Yellen Doubted by Market on Worst in Class: South Africa Credit

Investors aren’t buying the Federal Reserve’s assessment of South Africa being the least vulnerable among the “fragile five” emerging-market nations, as the rand collapses and sovereign risk climbs.

With an economy expanding at the slowest pace in five years, a quarter of the workforce unemployed and labor unrest threatening to spark a downgrade, the country is falling behind peers as U.S. monetary tapering increases competition for investment. While South Africa fared better than India, Brazil, Turkey and Indonesia, which Morgan Stanley dubbed the “fragile five,” it ranked below 10 other emerging-market nations on the Fed’s vulnerability index, released this week.

“The fact that we’re no longer the poorest cousin is cold comfort,” Mohammed Nalla, head of strategic research at Nedbank Group Ltd., said by phone from Johannesburg on Feb. 12. “We’re all in a sinking boat together. We shouldn’t be looking at how we compare against the worst in our class.”

The cost of insuring South Africa’s dollar debt against default for five years using credit default swaps has climbed 61 basis points since May 22, when the Fed first said it was considering trimming debt purchases. That widened the premium over contracts for Brazil, the second-most vulnerable nation on the Fed’s index, to 40 basis points, the most since September. The rand, which fell to a five-year low against the dollar on Jan. 30, is the worst performer after the Brazilian real in the period out of 16 major currencies monitored by Bloomberg.

Rate Surprise

The rand gained 0.7 percent to 10.8921 per dollar as of 5:14 p.m. in Johannesburg, paring its depreciation this year to

3.9 percent. Credit default swaps dropped two basis points to 227 after jumping nine basis points yesterday.

South Africa’s central bank surprised economists by lifting its policy rate 50 basis points to 5.5 percent on Jan. 29, the first increase in five years, after the rand slumped this year. While the currency has rebounded 1.8 percent since then, the Fed said in its Feb. 11 monetary policy report to Congress that rate increases and market interventions by emerging-market central banks are “stopgap measures.”

Developing nations also need to implement fiscal and structural reforms to lessen their dependence on foreign capital, said the Fed, where Janet Yellen took over as chairman on Feb. 3. That could include measures to boost growth, cut debt and increase foreign-exchange reserves, it said.

Vulnerability Index

The Fed’s vulnerability index ranks 15 emerging-market nations according to six risk factors: current-account balance, government debt, inflation, private-sector credit, external debt and foreign-exchange reserves. Turkey is the most vulnerable, followed by Brazil, India, Indonesia and South Africa.

“Those economies that appear relatively more vulnerable according to the index also experienced larger currency depreciations,” the Fed report said. “Investors appear to have been differentiating between emerging markets based on their economic vulnerabilities.”

Reforms “will take time, and global investors will be watching their progress closely,” according to the Fed.

Turkey’s central bank raised its one-week repurchase rate after a meeting on Jan. 28, by 5.5 percentage points to 10 percent. India surprised by increasing its key rate a day earlier to 8 percent from 7.75 percent, while Brazil has boosted rates for six straight meetings.

Deficit Balloons

The rate increases reversed the trend of the past five years, when the Fed’s stimulus spurred investment around the world and allowed central banks to cut borrowing costs. Cheap money in developing economies encouraged consumption and widened trade deficits, leaving those countries vulnerable as investors began to pull money out.

South Africa’s current-account deficit swelled to 6.8 percent of gross domestic product in the third quarter, less than Turkey’s 7.2 percent but more than that of Brazil, Indonesia and India. Foreign investors have dumped 25.5 billion rand ($1.4 billion) of South African stocks and bonds this year, according to JSE Ltd. data.

South Africa fares better on the other risks tracked by the Fed, according to John Cairns, a currency strategist at Rand Merchant Bank in Johannesburg. South Africa’s inflation rate, at

5.4 percent, is the lowest of the “fragile five,” while debt ratios, including the proportion of foreign debt, are relatively low.

Rate Threat

“Once you look past the headline current-account deficit, South Africa is not as vulnerable as the other countries,” Cairns said in a Feb. 12 note to clients.

Further rate increases as rand weakness fuels inflation could stifle an economic recovery, dimming South Africa’s investor appeal, Nalla at Nedbank said. Forward-rate agreements are pricing in a jump of 200 basis points in the next 12 months, though Reserve Bank Governor Gill Marcus said on Feb. 3 additional rate increases are “not automatic” and the bank will consider growth when making policy decisions.

The risk of a “populist backlash,” which would trigger another round of credit-rating cuts, is rising, said Gina Schoeman, an economist at Citigroup Inc. in Johannesburg. The ruling African National Congress is facing voter disenchantment over unemployment, poor service delivery and corruption before a May 7 general election, she said in a note on Jan. 16.

Market Nervous

Moody’s Investors Service downgraded South Africa’s credit rating in September 2012 to Baa1, the third-lowest investment grade, on a par with Russia. Fitch Ratings and Standard & Poor’s followed. Moody’s and S&P have a negative outlook on South Africa’s debt.

Finance Minister Pravin Gordhan will have to convince investors that he’s sticking to fiscal targets, implementing the government’s growth plan and resisting pressure for spending increases when he presents his budget on Feb. 28, said Michael Grobler, who helps manage about $343 million at Atlantic Asset Management.

“The market is still quite nervous, and a lot will depend on the policy response,” Grobler said by phone from Cape Town yesterday. “I’m not sure the storm has passed.”

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