July 31, 2019
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By Kevin Lings, STANLIB Chief Economist
South Africa’s economic performance has deteriorated noticeably over the past ten years. We’ve seen a substantial slowdown in economic growth and a rapid increase in government debt. Despite this, foreign investors now own almost 40% of the government’s domestic debt compared with only 14% ten years ago. South Africa has become increasingly reliant on this foreign capital to supplement low domestic savings, but this increases the risk of financial instability should circumstances change.
A decade of loose monetary policy in the major developed economies has heavily impacted global investment flows
Since the beginning of 2010 foreign investors substantially increased their holdings of emerging market equities and bonds. According to the Institute of International Finance (IIF), foreign investors bought around $2 trillion of emerging market bonds and $0.7 trillion emerging market equities over the past ten years. Their holdings of emerging markets assets increased every year for the past ten years.
It is no-coincidence that these record investment flows into emerging markets correspond with the extended phase of
extraordinarily loose monetary policy in the United States, Euro-area and Japan. That includes extremely low interest rates, and unprecedented levels of Quantitative Easing (QE). The low interest rates in developed economies, coupled with increased market liquidity, undoubtedly encouraged many investors to buy higher yielding emerging market assets, despite the relatively higher level of risk that is typically associated with these assets. In fact, since 2010 a number of emerging markets had their international credit rating revised lower. Yet, they experienced an increase in foreign
investment inflows in 2011, immediately after the downgrade, largely due to the attractiveness of their government bond yield. The net result is that almost every major emerging market, including South Africa, saw foreign holding of their bonds, and to some extent equities, rise meaningfully.
For example, according to data provided by the National Treasury as well as the South African Reserve Bank, in 2018 foreigners owned around 38% of South Africa’s bond market, up from a mere 14% in 2009.
Furthermore, data provided by the IIF shows that in September 2018 foreign holding of South African bonds and equities represented 69.9% of South Africa’s GDP, up from only 35.1% in December 2009.
This means that South Africa’s financial markets have become increasingly influenced by global developments. Changes in foreign investor sentiment are quickly reflected in South Africa’s financial markets including the value of government bonds, equities and the Rand exchange rate.
Similar trends are evident in many other emerging economies including South Korea, Peru, Malaysia, Mexico, Thailand, Chile and Czech Republic.
South Africa attracted foreign investment despite weak growth and credit rating downgrades
Ironically, the increase in South Africa’s foreign portfolio investment over the past ten years coincided with a very meaningful slowdown in South Africa’s GDP growth, rising unemployment, widespread evidence of corruption, regular electricity outages, subdued business confidence and weakening government finances.
It is no surprise, that most of the increase in South Africa’s foreign portfolio investment since 2010, especially foreign purchases of government bonds, was not motivated by South Africa’s economic fundamentals, but rather by the favourable yield differential between South African government bonds and developed market government bonds.
For example, in 2018 South Africa’s 10-year government provided an average yield of 8.4%, compared with only 2.9% in the United States, 0.46% in Germany and a mere 0.07% in Japan. Many foreign investors have simply been attracted by South Africa’s relatively high bond yield, despite weakening economic fundamentals, and are willing to stomach South Africa’s currency volatility or manage their overall portfolio risk through the use of financial derivatives, including currency derivatives.
On reflection, South Africa has done remarkably well at attracting a fairly steady inflow of foreign portfolio investment over the past ten years despite the recent credit rating downgrades, regular spates of negative press, and skepticism among many local investors who, have tended to diversify their own assets away from South Africa.
South Africa remains reliant on foreign portfolio investment and struggles to attract foreign direct investment
Unfortunately, while South Africa has managed to increase foreign portfolio investment since 2010, the country still struggles to attract a steady and meaningful inflow of foreign direct investment (FDI). (An example of foreign direct investment would include an offshore company deciding to start a manufacturing business in South Africa using domestic labour and local raw materials).
The lack of significant FDI flows appears to reflect foreign investor concerns about South Africa’s business environment, including high levels of crime and corruption, infrastructural bottlenecks such as electricity shortages, regular labour market disruptions in the form of strikes and work stoppages, policy uncertainty including land redistribution without compensation as well as a general shortage of critical skills.
In contrast, the relatively high level of foreign portfolio investment into South African Government Bonds as well as domestic listed equities partly reflects foreign confidence in the regulation of South Africa’s securities trading, including both the equity and the bond market. This includes the adoption of international rules and regulations, efficient electronic trading and clearing systems, as well as an excellent dispute resolution process.
Crucially, the savings-investment identity dictates that the level of savings equals the level of investment. At the end of 2018, South Africa’s savings amounted to only 14% of GDP, which is essentially the lowest ever recorded in the country, yet fixed investment spending amounted to 18% of GDP. This means that despite weak economic growth, South Africa is still running a significant domestic savings shortfall equivalent to roughly 4% of GDP, which is largely reflected in the deficit on the current account.
Stated differently, while South Africa’s perpetual and relatively large current account deficit may be indicative of a lack of international competitiveness and industrial capacity constraints, it also implies a shortage of domestic savings.
It also signifies that South Africa has become highly dependent on attracting foreign investment (savings) to supplement its poor level of domestic savings in order to fund a relatively low level of investment activity.
In addition, this level of foreign debt and investment flows needs to be funded, which means a steady increase in interest costs as well as dividend and investment income payments that have to be transferred back to foreign investors. Unsurprisingly, South Africa’s net foreign interest and dividend outflows have increased from R6.8 billion in 1994 to R151 billion in 2018, which is equivalent to a substantial 3% of GDP. All of this implies an increasing strain on South Africa’s balance of payments and the need to increase exports. Sadly, this position is likely to worsen as South Africa endeavours to increase economic growth and employment through increased fixed investment activity, such as infrastructural development. Under these circumstances, South Africa’s current account deficit is likely to increase further given the country’s high import intensity, thereby increasing the country’s reliance of attracting foreign capital.
It is not unusual for a country that is going through a period of rapid development and expansion to rely, in part, on foreign capital to modernise and expand the capital stock and infrastructure. However, a large savings shortfall leaves the country more exposed to possible episodes of turbulence in international financial markets. In this context, such a savings shortfall increases the importance of maintaining sound economic, social and political policies so as to maintain credibility with both domestic and foreign investors.
Are South African financial markets highly vulnerable to the vagaries of international financial markets by virtue of our stubbornly low savings rate?
There is little doubt that a sustained low savings rate, combined with a high propensity to import, substantially increases the vulnerability of any economy to changes in foreign investor behaviour. This is not a reason to try and exclude, prohibit or curtail foreign investment. Equally, it is also not a reason to introduce prescribed assets as a way of forcing the small pool of domestic savings into buying more government debt than would be regarded as prudent. Instead, the focus should be on ensuring sound economic policies that are conducive to increased private sector fixed investment, employment and income growth.
In the meantime, there is clearly a risk that foreign private investors simply stop adding to their existing holdings of South African assets, or even start to reverse their current investments on a more regular basis. This could be sparked by a number of scenarios, including a major change in South African economic policy that further undermines the country’s economic performance, or a marked deterioration in government finances, including a substantial increase in the amount of financial support required by the country’s major State Owned Enterprises such as Eskom. In addition, there is also the risk that a shock to the global financial system leads to a sustained increase in global risk aversion, resulting in the withdrawal of foreign investment from a broad range of emerging markets. Any of these risks could result in currency weakness, a rapid increase in inflation, higher domestic interest rates, a slump in domestic economic activity and a further deterioration of the country’s fiscal position.
Fortunately, the above scenarios do not fully reflect our current base-case expectation, which assumes some deterioration in the country’s fiscal parameters within the short-term (6 to 12 months), but thereafter a steady improvement in a broad-range of economic fundamentals as the new government administration starts to implement a range of economic, and institutional reforms.
Lastly, it is worth highlighting that South Africa’s financial markets, especially the bond market, is currently offering some downside protection including an under-valued and flexible exchange rate, modest levels of foreign debt, the re-introduction of more sensible fiscal policy, the continuation of sound monetary policy, a strong and stable financial sector and a relatively attractive investment yield.