Financial Depth – the Rand’s hidden asset

South Africa as a member of the “Fragile Five”

Macro Economic Research Sep 2013

Morgan Stanley’s strategists recently evaluated EM’s based on projected currency vulnerability. Using a multi-factor ranking, they isolated five currencies they believed most vulnerable to future depreciation – the “Fragile Five”: “these currencies will likely face headwinds over the medium term from various factors ranging from high inflation, high REERs, external vulnerability from initial conditions and vulnerability to further external deterioration based on a heavy reliance on fixed-income flows or China-related risks. The risks associated with these particular five currencies are also evident from the fact central banks in these countries have been among the most aggressive in their bid to support their currencies,”

As US interest rates rise, the vulnerability of EM’s generally, and the Fragile Five in particular, to capital outflows is huge cause for concern. How will the Fragile Five fund their current account and fiscal deficits? Not all deficits are the same Morgan Stanley’s “Fragile Five” classification gives us no indication domestic funding capacity for future fiscal deficits. I believe this can be a key point of difference in evaluating the currency and other market vulnerabilities of countries. For example, if France and the Netherlands currently have similar budget deficits, the fact that France has a state “pay as you go” pension scheme, and Netherlands has independently funded pension funds, is a key criterion when evaluating the trajectory and funding of future deficits. Firstly the demographic issues that France faces as the proportion of retirees v. contributing employees rises will have massive future deficit implications. Secondly, the Dutch deficit can be funded by issuing bonds to a natural buyer of domestic long duration assets, their domestic pension funds.

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Financial Depth – the Rand’s hidden asset

Macro Economic Research Sep 2013

The above chart illustrates the non-bank asset base of various developed countries, together with SA. This is a broad representation of “bond buying capacity”. SA has independently funded pension schemes and hence pension fund assets to GDP are comparable with many developed nations. In addition, remember that SA’s economy is a mix of developed and emerging, with the financial sector definitely being part of the “developed economy”. Hence SA has massive insurance assets and a very well developed mutual fund industry as the affluent households have saved way more than their pension fund contributions alone. SA’s big domestic balance sheet can’t leave Insurance companies and pension funds have Rand denominated liabilities, and hence prudentially need to maintain the majority of their assets domestically in SA. Capital controls also require some 75% of mutual fund assets to be invested domestically. Should a dramatic sell off of SA bonds occur through a panic exit of EM bonds by foreign holders, the higher yields will attract investment from the huge domestic balance sheet. Should it be required, the government could also consider financial repression measures, such as additional capital controls and prescribed assets (note that the financial repression of negative real interest rates is already wide spread in the developed world, and other repression measures such as capital controls and prescribed assets should not be viewed as outlandish in the “currency wars” world in the future). Where SA’s domestic balance sheet or bond buying capacity really stands out is against its EM peer group.

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Financial Depth – the Rand’s hidden asset

Macro Economic Research Sep 2013

Other EM’s, including the rest of the “Fragile Five”, are not as well endowed with domestic bond-buying capacity as SA, and in fact stand in sharp contrast to SA. If persistent foreign selling results in bond yields blowing off to enticing double digit yields in Turkey or Indonesia, there is no significant local balance sheet to take advantage of the opportunity, and hence to enable government funding in local currency to continue. In addition, should future deficits deteriorate in a hostile global currency environment, the ability to for governments to fund using financial repression is insignificant in many EM’s compared to SA. In addition, SA’s private sector has, possibly as a result of historic capital controls, insignificant external funding. This is in contrast to huge external liabilities in other EM economies (notably India, unhedged foreign loans to the private sector believed to be = 60% of their massive central bank reserves). Conclusion SA’s capacity to fund future deficits in an adverse economic environment is significantly better than the rest of the “Fragile Five” and other EM’s generally. To single out the Rand due to perceived external vulnerabilities may be correct for flow driven trades (given the substantial foreign ownership of our bonds), but the longer-term fundamentals are much stronger than other EM’s, so SA will never experience the negative feedback loop from the unavailability of domestic currency financing and the impact of a weaker currency on external debt.
Kevin Cousins is a portfolio manager at Brait Capital Management Limited. ("BraitCM"). This article is prepared by Kevin as an outside business activity. As such, BraitCM does not review or approve materials presented herein. The opinions and any recommendations expressed in this article are those of the author and do not reflect the opinions or recommendations of BraitCM. None of the information or opinions expressed in this article constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Either BraitCM or Kevin Cousins may hold or control long or short positions in the securities or instruments mentioned.

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