South Africa has not received much media coverage in the past few years, except for a few mine strikes. But in this unique macroeconomic environment, the stars may be aligned for it to play a much bigger role on the international stage, albeit a negative one.
In this article, I'll delve into the bigger factors that I believe are pushing the South African Rand (ZAR) to the brink. Later on, I'll go over the economic minutiae in more detail.
I think the most potent force behind a potential ZAR crash is psychology. The Great Financial Crisis and the European debt crisis bred a crop of prescient and wealthy speculators that love sniffing for trouble. In a more benign environment, the ZAR might depreciate slowly, but in the current environment, a few billion dollars shorting the ZAR and/or capital outflow could spark a chain reaction that leads to a rapid, sharp fall in the ZAR. And there is a plethora of investors eager to bet big on something that, in their experience, is expected to produce a nice, quick and satisfying gain.
You can see how after the JPY depreciated 20% across the board in 3 months. Market participants scrambled to short and/or make bearish calls on the GBP. Granted, economic fundamentals were not too bright for the UK, but I think a case could be made that the eagerness of participants to jump onto a depreciating bandwagon exacerbated the move.
Recently, Cyprus sent shockwaves throughout the financial community and within days, Slovenia is facing the music. Hungary might be next with a 10% depreciation in its currency in the last 2 months. Does anyone really know what's going on in Slovenia or Hungary? But plenty of people are eager to spot the contagion and bet on it.
Another key player in a potential crisis would be the other breed of investors that grew from the aftermath of the GFC - the yield chaser. Foreign holdings of South Africa public debt grew $40 billion since early 2009, around 10% of GDP and 25% of total public debt (In fact, gross public debt grew by about $80 billion in this period, so foreign net holdings accounted for half of new debt.). They came searching for yield in a zero interest rate environment. At some point, if the situation gets too uncertain, they, especially institutions, will have to dump their holdings, if only not to seem too stupid holding a big loss at the end of quarter when everyone else has liquidated their holdings.
I believe this interplay between aggressive shorters looking for the next big collapse and nervous yield chasers selling when the currency keeps depreciating will be the main force that pushes the ZAR off the cliff. The economy does not even have to be that bad in South Africa, and arguably it isn't much worse than other bubble "miracle" economies. But there's a story that attracts the speculators, there's QE eventually getting lifted making yield-chasers twitchy and there's the fact that South Africa only has $40 billion in forex reserves so it'll run out of moves relatively quickly. Unfortunately for South Africa, it is just the right size for a speculative attack. Not too big (some countries have $3 trillion forex reserves), yet not too small (can't build a position if shorting $100 million of a currency sends it down 10%). All these combine to create the conditions for a crash in the ZAR.
A crash in the ZAR would have many implications. After a catalyst sends the crisis fully into motion, reducing positions in emerging market ETFs - (EEM) etc. - would be my call, as contagion should spread fairly rapidly across emerging markets and confusion results. I would also expect gold prices (GLD) to bounce then on a broad risk-off and expectations of delayed lifting of QE. More on these later.
Hot air does not make a trend, there at least has to be some smoke! Next time, we'll look more closely into the economic nitty-gritty: inflation, tax revenue, credit growth and things like that, to see why this story is so enticing.
 Source: South Africa Reserve Bank Gross External Debt Statistics here
South Africa Reserve Bank Economic data detail(gross loan debt) here
Additional disclosure: May initiate short in South African Rand or Hungarian Forint in coming days.