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THERE is general agreement that countries with large external deficits (that are therefore the most dependent on continuing capital inflows to finance those deficits), weak fiscal positions, and liquid financial markets with substantial foreign holdings of local assets are the most vulnerable.
South Africa has unceremoniously been included in a grouping referred to as the “Fragile Five” (along with Brazil, Turkey, India and Indonesia) because of its current account deficit nearing 7% of GDP, a budget deficit in excess of 4% of GDP with government struggling to bring it down, government debt nearing 45% of GDP, and relatively liquid markets making it easy for foreign investors to adjust asset holdings.
Concern regarding South Africa’s “fragility” has already been expressed in a marked depreciation in the exchange rate of the rand. Addressing this vulnerability would require a tightening in macro-economic policy at a time when the economy is already struggling to maintain a 2% growth rate. We have already seen the first step being taken by the South African Reserve Bank (Sarb) last week.
But exactly how exposed is South Africa to the possible negative effect of tapering by the US Federal Reserve on capital flows?
In its Global Economic Prospects 2014 report, the World Bank argues that emerging markets face the greatest threat from a contraction in portfolio investment flows.
With reference to portfolio investment, there is no compelling evidence that net foreign purchases of South African equities have benefited greatly from the Fed’s quantitative easing policies. In fact, cumulative net purchases for the five years up to the end of 2013 amounted to R8.8bn, compared with R16.6bn for the previous five years.
As long as South Africa remains a constituent of the Citi World Government Bond Index, requiring inter alia that it maintains its investment grade sovereign credit rating, it will act as an incentive for foreign investors to hold South African bonds and a brake on foreign withdrawal in the event of an emerging market sell-off.
South Africa is also less vulnerable than many other emerging market countries to a reduction in capital flows into emerging corporate bond markets, as it did not experience a surge in new issuance similar to that in many other emerging market countries.
Statistics from the UK's Department for Business, Innovation & Skills (BIS) furthermore indicate that cross-border borrowing from international banks by South African banks has hardly increased in the past five years and is limited in extent – in October 2013 foreign loans amounted to 2.5% of total equity and loans for South African banks, making SA less vulnerable to an increase in interest rates in developed markets.
It is also striking that another indicator of hot money flows, viz bank deposits by non-residents, has hardly budged in the past five years – their current level is almost unchanged at R100bn compared to when the Fed started with QE in November 2008.
One should bear in mind that in order to benefit from the carry trade foreigners have to take an uncovered position in the rand and that the historical volatility of the exchange rate of the rand makes this a very risky strategy.
Although South Africa has experienced net sales of equities and bonds since the Fed first indicated in mid-2013 that it was contemplating an end to quantitative easing, monthly sales have been within one standard deviation with the exception of November 2013.
One could also argue that factors peculiar to different asset classes, e.g. historically high valuations in the case of equities (the price-earnings ratio for the JSE All Share Index rose to almost 19 in Q4 2013 compared with a 10-year average of 14,9) played a decisive role in investors’ decision to take profits, rather than it being due to expectations of Fed tapering.
It should furthermore be borne in mind that the withdrawal of central bank stimulus will in any case depend on a sustained improvement in economic growth and employment, which will be to the benefit of emerging market growth. If this is accompanied by a weaker rand in response to dollar strength the current account balance may well improve.
It can also not be ruled out that reduced foreign portfolio inflows will be accompanied by reduced domestic portfolio outflows as a weaker (and probably undervalued) rand will make offshore investment less attractive to local investors.
The weakness in the rand will by itself temper enthusiasm for foreign investors to sell SA assets; indeed, at some point a weaker exchange rate will make the case for re-engagement compelling. In other words, in assessing net portfolio flows the benefits of a flexible exchange rate should not be underestimated.
- Fin24
The above is an extract from Sanlam economist Jac Laubscher's Economic Commentary entitled Some thoughts on Fed tapering and capital flows to emerging markets.
South Africa has unceremoniously been included in a grouping referred to as the “Fragile Five” (along with Brazil, Turkey, India and Indonesia) because of its current account deficit nearing 7% of GDP, a budget deficit in excess of 4% of GDP with government struggling to bring it down, government debt nearing 45% of GDP, and relatively liquid markets making it easy for foreign investors to adjust asset holdings.
Concern regarding South Africa’s “fragility” has already been expressed in a marked depreciation in the exchange rate of the rand. Addressing this vulnerability would require a tightening in macro-economic policy at a time when the economy is already struggling to maintain a 2% growth rate. We have already seen the first step being taken by the South African Reserve Bank (Sarb) last week.
But exactly how exposed is South Africa to the possible negative effect of tapering by the US Federal Reserve on capital flows?
In its Global Economic Prospects 2014 report, the World Bank argues that emerging markets face the greatest threat from a contraction in portfolio investment flows.
With reference to portfolio investment, there is no compelling evidence that net foreign purchases of South African equities have benefited greatly from the Fed’s quantitative easing policies. In fact, cumulative net purchases for the five years up to the end of 2013 amounted to R8.8bn, compared with R16.6bn for the previous five years.
As long as South Africa remains a constituent of the Citi World Government Bond Index, requiring inter alia that it maintains its investment grade sovereign credit rating, it will act as an incentive for foreign investors to hold South African bonds and a brake on foreign withdrawal in the event of an emerging market sell-off.
South Africa is also less vulnerable than many other emerging market countries to a reduction in capital flows into emerging corporate bond markets, as it did not experience a surge in new issuance similar to that in many other emerging market countries.
Statistics from the UK's Department for Business, Innovation & Skills (BIS) furthermore indicate that cross-border borrowing from international banks by South African banks has hardly increased in the past five years and is limited in extent – in October 2013 foreign loans amounted to 2.5% of total equity and loans for South African banks, making SA less vulnerable to an increase in interest rates in developed markets.
It is also striking that another indicator of hot money flows, viz bank deposits by non-residents, has hardly budged in the past five years – their current level is almost unchanged at R100bn compared to when the Fed started with QE in November 2008.
One should bear in mind that in order to benefit from the carry trade foreigners have to take an uncovered position in the rand and that the historical volatility of the exchange rate of the rand makes this a very risky strategy.
Although South Africa has experienced net sales of equities and bonds since the Fed first indicated in mid-2013 that it was contemplating an end to quantitative easing, monthly sales have been within one standard deviation with the exception of November 2013.
One could also argue that factors peculiar to different asset classes, e.g. historically high valuations in the case of equities (the price-earnings ratio for the JSE All Share Index rose to almost 19 in Q4 2013 compared with a 10-year average of 14,9) played a decisive role in investors’ decision to take profits, rather than it being due to expectations of Fed tapering.
It should furthermore be borne in mind that the withdrawal of central bank stimulus will in any case depend on a sustained improvement in economic growth and employment, which will be to the benefit of emerging market growth. If this is accompanied by a weaker rand in response to dollar strength the current account balance may well improve.
It can also not be ruled out that reduced foreign portfolio inflows will be accompanied by reduced domestic portfolio outflows as a weaker (and probably undervalued) rand will make offshore investment less attractive to local investors.
The weakness in the rand will by itself temper enthusiasm for foreign investors to sell SA assets; indeed, at some point a weaker exchange rate will make the case for re-engagement compelling. In other words, in assessing net portfolio flows the benefits of a flexible exchange rate should not be underestimated.
- Fin24
The above is an extract from Sanlam economist Jac Laubscher's Economic Commentary entitled Some thoughts on Fed tapering and capital flows to emerging markets.
