Financial Depth - the Rand's hidden asset

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Financial Depth the Rands hidden asset Macro Economic Research Sep 2013

Please refer to the disclaimer at the end

South Africa as a member of the Fragile Five

Morgan Stanleys strategists recently evaluated EMs 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 EMs 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 Stanleys 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 marketvulnerabilities 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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The above chart illustrates the non-bank asset base of various developed countries, together with SA.

This is a broad representation ofbond 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 SAs 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.

SAs big domestic balance sheet cant 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 prescribedassets should not be viewed as outlandish in the currency wars world in the future).

Where SAs domestic balance sheet or bond buying capacity really stands out is against its EM peer

group.


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Other EMs, 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 EMs compared to

SA. In addition, SAs 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, un-

hedged foreign loans to the private sector believed to be = 60% of their massive central bank reserves).

Conclusion

SAs capacity to fund future deficits in an adverse economic environment is significantly better than the

rest of the Fragile Five and other EMs 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 EMs, 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 byKevin as an outside business activity. As such, BraitCM does not review or approve materials presented herein. Theopinions and any recommendations expressed in this article are those of the author and do not reflect the opinions orrecommendations of BraitCM. None of the information or opinions expressed in this article constitutes a solicitationfor the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice andany recommendations that may be contained herein have not been based upon a consideration of the investmentobjectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in anysecurities or other instrument should be based upon your own analysis and conclusions. Either BraitCM or KevinCousins may hold or control long or short positions in the securities or instruments mentioned.

Financial Depth - the Rand's hidden asset

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