Uncertainty, Financial Markets, and Fund Flows to South Africa

Economic growth in South Africa over the last decade has been disappointing. Even before the emergence of the Covid-19 pandemic, the economy was underperforming. South Africa needs high and sustained growth to reduce the rate of unemployment, which has remained stubbornly high at over 30% for many years. Fund flows may provide capital to spur this needed growth. Fund flows are a critical issue in emerging markets like South Africa as sudden reversals have also been associated with severe destabilizing effects. These concerns and the substantial growth in fund flows to South Africa in the past two decades motivate this study. We examine the relationships among fund flows, uncertainty measures, economic indicators, and financial market variables in South Africa. We estimate several vector autoregressions to account for the inherent feedback among fund flows and economic and financial variables. We find that the term structure of interest rates (TERM) is negatively related to equity fund flows (EFF) while positively related to bond fund flows (BFF). While BFF and EFF are both negatively related to most uncertainty measures, BFF is more sensitive to downside risk indicators than EFF. We show that the economic and financial development of South Africa is impacted by fund flows with GDP being more strongly impacted by BFF while stock returns are impacted by both BFF and EFF. We also uncover evidence that commodity prices increase BFF. Next, we show that the volatility of the South African equity market immediately reduces equity prices which attracts EFF after a two-to-three-month lag. Finally, we uncover convincing evidence that illiquidity as measured by effective spread reduces EFF to South Africa. The ability to better predict the direction EFF and BFF will allow policy makers to impose circuit breakers to mitigate the adverse impacts of sudden investment reversals. This is particularly relevant to the current situation where additional financial uncertainty due to the energy crisis in South Africa coupled with political instability may increase the likelihood of such reversals.