Over the last few months, emerging markets have faced headwinds in the form of tighter monetary policy in the US, renewed dollar strength, lower global economic growth, ongoing trade tension, a higher oil price and political uncertainty.
As global financial conditions tighten, country differentiation will be a key consideration for foreign investors, Dr Hendrik Nel, head of the financial stability department at the South African Reserve Bank (Sarb), said at the South African Institute of Financial Markets Regulatory Summit on Wednesday (August 8). Investors will likely favour emerging markets with relatively favourable metrics and turn away from countries with a heavy reliance on external financing, high rates of foreign ownership of domestic bonds, high and rising levels of US dollar-denominated debt (especially of a short-term nature), significant twin deficits and rising debt levels.
This raises the question: how vulnerable is South Africa, especially in light of its reliance on foreign capital? How does it compare to its emerging market peers?
The graph below shows the Institute of International Finance’s (IIF’s) emerging market scorecard, which measures how exposed emerging markets are to the US (especially in terms of debt), whether they have large deficits that must be financed and whether their assets are fairly valued. A level below zero highlights areas of concern.
Sources: IIF & Sarb
Nel says this highlights some areas of vulnerability. South Africa must finance twin deficits, its foreign exchange reserves are fairly low and there are various challenges at state-owned enterprises.
But there are also some positives.
South Africa does not have a high level of foreign denominated debt and its assets are fairly valued.
“It puts us amongst countries such as Ukraine, China, Argentina, Turkey, and others,” says Nel.
One potential challenge facing South Africa is the foreign ownership of assets. Foreign holdings of domestic local currency (rand-denominated) bonds is the highest among emerging markets at 41%.
Sources: JSE, Strate & Sarb
Nel says that in the case of a serious event like a downgrade, foreigners may be forced to sell bonds and South Africa may see quick outflows. However, local investors have surplus capacity to buy more South African bonds, which means there will be willing buyers locally to take up rand-denominated bonds in the event of a sell-off by foreigners.
The stability of the foreign investor group is also an important consideration, says Nel.
This would depend on a country’s credit rating. Countries with an investment grade rating will attract more stable investors than non-investment grade countries.
“At the moment we are investment-grade-rated by one rating agency [Moody’s] and non-investment by two others [S&P and Fitch], so it is a bit of a mix, but as long as you attract a stable investment group, 41% foreign ownership is not a risk,” says Nel.
“And when we market these bonds on roadshows, obviously we want the foreigners to buy it. We want them to invest in our economy, but then we must add that it could present a risk as well.”
An area where South Africa compares favourably to other emerging markets is its exposure to corporate US dollar debt as a percentage of its total external debt, which is relatively low at around 16%. Moreover, very few of these payments are due in the short term.