South Africa goes from international sweetheart to junk status

Inflows into South African assets over the past week are minuscule compared to the hundreds of billions that have left the country over the past decade due to the country’s stagnant economy and below-junk investment rating. 

South African assets have appreciated significantly in the past few weeks following the formation of a Government of National Unity. 

In particular, demand for government bonds has surged. Foreign investors’ purchases of these assets in 2024 have already exceeded the total for all of 2023. 

Since the country’s election at the end of May, bonds have risen 8.5% in dollar terms – the best permanence among emerging market economies. 

Investors bet that a government, including opposition parties, will boost state reforms, tackle government inefficiency, and enhance the country’s economic output. 

Foreign investors have bought R12.2 billion of local bonds since the election, bringing the year-to-date inflows to R22.2 billion, according to JSE data. This exceeds the R16.5 billion seen last year. 

South African stocks have also received increased interest from investors, with foreigners pumping over R9 billion into them at the end of June. 

As a result, local indices have soared since the end of the election. Financial institutions have particularly benefitted from the increased certainty expected from the new government and a strengthening rand. 

Money flowing into South African assets increases demand for the local currency, strengthening it relative to its peers. The rand is trading at around R18/$ after reaching close to R19/$ during periods of high uncertainty. 

This significant shift in sentiment cuts against the trend seen in South African financial markets over the past decade. 

Furthermore, the country’s experience of over 100 days without load-shedding and the state’s posting of its first primary budget surplus in 15 years have boosted positivity surrounding the new government. 

This can be seen in the graph below, which shows the sharp uptick in major South African indices at the beginning of June. 

However, despite the positivity surrounding the new government and billions invested in local assets, this is still a drop in the ocean compared to the significant outflows over the past decade. 

Some estimates place the total outflows out of South Africa at R1 trillion over the past decade, with the trend accelerating in recent years. 

The Reserve Bank noted in its Financial Stability Review that this has significant implications for the local financial system and the broader economy. 

It said foreign investors’ holdings of domestic shares reached a new low of 27.6% at the end of March 2024. 

Worryingly, it noted that local investors are now joining in, dumping South African assets in substantial amounts. 

Following a change to Regulation 28 to allow pension funds to invest 45% of their holdings outside of South Africa, these investment vehicles have slashed their local exposure. 

The average Regulation 28-compliant fund now holds just 39% of South African equities, compared to nearly 70% eighteen years ago.

This has resulted in the total offshore allocation of domestic institutional investors being equal in value to South Africa’s entire nominal GDP – more than doubling since 2012. 

The sustained trend of money flooding out of South Africa is shown in the two graphs below, one showing the net transactions of foreign investors and the other showing the change in holdings of local investors. 

The main driver of this has been South Africa’s poor economic performance, reflected in a looming financial crisis. 

South Africa’s debt-to-GDP ratio has almost doubled in the past decade as the economy stagnated and the government ramped up spending. 

Government spending is not bad in itself. However, state spending has had little to no benefit for economic growth and the provision of public services in South Africa. 

Thus, some economists argue the country’s economic growth crisis has manifested itself as a financial crisis. 

As the government’s debt has ballooned over the past decade, global rating agencies took note and steadily began to cut South Africa’s investment grade. 

Rising government debt and a stagnant economy have significantly increased the risk of investing in South African assets. 

This was put into stark relief by S&P Ratings cutting South Africa’s investment grade to junk status in 2016. 

Being placed into junk status prohibits many global pension funds and investment schemes from investing in South African assets as they are considered ‘below investment grade’. 

This resulted in significant outflows from South African assets over the past few years, significantly weakening the rand and further limiting economic growth. 

The graph below, courtesy of Standard Bank chief economist Goolam Ballim, shows the rise and fall of the South African economy through the lenses of its sovereign credit rating and debt-to-GDP ratio. 

In the graph, the debt-to-GDP is shown on an inverse scale.