South Africa rail recapitalisation sets new trend in local content on procurement, financing, employment, and skills transfer

South Africa's largest-ever rail recapitalisation programme has seen the country's state-owned freight logistics firm, Transnet SOC Limited, award contracts worth more than USD4 billion to four global original equipment manufacturers (OEMs) to build 1,064 electric and diesel locomotives. The OEMs involved are local subsidiaries of China's Zhuzhou Electric Locomotive Corporation Limited and CNR Rolling Stock, Canada's Bombardier Transportation, and US-based General Electric Technologies.

The acquisition of the locomotives is the country's largest infrastructure investment by a corporation. The locomotives are due to be completed by 2018 and will be deployed in Transnet's Freight Rail cargo division, which transports agricultural, automotive, mineral, and container cargo.

Stringent local content requirements make acquisition a landmark deal

The landmark features of the locomotive acquisition deal are the stringent local content, skills development and training commitments, which aim to localise the production of imported equipment and machinery. The local content amounts to 60%, even though the threshold was set at 40%. Almost all locomotives will be built at Transnet Engineering's plants in Koedoespoort, Pretoria, and Durban. The objective is for Transnet Engineering to share approximately 16% of the total build programme and so gradually to transform into an OEM. Emerging South African manufacturing and engineering firms also share about 5% of the build programme to create export capability. The local content of the deal is expected to contribute USD7.5 billion to the South African economy.

By hosting the manufacturing at its facilities, Transnet should gain a huge skill set to manufacture this type of equipment and be able to develop as a hub for transport manufacturing in the long term. Additionally, part of the agreement with China's CNR is to set up research-and-development facilities and joint training centres that will further enhance skills and intellectual property transfer.

Acquisition's financing is locally raised and locally denominated

The financing is completely denominated in the South African rand and is almost entirely raised through South Africa's banking sector. Transnet has committed to funding two-thirds of the whole capital investment through revenue generated from its operations. The remaining third has been raised from both domestic and international capital markets. In March, Transnet secured USD1.08 billion (in rand equivalent) in export credit facilities. Some USD498 million guaranteed by the US Export-Import Bank funded the construction of 293 locomotives by GE, with funds raised by Barclays Africa Group Limited (through its ABSA Bank subsidiary in South Africa), Standard Bank of South Africa Limited, and Old Mutual plc (which has a stake in South Africa's Nedbank). A further USD580 million was raised from Export Development Canada and South Africa's Investec Bank.

Outlook and implications

The significance of the Transnet acquisition is substantial and sets a new precedent on local content provision that will affect regulatory burden and contract alteration risks, especially for foreign investors in the manufacturing, engineering, transportation, construction, aviation, and defence sectors. Based on the Transnet precedent, major acquisitions and projects in these sectors will be required to implement far more stringent local participation, employment, financing, procurement, and ownership regulations. Under the Transnet model, state-owned enterprises will play a far more active role in economic development. This is in accordance with the governing African National Congress (ANC) party's ambitious flagship socio-economic growth plan, the National Development Plan (NDP).

The NDP is a broad framework for socio-economic policy direction to stimulate economic growth and to lower unemployment (currently over 25%), based on market-friendly initiatives and infrastructure development within public-private partnerships. It seeks to reverse the economic slide of 2012, which was marked by widespread industrial unrest, dwindling foreign investment, and several credit downgrades. The NDP will encourage partnerships between the government and the private sector, creating opportunities in petrochemical industries, metal-working and refining, as well as development of power stations (gas, coal and nuclear). However, the NDP encourages strong partnership with state investment vehicles, such as the National Empowerment Fund or the Development Bank of Southern Africa, as well as state-owned enterprises Eskom (power), Transnet (logistics), and Telkom (telecoms). State participation is likely to expose investors to risk of preferential treatment for favoured bidders. In the construction sector, for example, South African and Chinese firms are likely to be favoured. As the government has dismissed or rotated several heads of state enterprises, delays and frustration of projects also are likely.

Transnet's state-driven model is different from the approach used by countries such as Angola and, more recently, Mozambique, where foreign investors and operators in infrastructure development are either encouraged or required to partner local politically affiliated companies. The Transnet model offers greater contract security, poses lower reputational risk, and exposes foreign companies to less corruption risk than this approach.

The Transnet investment model is also likely to offer greater local development, since it offers a departure from previously popular massive mineral-backed deals in Africa, such as oil-backed infrastructure expansion in Angola or copper-backed infrastructure expansion in the Democratic Republic of Congo. In these cases, Chinese financing provided Chinese jobs to extract a mineral that was exported to China. Under the Transnet model, African financing is deployed to boost African employment and enhance the long-term benefits for infrastructural capacity for a key state-owned entity such as Transnet – which will boost trade, especially intra-regional trade within Africa,

Beyond local content, the Transnet acquisitions also indicate African banks are increasingly active in financing of major infrastructure projects within Africa. Previously, such financing was dominated by large multinational banks. Due to regulatory constraints such as Basel III capital requirements, multinationals have partly withdrawn, while export agency direct loan and securitisation guarantee programmes have offered smaller banks new opportunities to fund infrastructure and large original equipment deals.