This article was first published on Forbes and republished with the permission of the author.
As Africa’s wealthiest major economy, South Africa has played a key symbolic role in the emerging markets boom that has transformed the global economy in the past decade. Unfortunately, like most other emerging economies now, South Africa is experiencing an economic bubble that shares many similarities to the bubbles that caused the downfall of Western economies in 2008. Though South Africa has received a significant amount of attention after its currency fell sharply in the past year, there is still very little awareness and understanding of the country’s economic bubble itself and its implications.
The emerging markets bubble began in 2009 after China embarked on an ambitious credit-driven, infrastructure-based growth plan to boost its economy during the Global Financial Crisis. China’s economy immediately rebounded due to the surge of construction activity, which drove a global raw materials boom that benefited commodities exporting countries such as Australia and emerging markets. Emerging markets’ improving fortunes attracted the attention of international investors who were looking to diversify away from the heavily-indebted Western economies that were at the heart of the financial crisis.
Record low interest rates in the U.S., Europe, and Japan, along with the U.S. Federal Reserve’s multi-trillion dollar quantitative easing programs, caused $4 trillion of speculative “hot money” to flow into emerging market investments over the last several years. A global carry trade arose in which investors borrowed cheaply from the U.S. and Japan, invested the funds in high-yielding emerging market assets, and earned the interest rate differential or spread. Soaring demand for emerging market investments led to a bond bubble and ultra-low borrowing costs, which resulted in government-driven infrastructure booms, dangerously rapid credit growth, and property bubbles in countless developing nations across the globe.
The emerging markets bond bubble helped to push South Africa’s 10-year government bond yield down to a record low of 5.77 percent after the global financial crisis:
South Africa’s short-term interest rates were cut to all-time lows after the financial crisis as well, as the charts of the country’s benchmark interest rate, interbank interest rate, and bank lending (or prime overdraft) interest rate show:
Why South Africa’s Growth Is Driven By A Credit Bubble
Low interest rate environments are known for inflating credit and asset bubbles, which is what has occurred in South Africa in the past decade. South Africa has experienced two low interest rate periods in the last ten years: the 2004 to 2006 period and the post-Crisis period, both of which led to rapid credit growth that exceeded the rate of economic growth.
Though South Africa’s real GDP grew by 38 percent in the past decade, private sector loans surged by approximately 225 percent. Since 2008, South Africa’s real GDP grew by 12.7 percent, while private sector loans have increased by nearly 45 percent:
South Africa’s M3 money supply – a broad measure of total money and credit in the economy – paints a similar picture, with a 400 percent increase since 2004, and a 50 percent increase since 2008:
(Of course, GDP growth to credit growth comparisons understate the severity of credit bubbles because credit is a primary driver of growth during economic bubbles.)
South Africa’s total outstanding external debt, or debt owed to foreign creditors, increased by 250 percent in the past ten years, and nearly 87 percent since 2008:
South Africa’s external debt now totals $136.6 billion or 38.2 percent of the country’s GDP – the highest level since the mid-1980s – due in large part to the emerging markets bond bubble that boosted foreign demand for the country’s bonds. South Africa’s external debt-to-GDP ratio was 25.1 percent just five years ago. $60.6 billion of South Africa’s external debt is denominated in foreign currencies, which exposes borrowers to the risk of rising debt burdens if the South African rand currency depreciates significantly, such as the currency’s 15 percent decline against the U.S. dollar in the past year. To make matters worse, over 150 percent worth of South Africa’s foreign exchange reserves are required to roll over its external debt that matures in 2014.
Unsecured loans, or consumer and small business loans that are not backed by assets, are the fastest growing segment of South Africa’s credit market and are essentially the country’s own version of subprime loans. Unsecured loans have grown at a 30 percent annual compounded rate since their introduction in 2007, when the National Credit Act was signed into law. Unsecured lending has become popular with banks because they are able to charge up to 31 annual interest rates, making these riskier loans far more profitable than mortgage and car loans in the low interest rate environment of the past half-decade. The unsecured credit bubble is estimated to have boosted South Africa’s GDP by 219 billion rand or U.S. $20.45 billion from 2009 to mid-2013.
Like U.S. subprime lenders from 2002 to 2006, South Africa’s unsecured lenders target working class borrowers who have limited financial literacy, which has contributed to the country’s growing household and personal debt problem. A 2012/2013 report from the National Credit Regulator showed that South Africa’s 20 million citizens carried an alarming 1.44 trillion rand or U.S. $140 billion worth of personal debt – equivalent to 36.4 percent of the GDP. In addition, household debt now accounts for three-quarters of South Africans’ disposable incomes.
South Africa’s poorest borrowers have little choice but to rely on local loan sharks known as mashonisas (a Zulu word for ‘one who buries you under’), who commonly charge 30-60 percent annual interest rates. Rising indebtedness among South Africa’s poorest citizens was one of the primary reasons for the demands for better pay and strikes that led to the Marikana mine massacre in August 2012, when police officers killed 34 protesting miners.
In 2013, the Anglican Church chastised UK-based lending company Wonga for aggressively promoting its 5,853 percent annual interest rate loans to poor South African borrowers. The church also launched its own not-for-profit credit unions in an attempt to put unscrupulous lenders like Wonga out of business.
How Low Interest Rates Fueled A Housing Boom
South Africa’s two low interest rate periods of the past decade, 2004-2006 and 2009-present, have led to sharp housing price gains as well as a longer-term property bubble. Housing prices rose at a 15 percent annual rate from 2000 to 2002 and began to dramatically accelerate starting in 2003 after interest rates were aggressively lowered. Housing prices proceeded to rise by 21 percent in 2003, 32 percent in 2004, 22 percent in 2005 and approximately 15 percent in 2006 and in 2007. The combination of rising interest rates and the Global Financial Crisis caused South Africa’s housing prices to dip slightly in 2008 and 2009, until interest rates were dropped to record lows, which has fueled another housing price boom since then.
According to the FNB House Price Index, South Africa’s housing prices rose by145.2 percent in nominal terms and 42.6 percent in real terms from 2003 to 2013. Another housing price index published by The Economist magazine shows that South Africa’s housing prices increased by 193.5 percent in nominal terms and 67.6 in real terms from 2003 to 2013. South Africa’s housing prices rose by 10 percent in 2012 and 2013.
Here is the chart of the ABSA House Price Index since 2007:
Note: I am not as much of a proponent of adjusting housing prices for inflation as most mainstream economists are because I believe that doing so understates the risk of housing bubbles due to the fact that housing and credit bubbles tend to be significant drivers of inflation in their own right.
South Africa’s housing price surge last decade was financed by a mortgage lending boom that was growing at a 30 percent annual rate at its peak in 2006, which caused household mortgage debt as a percentage of disposable income to rise from 27 percent to just under 50 percent from 2003 to 2010. In recent years, however, the rate of mortgage loan growth has slowed to under 5 percent, albeit growing on a much higher base.
South Africa’s housing boom of the past decade was predicated on ultra-low interest rates, which makes it vulnerable to rising interest rates. In addition, stagnant economic growth and heavily-indebted consumers are a significant headwind for South Africa’s housing market going forward.
The Financial Sector’s Role In The Bubble
Though South Africa is commonly thought to be a natural resources-based economy, mining and quarrying currently contribute only 5.1 percent to the country’s GDP, while finance, real estate and business services are the largest sector, accounting for 21.2 percent of the GDP. South Africa’s financial sector is unusually large compared to most developed countries, including the heavily financialized United States, where the financial sector’s share of the economy never rose above 10 percent, even at the finance bubble’s peak in 2007.
While most other sectors have declined in relative importance in the past two decades, South Africa’s financial sector’s share of the economy has continued to grow steadily, even through the Global Financial Crisis. The financial sector added 1.5 percentage points to South Africa’s growth in 2007 and 2008, and added 0.2 percentage points in 2009 despite a 1.5 percent overall GDP decrease that year. South Africa’s financial sector received a boost from the country’s low interest rates, rapid credit growth, and rising asset prices over the past decade.
South Africa’s property market isn’t the only market that has risen significantly; the country’s JSE stock average has nearly quintupled in value since 2003:
South Africa’s stock market boom began around the same time that interest rates were sharply reduced, as well as the start of the country’s property boom. South Africa’s stock market has been riding the global liquidity bubble that led to 1.2 trillion rand or nearly $112 billion (at the current exchange rate) in net capital inflows into the country’s financial markets since 2003. In just ten years, South Africa’s stock market capitalization-to-GDP ratio soared from 108.5 percent to 227 percent, dwarfing the U.S. stock market’s current 121 percent ratio (which is at a historically high level as well). The large size of South Africa’s financial sector and equity market makes the country’s economy particularly sensitive to financial market swings, both to the upside and the downside.
Companies in the basic materials sector such as BHP Billiton and Anglo American account for approximately one-quarter of the JSE stock average’s capitalization, which makes South Africa’s stock market vulnerable to the eventual ending of the global commodities supercycle that was driven by China’s economic bubble (a key tenet of my post-2009 bubble warning). Financial companies, which have thrived on the back of South Africa’s credit and asset bubble, make up 20 percent of the JSE stock average’s capitalization:
A Public Spending Boom Is Boosting The Economy
The previously discussed emerging markets bond bubble helped to lower the yields on South Africa’s government bonds, which reduced the government’s borrowing costs in turn. The government took advantage of this global monetary largess by borrowing and increasing its spending by nearly 50 percent in the past decade:
South Africa’s government began to run large budget deficits to boost the country’s economy after the Global Financial Crisis:
South Africa’s public spending boom caused the country’s government debt to GDP ratio to rise from 27.4 percent in 2009 to nearly 40 percent in 2013:
The bulk of South Africa’s public spending boom was allocated toward social services for the poor, including healthcare and education, as well as fiscal stimulus packages in the wake of the recession.
Why South Africa Is Addicted To “Hot Money”
Starting approximately a decade ago (when much of the country’s bubble started), South Africa began to run a persistent and worsening current account deficit that was financed by 1.2 trillion rand in net capital inflows from abroad:
South Africa’s current account deficit to GDP ratio has risen to over 6 percent – a level that has led to currency crises in the past:
South Africa’s reliance on foreign “hot money” to finance its current account deficit and to support its financial markets makes it unusually vulnerable to changes in foreign central banks’ monetary policies. When rumors of an upcoming tapering or downsizing of the U.S. Federal Reserve’s $85 billion per month QE3 program first surfaced in the spring of 2013, South Africa’s currency and bond markets took an immediate hit.
South Africa’s rand currency dropped by over 12 percent during its May 2013 rout and ended the year with an 18 percent loss, making it the worst performer among 16 major currencies:
The global emerging markets bond sell-off caused South Africa’s 10 year government bond yield to spike from 5.77 percent to nearly 9 percent within the past year:
To add insult to injury, confidence in South Africa’s economy and financial markets was shaken by ongoing mine strikes and falling commodities prices, which threatened to exacerbate the country’s current account deficit.
I warned about the risks in South Africa and other emerging markets just a few months before the 2013 emerging markets panic in a report that I wrotewhen I was a contributor to Business Insider called “All The Money We’re Pouring Into Emerging Markets Has Created a Massive Bubble.”
South Africa’s turmoil led to its inclusion in a group of emerging economies that were nicknamed the “Fragile Five”, which also includes Turkey, Brazil, Indonesia, and India. The Fragile Five were hit the hardest of all emerging markets since the spring of 2013 because of their large current account and trade deficits, high inflation, significant dependence on foreign capital inflows, and slowing economic growth.
How South Africa’s Bubble Will Pop
In response to the rand’s decline, the South African Reserve Bank raised its benchmark interest rate 50 basis points to 5.5 percent in late-January 2014, which helped to pacify the country’s financial markets for the time being. Though not a drastic rate hike, the Reserve Bank’s move is a reason for concern because it may signal the beginning of the end of South Africa’s low interest rate environment that its economy and asset markets have become so reliant upon.
The key risk that South Africa faces is the further weakening of the rand currency and rising bonds yields as the Fed completes its QE3 tapering within the next year or so, leading to even more rate hikes, which would eventually pop the country’s credit and asset bubbles. The rand may also decline if difficulties arise as South Africa attempts to roll over its large amount of long-term external debt that matures this year.
Regardless of the specific path taken, rising global and local interest rates are what will ultimately pop South Africa’s bubble, whether it happens this year or in a few years from now. The popping of South Africa’s economic bubble is likely to coincide with the popping of the commodities bubble as well as the overall emerging markets bubble.
Though South Africa has received a significant amount of attention in recent months because of its weakening currency and its large current account deficit, virtually no attention has been given to the country’s credit and asset bubbles that are an even greater threat to the economy. I view this discrepancy as evidence of how little awareness there still is about South Africa’s economic bubble, which I hope to change with this report.
Here is what to expect when South Africa’s economic bubble pops:
- The credit expansion will turn into a bust
- Over-leveraged consumers will default on their debts
- Banks will experience losses in their credit portfolios
- Unemployment will rise
- The economy will contract
- Property, the rand currency, stock, and bond prices will fall, resulting in higher interest rates
- The basic materials sector will experience pain as economically sensitive commodities fall in price; mine closures are likely
The popping of the overall emerging markets bubble will likely lead to a crisis that is worse than the 1997 Asian financial crisis due to the fact that more countries and regions are involved this time (Latin America, China, and Africa), and because the global economy is in a far more precarious state now than it was during the booming late-1990s.
I will be publishing many more reports about dangerous bubbles that are currently developing around the entire world – most of which you probablynever even knew existed. Please join my 70,000+ person community by following me on Twitter, Google+ and liking my Facebook page so that you can stay informed about the most important bubble news and my related commentary.
This article was first published on Forbes and can be viewed here.