Turkish lira woes reignite fears of South African rand contagion

The South African rand has consistently been seen as a prime candidate for contagion. Stéphane Monier, chief investment officer at Lombard Odier Private Bank in Geneva, last August argued that, based on fundamentals, South Africa was among the most vulnerable emerging markets currencies to Turkish contagion. True to form, the rand last week fell to its weakest since early January.

In the mind of the market, the Turkish lira and the rand are clearly connected. In a briefing on the risk of Turkish contagion during the last turbulence event last August, a risk indicator used by Oxford Economics identified the currencies of Turkey, South Africa and Argentina as the most vulnerable to a currency crisis. The indicator was able to explain 70% of the variations in four-day moves among these currencies.

Domestic fundamentals

In its Emerging Market Outlook for 2019, Société Générale Cross Asset Research took a bearish stance on the rand, pointing to weak fundamentals such as high unemployment, a widening current account deficit, low potential growth and a dangerous expected trajectory of government debt. These factors, as well as the forthcoming general election in May and the risk of sovereign credit downgrade, will outweigh the capacity of the central bank to limit rand depreciation through interest-rate increases, Société Générale argued.

That context means that South Africa’s currency will stand or fall on its own merits, rather than as a function of the Turkish lira or other vulnerable emerging market currencies. The fact that the emerging market universe has come to be dominated by China and India is one reason for this.

• Anatole Kaletsky at Gavekal Research argued in August 2018 that, whereas in 1998, the four biggest emerging markets by market capitalization were Brazil, Mexico, South Korea and South Africa, now they are China, South Korea, Taiwan and India.
• In 1998, Asia represented 37% of the MSCI emerging markets universe, compared with 73% in August 2018.
• The emerging markets slump last August, Kaletsky argued, was prompted by exaggerated fears of China’s dependence on the US market, exacerbated by Turkey’s financial crisis. These factors had “very little relevance” for emerging markets as a whole.

Ben Payton, head of Africa research at Verisk Maplecroft in London, agreed last week that it is “difficult to disaggregate the lira’s impact on the rand from wider concerns over South African economic policy.” The stance taken by Moody’s, which on Friday postponed the announcement of a credit rating decision on South Africa, will have a far greater impact on the rand than external factors, he says.

• Recent budget data showing an ever-widening fiscal black hole, plus the increasingly grave financial and operational crisis at Eskom, will continue to weigh on the rand in the coming weeks, Payton says.
• A sustained recovery, he argues, is unlikely at least until after May’s general election, with investors waiting to see if President Ramaphosa can use the polls to consolidate power and commit to economic reforms.
• “The rand wouldn’t be so vulnerable to global market jitters if investors weren’t already so concerned about domestic factors.”

Bottom line

In the short term, Moody’s rather than Turkey holds the key to the fortunes of the rand. After the May elections, South Africa will need to rapidly attack its domestic problems to keep its investment-grade status and avoid a sharp rand decline.