Country Risk Analysis of South Africa and Its Gold Mining Industry - Report Example

International Corporate Finance- Business Report Executive Summary This study is on the situation where the Australian Investment bank has to advice King Minerals Limited on the country which would be suitable for exploration or expansion of mining business. This is possible through conducting a country risk analysis, where the political and economical risks of the country would be evaluated in details in order to take decisions for the same. The country chosen is South Africa and gold would be best option when it comes to choosing mining mineral in South Africa. This is because South Africa is one of the major producers of gold in the world. The Foreign Direct Investments policies of the country and a suitable market entry mode have been suggested in order to direct KM an entry path towards South Africa. Table of Contents Executive Summary 2 Introduction 5 Background 5 Mission of King Minerals Limited (KM) 6 Outline of the Study 6 Country Risk Analysis 6 Political Risk Analysis 6 Government in South Africa 8 Government Policies for Mining Industry 8 Economic or Financial Risk Analysis 9 Gold Mining Contribution to GDP 10 Gold Mining Impacts on South Africa 12 Affect of Gold Mining on the Economic Condition 12 Taxation System for Mining Industry 13 Foreign Direct Investment 14 Conclusion and Recommendations 15 References 16 Bibliography 18 Introduction Background The study aims at conducting a country risk analysis to assist the Australian Investment Bank in advising about investment opportunities in South African gold mining industry. King Minerals Limited (KM), an Australian mineral firm wanted to float an ambitious program for exploring and extracting gold in Africa, so it is important to conduct an analysis of Africa and its gold mining industry. The political, social and economic record of South Africa to a large extent is influenced by the exploration of a glittering metal called Gold. The gold mining industry played a very significant role in the economy of South Africa, with respect to its employment opportunities, exports, financial growth and a huge contribution to the revenue generated from government tax. The gold mining industry contributed about 1.4 percent to the GDP of the country in the year 2004 (Kearney, 2012). However, in 2006, the prices of gold increased as the focus was mainly on productivity and cost. The production of local gold decreased by 7.5 percent, which was about 275 tons, but in spite of this the gold industry of South Africa is in the top most producer of gold in the global market, which is about 11.2 percent. Gold mining sector is critical for the South African economy. In the year 2006, this sector contributed R36.7 billion to the total export of South Africa, which was about 8.4 percent, and 1.1 percent of the GDP (Chamber of Mines of South Africa. 2008). The gold industry is also linked to the other developments in the country such as the infrastructure development, formation of capital, and also urbanization. The gold industry is taxed in a much different way that the other industries of South Africa. The taxes are imposed on a formula basis, while all the other mineral industries are taxed on a flat rate in case of income tax filings. However, the tax authorities in South Africa have decided to introduce revenue system that is based on royalty for imposing tax on the gold revenue mining. This regulation has been imposed since 2009 (PWC. 2012). Mission of King Minerals Limited (KM) King Minerals Limited (KM) is committed towards creating and delivering outstanding values to the stakeholders through the development, exploration, and mining of gold and other valuable metals. Outline of the Study The study attempts to focus on the country risk analysis of South African gold mining sector and assess the various risk factors that need to be analyzed before developing a business proposal for exploration and mining activities in South Africa for gold. The study begins with a background of the gold mining industry of South Africa. This would give a quick review of the gold mining sector of South Africa, in the present times and its significance in the country. Then the mission of the Australian mining company KM has been mentioned in order to state the purpose of developing this study. Further, a country risk analysis is conducted on South Africa, which would focus on the political, economic and legal factors of the country. Country Risk Analysis Political Risk Analysis The political environment of the country has a significant impact on the international activities of the company. South Africa is a parliamentary republic country and the president of South Africa is the head of the states as well as the government. As in 2012, Jacob Zuma of African National Congress party is the South African president (Kesselman, 2012, p. 245-246). In this section the political risks of South Africa would be discussed, though the political changes affect the different industries differently. The political risk is considered to be macro in nature when the changes affect the foreign investments (Jacobs, n. d.). When expansion or exploration is conducted in developing countries, the risk of civil disorder, expropriation or war is there and these may lead to labor disruptions, or fluctuations in prices, so that all those organizations doing or planning to do business outside their home country should be aware of the political changes and risks associated with that. This would assist them to handle the political decisions (Solberg, 1992, p. 118-119). It is necessary to identify the value drivers and the risks before expanding the mining operations in South Africa for reaping rewards which the country can offer. The country holds 20-30 percent of the worlds entire metal and mineral resource, but still it is underexplored. However the political threats are the major challenge in Africa. The threat of poor governance, fragile security system, tedious legislative framework, unclear tax policies are major concern in Africa. So the company must undertake a rigorous analysis of the acquisition target with respect to parameters like geographical, climatic, rights, existing operations, etc. The mineral company will have to consider three major steps in political risk assessments namely, risk framing, quantification of the impacts, checking the probability of the risk, and determining the risk profile (Guzek, Kruger, & Alberts, n. d., p. 1-3). Government in South Africa The economy of Africa is growing, but the threats from political instability remains in the country. Apart from this hike in food and oil prices, unemployment, and global recession are making the matter worse. African Development Bank states that, a growth of 4.5 percent is expected in 2012 and 4.8 percent in 2013 (Xinhua, 2012). On the verge of the global recession, the African National Congress has been focusing on solving the battle between President Jacob Zuma and his enemies, rather than focusing on the economic aspects. The policy meeting conducted by the government only highlights issues like education system, unemployment and labor laws. This has not impressed the investors much. The leading labor federation in South Africa went on mass protest for utilizing temporary workers. The government top financial advisors are formulating policies which are not union friendly. This will compel the firms in Africa to hire and also fire the employees at their own easily with any solid reasons. However, the bills were sent to the parliament for approval, which further created pressure on the employers and created more barriers for hiring seasonal labors. The Economist reveals that, the South African government has to cut down its stiff policies in order to reduce unemployment in the country. A million workers lost their jobs due to such policies of the Zuma government. Government Policies for Mining Industry South Africa accounts for about 15 percent of the gold production in the world in the year 2002, which reduced to 12 percent in 2005. According to the Chief Executive of AngloGold Ashanti, the economic conditions particularly related to the gold mining industry are expected to be competitive in future and earn revenue. The government policies in relation to the labor laws and new resource tax system have been criticized, as these are the few barriers that can be considered for the mining industry as well. These policies were considered absolutely inconsistent with respect to its employment and growth objectives. The increasing tax rates have also reduced the investment in the sector. Moreover talks of nationalizing the mining of gold and platinum are also on hold. It also seems that the minerals resource industry is not going in the right direction due to certain misleading wrong polices of the government (Reuters Africa, 2012). Economic or Financial Risk Analysis The economic development in South Africa started since 1886, when gold was discovered in the country. The economical structure of the country changed its focus from agriculture to mining economy, leading to an industrial economy and now it has become a service oriented economy (South African History Online, n. d.). This section would focus on the contribution of gold mining industry towards the GDP of the country, its impact on the economic condition of the country, effect on the government revenue, and taxation system in case of gold mining industry. Further, an analysis of the South African currency exchange rates would be examined, the significance of foreign direct investment would be evaluated and modes of market entry for foreign companies in the mining industry would be studied (Carbaugh, 2010, p. 319). Gold mining requires huge capital investment and specific equipments. The lead time required for development activities to actual production of gold is long. Previously the Rand exchange rate was weaker than dollar, so the pressure of cost could be neglected, but after 2002 the condition has reversed and the miners have lost their cushion of high price of rand as shown in Figure 1. In chart 1 of figure 1 the price of Rand is shown in the graph with comparison to dollar from 1994-2004. Similarly in chart 2 of Figure 1 the rand gold price is show from1994-2004 (Mogotsi, n. d., p. 15) Figure 1 Source: (Mogotsi, n. d., p. 15) Gold Mining Contribution to GDP In this section we would be investigating the contribution of the gold mining sector to the GDP of the country over a period of 10 years that is from 2000 – 2010. The gold contributions of South African mining companies are stated below in figure 2. Figure 2 states the gold output of South Africa from 2001-2010. The statistics contain the figures for the total amount of raw gold derived from mines, amount of gold treated or refining and the total value of the gold produced per year. Figure: 2 Source: (Bullion, 2010, p. 23). Since 1950 – 2004, the contribution of the gold mining industry to the GDP has been gradually decreasing. In the year 2001, the GDP was 3.1 percent, which increased to 4.1 percent in 2002, but it again fell to 1.8 percent in the year 2003 and 1.4 in 2004. Further it has come down to 1.1 percent in 2006. The reasons behind this fall might be the upcoming competitors like China in the gold mining industry, the global economic slowdown or the instable government of the country along with their de-motivating tax and labor policies. The gold mining contribution to the mining industry of South Africa has also decreased with time; such as 81.9 percent was in the year 1911, which fell to 21.4 percent of gold mining was in 2004. Gold Mining Impacts on South Africa The change that comes in a poor nation to a rich society includes changes in employment opportunities, trade and commerce, production, demand, etc. South Africa today is also the effect of such change that gold mining infused in the basic framework of the country. Gold is one of the major export commodities in South Africa. Due to the inflow of the foreign investments in the gold mining industry of South Africa, the domestic savings of the country could be channeled for the development of the other sectors or projects. The capital generated from gold mining in the country is spent on infrastructure such as developments of roads, railways, and electricity, sanitation and communication facilities. The railway system in the country was set mainly for the purpose of gold and diamond mining in the initial stage (African Development Bank Group, 2012, p. 6-8). Affect of Gold Mining on the Economic Condition The industries are linked to other industries in different ways. The products of the explosive industry are utilized in gold mining industry such as dynamite, so gold mining industry also creates opportunities for explosive and chemical industries. Further gold mining industry would also directly affect the jewelry sector in different countries where gold jewelry is very important, especially in Asian countries. This would also motivate firms to setup local gold refineries. The employee earnings working in the gold mining industry has been increasing, after the decrease due to the economic slowdown, as can be seen in figure 3. Figure 3 states the total earning that the employees working in the gold mines of South Africa earned from 2001-2010. It gives a comparative analysis of the total number of employees in each year and their total earnings. Figure 3 Source: (Bullion, 2010, p. 23). Taxation System for Mining Industry The mining laws in South Africa has been revised a number of times with the changing economic situation of the global market. A flat rate of 28 percent was imposed on all the mining companies except gold mining. The gold mining industry has to pay the tax based on a formula, which considers the profit ratios to its revenues. The proportion of tax increases with increasing in profit percent, so this means that no profit would lead to payment of no tax. This system is helpful during the slowdown period. Though it can be considered negative too because the mineral company has to pay higher tax with higher income and there is no scope for earning supernormal profits (Curtis, 2009, p. 6-7). A new royalty bill has been introduced in 2008, which includes that the privately owned miners has to pay a royalty which would be determined through agreements between the miner and the local chiefs and the state owned companies would have to pay 1 percent royalty on all minerals except diamond and 5 percent on diamonds. The draft was revised and separate royalty rates for each mineral were ascertained. Gold mining would incur 3 percent royalty. The royalty was charged on turnovers, but then it was revised and charged on profits. However, companies are still earning considerable profit after paying the relevant tax and royalties too. Mining industry is the most lucrative industry for South Africa, so the government also implements such systems, so that it can derive maximum revenue from this sector. Foreign Direct Investment South Africa is richly gifted with precious minerals and also posses the major reserves of gold in the world. So among the countries in the sub-Saharan region, South Africa receives the maximum FDI. However, there have been variations in the FDI due to the investments in the government utilities such as communication, etc (Geological Survey (U. S), 2010, p. 1.6). The relaxations in the barriers to free trade have eased the control of the exchange, which has led to increasing foreign investments after 1994. The FDI in the year 2007 was about $1.3 billion in the South African mining sector. It would be advisable that KM gets into Joint venture with one of the top players in South Africa to avoid the risk of loses as well the company would be able to utilize the expertise of the host company as it would already knowing the norms and policies of the government for mining. Moreover, the major mining company in South Africa would have the know-how of the geographic locations for exploration (Gelb, & Black, n. d., p. 180). Conclusion and Recommendations The study aims at conducting a country risk analysis of South Africa and its gold mining industry, so as to assist the Australian Investment Bank in advising the Australian mining company, KM in developing strategies to start exploration activities in South Africa. Country risk analysis includes two basic factors such as political analysis and economic analysis of the factors related to gold mining industry in South Africa. The political factors revealed that the government of the country was unstable and was not adequately capable of taking effective decisions or formulate motivating policies, so that the developing industries of the country, such as gold mining can be utilized to generate more revenue. The economic conditions are stable due to improvements in the financial condition of the mining sector, including gold. However, threats from other countries like China are also quite significant, so South African government has to develop policies in terms of its labor laws, and tax regulations to remove the barriers. Also FDI should be welcomed in order to receive more foreign investors and investments. Inflation should be controlled and basic commodity prices should be reduced in order to improve the standard of living. References African Development Bank Group. (2012). Gold Mining in Africa: Maximizing Economic Returns for Countries. Retrieved from: http://www.afdb.org/fileadmin/uploads/afdb/Documents/Publications/WPS%20No%20147%20Gold%20Mining%20in%20Africa%20Maximizing%20Economic%20Returns%20for%20Countries%20120329.pdf. Bullion. (2010). Facts & Figures 2010. Retrieved from: http://www.bullion.org.za/Publications/Facts&Figures2010/F%20and%20F%202011-small.pdf. Carbaugh, R. (2010). International Economics. (13th ed.). Connecticut: Cengage Learning. Chamber of Mines of South Africa. (2008). The importance of gold mining to South Africa. Retrieved from: http://www.bullion.org.za/content/?pid=84&pagename=Gold. Curtis, M. (2009). Mining and Tax in South Africa: Costs and Benefits. Retrieved from: http://www.curtisresearch.org/SAfrica.MiningTax.Feb09.Curtis.pdf. Gelb, S., & Black, A. (no date). Foreign Direct Investment in South Africa. Retrieved from: http://www.dfid.gov.uk/r4d/PDF/Outputs/CNEM/drc07_south_africa.pdf. Geological Survey (U.S.). (2010). Minerals Yearbook, 2007, V. 3, Area Reports, International, Latin America and Canada. Washington D. C.: Government Printing Office. Guzek, J., Kruger, L., & Alberts, C. (no date). Identify value drivers and risks when expanding your mining operations into Africa. Retrieved from: http://www.deloitte.com/assets/Dcom-SouthAfrica/Local%20Assets/Documents/Risk%20and%20value%20drivers%20when%20expanding%20into%20Africa.pdf. Jacobs, H. E. D. (no date). Political and Economic Stability in South Africa: An Overview. Retrieved from: http://www.hri.org/MFA/thesis/summer98/stability.html. Kearney, L. (2012). Mining and minerals in South Africa. Retrieved from: http://www.southafrica.info/business/economy/sectors/mining.htm#.UFLoGa7wniQ. Kesselman, M. (2012). Introduction to Politics of the Developing World: Political Challenges and Changing Agendas. (6th ed.). Connecticut, Cengage Learning. Mogotsi, L. (no date). Challenges Facing the South African Gold Mining Industry. Retrieved from: http://www.lbma.org.uk/assets/alch38_safrica.pdf. PWC. (2012). Corporate Income Taxes, Mining Royalties and Other Mining Taxes. Retrieved from: http://www.pwc.com/en_GX/gx/energy-utilities-mining/publications/pdf/pwc-gx-miining-taxes-and-royalties.pdf. Reuters Africa. (2012). S.African Mining Policies Inconsistent: Anglo. Retrieved from: http://af.reuters.com/article/topNews/idAFJOE82S07O20120329. Solberg, R. (1992). Country Risk Analysis: A Handbook. Oxon: Routledge. South African History Online. (no date). 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