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When the South African government announced last month that HSBC Investment Bank was to be its adviser on privatization, it took the wind out of the sails of the major domestic banks. There was, though, still a local connection: HSBC subsidiary James Capel recently bought South African stockbroker Simpson McKie, now Simpson McKie James Capel.
The snatching of the one-year advisory deal does not mean that South African banks are being altogether sidelined as foreign competition builds up. But it does show that local bankers no longer have it all their own way, which had been the case since such foreign banks as Barclays and Standard Chartered withdrew at the height of the sanctions and sold out extensive local operations.
Since the April 1994 elections, 55 foreign banks have set up operations in South Africa, while others enter and leave on ad hoc tasks in what the local bankers call "parachute operations". None of the foreigners has so far attempted to get into the retail market. Local bankers believe only Citibank is capable of doing so, but doubt that it will at this stage.
In general foreign competitors can't expect an easy ride. Since the lifting of sanctions and a consequent explosion in business local banks have upgraded and restructured their merchant bank activities particularly the broad-based service banks, such as Standard Bank and First National Bank (formerly Barclays) which restructured their merchant and investment banking arms last year. Standard Merchant Bank was expanded into Standard Corporate & Merchant Bank, which is responsible for all wholesale business; First National Bank restructured itself into three divisions: retail; corporate and institutional; and finance, risk and group communications.
Two merchant banks that retained their existing merchant and investment bank profiles were Rand Merchant Bank and Investec. Both have recorded sound growth on the back of an expanding market: in 1995 Investec grew by 44% and Rand Merchant Bank by 36%. Most local banks are actively joining in the global fray, but some still tend to be inwardly focused on more traditional areas such as mergers and acquisitions, structured finance, and money market and foreign exchange dealing.
Generally, South African banks are comparable with the best but are somewhat lacking in international experience, including such areas as privatization. Local bankers claim they suffer from some local corporates incorrectly believing they do not have the expertise to raise money on international capital markets.
All the major banks have had footholds offshore for many years and have recently been expanding these operations rapidly, says Div Geeringh, senior general manager of the Standard Bank Group of South Africa, which put together a consortium of local black-owned business and international advisers to bid for the privatization advisory job. He admits that local banks could be slightly behind in research, but says the lag is being rapidly overcome. Local banks also argue that they are prepared to take risks, while foreign banks are looking mainly for fee-paying business. Geeringh believes that both local and foreign businesses would prefer to deal through a South African bank for local deals because of such factors as extensive local networks. He adds that if the perception persists that local banks cannot handle international transactions or raise capital offshore, then such experience will never be built up.
Stephen Koseff, managing director of aggressive and comparatively young banking group Investec, is forthright: "South African banks don't have to run and hide." Koseff says South African banks are not only keen and able to take on foreign competitors on their home turf but are also prepared to face up to them on foreign soil in some market niches. His bank has a foothold in the Netherlands and in London, and has acquired a banking group in Israel Israel General Bank from Baron Edmund de Rothschild, subject to the approval of bank regulatory authorities..
All major South African banks have set up offices offshore. First National Bank owns London-based Henry Ansbacher, which last year acquired the Jersey-based offshore private banking operations of Westpac Banking Corp of Australia. And Standard Bank has extended its London-based subsidiary, Standard London, to Hong Kong and New York. South Africa's largest bank, Amalgamated Banks of South Africa, which trades in the retail market under four brand names, established Absa Securities in New York and bought Bankhaus Wölbern in Hamburg.
International competence
Koseff says that South African banks can raise money internationally, with most having developed the capacity to act for South African corporates. "We did a convertible bond issue of $100 million recently, advised by Citibank," he says. "They gave advice but the selling was done by us. I don't believe that it is difficult to develop international networks." Foreign operations will expand as foreign exchange controls on South African residents are further eased.
Both Geeringh and Koseff say that although competition has increased, their institutions are not feeling any heat, because with the lifting of sanctions the market has grown dramatically. South African institutions have also found that their fees are considerably lower than foreign institutions, enabling them to increase them while still offering keener pricing.
Koseff says foreign banks claim to have made about R300 million ($88 million) in profits last year from operations in South Africa, but he argues that most of this came from cherry-picking rather than offering broad services. So far, foreign banks operate mainly in corporate finance, treasury operations and securities.
Mark Barnes, deputy managing director of Standard Corporate & Merchant Bank, says that not only do the larger local banks have the networks, but they also have strong balance sheets and a capacity for coping with credit risk and country risk that is not shared by foreign banks.
Standard Bank's international competitiveness was reflected in its being the primary market-maker in the rand. "We have always been able to make a price even in these volatile times," says Barnes. This, he believes, gives his bank a definite edge over foreign competition. Foreign banks, however, may well have a lower cost in raising trade finance denominated in foreign currencies.
More foreign banks means increased competition for staff. "There is a limited and expensive skills base," says Barnes. "The foreign banks have been able to attract local staff with one-off hikes in remuneration packages and the lure of foreign-based appointments. Essentially, they are attempting to buy local contact networks."
But access to networks is not enough. The foreign banks have been limited in the amount and type of business they can take on without back-office settlement and credit-assessment capabilities.
Despite the initial advisory role on privatization having gone to HSBC, Barnes believes that when it comes to the merchant banking involved with the actual privatization programme, local banks will still have an important role to play. Altogether, it is estimated the government is planning to raise about R100 billion from privatization over the next decade.
Koseff points out that Investec has already been active in some smaller privatizations worth up to R1 billion, such as selling off some of state radio and TV operator SABC's stations. When it comes to bigger sell-offs, such as telecoms company Telkom, Koseff says: "We will bid for the work jointly with overseas partners. Telkom will need both local and international assistance."
Alliances either long-lasting or temporary seem to be the strategy favoured by both local and foreign players, particularly in privatization, but they have also stretched to such areas as asset management. The most significant tie-up has been NatWest's with Cape Town-based Board of Executors, renamed BOE NatWest. BOE was an independent company involved in private and merchant banking. It has R11.4 billion in assets under management and has brokered some major corporate deals in recent years.
While this is a relatively formal arrangement, several one-off associations have also been established. Recently Hambros worked closely with Rand Merchant Bank in structuring a R200 million Eurobond for the World Bank.
Foreign alliances
Cooperation has been stimulated by two things. First, the easing of exchange controls on South African residents has enabled asset managers to undertake swaps of locally owned assets for foreign ones. Second, the deregulation of the Johannesburg Stock Exchange has allowed banks to act as brokers. Rather than set up their own brokerage departments, most have formed partnerships or taken over local stockbrokers. Other South African stockbrokers have formed foreign alliances to strengthen their positions and also to allow them to move into non-traditional areas, such as investment banking.
There has also been cooperation with overseas operators in asset management. Some of the more significant partnerships are Capital Alliance with SBC Warburg; Fedsure Asset Management with Liechtenstein Global Trust; Liberty Asset Management with Union Bank of Switzerland; RMB Asset Management with Morgan Grenfell Asset Management; Sanlam, the second biggest life assurer, with Capital Alliance; and Standard Bank with Fidelity International. The relationships vary: some are advisory and some cover only research; others extend to marketing each other's services and products.
Apart from privatization and trade finance, another major slice of business is the unbundling of some of South Africa's corporates, particularly sell-offs to black economic empowerment groupings. Important deals have included selling off life assurance companies and the Afrikaans-language newspaper group Perskor to black interest groups. One of the largest deals currently involves the Johnnic subsidiary of South Africa's largest corporate, Anglo American.
However, it is not only the need to give blacks a greater stake in the economy that is stimulating the unbundling of South Africa's complex holdings but also the wider need for investment, both inward and outward. Barnes says: "I think unbundling will expand, given the concentration of shareholdings and the diversity of potential interest in our stock market. Market forces and regulation will force the pace, but it will not be an overnight process."
However, he does not see foreign corporates raiding South African soil: "To get control of anything in this country is a significant undertaking." But, as Koseff says, as other companies unbundle to realize their full value "there will be pretty nice pieces of corporate South Africa that foreign companies will want to own".
Koseff says international players have some advantages over local banks. They can provide a cheaper source of funding because of lower risk premiums and they have global networks for distribution of products, closer access to technology and a larger pool of high-calibre staff. South African banks have to compete on those fronts by ensuring that they employ the highest-quality staff and make use of their local knowledge and niche strategy to protect their turf.
It is not clear whether further mergers of local banks can be expected in order to provide the muscle needed to become significant players. But a shake-out is expected among foreign banks operating in South Africa. Geeringh expects their numbers to dwindle when they discover that it is not that easy to displace local players. Barnes adds that there is not sufficient depth of business for all the foreign banks to make a living. On top of this, margins have fallen drastically in both trade finance and capital funding, with margins as narrow as 30 to 50 basis points above Libor.
South African banks have the additional advantage of holding proportionately much more South African risk on their balance sheets than foreign banks do. Although foreign banks came in with a wide range of instruments, up-to-date technology has provided South African banks with the ability to keep pace. Barnes sums up the position: "We have the client base and we intend to be around for ever."
Set the rand free
South Africa has an uphill task recovering from apartheid. It isn't helped by the fact that the rand has plummeted this year. An influx of foreign investors searching for new opportunities has added another bucketful of volatility to an already heady mix. Eager to maintain stability the government is hesitant about removing the last layer of exchange controls but investment experts believe they should be dropped at once
The South African rand has taken a pounding this year, dropping in value by 25% in the first two quarters. As if all the other problems the new South Africa has to face were not enough of a deterrent, currency risk has now jumped high up the list of fundamental issues frightening away urgently needed foreign investment.
The other problems include a high government deficit level (5.8% of GDP), foreign reserves that have at times been sufficient to cover only six weeks' imports, the maintenance of foreign exchange controls, low labour productivity, high trade barriers and uncompetitive industry.
These problems are nearly all a direct consequence of the isolation of the apartheid era, not of current government policies. South Africa is slowly emerging from a siege economy forced upon it by years of international isolation. After four years of negative economic growth at the tail end of the apartheid era, when trade and financial sanctions bit deep, the economy has turned around. This has at least enabled the government to start introducing structural changes.
It has moved fairly quickly over a wide front to reverse the backward economic slide of the 1980s and early 1990s, in the process often jettisoning ideologies that had been held dear by the ruling African National Congress (ANC) during the years of struggle.
The country is "at least on the right track", says Roy McAlpine, chairman of the asset management arm of South Africa's biggest proprietary life assurer, Liberty Life, which also has a substantial international position, particularly in the UK. But he adds that it will take a year or two before there can be certainty about whether targets can be achieved and before the country can claim to be well down the path towards a soundly based economy.
Achieving a stable rand first required a stable political and economic policy. The question asked by international investors was whether the ANC would do more to meet the expectations of its constituency with populist policies or whether it would "hold its ground".
Earlier this year the government released details of its macroeconomic strategy, dubbed growth, employment and redistribution (Gear), aimed at sustainable, high-level economic growth. However, some of the reforms it is implementing are making its task more difficult and putting added pressure on the rand.
For example, because of its comparatively small manufacturing base, South Africa moves into trouble fairly quickly on the balance of payments current account whenever there is an upturn in the economy, because of a boom in import demand, particularly for heavy equipment. In the apartheid era this resulted in short boom-and-bust cycles. However, in the latest phase of growth following last year's general elections the pressure on the current account was initially more than compensated for by massive inflows on the capital account. McAlpine argues that South Africa cannot run large deficits on the balance-of-payments current account while counting on short-term capital inflows to stabilize the value of the rand.
Dave Mohr, chief economist of Old Mutual, South Africa's largest life assurer, says the value of the rand will ultimately depend on the economic growth record. "A lot of things have to come together, but the key focus area is government spending," he says. He believes that if the government's macroeconomic strategy is implemented "we have got a good chance", and that although there will not be 100% delivery of the targets, the country should be able to get most of the way. "It is the only way we will get sustainable growth over the next 10 to 15 years."
All the elements of the plan have to be implemented, says Mohr. For example, there has been economic growth but little job creation. In the interests of social stability, job-creation recommendations have to be implemented quickly. And there will be keen concern that the government can deliver on social services while maintaining fiscal discipline and keeping tax rates under control.
To achieve the Gear targets the government will have to act more quickly and make bolder decisions, says Stephen Koseff, chief executive of Investec Bank. He cites an example on the social services front, where provision of housing is being held up by bureaucracy. The money is there but delivery is not taking place.
A great deal of effort will have to be put into developing exports other than primary commodities, particularly non-traditional manufactured exports, which account for only 10% of exports. "If South Africa can get competitive in manufactured exports we can feel more relaxed," says Mohr.
Privatization can't wait
The government should also have moved two years ago on privatization, says Koseff, "but it is still dawdling. By the time it moves decisively it could be too late, because the competition for foreign capital is increasing as countries around the world go down the privatization route". McAlpine agrees, arguing that privatization could halt the current depreciation of the rand by bringing in foreign capital. "We need to take brave steps on issues such as privatization. It is still an emotional issue. We have already done a 180-degree turn on the issue, with the ANC distancing itself from its original policy of nationalization. Now we have to turn the other 180 degrees and privatize."
Since the end of apartheid foreign investment in both the bond and equity markets has soared. Outsiders are looking for emerging-market-style opportunities in an economy that, in fits and starts, is attempting to join the global mainstream. And South Africa now faces the twitchiness of foreign investors who often damn the government if it does, and damn it if it doesn't.
The volatility of the markets and the rand has been aggravated by investors leaping in and out, often on what the government is starting to suspect are orchestrated rumours ranging from stories about the resignation of Reserve Bank governor Chris Stals to hints that president Nelson Mandela is in poor health.
There are difficulties enough that are not based on rumour. If something is not done soon to halt the depreciation of the rand, South Africa could be on a spiral of high interest rates, high inflation, higher demands from organized labour, and further depreciation of the rand. The drop in the value of the rand has halted the government's efforts to make it fully convertible and has already knocked at least 1% off expected economic growth this year.
The rand's difficulties spring essentially from perceptions of the political future of the country and concerns over whether necessary structural changes can be successfully implemented. With pressure on the rand continuing, the government has had to weigh the effects of pushing real interest rates, already above 10%, to new highs with consequent effect on economic growth and the government's ability to meet the needs of a population that is mostly deprived of the full range of social services.
When it came to power, the government moved quickly to make the rand fully convertible, its single most important measure being the scrapping of the dual currency system. This had been created in 1986 with the introduction of the financial rand which sought with a debt standstill to ward off the worst effects of financial sanctions. These began when Chase Manhattan refused to roll over short-term loans to the government.
The financial rand (finrand) was a defined pool of money. The currency traded at a discount to the commercial rand varying from 8% to as high as 50% depending on the degree of foreign confidence. Because the finrand was sanitized out of the system there was little effect on reserves and on the commercial rand, which was used for trade transactions.
The commercial rand's value moved (consistently downwards) on the differential between South Africa's inflation rate and an inflation rate based on a basket of currencies of the country's main trading partners. On March 10 last year the finrand was abolished. The previous day it had been trading at a discount of 2.55% to the commercial rand, which was priced at R3.65 to the dollar. The following day the commercial rand shrugged off any effects of the change, maintaining the same trading range.
A rougher ride
Old Mutual's Mohr says that in retrospect it is clear the finrand was hopelessly undervalued. It was, he says, essentially a shock absorber: "Previously we were protected [by the finrand]. Now we feel it directly when capital comes and goes."
And South Africa certainly has felt it over the past six months, as the value of the unified currency has taken knock after knock. Just when everyone believes it cannot drop any further, down it goes again.
However, at the beginning of the year central bank governor Stals had considered the rand then trading at R3.64 to the dollar overvalued; it gave the government excess liquidity problems as enormous amounts of short-term foreign capital poured into the bond and equity markets.
But at times the correction looked more like a meltdown as the currency lost about 25% of its value in the first significant slide. Mohr says the government's difficulty in controlling the volatility of the currency has been exacerbated by the recent development of a Eurorand market: "Much the same happened in the US when the Federal Reserve had the control of the dollar taken away from it because of the development of the Eurodollar market."
And with the scrapping of the financial rand all controls over foreigners investing and moving both capital and earnings in and out of the economy were removed. "They can come and go as they like," says Mohr.
But as well as adding volatility to the market, foreign investors are now demanding that exchange controls on South African residents are phased out, although the government's efforts to achieve this have been slowed by the run on the rand. While these controls are in place, it will be impossible to establish the true value of the rand. As a result, the signal being given by foreign investors to the government and local institutions is that they are still jittery about investing in South Africa.
The government has so far taken a salami-slice approach to lifting exchange controls on residents. Until July last year South African residents were almost totally barred from making foreign investments. Companies wishing to invest abroad had to make individual applications that were granted or refused on the whim of officialdom and according to the current state of reserves. But how effective the controls have been over the years is open to question; it's estimated that at least R30 billion is held offshore illegally by South African residents.
Both the government and the South African Reserve Bank are understandably jittery about going for the big-bang approach and scrapping all remaining controls overnight a measure favoured by many of the country's top financiers. Investec's Koseff is one who favours waiting no longer. He argues: "Exchange controls limit rather than protect capital. The sooner we operate on a level playing field the better for the long-term health of the economy. At some point in time we are going to have to take the punishment that will go with it."
Koseff makes a comparison with east European countries such as Poland, which grasped the nettle, scrapped all exchange controls and have now come through the dip. McAlpine of Liberty Life says the government missed a window of opportunity by not scrapping all exchange controls when it abolished the financial rand. "Right now we have the worst of all worlds. The rand has fallen out of bed, and we still have exchange controls."
Roddy Sparks, Old Mutual assistant general manager investments, says scrapping exchange controls could cause "initial indigestion for three to six months", but argues that logic is often defied by what happens in practice and the process could be smoother than expected.
Those arguing for the big-bang approach say there is hardly likely to be a major withdrawal from local equity and bond markets, because of the detrimental effect this would have on remaining assets, although there is pent-up local demand for offshore diversification, particularly among asset managers. Mohr says it is a strange situation for controls to remain on local individuals and institutions when a sophisticated market in the rand has developed internationally.
Asset-swap investment
The noose on individuals and institutions has, however, been gradually loosened. South African corporates are being given greater leeway to invest abroad, although most of these investments, particularly in Europe and the US, have been effected by leveraging funds offshore. The government has been particularly keen to encourage South African companies to expand into neighbouring countries in an attempt to develop the regional economy. Investing in Africa is now almost a formality when it comes to exchange control approval.
The most significant change for individuals, however, was the introduction in July last year of the asset swap concept. This permitted retail products that incorporate rand foreign investments. This concept has been much criticized because it is bureaucratically unwieldy, with each transaction requiring official permission. And the technique has been restricted to life assurance companies, unit trust companies and retirement funds.
Local savings and investment institutions are allowed to swap locally held assets (equities or bonds) for assets (including cash) offshore. This is conditional, however, on the institutions being limited to arranging swaps to a maximum of 5% of assets under management; they also have to give assurances that if foreign holders of the South African assets want to dump their investments back in South Africa the foreign holdings will be repatriated.
Sparks, who organizes the Old Mutual asset swaps, says that however unsatisfactory the mechanism, institutions have felt impelled to get involved. "If we didn't do it we knew our competitors would."
Other players, such as Investec, advance with caution on asset swaps, because investment houses are at a disadvantage to insurance companies. The latter, according to current regulations, are able to structure retail products not available to others.
Koseff says that the swaps are being effected at a discount because of the costs and liquidity concerns, if for no other reason. He believes that if direct investments were possible the discount would narrow. The Reserve Bank, though, insists that there should be no discount for foreign investors; Sparks says there are in practice no discounts apart from the costs.
Sparks believes that international diversification is sensible, even under the restrictions and disadvantages of the asset swap regime. But, in his opinion, there are levels below which local institutions would not be prepared to deal. "There is some sort of self-correcting level," he says.
Sparks adds that the gradualist approach has helped to build up local knowledge of international markets and allowed local financial institutions to make considered decisions about offshore investments. Some of the institutions, such as Old Mutual, already had a solid foothold offshore, running successful fund management operations. Others, however, had concluded strategic relationships, and some had been taken over by foreign institutions. Only major players such as Old Mutual would be able to operate offshore without alliances. "It needs time, patience, a brand name and critical mass to be able to remain independent," comments Sparks.
He says that those institutions carrying out swaps are playing it close to their chest, releasing little detail beyond their value. Sparks predicts that when exchange controls go and individuals are allowed to make direct foreign currency investments offshore, local institutions will face a lot more competition. This will particularly affect the savings/investment industry.
The asset swap arrangement has revealed extensive evidence of public demand for investment abroad. Life assurance companies have developed endowment (investment) products with the funds fully invested offshore, and the mutual fund industry is marketing "global funds" that are partly invested abroad. Individuals, however, can make rand investments only in the products of the institution making the foreign currency arrangement; the retail products can be traded only within South Africa.
Sparks estimates that at the moment only about 2% to 3% of assets of the approximate R700 billion under management in the savings and investment sector have been placed offshore through assets swaps. But in an environment free of exchange controls, South African asset managers could be expected to move between 15% and 20% of managed assets into offshore investments.
Demand if the price is right
Sparks expects the volume of asset swaps to increase as more local institutions establish relationships with foreign institutions and also because the local equity market is currently flat compared with offshore markets. Sparks would like to see exchange controls finally phased out within two years.
Further exchange control relaxations were announced under the Gear economic programme. Among other things, asset swap limits were extended to 10% of assets under management. For the first time this included a cashflow amount equal to 3% of cashflow of the previous year, unlinked to asset swaps but included in the limit of 10% of total assets under management.
No-one knows how individuals will behave when exchange controls finally go, but it is generally expected that, as with institutions, there will be a level at which they will not be prepared to buy assets offshore. If the rand takes a pounding, individuals will not be prepared to take a perceived depreciation of their savings.
There is a pent-up demand for foreign investment which, says Mohr, will be a key factor in setting the true value of the rand. Apart from this potential demand, there is also currently a R14 billion overhang in the spot market as a result of forward buying by the central bank in an attempt to smooth the passage of the rand through its recent phase of volatility.
A persistent hope is that South Africa could prove the springboard for economic revival in sub-Saharan Africa; some have even predicted that in the short term the Southern African region could soon form a single trading bloc, with a single currency the rand.
But until its reform programme really gets going, South Africa will have to continue to live with a volatile currency and hope that other fundamentals such as continued solid profit growth of South African companies and high interest rates will cancel out the currency risk perceived by foreign investors.
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