Waiting for the growth wave to carry us forward…

We have been spoiled, and our past success has got us so complacent that we as a nation likely need a little slap to get back on the right track

Source: Conjoncture – July-August 2013

The world has become an increasingly difficult place to thrive in these days and riding on the global growth wave shall no longer be enough to carry Mauritius forward anymore. While the US economy appears to be on a moderate path to recovery, growth remains fragile, and recent outflows out of the bond market following the Fed taper talk has caused medium and long term bond yields to rise very fast, pushing mortgage rates upwards along with it.

The key to the US economic recovery is not only due to the good days on Wall Street but to the nascent housing recovery and to a dynamic private sector that is playing its cards increasingly well on the global stage. The Federal Reserve is hence playing it safely. They will likely begin to taper their massive bond purchases by year end, but monetary policy shall remain quite loose until 2015 when it all goes well, and the Fed Funds rate is likely to edge up once again.

The United States may still have a huge debt overhang, but fiscal consolidation is no longer a myth. The US empire has learned at a heavy price that while its military can win wars easily, it cannot maintain control and the peace in any country it invades cheaply. Libya was the last straw, and besides the US is increasingly becoming less reliant on Middle East oil as domestic oil production ramps up. Hence, the US shall continue to try to dominate Asia and checkmate China not by costly interventions but by inexpensive proxies. The superpower has matured.

Russia, in my view, is no longer an emerging market but a submerging market. The country faces low growth, high dependence on natural gas, an ageing population, demographic problems between Christians and the fast growing Muslim minority, and a dangerous rise in nationalism and xenophobia. With low global growth has come a terrible bear market in the commodities space. For a commodities dependent economy like Russia, it means that it is out of the global superpower picture for a long time to come.

While many continue to talk about China as a so-called alternative, it is pretty clear these days that an economic model involving multiple firms, many of which have been heavily financed by regional banks, engaged in the export sector with a strategy involving razor thin margins is not sustainable. While official Chinese growth data remains rosy, anyone who reads up on China and its murky statistics knows better. Chinese growth is more likely than not exaggerated and the fall in the Australian dollar, of commodity prices, especially those of base metals, weakening Taiwanese and South Korean export growth towards China, the huge fall in the Baltic Dry Index, weakening German export figures towards China confirm this story.

Those who follow Chinese politics and understand the running of the new leadership also know that China is increasingly looking within as the regime tightens its grip on power and focuses more and more on managing discontent, especially from the poorer parts of the country. China may be attempting to soft land its economy and reforming its interest rate structure as was done a few days ago, but growth has slowed, even if you look at the official figures, and the economy is undergoing a structural shift. India on its part is in such a mess that it does not even deserve more than a line in this article.

The point is, the US is not doing that great but it is getting better and is doing relatively better, emerging market powers are slowing in terms of growth, hence the massive outflows of money over the past year by investors. Europe, our biggest market, remains in a nasty mess with recession likely to last until the middle of next year. Europe, especially the United Kingdom, will recover by 2015, but growth will remain timid while risks shall remain high within the monetary union as unrest and diverging political interests shall constrain the ability of the European Union to become a true and dynamic union.

We should not expect the world economy to grow by more than 3.5% even in 2015. But more importantly perhaps, a relatively better US economy and the higher probability that it may tighten monetary policy sooner than the others equals to a strong dollar, hence low commodity prices (coupled with subdued global demand), moderate inflation and an increasingly competitive global economic landscape as emerging markets do more to attract increasingly hard to find foreign inflows. Why invest in emerging markets when the US is doing better!

Too little money on too many programmes achieving sub par results

Where does all of this leave Mauritius, you may ask? For one, we often play this game in the media wherein so-called experts blame all of our domestic weaknesses on the global crisis. The new world order will require us to be increasingly competitive and dynamic, but are we even close to being that? My thesis about Mauritius has been the same for a few years now and sadly the forecasts remain as accurate as ever.

In a country where Government is unable to execute proper infrastructure projects on time, which in itself requires much introspection in the way it manages projects and selects people to do this, in an environment where fiscal consolidation without proper reform and stimulus appears to constrain overall Government spending, and finally in an environment where a highly indebted private sector is not enticed to delever and improve the way it runs its businesses, growth in this economy shall remain constrained. While many seem to be obsessed by a potential growth rate of 4.4%, the reality is that Mauritius has undergone a structural shift as the growth which was boosted by a levering up of the private sector between 2006 and 2010 is no longer sustainable.

Major private sector companies in Mauritius cannot take on much more debt and are either engaged in ongoing soft defaults (debt restructuring) or in doing anything possible to pay down their debt. At the same time, Government will be constraining its debt intake as well. If Mauritius begins to reduce its leverage, which is perhaps a good thing over the longer term, then one cannot expect growth to pick up at levels set when it was leveraging up. It is basic finance.

In my opinion, this economy will remain stuck in third gear unless we change our ways, and it shall not grow much above current levels for a long time to come, not with this ever falling savings rate anyway. So what should we do?

Governments from both sides of the isle have historically spent too little money on too many budget programmes achieving sub par results. As Mauritius has transitioned into an upper middle-income economy, something we should give our leaders credit for, the marginal gains from our expenditure strategy has continued to fall. We need a more focused government, one that focuses on much fewer programmes such as infrastructure, human capital development and health care for the poor and lower middle class. We also need to encourage competent people to move up within the civil service and let go of the current system that, let us face it, is not always based on merit.

As economic growth remains moderate in the coming years and as revenue growth remains constrained, we shall either need to do the above or remain in a middle-income trap. Fiscal consolidation via the reduction of the scope of government, giving it more focus on fewer things that can in turn be well funded, is in itself the best economic stimulus that this country needs.

Then comes the fascination with real estate policies. The Mauritian economy is not competitive enough, hence the huge current account deficit (and dismal total factor productivity growth figures), one of the highest in the world! To plug this, we have relied heavily on foreign inflows, much of which have gone towards real estate which has been sold as lucrative investments to foreigners. We have a high current account deficit because our current policies encourage consumption, not savings, something that is not only leading to increasing levels of household indebtedness but to asset rotation from deposits which yield negative returns in real terms to real estate where the good performance of the past is assumed to last for the foreseeable future.

Secondly our high current account deficit is caused by the fact that our growth rate in exports has historically not kept up with those of our imports. If you simply look at export items above one million dollars over the past twenty years, we have barely made progress on high ticket items. Just getting better machines does not make you more productive as many in the textile sector have claimed. You need to generate more money and have your margins grow.

The two largest textile companies in Mauritius continue to do well with Ciel Textile having really done the required introspection and turned the corner (helped of course by Bangladesh operations and higher wages in China). But regarding the smaller ones, how are their profits doing, what is their return on equity? How is the debt doing? What is their free cash flow yield? It will not be a pretty picture.

Dilute shareholding or change management

While many love to pick on government efficiency, anyone who looks at the annual reports and abridged accounts of the top listed companies of the Stock Exchange of Mauritius and the DEM, our largest companies, will realize that most have returns on capital employed less than their cost of debt, let alone their weighted average cost of capital. Free cash flow levels tend to be poor or even negative, short term debt especially the reliance on high interest bearing overdraft tends to be high, and overall debt levels tend to have increased. Cash in hand and at bank has been on a massive free fall over the past six years along with profitability. Bank profits may have sky rocketed over the past few years, but the non-bank private sector has seen its debt levels increase and its profitability fall. You do not need to be a great analyst to figure out that this is not sustainable.

Worse, if you simply look at the market capitalisation as a percentage of enterprise value of those top listed non-bank companies, you will notice one scary thing, in many cases either banks own more of the companies, i.e. debt to enterprise value is higher than market cap to enterprise value, or the trend has been deteriorating fast. Remember that in many cases, lack of regulations in land and real estate valuations have been of great help, for revaluation gains have artificially boosted the book value of equity of many of these firms. Very often, investors have in fact pushed share prices higher in response to expectations of revaluation gains, especially those of sugar stocks.

If you look at the first quarter results of Lux, Sun Resorts or New Mauritius Hotels, the debt situation remains quite tight with operations in other islands more often than not saving a certain company from almost certain bankruptcy. If a large hotel group does not turn around its foreign misadventure on time and sells enough villas even at low profit margins, it will have a huge debt overhang while another large group must really do a lot of introspection as to why it mismanaged its short term liabilities so much a few years ago.

Management errors are not restricted to the hotels sector. Just look at the accounts of a certain conglomerate. Short term liabilities continues to rise, overall debt continues to go up with the D/E ratio now above 1, free cash flow remains poor, but yet more spending continues to be announced and ever higher dividends continue to be paid. The list can really go on. Unlike in the West where companies restructure, change management, in Mauritius the unwillingness of many large groups to dilute their shareholding and/or to change a management team that has not performed continues to hinder the ability of the private sector to generate returns on capital that make viable business sense. Times have changed, marginal returns are increasingly difficult to generate, and not all business heroes of the past can succeed in the new world order. The sooner the private sector delevers and, more importantly for the long term, restructures, the better for the economy.

Unless we change the way we run our companies…

My sense is that everyone in at risk sectors is waiting for the world economic wave to get better and to bail them out. While such a scenario is indeed possible, unless we change the way we run our companies, the same lot who got the companies in the mess they are in today should not expect to avoid the same mistakes again nor to get this economy out of the middle income trap. The private sector in Mauritius generates some of the lowest returns on equity versus the cost of equity that I have seen in my life. We need to get real over here.

The figures in any event speak for themselves. Private sector investments are not rising anymore, Government spending is not making up for the slack, and we all seem to be putting high hopes on a strong global economic recovery or on the resilience of the Mauritian consumer whose savings are falling, and debts are rising.

We all seem to be talking about Africa a lot these days. As someone who set up something which actually made money in Africa, my biggest fear of seeing highly indebted groups now talking about Africa is as follows. If they cannot even make decent returns on equity in Mauritius and decent free cash flow in a country where they are near monopolies, how in God’s green earth will they make it in Africa? I am not saying that the likes of Ciel have not made it because they in many ways have done well, but there are a whole bunch of companies now talking about Africa with already high debt levels, and that scares me.

The outlook in terms of overall economic growth potential can become more negative if the asset rotation out of deposits to real estate that many are making to protect and grow their wealth does not work out the way they planned. My sense is that we are not likely to change by ourselves but by the continuation of the current glut in growth. We have been spoiled, and our past success has got us so complacent that we as a nation likely need a little slap to get back on the right track. We are a small country and we have the potential to be much more than what we are today. The world is a big market for us to be successful in. We need to seize our opportunity, or we risk waiting for the growth wave to carry us forward for a very long time.

Sameer Sharma is a chartered alternative investment analyst and a certified financial risk manager


* Published in print edition on 27 July  2013

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