growth this year and next averaging about 3%.
Fixed investment shows a nice correlation with business confidence. We expect a mild fixed investment recovery of just over 2% this year and just over 3% next year, with business reportedly sitting on a huge cash pile of some R470bn. If only more of that money could be put to work!
Cees Bruggemans: What drives this fixed investment picture from the demand side, thinking public infrastructure and private capacity needs?
Pierre Blaauw: In the public sector we have seen serious attempts at public-private-partnerships (PPP) and user charging, with the latter having encountered resistance.
Eskom is being allowed to improve its cash flow through high tariff increases in order to fund its infrastructure maintenance and expansion, but large electricity users keep objecting.
The recent experience of Sanral with toll roads is significant for its impact on private sector views as to how to unlock investment in the country.
In 2004/2005 there was an instance of a toll road PPP idea that was at first sold to the government, only to be undone. Today there are new attempts at toll roads which seem to be failing, with question-marks about this funding mechanism. It is causing construction industry doubts about sufficient government commitment to make this work.
There appear to be doubts about using the mechanism of PPPs, which is creating doubt about the next phase of highway expansion. We appear to be at a fork in the road as to what to do next, in building roads, but it really goes wider than that.
South Africa is consuming its existing infrastructure on a daily basis through wear and tear, and it massively expensive to maintain, replace and expand.
If government doesn’t have the funds, and private funding is cut off, it isn’t obvious that we will be expanding our infrastructure at a pace adequate to support our expected growth. Compromises will be needed.
Elsie Snyman: In fact the government last week cancelled the much-delayed PPP arrangements for four new prisons, which were initiated in 2003 and never consummated, intended to add 3000 bed spaces to Paarl, East London, Nigel and Klerksdorp correctional centres. Apparently, the cabinet has decided on a review of all PPP models across government.
Erwin Rode: Know the joke about Nigeria? They have the cheapest electricity in the world, except for the fact that they actually don’t have any electricity!
We may have to swallow our objections and pay up. If we don’t pay, we may not have much infrastructure left before long.
Johan Snyman: A client of mine experienced 28 power-outs at one of their factories during the year, twelve of which occurred in June/July. That implies a lot of damage (to equipment) and losses (output, sales, also economies of scale foregone giving higher unit costs).
Hugo Pienaar: The Finance Minister in his medium-term budget this week emphasized that the cost of not building the required infrastructure is much higher than doing it.
Pierre Blaauw: Whatever compromises are reached, it needs to restore investor confidence about returns on investment for the needed private capital to be forthcoming.
Hugo Pienaar: One would prefer government borrowing to pay for more infrastructure rather than funding higher public sector wages bills. Markets won’t penalise us unduly if there were to be more borrowing this way to fund more infrastructure if other government expenditures can be contained. It is unthinkable that needed new infrastructure were not to be forthcoming.
Pierre Blaauw: This debate was always inevitable, considering our enormous infrastructure backlogs and future needs.
Hugo Pienaar: We tend to get carried away by nice words in budgets, such as R802bn for infrastructure spending these next three years. But as percentage of GDP it actually comes down from 7.8% in 2011 to 6.8% in 2014/15. It would be preferable to keep this ratio high and stable. Instead we are seeing some slippage here.
Cees Bruggemans: Mining should potentially keep benefiting from the global commodity boom. Though there may be some slippage here, too, on account of somewhat more modest global growth, South Africa hasn’t had its fair share yet from this boom compared to the stupendous increases in mining output enjoyed by the likes of Brazil, Chile, Canada and Aussie. Our problem in mining isn’t insufficient demand, which likely will remain vigorous in coming years, Asian-led.
Erwin Rode: What are the chances of the Chinese property market seriously heading south?
Cees Bruggemans: Many people keep fearing this, and China has of course tightened policy, and caused prices to come off, even steeply in certain cities, but it seems a well controlled property easing. I don’t expect it to go too far, though many people worldwide keep fearing just that.
Christelle Grobler: Manufacturing’s global prospect worsened in recent months, and locally things were distorted by labour action, though September’s Kagiso Purchasing Managers Index went up again (to 50.7).
Even so, the BER has lowered its consumption growth estimate for 2012 to 3.3%. It should see manufacturing demand slow, too.
Erwin Rode: Why this consumer slowing?
Christelle Grobler: Mainly because real income growth is expected to be slower.
Craig Lemboe: This is mainly because inflation is still going up while nominal income growth won’t keep pace.
Cees Bruggemans: If inflation after next year doesn’t come down much, sticking in 5.5% territory, real income growth of households also shouldn’t change much. This does suggest relatively slow consumption growth and weak demand for manufactured goods also post-2012.
If post-2012 we want to see higher GDP growth than the present 3%, it will require faster fixed investment (and export) growth, with those two becoming the main drivers later in the decade, as compared to consumption which will be in a more supportive role.
Erwin Rode: Aren’t we ignoring confidence here?
Christelle Grobler: At this stage low confidence is really impacting on businesses, keeping fixed investment gains limited.
Cees Bruggemans: By all means, but should we stick with this rather negative view for later years? I suspect we have a long if slow business expansion on our hands, taking a long time to get back to full resource utilisation and any chance of overheating.
Business confidence may be down of late, but the underlying trend is still cyclically rising. That could take business confidence to still higher cyclical levels later in the decade, and their fixed investment response with it.
Hugo Pienaar: Global prospects may improve later in the decade but our domestic issues may remain a more negative factor influencing private fixed investment.
Christelle Grobler: Later this decade there could be more confidence and more fixed investment lift than now the case, despite the many imponderables.
Cees Bruggemans: How do we see building demand in 2012, and beyond to 2015?
Erwin Rode: if there is interest rate cutting shortly, it would provide some relief, accelerating property prices somewhat on a nine month view. This could ease the affordability issue and provide a slight boost to residential building activity.
But in the main I stay with my broad framework of short-term housing oversupply, falling real prices and little investment demand still for a number of years.
Cees Bruggemans: Any new takeoff in house building activity will probably only really commence in the second half of the decade once oversupply has been digested, debt burdens adjusted relative to income, and the gradually increase in urban population in formal employment makes itself felt anew.
The same can be observed in the US. Currently, new housing starts there are less than half household formation as they eat their way through the overhang of existing supply. But once that’s behind them, there awaits a doubling up in activity levels. Something like that also applies to us, probably later in the decade.
Elsie Snyman: The only builders to survive that long are the ones able to adapt to the changed environment, the obvious route being affordable housing.
Craig Lemboe: The building developers we are currently sitting with are already survivors in these prolonged tough times. Many of these have already shifted and are now working more with public corporations and a mix of other activities. The residential building industry in particular is stripped down to its bare essentials now, geared for survival mode.
Cees Bruggemans: How certain is it that the affordable market comes on stream?
Erwin Rode: It is not for the faint-hearted, a specialised niche requiring highly professional marketing.
Elsie Snyman: South Africa will be forced to consider using alternative building technologies, an example being the Moladi injection mould system. It is some 30%-50% cheaper to build for the affordable market.
Erwin Rode: It is selling internationally, also in Africa, but not so far our own government.
Elsie Snyman: We are still very much bricks and mortar.
Cees Bruggemans: Is the non-residential building sector one of the few experiencing a ‘normal’ cycle?
Elsie Snyman: Demand for non-residential space at present is like a checkers board, with the same people moving around, vacating here and moving there, but no new clients. Vacancy rates are high and are remaining high.
Johan Snyman: Currently, non-residential buildings plans passed for offices, industrial, warehousing and retail space is moving sideways. I see alteration/addition activity as low and still declining. Nevertheless, July/August 2011 plans approved data were better than in May/June 2011.
Elsie Snyman: I see a pick-up in non-residential renovations.
Erwin Rode: Sandton office vacancies stand at 10% today and this happens to be the average of the past 20-years, so this trough has been mild.
Cees Bruggemans: So they are having a fairly normal cycle?
Erwin Rode: Offices and industrial are normal.
Johan snyman: A normal downswing.
Elsie Snyman/Craig Lemboe: Sharper than normal downswing.
Cees Bruggemans: But they are in a bottom phase?
Johan and Elsie Snyman: no, only in 2012 or later.
Cees Bruggemans: when does the non-residential cycle start to pick up?
Johan Snyman: 2014
Elsie Snyman: 2015 (for the private sector, still the biggest player, but the public sector is embarking on huge investments in schools and hospitals causing the actual turn, cushioning the sector).
Johan Snyman: Residential building activity has an abnormal cycle at present in terms of depressed credit access and high debt loads. There will be a bounce back eventually, probably even strongly when it comes later in the decade as you suggested earlier.
Erwin Rode: There is one abnormal subsector in non-residential building activity, namely shopping centres. Currently there is huge oversupply as a consequence of the consumer boom of 2006-2008.
Craig Lemboe: Residential building activity at present keeps underperforming non-residential building activity, according to BER building confidence opinion surveys. This isn’t typical (and should normalise eventually, probably only in the next building cycle upswing).
Regarding additions/alterations, there has been a strong pickup (with appetite to renovate rather than build new). But cement sales going into such activity have of late slowed tremendously. Could it be that those who could afford alterations/additions have done so, with the market running out of new clients?
Cees Bruggemans: Could be that affordability remains an issue in these trying times, but the past few months have also been an exceptionally fearful time, especially in Europe and overseas generally. I wonder to what extent this has made South Africans intending renovation to hesitate, and delay until things are clearer? Next year should provide an interesting test of these propositions.
Johan Snyman: Non-residential building activity may be moving sideways, but can still go down further when considering historic cyclical relationships and how these are currently faring.
In the case of office space, demand is derived (narrowly correlated with) consumer spending. With the latter seen as moderately slowing, there could still be falloff in office space demand on this score.
The same reasoning applies to industrial and warehousing space (with manufacturing prospects still uncertain).
Retail space keeps suffering from oversupply due to the many institutional developers having re-entered this sector in recent years.
South Africa is increasingly becoming a service economy. Office space should therefore be doing better, but it isn’t. There is still a lot of financial strain, making things difficult for developers. And there are technological and lifestyle changes. Also, corporate cost cutting favours alternative working arrangements.
Besides, developers only really start new projects when existing vacancies are seen to be declining, with real rentals rising, so as to contain their risks.
Erwin Rode: If there were a ‘normal’ economic upturn, there should follow a normal non-residential building upturn within 3-4 years. Given that the present economic upswing dates from 3Q2009 that makes early 2013 the earliest start date for a non-residential upturn.
If our economic upturn remains subpar as seen to date, the non-residential building upswing may be delayed a little to 2014. Another economic dip shortly would of course delay things even more (but this isn’t expected).
Elsie Snyman: And that upswing will be possible due to reputable/responsible developers having survived the present tough times.
Cees Bruggemans: Are there any ‘issues’ that could hold back developers, as we heard about in foregoing years?
Elsie Snyman: There are issues such as municipal electricity connectivity, but the more efficient, adaptable, flexible developers will find a way around these problems. It shouldn’t hold things back unduly.
Erwin Rode: There is no institutional constraint to hold back our building construction sector.
Elsie Snyman: Don’t underestimate the current oversupply.
Cees Bruggemans: How about manufacturing? What are the fixed investment prospects?
Hugo Pienaar: A sustained more competitive Rand would shield our industrial activity from the impact of any EU growth slowing. Also, there is the possibility of import substitution, perhaps further enhanced by the intentions of the government’s new industrial policy support.
Christelle Grobler: I expect a normal cycle, with the main drivers of manufacturing fixed investment (especially in machinery and equipment) being rising capacity utilisation, business confidence (or the lack of it, given present uncertainty).
Hugo Pienaar: The Asians are coming, especially the Chinese and Indians (in the footsteps of earlier arrivals such as the Japanese, Koreans and Taiwanese). The motor industry is likely to be one entry point.
Cees Bruggemans: Two major manufacturing sub-sectors are underperforming at present, namely steel and oil refining. A steel mill is out of action, causing local shortages. The existing oil refineries are old and are consequently out of operation more frequently for repair and maintenance, among other things contributing to gas and bitumen shortages while new petrol/diesel quality standards loom. There remains interest in building a major new oil refinery at Coega. That would be a major construction boost.
Christelle Grobler: Construction surveys suggest mining fixed investment is mainly aimed at maintaining existing capacities rather than expanding capacity. The state of the world economy will have a major bearing on such strategic decisions.
Cees Bruggemans: As will the risk of state intervention (known in its extreme sense as nationalisation) and the constraints offered by limited infrastructure (electricity, railway lines). But global commodity demand is good and the world economy is expected to keep running, with especially high Asian commodity demand.
Christelle Grobler: Cement performance recently has been interesting. The 1H2011 sales volumes were essentially flat (-2.8% in 1Q and +2.8% in 2Q), but the 3Q2011 was up more than 5% y/y. Producer price inflation for retail cement was low in 1H2011, but shot up to around 10% on average during the 3Q2011. This suggests people have started buying more cement again.
Elsie Snyman: Cement has now had five months of positive growth.
Johan Snyman: Cement is through its trough and prospects are improving of a modest cyclical upswing underway.
Christelle Grobler: Still, cement is off a low base, so far only back to 1Q2005 levels, still very low.
Cees Bruggemans: But with considerable upward potential.
Elsie Snyman: Civil engineering and building renovation activities are helping cement a bit at present. The sub-sector has reached its lower turning point and now looking at renewed growth, but slow for now.
Christelle Grobler: So we don’t expect the 3Q2011 speed to be maintaind, slowing in 4Q2011.
Cees Bruggemans: Unless there is something we don’t understand or haven’t picked up about the subsectors using cement. The 4Q2011 will be a nice test case. Watch those monthly data (cement sales per trading day).
Elsie Snyman: We can ‘hope’ for better performance from residential building activity, but it isn’t there really. Cement producers are only at 64% capacity utilisation at present (producing 11mt on a capacity of 15mt). The last peak year was 2007 with sales of 17mt, of which 2mt imported).
Cees Bruggemans: This shows the upside potential this decade, with the country willing.
In conclusion, given the huge uncertainties still in the global economy the next 6-12 months we may expect people, including South Africans, to remain unsure about the sustainability of demand.
This may keep private fixed investment suppressed, and largely explains GDP growth of only about 3% (also as higher inflation is expected to moderate real income growth and household consumer spending).
The medium-term objective post-2012/2013 is 4% GDP growth at least, given the state of the cycle so far, with the present underperformance potentially making for a long upswing lasting most of this decade at a mostly modest pace before the economy reached its limits, and policy and/or external events pull us back anew.
This in turn suggests fixed investment growth in the region of 6%-7% in the second, more mature, part of this potentially long upswing.
Also, once we get to 2015, we may be getting passed the recent severe infrastructure bottlenecks in electricity, rail transport and possibly even roads. That could lift the growth potential, provided the public sector keeps delivering.
In the interim, we may find in certain instances that high tariff increases (electricity) will serve to suppress demand growth. On the other hand, there will much long-term infrastructure building going on lifting constraints eventually, if in certain instances only minimally.
Around 2013 we may encounter the next round of infrastructure project ‘bunching’ (as last seen so very graphically in 2005-2007), which suggests strong construction and fixed investment gains generally in the second half of this decade.
Still, there are institutional blockages to take into account (how will we pay for it, will the technical manpower be there, also in the public sector?).
Interruptions of any kind may push out the time table, as we are now seeing again with Medupi power station, with the first generator set now 10 months delayed to 1H2013. This will remain something to be cautious about.
Source: Cees Bruggemans, November 1, 2011.