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Foreign capital flows back into SA

After record outflows earlier this year.

Cape Town – Towards the end of January this year, there were major rumblings about the potential for an emerging market crisis. Money was being withdrawn from emerging market funds at an alarming rate and the investment world was buzzing with talk about serious trouble brewing in the “Fragile Five”.

These were the emerging markets of Brazil, Turkey, Indonesia, India and South Africa that all faced the unhealthy mix of rising inflation, weakening growth and current account deficits. Morgan Stanley first coined the term last year, identifying these five markets as the most vulnerable to the US Federal Reserve’s tapering of its monetary stimulus policy.

The fear was that as a cheap supply of money dried up and US Treasury Bond yields rose, investors would become more discerning about where they looked for returns. The expectation was that they would pull out of these markets in favour of less risky destinations.

And for a moment, this seemed to be exactly what was happening. In November, December and January, emerging markets experienced record foreign capital outflows.

South Africa was caught in the midst of it as the Fragile Five bore the brunt of these withdrawals. There was even talk of a perfect storm that could spread to all emerging markets as the lack of confidence took hold.

All five of the Fragile Five’s currencies fell at least 13% against the dollar in 2013, led by a 21% decline in the value of the Indonesian rupiah. Political problems in Turkey and pending elections in India, Indonesia, South Africa and Brazil also added to concerns as there has been a pattern in the past of emerging market crises hitting after elections.

However, thanks to a combination of factors the worst never happened.

For a start, a sustained increase in US Treasury Bond yields didn’t materialise. In fact, yields have come down.

And, secondly, central banks in many emerging markets took some pretty strong action. On 28 January the Turkish Central Bank raised its overnight lending rate by 425 basis points from 7.75% to 12.0% at an emergency late night meeting. India also increased its key rate, while Brazil’s central bank had been raising rates for six straight meetings.

The South African Reserve Bank joined the trend too, lifting the repo rate from 5.0% to 5.5% just a day after Turkey’s hike. In Indonesia, the interest rate was raised from 5.75% to 7.5%.

This combined action stabilised these currencies and brought some composure back to the market. And what followed, was not just a moderation of outflows, but a substantial return of foreign investment.

Since February, South Africa has seen nearly R60 billion in foreign capital capital coming in to bond and equity portfolios. This is a record for any four month period.

As the below table shows, although the funds flowing in since January have not yet surpassed those that went out in the three months from November, there has been a clear shift.

 

Foreign capital portfolio flows to/from South Africa

Month

Inflow

Outflow

October 2013

R1.36 billion

 

November 2013

 

R37.33 billion

December 2013

 

R6.58 billion

January 2014

 

R26.40 billion

February 2014

R13.57 billion

 

March 2014

R15.85 billion

 

April 2014

R13.40 billion

 

May 2014

R16.87 billion

 

Source: RMB Global Markets

“At the end of January we saw Turkey’s very aggressive action and the South African Reserve Bank interest rate hike, so fears over emerging markets eased,” says John Cairns of RMB Global Markets Research. “And at the same time we had quite a rally in US Treasury Bond yields, from 3.0% in January down to 2.5% on Friday.

“The threat last year was rising US yields, so emerging market yields didn’t look so attractive,” he says. “But US yields have actually come down, so inflows have returned across all emerging markets.”

This is also illustrated by the performance of equity markets in these countries over the last few months. MSCI’s main emerging market index has rallied nearly 7.0% in the last three months. Although it is still negative over the last year, its short term performance has far outpaced that of the MSCI World index, which tracks stocks in developed markets.

Global equity index performance to 16 May 2014

Index

3 Months

YTD

1 Year

MSCI Emerging Markets

6.78%

2.92%

-1.37%

MSCI World

0.49%

1.36%

11.65%

Returns measured in US Dollar terms

Source: MSCI

Another positive for emerging markets has been that two of the four elections scheduled for this year have taken place without any major problems and positive outcomes. Although South Africa’s election result was never in question, credit ratings agency Moody has called the ANC’s decisive victory “credit positive” as it allows for the government to push ahead with economic reform through the National Development Plan.

It is however the result of the Indian election that has been particularly well received. The landslide victory of the Bharatiya Janata Party and its coalition partners over the incumbent Indian National Congress has provided hope that reforms will be instituted to address that country’s macroeconomic challenges.

This has allayed some political fears, although elections in Brazil and Indonesia still need to be negotiated.

The positive effect on the rand of these inflows into South African bond and equity markets has also been significant. The rand reached its weakest level of over R11.30 to the dollar towards the end of January, but has since rebounded to current levels around R10.35.


 
Source: RMB Global Markets

“The strengthening of the rand has been a direct reflection of inflows,” Cairns says.

It’s not all good news

While all of this looks positive, it doesn’t mean that everything is suddenly rosy again. The fundamental issues that made Morgan Stanley identify South Africa as a vulnerable market have not disappeared.

“The inflows have brushed over South Africa’s problems,” RMB noted in a report. “Rebalancing away from domestic demand to exports is happening slower than required, leaving South Africa vulnerable to the next bout of emerging market panic.”

The current account deficit, which is the primary cause for concern, remains stubbornly high close to 6% of GDP. That means that the country remains very dependant on inflows of foreign capital and susceptible to shocks when it is withdrawn.

The inflation rate has also been climbing steadily this year and is pushing 6%, which is the upper limit of the target band. This would be less concerning if it were happening at a time of economic expansion, but the growth of the local economy remains sluggish.

RMB believes that there is an “outside chance” that the Reserve Bank will hike the repo rate at its monetary policy meeting this week. This will be inspired by the rising inflation rate and may be good for the currency, but it will also restrict consumer spending at a time when the economy really needs stimulation.

And finally there is ongoing concern around Chinese growth. Many emerging markets have fed off Chinese expansion, but particularly those like that South Africa that rely on commodity exports.

As the Chinese economy continues to show signs of slowing down, it remains too early to say that sentiment towards emerging markets has fully turned around. The potential for shocks is still out there.

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