What happens to South Africa’s debt and that of emerging markets if Russia defaults?
In 1998, Russia defaulted on its debt, and what is known as the ‘butterfly effect’ spread out over emerging markets, fuelling SA’s inflation rate to more than 13%. It seems very likely that Russia will default again within the next month. Should we be getting butterflies in our stomachs?
Years ago, the science fiction writer Ray Bradbury wrote a short story called A Sound of Thunder in which safaris into the future were possible, but time-tourists were warned not to disturb anything. After one trip, the group arrived back to discover the entire world was different – because one tourist had accidentally stepped on a butterfly. That tiny event magnified over the years and changed the future. It also gave rise to the phrase “the butterfly effect”, the idea that the flapping of a butterfly’s wings in one part of the world could cause a hurricane on the opposite side of the globe.
In capital markets, there is always the danger of the butterfly effect, and nothing demonstrates this better than the 1998 default by Russia, which formed part of the larger emerging market crisis of the period. Interest rates shot up all around the world, and South Africa, with its tradable currency and comparatively open economy, got unfairly thumped. Even the dollar slumped 10% against the yen in two days, the most it has ever fallen against any currency in modern history.
For SA, the effect was enormous. The local prime rate shot up like a rocket, up all the way to a record 25.5%, and the 10-year bond yield hit 20%.
Could the same happen this time?
Mike Schussler, founder and owner of economists.co.za, doesn’t think the effect will be anything like as large this time, and SA, he suspects, will be one of the least affected of the world’s emerging markets.
One key indicator, he points out, is that SA’s inflation rate is now lower than the world average for the first time in 18 years. This alone has all kinds of virtues.
First, it should be cause for a stronger currency. Second, the global “inflation monster” will affect South Africans less. Third, it reduces pressure on the Reserve Bank to continue raising interest rates, which should bode well for the economy.
SA’s bonds trade at a slightly higher interest rate premium than its peers, and its comparatively lower inflation rate should reduce that premium.
All of these things play in the minds of investors, so it’s possible that SA will be less affected than emerging markets generally.
“It does suggest the [SA Reserve Bank] has played its cards right, through the Covid period,” Schussler says.
What about emerging markets generally? The crucial aspect to remember is that inflation was a major factor even before Russia’s invasion of Ukraine.
Stanlib economist Ndivhuho Netshitenzhe points out that according to the International Monetary Fund, the average rate of consumer inflation in emerging markets was 5.8% year on year in December 2021, from just 4.4% a year ago. In developed markets, it rose to 3.5% year on year in December 2021, from only 0.5% a year before.
She says 32 countries, mostly emerging markets, have increased their interest rates since 2021.
The potential for “policy errors” by central banks has increased, either by under- or over-estimating the global inflation risk. Both the US Fed and the European Central Bank at their most recent meeting left interest rates unchanged.
“Growing expectations of tightening by the Fed have contributed to most emerging market central banks adopting hawkish tones this year, as they seek to maintain attractive interest rate differentials.”
A Russian default in these circumstances is making markets edgy. However, economists have pointed out that since the 2008 financial crisis the global banking system is much stronger.
But, unusually, the rand has remained comparatively stable over the past few months. No longer is the rand a proxy for emerging market currencies, Schussler says. Other currencies, like the Turkish lira, are now as highly traded as the rand once was.
“If there is a Russian default, I’m fairly confident the rand will get hit, but of course nothing like as badly as Russia itself,” says Schussler.
Old Mutual Wealth investment strategist Izak Odendaal agrees. The rand is still resilient, he says, considering everything that is happening in the world, largely thanks to higher metals and coal prices.
“A sharp depreciation of the currency has historically seen the Reserve Bank react quite forcefully (though the pass-through of exchange rate weakness to domestic inflation has declined considerably over time). This time there is no need for such urgency.
“Therefore, the economy is unlikely to face an interest rate shock to compound the misery from higher fuel and food prices.” DM/BM