What path is South Africa on? The market (and to a lesser degree ratings agencies) are still making up their minds. We think one thing is certain – this is not a ‘normal’ sentiment shock, nor a brief negative to be reversed shortly after like Nene-gate. This is a sticky situation with deep consequences.

But what exactly has happened? The President has broken no law in reshuffling cabinet; there is no constitutional crisis in that sense. The National Assembly will likely vote against a no-confidence motion but again as is its right under its rules and will not be a constitutional crisis. We need to be very careful to separate out a crisis of leadership and crisis of out-of-date collectivism in the ANC around the reshuffle, from a constitutional crisis which is not occurring at this point, from the merits of the decision itself and the negative implication for institutions and credit quality and the policy implications that flow from that.

We see South Africa in a cycle now of reinforcing the status quo, a path it is already on of low growth (negative to zero per capital growth), rising inequality, rising unemployment, high rent extraction, eroding institutions and slowly rising debt to GDP. It is reducing the chances of upside and opening up some increased probability of downside risks of the path South Africa takes from here. In this sense for us not a whole lot changes, we have always been bearish on the underlying structural and political issues. This said, we should note that the market was previously too optimistic and so will be surprised to a larger degree, having assumed SA was on more of an ‘upward’ path. It was positive on the short term (the growth turnaround etc through end-2016, start 2017) but also the structural factors (level of reform, long-term growth levels, political outcomes from the elective conference etc). As such, just being on the status quo, general continuation path, is a market and ratings event and requires repricing – and indeed more to go.

We use the term re-pricing quite specifically. We think USDZAR should trade higher to around 15.50 whilst 10yr SAGBs should trade weaker to 9.50-9.75 area and 5yr CDS should trade out to 275 area. However, we think in the current global environment that still sees a strong and unquenchable need for carry – where China hard landing risks are out beyond the forecast horizon and with US fiscal risks again a more drawn-out phenomena – so it will be a slow path to get there, limiting the risks of more significant or disorderly overshooting. As such, while we have continued to discuss the modalities of SARB FX intervention (on a breakdown of FX price formation), we do not see it occurring.

Other factors also continue to support a step level repricing and not a ‘crisis’ in a real market (‘proper EM’) sort of way.

• Exchange control caps on offshore investments limit the amount of local portfolio investment outflow that can occur – we think the system is currently under the 25% offshore cap with some room for outflows, but some key large asset managers are likely to be dragged over the limit as the currency sells off and will have to bring money back onshore over the following year (in line with SARB guidelines). This tempers weakness.
• Similarly there is only so much underweight trapped local investors can have on bonds and a bond-buying strike (after Futuregrowth’s suspension of funding SOEs last year) does not look possible.
• Banks are both highly liquid and very well capitalised which means the risks of financial stability shock is very low. We see a more severe P&L cycle for banks this year now, but not a structural shock.
• External vulnerability is low (at 46%GDP external debt as of Q3 2016) with capital control preventing significant build-up of corporate FX leverage and with virtually no household FX leverage. Most FX liability exposure sits on SOEs and sovereigns balance sheet and even then is a small share (10% of total gross debt stock). External vulnerability is mainly on the sizeable income account with the trade balance now oscillating around balance.
• Given all this we see no ‘call the IMF’ moment on the horizon which is both good in the sense that it means there is no BOP risk and bad in that there would be no policy reform straightjacket either.

With these backstops we see the market as justified to ‘buy at the right price’. The question, as we have always said – is that more premia is needed and we aren’t there yet. The levels indicated above reference that need for more premia.

Added to these fundamental factors are several issues around the currency story which mean it is a slow grind:

• While we have revised down growth very sharply for this year from 1.1% to 0.2% the data for the post-reshuffle period will only really start to emerge from June and then quarterly data on in September. It is a long wait. Similarly high frequency fiscal numbers may take a few months to catch up with the shock. We should watch credit extensions and import growth as a higher frequency indicator.
• While Fitch already has both foreign currency and local currency (FC/LC) ratings in junk, and we think S&P will cut LC to junk given in June given it has maintained its negative watch and the growth shock, lack of fiscal flexibility and particularly nuclear issue should force the move. That leaves Moody’s as the laggard and its ratings framework here seems far too optimistic in both view and framework. First, it is trying to take a more optimistic view anyway than the other agencies on the starting point of the reshuffle in terms of growth and reforms. But more importantly it seems overly reliant on very much lagging quantitative institutional quality indices as well as the circular argument that it will watch portfolio flows before making a decision. We do think it will cut in the 5 May to 3 July window and bring both FC and LC down to just on the IG/junk boundary. June might be a key time to watch given data timing. We think a double-notch move now is unlikely given the apparent bias Moody’s has. However it will then we think, from this optimistic starting point, take the actual emergence of the fiscal shock, of low growth data, of nuclear, of much greater risks and portfolio outflows, to get them to cut to junk. That could be after the MTBPS (it has pencilled in an update on 24 November) or it could be after the Budget next year (say start March). We see loss of position in indices as a slow and long path. There was an announcement that South Africa fell out of the JP Morgan IG indices last Friday though the actual event itself won’t be until the end of May (again a decent lag here before the market forced selling). We think that will amount to around USD1.5bn of passive outflows. Then South Africa should fall out of a wider variety of JP Morgan and Barclays indices after the S&P cut, so into early Q3 for the market forced reaction. That may be around another USD2bn. The big one we are waiting for however is WIGBI which requires both S&P and Moody’s LC to be in junk and would come therefore either just after the MTBPS or just after the budget. This would amount to USD6-7bn of outflows we believe. Overall, our estimate of all passive rating sensitive investments onshore in SAGBs is around USD10bn which is about 9% of the debt stock (ie, sizeable) out of an estimated 38% foreign ownership of local debt.
• The nature of the South Africa story here is one things looking ‘ok’ on the surface but it’s the issues around SOEs, procurement etc below the surface that will be hard for investors to track and rely on media leaks, court cases, parliamentary inquiries etc. This will make it tough for investors and lead to a market that goes in fits and starts.
• The story is going to be highly complex. In terms of the nuclear issue alone, we think the market will struggle to get its head around the differences between overnight cost, total cost, feed-in tariff costs etc.
• There will likely be continual optimist berthing points – events that the market can harness positivity from, no confidence votes, protests, ANC meetings, the policy and elective conferences etc. This should make for a volatile market path to come. Similarly we expect continual noise of splits and disagreements and rouge voices within the ANC which the market will latch onto.

Through all this, however, we need to remember a few key things. 1) There is a serious and considered strategy being undertaken by the President who is a master at playing the ANC at its own collectivist game. 2) Events will likely be much wider than just National Treasury (NT) and involve the judiciary, parliament, security services, other ministries and SOEs etc. 3) The strategy here is long and goes through the elective conference and a win by Nkosazana Dlamini-Zuma and we should consider her as a more left-wing, ideological version of the status quo, not some clean break. 4) While in 2019 the ANC is certainly at risk of losing power and majority control, we continue to say that it’s far from obvious this is a done deal especially with a new ANC President (who is possibly already President of the country into the election). 5) As a result we wrote recently that the probability of Zumxit was low at just 20% (here).

Scenarios and time frames

Within this somewhat ‘contained’ backdrop we can lay out the pathway from here in the short term, medium term and the long run.

Some of the details here are referenced in more detail in previous reports, particularly our scenario analysis from last year here (ANC’s factional fractions – Scenario analysis deep-dive).

Here we look quite specifically through our baseline status quo outlook which means President Zuma stays and the reshuffle is sticky. There are clearly alternative outcomes as well involving Zumxit, which would lead to more political uncertainty but market strength and some recovery in sentiment and growth in the economy. However, we would still be sceptical that such scenarios, again given the contestation within the ANC on such an event, would lead to meaningful reform however.

Short-term outlook

• Key focus of the market will be on rhetoric from new National Treasury management team including a new Director General likely to arrive in May. Language will be important and especially an exposition of what ‘Radical economic Transformation’ is, not just in generic terms but in specifics of policy to be applied by NT. We think procurement will be key and associated local content rules that NT had blocked in the past.
• We do not expect meaningful movement in NT policy on the surface in the short term until the MTBPS with the exception of procurement. The same is true from the rest of government though we watch legislative passage on the expropriations bill especially closely but expect no major new populism there at this time.
• The nuclear issue should move forwards much more aggressively not just with change in NT management but also with new Energy Minister. Eskom will complete its current request for information on 28 April, and will then move through a cost/benefit exercise at NT, utilising vendor financing models submitted during the current RFI process, that will be required to be signed off by the Minister of Finance before a June date when Eskom (and NECSA the South African energy authority) move to RFP from vendors.
• Moody’s ratings action in May-July window. We expect a downgrade by one notch.
• Continual rolling mass protest action and possibly multiple no-confidence votes in National Assembly during this time. We see neither being effectual. Zumxit probability at 20%. Constitutional Court cases possible on an ongoing basis.
• End May (weekend of 26?) ANC NEC will be watched very closely and will be important for the Zuma camp to also show strength there and win any possible recall motion brought in that forum. That said, there is a high hurdle in the NEC given things need to be decided by ‘consensus’ which means more than some slim majority and hence status quo is normally sticky.

Overall, we think official communications are unlikely to change significantly and it is more likely to be leaks etc that are key to understanding the progression of the narrative here. Specific contracts that were previously blocked by NT under Pravin Gordhan will also be watched as well as oversight issues on SOEs.

Medium-run outlook

• Growth shock felt through mid-year with some chances of a technical recession given weaker point of entry to the reshuffle of economy than pre-Nene-gate. Works into revenue shock and fiscal underperformance grows in the high-frequency data.
• Possible S&P downgrade of LC in June.
• SARB forced to hike rates to offset second-round effects if ZAR weakness continues. We have pencilled in 50bp for May but this could fall to July or be more spread out depending on how ZAR, CPI and expectations move. We would take out the hikes from the forecast if ZAR did not end up moving for whatever reason.
• We expect a deep policy split at the policy conference at end-June start-July with the Zuma camp pushing further on economic nationalism and populism but with the end statement showing few specifics on a major new policy direction.
• MTBPS at the end of October is likely to be highly challenging. There is a question of both how NT works at that point after the reshuffle and with any staff exits, but also in terms of staff vs minister splits on policy issues. A major fiscal shock on top of already overaggressive growth and revenue buoyancy baseline is likely to compound the problem. We see the expenditure ceiling falling further in line with quantitative framework but no major additional expenditure moves (either cuts or increases). Expenditure shifts should go on beneath the surface. Markets will watch closely what ‘reprioritisation of the budget’ means in this environment, mentioned recently by the minister and by previous ANC NECs. We expect some deterioration in the primary fiscal path with removal of reserves, unspecified revenue increases (to be detailed at next February’s budget) as well as reliance on debt financing and sharp revision up to issuance numbers. Intra-year tax hikes seem highly unlikely as they would hint at panic. We see potential risks, however, to a more credible document if staff manage to win over the minister or if he remains fiscally conservative in order to prioritise other issues at NT like procurement.
• We see political contestation and path to the elective conference meaning no wider reforms ongoing. Things like the government/business coordination group (set up by Pravin Gordhan) should survive but become talking shops.
• Elective conference at start December. We expect Nkosazana Dlamini-Zuma (NDZ) to win. The market is likely overestimating the chances of a Cyril Ramaphosa win but should give some benefit of the doubt to a Dlamini-Zuma presidency, overplaying a ‘fresh start’ vs our view of a status quo.
• Likelihood of a split off of SACP after an NDZ victory. But true, deeper splits in the ANC remain less likely given collectivism, history and a wider challenge from DA and EFF (and even a new left-wing union party emerging around Zwelinzima Vavi).
• We still see a transition of power to NDZ around May next year when she takes over from President Zuma as President of the Republic to allow her momentum to go on to win the 2019 elections.
• Possibility of a final notch from Moody’s after MTBPS or February budget to take into Junk. South Africa falls out of WIGBI?

The medium-run outlook through H2 will really be about dealing with the fallout and the shock of the reshuffle, the most intense phase of the elective conference battle and then ultimately (we expect) victory for the status quo.

It’s important to note that the ‘true reform scenario’, or the ‘grind to a halt’ (aka Zimbabwe scenario) that we have talked about before are not really seen in the short to medium run if Zumxit doesn’t occur. Even if it did we would expect paralysis to prevent a move down either route before the 2019 elections.

We think this climate of political contestation and the capacity constraints of the state, not to mention the risk of institutional degradation after the reshuffle, make ‘true reform’ impossible to see. Similarly, we think such constraints prevent policy shifts towards the ‘grind to a halt’ path.

Elements of each, however, are possible. For instance, our previously discussed ‘efficient rent extraction’ scenario could be at risk of playing out if Minister Gigaba held a conservative fiscal line in order to prioritise procurement issues and SOE issues. However, still the knock taken to growth and reform agendas means we don’t assign any probability to this scenario in the short to medium run.

Similarly the ‘grind to a halt’ scenario could see elements play out such as the use of security services and other forms of pressure on the ANC internally and within parliament. The shifts in language from the President already to accuse protestors of being ‘racist’ also suggest this scenario. However, we do not expect the fundamental things required to properly go down this path – abandoning the constitution through a state of emergency, land grabs, ignoring the judiciary.

The nub of the issue – the long-run outlook

This brings us to the heart of the matter here. Imagine a see-saw between ‘true reform’ and ‘grind to a halt’, between 5% growth and 0% growth. You can call it between dictatorship and democracy or between free market and command and control economy or between 0% rent extraction and patronage and 100% rent extraction and patronage.

This reshuffle was not about going to sit at the other end of this see-saw. It was about slightly moving the focal point a little more towards the ‘grind to a halt’ end, about removing blockages to patronage and ensuring an efficient political economy in this sense within the Zuma faction.

As such, we view the reshuffle as being a subtle realignment of an existing position, to secure that status quo.

This of course can have profound risks and implications for the long run:

On the positive side:

• The ANC could simply wither if internal divisions affect its ability fight the 2019 elections.
• Constitution change in long run to entrench constituency representation and making parliament less beholden to political parties.
• A small ANC breakaway party that gives up on the main party could form that fights the 2019 elections and maybe gets only 5% of the vote (concentrated in Gauteng and major cities say) but can act as a stabilising factor in coalition with the ANC after 2019. ANC is dragged to a low-corruption, more reformist place.
• Death of South African exceptionalism would bring more realism, activism and shift in policy debate.

And on the negative side:

• A stranglehold on the ANC by the Zuma faction could infect the government with more authoritarian tendencies after the elective conference including ignoring the courts and more radical implementation of a transformation agenda that ignores property rights and the constitution.
• Violence could increase around repeated protest action for Zumxit. ANC structures like ANCYL and MKVA could become more militant.
• The ANC would likely not give up power if it were to lose to an opposition coalition in 2019. Rule by decree (could be provincially as well as nationally).

This collection of risks highlights how, while the reshuffle may be an indication of a subtle shift, actually it can move in chaotic and unpredictable ways for better or worse, that things can go two ways but broadly in the long run we still believe in the status quo bumble along scenario. In particular, we think the debate and centre of gravity of (activist) society is too left-wing to generate meaningful investor- and growth-friendly long-run reforms. This has been seen in the debates over whether or not to ‘protect’ NT as a ‘neoliberal’ institution in decent weeks.

Something more fundamental needs to shift in South Africa to move it onto a higher growth path.

It is not clear this happens if the ANC drop below 50% in 2019 given the constraints and policy contradictions of opposition parties. An intermediate step towards a better high growth future could be a more positive low growth low corruption environment but a shift would ultimately be required that pulled the state back from the economy and allowed growth to emerge. It cannot be ‘forced’ as most politicians in South Africa seem to think.

The most positie long-run scenarios would be if there can be a transition to a high growth, high reform plan, that balances the needs of transformation and historical redress without hampering the required job creation. Such a path does not seem to be obviously on offer in South Africa from any political party at present.

However, so much is now up in the air in South Africa the long run may well arrive a lot quicker and force deeper changes of view within the political and economic debate in South Africa. This could be the route to better long run growth.

What is radical economic transformation and how does it apply to NT?

This is the key question but on which we know very few specifics. We have stated before that while we know broadly what the definition is, policy specifics are lacking. Indeed, the policy documents for the forthcoming ANC policy conference were not particularly radical or transformative. The phrase has existed for some time in the ANC but only really come into its own through the Mangaung elective conference in 2012.

President Zuma said this last week on the high level definition:

“I want you to listen very carefully. It is not a rhorho. [isiXhosa word for leeches] By Radical Economic Transformation we mean the fundamental change in the structure and systems, institutions and patterns of ownership, management and control of the economy, in favour of all South Africans, especially the poor, the majority of whom are African and female. We cannot say it’s all fine, the gap must be closed.”

What that means in specifics for us, given ongoing conversations on this with the ANC since 2012 is as follows:

• Pushing for a more capable developmental state with more capacity to more efficiently drive transformation. Actually implementing existing policies that have been ignored or that have withered.
• Removing neoliberal blockages like NT and bypass banks.
• Macro-fiscal and monetary policy remain broadly conservative but need some reprioritisation.
• The state should be correcting market failures more, either through the competition commission processes or through state bodies like a Post Bank or state pharmaceutical company.
• Reformed industry charters give ministers much more discretionary power, embedding transformation and burden of change on private sector.
• Ownership of assets is shifted through more aggressive redistributive taxes, a wealth tax (opposed by NT so far), more aggressive land redistribution within existing constitution (mainly helped by a state mechanism with more capacity).
• Government should drive local content through procurement rules with the Preferential Procurement rules which have a 30% set aside for local content and NT viewed as blockage in the past. Strictly implement 30-day payments for government contractors at all levels.
• Tighter labour laws on demographic quotas.
• More power for traditional leaders.
• Higher minimum wages, wider social wage.
• Removed benefits from the rich like ability to have private health insurance, remove tax breaks from private schools etc.
• An efficient well-oiled patronage machine at various levels of government. Efficient state owned enterprises to most effectively enable this.
• Full integration of ANC and state at every level including SOEs.
• Only partial care for ratings agencies and foreign investment capital. Preference for BRICS, South-South and government bilateral funding that is cheaper and with fewer constraints.

This still isn’t entirely clear and we think this is the problem and why there will be so much uncertainty about policy from a minister like Malusi Gigaba who looks to sue this term – if only for the first point – that capacity will not easily be built to drive forwards the rest of the agenda.

Forecast reminder

We recently updated our forecast outlook to include a growth shock, fiscal shock, weaker ZAR and rate hikes from mid-year. A reminder of our full forecast is given below. We still see downside risks to growth but do not formally forecast a recession.