South Africa's dependence on bond inflows is starting to look like a dangerous addiction.
South Africa's dependence on bond inflows is starting to look like a dangerous addiction.
Distinguished among emerging markets by the sophistication and liquidity of its financial systems, South Africa has attracted a tsunami of portfolio flows into its domestic bonds ahead of its inclusion next month in the prominent Citigroup World Government Bond Index (WGBI).
As of Wednesday, foreigners had bought 72.1 billion rand of bonds to date in 2012 and several analysts reckon this could be a record year because of the entry into the Citi bond index.
The Treasury said foreign holdings of local debt have hit their highest ever levels this year and stood at about 33 percent by the end of August.
But this portfolio stream is the only thing plugging the gaping current account, which recorded its largest deficit in nearly four years in the second quarter, reaching 200 billion rand or 6.4 percent of GDP.
A sudden change in the course of flows could have profound implications, including a sharply weaker currency which in turn would fuel inflation at a time of mounting social unrest.
Given the volatility of portfolio flows, which can change tack at the touch of a trader's button, South Africa would be better off diversifying its external capital sources to include a steady channel of fixed investment.
It has not been doing so and the wave of violence and illegal strikes sweeping the mining sector will do little to convince sceptical investors to commit long-term cash.
"The problem here is that the current account clearly cannot be funded at this level forever as it's totally reliant on bond buying," said Peter Attard Montalto, an emerging market analyst for Nomura.
"And there is no foreign direct investment (FDI) to support it. South Africa can't attract FDI given the usual mix of policy issues, especially labour, and political and policy uncertainties," he said.
The divergence between FDI and portfolio investment is huge.
According to central bank data, in 2010 South Africa's portfolio inflows reached 108 billion rand against 33 billion rand that left. In 2011 inflows were 47 billion rand and outflows were 44 billion rand.
Direct or fixed investment over the same two years added up to around 51 billion rand.
Portfolio investments this year are scorching. Bonds have rallied aggressively since the April Citigroup announcement that South African bonds would be included in the prominent WGBI.
More money should hit South Africa's shores on October1, the day it is included in the index as some pension funds and unit trusts can only buy local bonds on the actual inclusion, while many are also buying in advance.
The index includes 22 developed and emerging market bonds with different weightings. The exact number of funds that are indexed against the fund is hard to quantify but analysts estimate portfolio flows of around $9 billion into South Africa.
"The current account deficit itself is not the whole story. It's the financing of it," said Di Luo, an emerging market strategist at HSBC. "The bond inflows are already at record high pace so that means that the structural volatility is actually rising."
A BOND IS NOT FOREVER
For example, the bond bull run cannot go on forever.
"The bonds have run so far that their value is questionable," said George Glynos, managing director of financial consultancy ETM.
"There is going to come a point in time when local bonds are just not going to attract the level of inflows required. And when that happens your currency comes under significant pressure."
Government yields have persistently tested record lows this year as foreigners pile into the local market, largely on the WGBI inclusion.
The yield on the benchmark three-year bond fell 142 basis points to a record 5.27 percent since the April announcement which prompted bond prices to rally, compared to 6.67 percent during the same period a year ago, when it fell just 42 basis points.
Reversals could come if, for example, the social strife that has set the mining sector ablaze led to a downgrade of South Africa's debt, which would expose the dangerous dependency on bond purchases.
"We don't get fixed investment so we become more dependent on portfolio flows," said Mike Schussler, director of economists.co.za, a Johannesburg-based research house.
Then there is the question of jobs, a pressing issue in a country where unemployment has been estimated to be as high as 40 percent, alongside glaring income disparities.
"Fixed income brings jobs, portfolio inflows do not. And we need jobs," Schussler said.
Finance Minister Pravin Gordhan said on Friday the mining strikes could have an "extremely damaging" impact on the economy, such as more imports than exports as minerals production declines.
"If you export less, and we continue to import at the rate that we are importing, it widens our current account deficit and it means that we rely on savings from other countries to come into South Africa, in order to keep the current account satisfied." Source: Moneyweb
