No More Grey Days for South Africa

Late on Friday afternoon, 24 October, a piece of lost confidence was restored as the Financial Action Task Force (FATF) announced the removal of South Africa from the grey list. The decision came after South Africa executed the necessary action items laid out by the FATF, bringing the country in line with global standards.

The FATF, Grey Listing & Why It All Happened

The FATF is an intergovernmental organisation with the sole purpose of combating money laundering and terrorist financing. By implementing global standards and holding nations accountable, they promote confidence in the systems and institutions underpinning payments, transactions, and investments. A financial system rife with criminal activity leads to problematic outcomes within an economy, including:

1. Lack of financial integrity
2. Economic instability
3. International sanctions
4. Corrupt governance

Effectively, the FATF to stop criminals from using the financial system to store, increase, or disguise the origin of their wealth. If Pablo Escobar was able to open a bank account with one of our local banks to store his illegal profits or open an investment account with one of our asset managers to grow his wealth without the institutions knowing who they were doing business with, it opens up the financial system to widespread abuse. Criminals become wealthy enough to bribe the government and influence policies, own and run public companies and continue to engage in activities that reduce the welfare of a country.

Earning a place on the grey list indicated risk and uncertainty in South Africa’s financial markets, which international investors avoided. Similarly, any local businesses attempting to partner with international institutions offshore were met with stricter compliance hurdles, making international relationships a greater challenge.

A big ‘KYC’ movement was the key to getting off the grey list. Institutions needed to know who and where they were receiving money from and only accepting the legit sources while declining the dodgy sources. This made it harder for the “Escobars” to conduct their illegal activities. In addition to identification, prosecution was another major flaw that needed to be rectified. In other words, we knew who the criminals were but did nothing about it.

South Africa got its A into G as it increased compliance measures, made necessary arrests and asset seizures so that, 33 months later, it earned its removal from the grey list. Removal had been highly anticipated by markets for a few months, which is why there were no fireworks from markets on Monday. While the move may not be a catalyst that leads to a market rally, it should be seen as a stabiliser for financial markets. Moving forward, our stocks, bonds and currencies may be a little less volatile than before. Coming off the grey list is not a once-off accomplishment but a standard that needs to be upheld for that confidence to improve. After all, investing is a confidence game which needs to be built up to see a positive repricing in our assets.

Derisking in South African Asset Classes

An important component of international investing is a country risk premium. Every country has one, and it highlights the return an investor demands from a country given the risk of investing in that country. Investors may be happy with a 5% return from US government bonds, given its prominent position in the global economy, low risk profile and confidence investors have in earning that return, while it is unlikely an investor would be willing to settle for a similar return in South Sudan. A 35% return may be more enticing for an investor to get involved. This 30% difference is made up of many components, but the bulk is dominated by the country risk premium.

Right now, South Africa is perceived as ‘less risky’ than it was a few months ago, which means our country’s risk premium is expected to decline. The movement doesn’t just happen at once but gradually as South Africa proves itself to be a less risky investment. Foreign investment should slowly return, and foreign institutions should be less harsh when doing business with us. As our country risk premium shifts down, investors may be happy to pay more for the assets they invest in, which will push the value of bonds, equities, real estate and other assets up.

Typically, when there is a change in the risk rating of a country, the first assets to benefit are government bonds. They have the lowest level of risk outside of cash and are an attractive place for foreign investors to dip their toes back into the SA market. As trust is built from the short-term into the medium-term equities start to benefit more as their price-to-earnings ratio grow because investors feel more comfortable paying a higher price for R1 of earnings.

What does this mean for us?

At WealthStrat, we are positioned well for the near-term benefits through our overweight exposure to South African bonds, which have already contributed well to our portfolio year-to date. A derisked environment moving forward will likely see us pivot into a higher equity exposure to benefit from attractive risk-adjusted returns.

Overall, increased asset values contribute favourably to economic growth through many different avenues, including stronger business confidence, lower cost of capital for government and companies, the wealth effect among consumers and increased tax revenue to help contain the budget deficit. This may not be the sole answer to South Africa’s economic woes but forms a vital piece in helping achieve an even greater milestone by returning to investment-grade status in the global economy.