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Time to Exit South Africa ETF?

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Recent violence at a platinum mine in South Africa, which resulted in 34 deaths and scores of injuries, left the country in shock and the investors spooked. The incident actually hits at larger socioeconomic problems that the country faces and the risks as well as the uncertainties that lie ahead for the investors.

Labor unrest is nothing unusual in the country. The mine in question is owned by Lonmin Plc, the third largest platinum producer in the world. The operations at this mine as well as others have been suspended many times in recent past.  In May last year, the company had sacked 9,000 workers after a strike. Earlier this year, violence at Impala Platinum Holdings led to four deaths and six-week closure. (Read: Malaysia ETF: the Perfect Emerging Market Fund?)

Economists warn that the damage to the mining industry, which accounts for 60% of the country’s exports, would hurt economic output and impact growth. Country’s economic growth is already constrained by recession in Euro-zone (destination for ~29% of the country’s exports) and slowdown in China (~ 14% of the exports). (Read: Forget the BRIC ETFs, Focus on the PICKs)

Since its transition from Apartheid in 1994, the largest economy in Africa has grown at an average rate of 3.3% while the inflation has remained modest within 3% to 6% range. The country has a well-developed financial system and modern infrastructure. It is one of only four African countries that have been classified as upper-middle income countries by the World Bank.

South Africa has been endowed with vast natural resources. The country is the largest supplier of platinum (~67% of total supply) in the world and also one of the top producers of gold, diamonds and palladium. (Read: Five Top Performing Single Country ETFs of 2012)

The economy grew at 3.1% in 2011, but is expected to slow down to just 2.6% in 2012 and then grow at 3.3% in 2013 (per IMF estimates). The growth rates are much lower compared with the broader sub-Saharan Africa which is expected to grow at 5.4% and 5.3% respectively in 2012 and 2013.

The country is among the worst in the world in terms of income inequality, which is further exacerbated by low employment growth in the country. Savings and investment rates also remain low. Last month, the central bank cut the key rate (for the first time since 2010) by 50 basis points to 5% , to boost growth.

The unemployment rate is close to 25% currently; in fact it has remained above 20% for the past 15 years.  About 70% of the country’s youth are unemployed and about 86% of the country’s unemployed are black. For approximately a third of the South Africans, government grants are the only regular income. Per central bank’s estimates, a growth rate above 7% is needed to make any significant dent in the unemployment rate.

All three major rating companies have lowered their outlook for South Africa's debt to negative from stable in the past six months due to growing unemployment, income inequality and policy uncertainty. (Brazil ETFs: More Trouble On the Horizon?)

Despite significant reforms in past 10-15 years, the government still had wide control over the nation’s economic activity. Further, market liberalization measures now seem to be on the back burner as the government struggles to deal with issues like high spending and corruption.

Compared to the size of the economy and external trade, the level of foreign exchange reserves is low (~$48 billion), contributing to increased volatility of the currency, which remains vulnerable to commodity prices and global risk perception.

As a fall-out of the violence, platinum prices went up by about 5% in the last two trading days though the gains may be limited due to supply surplus and the lack of significant demand. The precious metal has gained only about 4% year-to-date.

On Friday, the Rand fell  by 1.3% against the US Dollar and the MSCI South Africa Index Fund (EZA - Free Report) went down by about 2.7%.

We think that the upside for MSCI South Africa Index Fund (EZA - Free Report) will be limited in the near-to-medium term, given high risk and policy uncertainty in the country.  As such the investors may like to underweight or avoid the ETF for the time being.

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