Bottom Line:

  • Portfolio flows have significantly influenced the performance of the ZAR. The performance of bonds, in particular, appears to fit very closely with the performance of the ZAR, implying that one is a significant driver of the other. If one can therefore understand the investment prospects for bonds, one gains insight into at least one of the drivers of the ZAR and vice versa.
  • Both foreigners and locals have sought to diversify their portfolio assets away from SA. Locals have taken advantage of looser exchange controls to take a larger proportion of their funds abroad, while foreigners have steadily become an ever-shrinking holder of SA bonds relative to the total in issue. The conclusion is that there has been diversification away from SA as an investment destination, and much of that unfolded in the first few months of 2023.
  • However, with much of the bad news now priced in, investors will start to look at SA markets more cyclically, and the probability is high that the ZAR could recover, despite portfolio flows being overwhelmingly negative so far this year. Locals will feel the pain of having taken so much abroad at such unfavourable rates, and foreigners will enjoy the discounts on offer through a grossly undervalued ZAR and much higher interest rates.

Conclusion: A combination of changes to Reg 28 that allowed funds to take more of their portfolios abroad, coupled with the outflows related to the greylisting and all the negative press SA has received, especially on its geopolitical position regarding Russia, has weighed on the ZAR. But a huge adjustment is now behind us. Going forward, exposure to SA may hold some merit

ZAR breaks its cycle of being the worst-performing currency to being one of the best

For much of this year, the ZAR was the worst-performing currency. As of the beginning of June, it has underperformed both the TRY and the RUB. In the past two weeks, that has reversed spectacularly, and the ZAR’s latest bout of appreciation has rivalled that of Colombia’s peso, which has also performed extremely well.

One of the main drivers of the performance of the ZAR has been the portfolio flows data. As portfolio flows have waxed and waned, so they have influenced the performance of the ZAR. It is always difficult to know whether the gains in the ZAR prompted the recovery in bonds, vice versa or a combination of the two, but it is clear that the relationship is symbiotic.

This week, bonds performed particularly well, and as they have done, the ZAR has extended its appreciative trend and appears to be on the verge of breaking a long, well-established trend of outflows since the start of the year.

Bond market portfolio flows a key driver of ZAR direction  

The accompanying chart clearly shows the relationship between the ZAR and inflows or outflows into equities and bonds. Visibly, the fit of bonds to the USD-ZAR is much tighter than that of equities. Therefore, one can deduce that the real flows related to exposure to SA’s bonds are an important currency driver.

It then becomes important to try and understand the valuation of SA bonds and the kind of value available to foreign investors. They have been given a golden opportunity to access double-digit yields against declining inflation, thanks to several regulatory changes that have impacted cross-border flows.

The first was the loosening of capital controls that allowed Reg 28 constrained funds to take up to 45% of their assets under management abroad. The second was SA’s greylisting which has prompted some rotation away from SA, more or less in line with the guidance given by the IMF, whose study revealed that greylisted countries can suffer outflows of up to 7% of GDP.

Current account deficit narrows to hint at a shift in the bias

This week’s current account data made for interesting reading. The current account data of the balance of payments narrowed to -R66.2 billion in Q1 2023 from a revised -R155.3 billion in Q4 2022. The Q1 outcome was better than consensus expectations of -R182bn. As a % of GDP, the current account narrowed to -1.0% in Q1 2023 from a revised -2.3% in Q4 2022. The narrowing of the current account deficit should support the rand exchange rate.

However, South Africa’s risk profile has deteriorated recently because of load-shedding, greylisting, Reg 28 changes and unfavourable political alignments with Russia. The result has been financial outflows and a sharp depreciation in the rand exchange rate. Somewhat paradoxically, a weaker rand may support a positive trade balance in the longer term. While consumer goods become more expensive, commodity exports are priced higher. On top of the weak currency, weak domestic economic growth will likely further hamper the demand for imports.

This is how the ZAR cycle eventually reverses and sets in motion specific policy responses that generate a more virtuous cycle and an extended phase of ZAR appreciation. In these morning notes, we have often highlighted how phases of weak economic growth can often be ZAR-supportive, and 2023 is shaping up to be another example of this. Higher interest rates, a global slowdown and underperformance of local SOEs, most notably Eskom will detract from economic growth.

Locals take advantage of Reg 28 changes to take more funds abroad

Ever since the regulators loosened prudential requirements and allowed investors to hold a greater proportion of their funds abroad, we have noticed that fund managers have taken advantage. Since the start of 2021, the amount held by locals abroad has more than doubled.

That obviously represents a net outflow of funds that will naturally weigh on the performance of the ZAR as investors choose to shield their portfolios against the ravages of domestic politics and their negative impact on asset prices.

With locals now able to hold up to 45% of their assets under management for those funds governed by Reg 28, perhaps more could flow out of the country to ensure that the ZAR remains vulnerable to any sharp deterioration in sentiment. The accompanying chart highlights the underlying trends extracted from the current account data, and clearly, there has been a significant shift to hold more funds abroad.

US monetary policy pivot expected before year-end

Allied with the increased purchases of offshore assets, one would expect to see SA maintaining a positive external net investment position. I.e., SA investors own more assets abroad than foreigners own in SA. On the one hand, that is positive and helps ease the pressure on the current account as dividends and coupon payments generated abroad can be repatriated and offset the dividend and coupon payments locally.

On the other hand, it also means that foreigners have lightened up on their exposure to SA, which is not as positive. The higher the net International Investment position, the more one can interpret that as being a vote of no-confidence in SA and its investment prospects. A similar trend is evident when looking at foreigners’ foreign holdings of SA bonds. Whereas foreigners used to own more than 42% of the bonds in issue, they now own less than 26%.