The tide is out and SA is exposed

In the last 90 days, the rand has lost 15% of its value against the US dollar, and 10% of that in the last week. At the same time, the South African Reserve Bank has announced that SA is in a technical recession following two consecutive quarters of negative growth.

In a country whose emotional thermostat fluctuates with the weather, and which has gone from Ramaphoria to Ramaphobia in three short months, the announcement of a recession should not have come as a surprise: declines in employment, business confidence, manufacturing output and industrial production, as well as falling retail and vehicle sales over the last few quarters, was a clear indication that all was not well.

“We have been standing close to the edge for some time,” says Mehul Daya, a strategist with Nedbank CIB. “South Africa’s economy is hamstrung by structural problems, the burden of inefficient SOEs [state-owned enterprises] and a lack of foreign direct investment. None of this is new, and none of this changed just with the changing of the ANC president.”

He says, however, that while internal and external factors affect the rand, what is happening currently has more to do with external factors than internal ones. The fall in the value of the rand was predictable from as far back as January, he says. In a note to clients, he and Nedbank CIB senior strategist Neels Heyneke explain that the expansionary monetary policy followed by the US, European and Japanese central banks over the last decade has resulted in excess liquidity in the system. But now that the quantitative easing is over, “this tide of excess liquidity is receding, and as it does it reveals the misallocation of capital and the mispricing of risk”.

“We have seen the fundamentals of emerging markets drift back to close to where they were in 2009/10,” Daya tells Moneyweb. “Despite the fact that their sovereign credit ratings reflected higher levels of risk, investors continued to pour money into these markets.”  

The chart below shows that between 2008 and 2016 capital flows moved in lockstep with investment ratings. In 2016 this trend diverged with negative ratings no longer serving to slow the inflows of capital.

There are good reasons for this, Daya says. With zero or negative interest rates in developed markets, returns were hard to find. So investors followed the opportunities into markets with higher returns – such as SA, Brazil, and Turkey. “Under Zuma’s watch, the rand strengthened from R15 to R11 against the dollar. This had nothing to do with improving SA fundamentals, and everything to do with capital inflows. Investors place less emphasis on the underlying fundamentals – this is ‘hot’ money and is purely speculative,” Daya says.  

However, as the tide of excess liquidity recedes, many emerging markets have found themselves exposed, and they are feeling the pain of this misallocation of credit.

“If the US Federal Reserve slows their interest rates hikes the dollar will stabilise. But they have no reason to do so because the economy is doing so well.”

The end of quantitative easing is not the only factor dragging emerging currencies lower against the dollar. Escalating trade tensions are also fuelling the problem. When broad tariffs on steel and aluminium were first imposed by the US in March, it was seen as a cold war that would soon be resolved after some negotiations, says Hussein Sayed, chief market strategist at ForexTime. “But there are no signs of this trade war ending and we are expecting now that the US will impose an additional $200 billion on Chinese imports, potentially this week. This will not only harm the two largest economies but would severely disrupt global supply chains, particularly [in] emerging markets which may see their currencies fall further in the weeks ahead.” 

The Argentinian peso and Turkish lira have both been in free fall, losing half their value this year. Indonesia’s rupiah fell to its weakest level since the 1998 Asian financial crisis, and the Indian and Sri Lankan rupee dropped to all-time lows.

As long as the dollar remains the reserve currency and most of the foreign-owned debt is denominated in US dollars (USD), the dollar will remain king. “A weaker USD is associated with a stable and healthy global environment where the global supply of USDs is abundant. A stronger USD is usually associated with volatility and a risk-off phase as liquidity contracts,” Daya explains.  

South Africa, possibly more than any other emerging market, feels the rumbles from the giants. “The volume of ZAR that trades daily is 20% of GDP – that is enormous for a small economy that is less than a percent of global trade. The rand has become the proxy currency for all emerging market currencies.

“Yes, South Africa has genuine economic problems. But this swing from Ramaphoria to Ramaphobia was extreme,” Daya says. “When the tide went out, as it was destined to do, we were always going to be naked. It was impossible to expect that 10 years of economic mismanagement could be turned around in nine months.”