Mitigating Financial Risk; Evaluation of Public Enterprises 2007/08 Budget: briefings

PUBLIC ENTERPRISES PORTFOLIO COMMITTEE
07 March 2007
MITIGATING FINANCIAL RISK; EVALUATION OF PUBLIC ENTERPRISES 2007/08 BUDGET: BRIEFINGS

Chairperson: Mr Y Carrim (ANC)

Documents handed out:
Using Budget Analysis to Scrutinise the Public Enterprises Budget Vote

Audio recording of the meeting

SUMMARY
The Committee was briefed by one of its Members on mitigating financial risk and the rationale for a Stock Exchange. They were informed of its function, how people can invest in companies listed on the Stock Exchange, shares, dividends and Initial Public Offerings. Members found the briefing highly informative and asked numerous questions of clarity.

A representative from the Institute for Democracy in South Africa evaluated the 2007/08 budget of the Department of Public Enterprises and provided ideas for the manner in which the Committee should evaluate the Department’s budget as part of their oversight role. The Committee was unanimous in its praise for the input; highlighting that it would assist it greatly before the Department’s budget vote was debated in May.

MINUTES
Presentation on mitigation of financial risk
Mr Martin Stephens (DA) gave the Committee a presentation on mitigating financial risk. He explained that the financial risk he spoke of was the risk of losing money. He started his presentation by giving the context of the origins of companies and stated that this was about 200 years ago in Britain. Every business contained a risk of losing money. Owing to this risk business people expected profits from the business. To mitigate financial risk and personal liability people created companies as the risk is limited to the money put into the business by shareholders.

He articulated that the (Pty) designation meant proprietary. This meant that ownership was limited to a small group of owners who ran the business. In such a private company the shares were not freely transferable. If one of the owners wanted to sell their shares, they had to be offered to other shareholders first and then to the public although the other shareholders could refuse the sale of shares to the public. If however a company was Limited it meant that the shareholders had limited liability if the company owed others money. The only assets these creditors could claim against were those belonging to the company and not the private interests of shareholders.

Ms N Kondlo (ANC) interrupted and asked for conceptual clarity relating to what had been presented. How can one differentiate between a company and its shareholders when there could not be one without the other?

Mr Stephens replied that a company is separate from its shareholders. Shareholders only provide capital for the company and as such have limited liability against claims instituted against the company.

He continued his presentation by stating that the amount of money a company had was reflected in the number of shares it had. A person who had invested in the company received shares proportional to the amount contributed. Shares usually had a nominal value of R1. The role of a business was to make a return on capital and make a profit. When a company made a profit this money belonged to the shareholders and is called a dividend. He clarified that dividends paid to individuals were also calculated on a proportional basis depending on one’s shareholding in the company. A company need not declare its entire profit as a dividend as some of the money could be reinvested in the company.

He stated that the company tax in South Africa at present was 29% and that companies had to pay this tax before they declared dividends. Essentially, shareholders paid this tax.

Mr Stephens informed the Committee that shares in listed companies were freely transferable. When these shares increased in value the shareholder made a profit. The Johannesburg Securities Exchange (JSE) was a central market place where buyers and sellers came together. It was basically a permanent auction. The JSE had many rules to ensure that all transactions were guaranteed and that this mitigated risk. The price mechanism of a stock exchange functioned owing to ongoing bids and offers. The intra-day volatility was also down to the constant bidding. The markets were driven by emotion. There was a lot of fear and greed associated with stock exchanges and this was best highlighted by investments in emerging markets. As emerging markets had higher risks associated with them, they also had higher returns. However based on an irrational whim as occurred in 1998 and more recently concerning China, international investors and speculators thought there would be a downturn in the fortunes of emerging markets. This is a self-fulfilling prophecy as when investors start withdrawing their investments from these emerging markets, there would indeed be a downturn.

He explained that companies listed on the JSE did not make any money when their share price increased. Brokers and other investors made this money. The only time a company made money off the JSE was at its Initial Public Offering (IPO) when it offered shares in its company for sale. This sale usually happened at a premium based on the calculations made by investment banks. The company took this premium as part of its capital.

Discussion
Ms Kondlo asked why one would want to buy shares when another is selling them as this seemed counter intuitive.

Mr Stephens replied that this was because of different views of the company. This was true as the one buying the shares believed there was still some value to be unlocked in the company and that the share price would increase.

Mr P Hendrickse (ANC) asked whether, when companies increased the number of shares available, this would not dilute the shareholding of the initial shareholders.

Mr Stephens replied that the company and shareholders would have to agree to the issuing of more shares owing to the company being in need of more capital.

Professor E Chang (IFP) stated that the stock exchange was nothing more than a gamble.

Mr Hendrickse asked for comment on the ‘herd mentality’ of investors as evidenced by the contagion effect that hit emerging markets. He also asked why South Africa was grouped with all other emerging markets when it had its macroeconomic fundamentals in place.

Mr Stephens discussed Black Economic Empowerment (BEE) in listed companies and stated that as most of these black entrepreneurs had not paid for their shares and would only use their dividends to pay off these shares, the difficulty became apparent when the company went under. This was as creditors would want their money back from the company and this would leave the BEE entrepreneurs in a very precarious position.

The Chairperson enquired if the average person knew the cause of fluctuations on the stock exchange. He also wanted to know if there was an objective criterion one could use when deciding whether to buy or sell shares. Moreover, he asked for reasons why a private company would go public. He qualified this by asking for the role of investment banks in IPOs.

Mr Stephens stated that private companies would go for an IPO as the capital companies get from selling shares does not have to be repaid, whereas a loan does. A good company normally had a healthy balance between share capital and loan capital. If a company did not borrow money it would be caught in ‘low gearing’ and would never pick up business momentum.

Administrative Issues
The Chairperson thanked Mr Stephens for the presentation and bade him farewell as he was leaving the Committee. He informed the Committee that ESKOM had been given seven days to respond to questions from the Committee and yet three weeks later none had been received. He asked the Committee Secretary to follow it up.

Mr Hendrickse enquired when South African Airways (SAA) would be coming to address the Committee. He also asked that when State Owned Enterprises (SOE) appeared before the Committee they should be asked for the remuneration packages of their executives and how these figures were arrived at.

The Chairperson suggested that the Committee attend the SAA briefing to the Standing Committee on Public Accounts (SCOPA) next Wednesday.

Mr K Minnie (DA) asked where the Committee's programme for the year was.

The Chairperson informed the Committee that the secretary would look into it as it was supposed to have been disseminated already. He then proposed that the Committee look at Budget Vote 30: Public Enterprises. He informed Members that Mr Len Verwey from the Institute for Democracy in South Africa (IDASA) had kindly agreed to help the Committee evaluate the Department’s budget.

IDASA Evaluation of Department of Public Enterprises (DPE) 2007/08 budget
Mr Len Verwey (Senior Researcher) started his presentation by informing the Committee he was not an expert on matters related to the SOEs or Department of Public Enterprises. His role was to merely assist the Committee in its oversight role.

He articulated four tools used when analysing budgets, namely: priority, progress, equity and adequacy. Priority dealt with whether the budgetary allocations reflected relative departmental goals and priorities. Progress looked at trends in relative priority over time. Equity was the extent to which the activities of the department ensured that SOEs were able to achieve their social and commercial objectives. Adequacy looked at whether the allocations to the DPE were adequate for their functions.

Mr Verwey advised Committee Members to be suspicious when evaluating the budget if there are huge changes in spending and allocations. They should do this with caution as some of these spikes may be explained by capital recapitalisation as was the case with DENEL. When looking at the allocation to each of the DPE’s programmes the Committee should consider whether the allocation is in line with the relative priority of the programme. He highlighted the fact that the DPE’s budget had increased tremendously in 2005/ 2006 and 2006/ 2007. Questions should be posed to the department why the budget share given to Energy, Broadband Infrastructure and Mining Enterprises has decreased and why such large allocations are going to manufacturing enterprises. Moreover, it was interesting to note that the allocations given to SOEs are expected to decrease in 2008/ 2009 and the Committee should find out how realistic this projection is owing to the fact that SAA recently needed assistance from government.

The Chairperson informed the Committee that as the country changed its macroeconomic policy and role to that of a developmental state the role of the SOEs had increased tremendously as they would become the primary drivers of the economy. The figures presented by Mr Verwey indeed matched the strategic objectives of the DPE and indeed government. He asked Mr Verwey if he could account for the big discrepancy in budgetary allocations between 2006/2007 and 2007/2008.

Mr Verwey replied that the figures might have been distorted owing to the huge chunk the Energy, Broadband Infrastructure and Mining Enterprises had received.

Mr Verwey went on to explain the process of adjusting allocations for inflation. This was done to look at the real purchasing power in constant Rands as the Committee would be unable to reach definitive conclusions when looking at nominal values. The Committee should look at whether the transfers to SOEs are long term or short term. He also highlighted the nominal increase of 62.5% for consultants and suggested that the Committee seek clarity regarding this and whether a better solution would not be for the department to retain expertise in house. Furthermore, he asked how the department ensures it was getting value for money from these consultancy services. The Committee should seek clarity as to why the allocations to the DPE’s capital assets were declining so rapidly and whether the DPE can explain the basis on which travel and subsistence allocations are calculated as there had been a radical change.

Discussion
Mr Minnie enquired whether the Committee would receive any more briefings before the budget debate in May.

The Chairperson replied that there was not to be another briefing before May. In order to get in more specialists the Committee would need to go out on tender. As IDASA had graciously offered their services free the Committee would continue to use IDASA specialists when they were available. He took that opportunity to thank Mr Verwey for his presentation. The Committee would ask the department to respond to the issues raised and explain discrepancies that would lead to a more fruitful engagement. He invited IDASA to the briefing with the Department.

Mr Minnie asked when the DPE’s Chief Financial Officer (CFO) would be making a presentation to the Committee.

The Chairperson responded that this would be on 2 May. The change in the DPE’s programme had thrown the Committee’s programme into disarray.

Ms Kondlo wanted clarity on whether the spikes in allocations were owing to under spending and over spending.

My Verwey replied that although he was not an expert on the DPE he did not think that performance related to spending patterns would be a major contributing factor in allocations, but rather that allocation was according to the Department’s strategic objectives.

The Chairperson sought clarity on how the National Treasury decided on its Medium Term Expenditure Framework (MTEF) and whether it was consistent. He also lamented the Committee’s budget reports and took it upon himself to improve them.

Mr Verwey stated that the primary determinant is the macroeconomic environment. The allocations were a fundamentally political process in line with government’s objectives. The MTEF was overly cautious in his opinion and he suggested the Treasury could run a more expansionary fiscal policy.

The Chairperson thanked Mr Verwey and closed the meeting.