History is littered with examples of countries that have experienced turmoil in financial markets due to large current account deficits. Turmoil in the markets is more pronounced if the deficit is being financed by short term portfolio investments.
The classical textbook definition of a current account deficit is the difference between imports and exports of goods and services. A decline in trade balance caused by either increased demand for imports and or poor export performance, as was the case in the second quarter of 2014 according to the Reserve Bank’s latest quarterly bulletin reported last Tuesday can increase the current account deficit.
A large current account is an imbalance which is always undesirable. However, for investors to navigate the treacherous waters caused by a current account deficit it is important that they establish the source of imbalance and how it has been financed. Because being large in itself may not necessarily lead to turmoil in the markets, case in point- the US has been running huge current account deficits since 2006 without any negative repercussions on the financial markets. Although studies by the IMF have shown that large deficits are ultimately not sustainable as a result of financing problems or a change in investment patterns in a domestic economy.
In the case of South Africa, a stubbornly low savings rate has meant that the country has had to rely on foreign investment to fund the deficit since first quarter of 2006, in particular through “…a combination of direct, portfolio and, to a lesser extent, other investment flows”. This has not been a problem in the past, especially in the wake of the global financial crisis which later morphed into a full blown economic crisis resulting in ultra-loose monetary policy, circa 2008 in the US and Europe making emerging markets attractive investment destinations.
The times are changing though. Whereas in the past 6 years, the only risk to South Africa’s attractiveness as an investment destination was external- from global markets. At the moment South Africa’s macroeconomic environment is weak, implying risk may arise internally as well.
Contrast these prevailing economic conditions in South Africa with recent developments in both the US and the UK where monetary authorities have already made the commitment to put an end to their respective quantitative easing programs and are seriously considering hiking interest rates. A rate hike in the US specifically, will fundamentally alter investment options across the universe posing a threat to the attractiveness of South Africa along other emerging markets as investment destinations.
Given the scenario as described above. Is it time for investors, foreign ones in particular to dispose of their equities in SA stocks? My view is that not yet, not least because returns on capital on the JSE represents income from outside the borders from South Africa but the country despite its economic and social challenges continues to attract capital and investment inflows, the latest bulletin from the Central Bank highlights the fact that foreign direct investment has more than tripled in the second quarter to ZAR 24.6 Billion Rand from ZAR 8 Billion in the first quarter.
Given the ever widening deficit and other disappointing data, it is counterintuitive that investments especially in long term projects have increased. However, it is important to note that these inflows are a vote of confidence in the future of South Africa despite what the credit rating agencies may think. Embedded within this economic data- inflows- is a key political and social message subtly making a positive judgment call about the relative capacity of South Africa’s monetary and fiscal authorities operating within the existing political system to come up with a feasible plan to narrow the current account deficit. And this has and continues to inform my optimistic outlook on the fate of domestic financial markets.