JOHANNESBURG — Earlier this month, South Africans had a taste of emerging market turmoil when the Turkish lira plunged, knocking the highly liquid rand. The rand did pull back, but it also put South Africa under the radar of traders who feel that South Africa’s economic fundamentals are shaky. And as Ronak Gopaldas explains in this article, South Africa better start getting its financial house in order or risk being totally blown away in a future financial crisis. – Gareth van Zyl
By Ronak Gopaldas*
What to make of financial markets? As we currently sit in the throes of a Turkey initiated emerging market sell-off, anxious investors are wearily contemplating their next moves. The rand has sold off dramatically, the Indian rupee has reached historical lows, the Turkish lira moved by 14% in a single day. Meanwhile, the MSCI emerging market bond index plunged to its lowest level in a year, while stock markets across Asia, Latin America and Africa turned deep red.
There’s a sense of déjà vu akin to the 2013 taper tantrum and fragile five fallout. The incidental cause of this current contagion? Turkey. As financial times correspondent Joseph Cotterill succinctly tweeted in reference to Turkey’s economy – “Imagine if a country had also done Nenegate… but had then just kept going”. Now, fears of a Turkey hard-landing have placed the economic and political problems of other countries firmly in the spotlight. Positive sentiment has been eroded, a wave of capital flight and contagion has been triggered and retreating investors have flocked to safe haven assets amid the prevailing uncertainty.
It goes without saying that South Africa is vulnerable in this context. Despite the tendency to frame South Africa’s issues as domestically driven, the reality is that our economy does not operate in a vacuum. What happens in the rest of the world has a profound influence on SA – meaning that when emerging market contagion takes root, a small open economy reliant on portfolio flows, like ours, will be under stress. As the most liquid tradeable EM currency and a proxy for EM sentiment, the effects of such a reversal are especially pronounced in a risk-off environment.
But here’s the really worrying thing – Turkey is not even the most important risk to consider. Even before the most recent bout of volatility there had been a feeling among financial markets that we were approaching an inflection point. After a “goldilocks” period, low interest rates facilitated by low inflation, the tide is finally starting to shift. And with that, all will change.
Indeed, the normalisation of the rate cycle poses significant risks. But, noteworthy, inflation and interest rates don’t necessarily need to get out of hand to effect changes. Markets, driven by human emotions, only need conditions to be slightly worse than what they are accustomed to for reactions to occur. If this happens, it will present a serious headache for emerging market policy makers to contemplate.
This policy dilemma is best explained by using a fable, namely the story of the three little pigs and the big bad wolf. For those unfamiliar – The Three Little Pigs is a fable about three pigs who build three houses of different materials. The two pigs building houses of straw and sticks scoff at their brother, building the brick house. But when the wolf comes around and blows their houses down, they run to their brother’s house. And throughout, they sing the classic song, “Who’s Afraid of the Big Bad Wolf?”
Thus, taken both metaphorically and literally, those economies that have built their houses on poor foundations stand to be blown away by the big bad wolf – in this case, higher global interest rates, driven by hikes from the US Federal Reserve. Where South Africa features in this EM universe is the key question – will it suffer the same fate as Argentina or Turkey or can it still shape a different path?
As the fable goes, the big bad wolf starts with the straw house.
Let’s call this the house of ‘bad economics”. Typically, these are countries that spend too much, borrow too much and save too little. The hallmarks of such economies are twin deficits, a lack of policy credibility, fiscal laxity, and a huge reliance on external funding.
Such characteristics have been firmly displayed in Argentina, which again finds itself knee deep in a balance of payments crisis. Argentina is especially vulnerable to the vagaries of global financial flows because it is so dependent on foreign borrowing. Another vulnerable candidate is commodity dependent Zambia, which faces the challenges of ballooning debt, balance of payment stresses and poor investor sentiment. The country is seen by bond investors and analysts alike as the most likely African sovereign to renege on its debt obligations in the event of a sustained risk-off environment.
Countries that exhibit these features are going to be in trouble in a less favourable monetary backdrop. In short, when the big bad wolf comes the economic fragility of their straw houses will be exposed.
Next, the big bad wolf went for the stick house – let’s call this the house of bad politics.
Such houses are characterised by democratic regression, corruption, nepotism and a lack of independent policymaking. In Turkey, the confluence of all of these factors has been evident. Following the recent election, President Recep Tayyip Erdogan duly installed his son in-law as finance minister in a move that spooked markets. Interference in monetary policy has compromised the independence and credibility of the central bank – another red flag for investors. Rising authoritarianism and a diplomatic spat with the US has further exacerbated the negative view towards the country, and investors pulled their cash as the yield on their debt was not viewed as sufficient to accept such heightened risk. Taken together and fanned by erratic and haphazard policy decisions, Turkey’s political own goals have turned a bad situation into a full-blown crisis.
But they’re not the only ones. With a packed election calendar for 2019 including Brazilian, Indian, South African, Nigerian and Indonesian elections – political developments will be front and centre of investors’ thinking. Any indications of escalating political risk along with signs of imprudent economic management will be severely punished. South Africa saw a glimpse of the devastating effect of this in 2015 and should be cautious of the pitfalls of building a stick house.
Finally, the house that survives is the one built on a sturdy foundation. This is a house built from bricks – it takes longer than the others and requires more hard work. But despite the unpopularity at the time, it is a wise decision, as it withstands the threat from the big bad wolf.
So, what features do countries with brick houses exhibit? Policy certainty and coherence, and strong fiscal discipline are non-negotiable traits. Sound governance and the political will to execute a reform agenda are essential. Typically, measures to improve the business environment and enhance competitiveness are prioritised. Mostly importantly, these are houses where short-term political expediency is sacrificed for longer term economic sustainability.
As it stands, South Africa’s foundation is precarious. The country is in a low growth bind, faces uncertainty around key policy issues such land reform and the mining charter, and despite an initial wave of Ramaphoria, the investment cycle failed to take off. What is clear is that given the country’s twin deficits, governance challenges, and weak balance sheet, it is going to be in the firing line, unless drastic action is taken.
But what will actually happen when the big bad wolf arrives?
EM countries have constrained policy war chests. Countries with the combination of dysfunctional politics, and growing populism should be concerned about the arrival of the big bad wolf, who may well blow down the entire house.
For with higher interest rates comes, naturally, a higher cost of debt funding. And with this comes trade-offs and hard choices. In the wake of quantitative easing, with money too cheap to mention, politicians globally have often managed to avoid having to choose between competing spending priorities, jostling recipients of state patronage (whether official or not) and protesting tax bases.
However, the steady upward march by US rates will see these issues emerge at the forefront of market narratives as funding becomes harder and harder. It is highly plausible that when faced with questions on what spending to cut or what tax to raise, politicians will answer with a third question: how much more borrowing will the market let us get away with? On the former, the self-reinforcing feedback loop of higher yields, higher financing stress, higher credit risk and then back to higher yields is one with plenty historical precedent.
Markets will also be highly reactive due to the potential for sudden deteriorations: as Hemingway said, when describing the process by which he personally went bankrupt: these things happen gradually, then suddenly.
The message to emerging markets and SA is therefore clear – fortify your houses to sure up the economic and political fundamentals or risk being blown away by the big bad wolf.