DJ South Africa, the Next Emerging-Market Domino, May Not Fall -- Barrons.com

By Craig Mellow

A few short weeks ago, emerging market analysts insisted that Argentina and Turkey were "idiosyncratic" stories whose financial woes would not affect the broader asset class. Now the word of the day is contagion, as investors fret over which country's currency and equities will pitch into free-fall next.

South Africa is a prime candidate. Its current-account and budget deficits are in amber, if not red-alert territory, at 3.3% and 4.3% of gross domestic product, respectively. Economic growth is deteriorating from snail's-pace to negative as prices sink for the country's metals exports. President Cyril Ramaphosa, whose within-the-party ouster of corruption-tarred Jacob Zuma was hailed as a reformist breakthrough last December, seems bogged down in a revived debate over land redistribution--a subject sure to jangle investors' nerves. South Africa's investment-grade credit rating is in imminent peril. Moody's, the only global agency maintaining it at one notch above junk, will review it next month.

Investors have reacted accordingly. The iShares MSCI South Africa exchange-traded fund (ticker, EZA) has dropped by 13% since Aug. 27, while the national currency, the rand, shed 7% against the dollar. "South Africa is between a rock and a hard place," says Uday Patnaik, head of emerging markets debt at Legal and General Investment Management. "They have to cut spending to be credible for Moody's, but that will be still more anti-growth."

Yet there are reasons for the South Africa domino not to fall, too. Unlike Turkey and Argentina, both the government and private sector have been conservative about taking on hard-currency debt. About half of Turkey's financial flows are dollar-based, estimates Ricardo Adrogue, chief of emerging markets at Barings. South Africa has a small fraction of that exposure. So a devaluing rand does more good than harm by stimulating the country's all-important exports, he argues.

South Africa also maintained an independent and competent central bank through the darkest days of Zuma-ism. Benefits include a manageable inflation rate around 5% and a comfortable stash of foreign reserves. "South Africa doesn't have a funding problem," says Gorky Urquieta, co-head of emerging markets debt at Neuberger Berman. "If they did a dollar bond tomorrow, there would be buyers."

Investors are still inclined to see Ramaphosa as doing his best in a challenging situation. He needs to hold the fractious African National Congress together until elections next year, and balance voters' demands for income equality with policies that placate business and markets. "The leadership is far superior to what was in place," Urquieta says. Not to mention far superior to Ramaphosa's opposite number in Turkey, Recep Erdogan.

It would take a brave soul to plunge into South African securities right now, even with stocks close to a 30-month low and sovereign bonds yielding more than 9% in rand. Investors need to see the country pass the Moody's gauntlet first. In the political arena, all eyes are on the Economic Freedom Fighters, the ex-ANC renegades who are pushing hard for land expropriation and nationalization of various productive assets.

An export-led economy with a freely traded currency will remain highly vulnerable to external ructions from the usual suspects: Federal Reserve tightening, U.S.-initiated trade tensions, and a Chinese slowdown. "In this kind of environment, anything is possible, and the microscope is plainly on South Africa," says Brian Giuliano, a fixed-income portfolio manager at Brandywine Global Investment Management. Yet if Ramaphosa & Co. can stave off disaster, that might turn the tide for emerging markets everywhere.

(END) Dow Jones Newswires

September 07, 2018 11:03 ET (15:03 GMT)

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