Exchange control amendments – have we reached a tipping point?

Whilst the world may debate whether the quote above has its origins in Lenin or Marx, no one will dispute the truth of the message it advocates: big changes happen suddenly, and often unexpectedly, and tipping points are only recognised after they occur.

And so it was with the unexpected exchange control circular published by the South African Reserve Bank on 24 February 2022, which increased institutional asset swap capacity for all qualifying institutional investors to a maximum of 45% of the institution’s assets.

South Africa has been on a trajectory of relaxing exchange controls since the late 1990s. So many might be left wondering why this announcement is considered so important.

Well, firstly, it is a significantly positive development for South African investors, especially when viewed against the past three years of negative press commentary about the investment restrictions inherent in Regulation 28. With a struggling local economy and sluggish domestic investment returns, investors had become anxious to increasingly expand their investment horizons offshore.

However, there are two factors that make the February announcement probably as significant as the introduction of institutional asset swap capacity back in June 1995:

1. The increased allowance means that institutional investors can now invest almost half of their portfolios offshore. This has profound structural implications for investment strategies, long-term strategic asset allocation and product construction.
2. The quantum of the increase for retirement funds is material – the effective offshore non-Africa exposure limit has been increased from 30% to 45%, which is a 50% increase in the cap on a R2.7 trillion asset pool (excluding the Government Employees Pension Fund).

In this article, we expand on some of the implications of the new exchange control limits for the local industry.

What is the expected impact of the new limits on the domestic economy and local financial markets?

If we consider the impact of the new allowance on retirement funds, up to 15% of R2.7 trillion of retirement fund assets could shift offshore over the next 12 months. This number represents around R400 billion of outflows from the local investment markets. Adding additional flows from collective investment schemes (CISs) and insurance companies, we expect between R400 billion and R600 billion of assets to leave domestic investment markets over time.

On balance, the impact of this on the local investment markets and the rand is unlikely to be material. More relaxed exchange controls have historically attracted foreign investors to our shores, to some extent offsetting the capital outflows of South African investors. However, the R500 billion-plus expected to leave our markets, is largely managed by the South African asset management industry. Only some of this money will remain with South African asset managers after it has gone offshore, representing potentially significant asset losses to these managers.

What are the implications for investment platforms, life companies and CIS management companies?

The table summarises the recent increase in asset swap capacity for various institutions. The 2018 limits shown are the ex-Africa exposure (i.e. the foreign non-Africa exposure):

Harmonising offshore investment limits

There are two subtle points from the table that can easily be overlooked.

1. Firstly, before 2022, retirement fund limits were always below CIS exchange control limits. This gap has been critical as it has allowed CIS managers with large balanced funds to use the extra 10% capacity to offer offshore feeder funds. As Regulation 28 retirement fund mandates now push up their offshore exposure to 45%, CIS companies with mostly balanced fund assets will find themselves running out of capacity, forcing them to close their feeder funds to new flows.
2. Secondly, linked life licences used for living annuities will continue to face challenges with their offshore capacity, despite the increase in their capacity. This will happen because Regulation 28 balanced funds (popular in living annuity portfolios) will increase their offshore exposure to the new limit of 45%, taking up most of the increased offshore limit for the linked life company.

It is now critical for investors and advisors to understand the offshore capacity constraints of their product suppliers, and how the range of funds available fits in with their investment strategy.

How do the higher offshore limits impact portfolio construction?

Since February’s announcement, a key question has been: what is the appropriate offshore exposure for a South African investor who intends staying in South Africa?

Many industry players have published the results of modelling work looking at answering this question. At Ninety One, we have done similar analyses, both for long-term lump sum investors, as well as for investors drawing a regular income from living annuities.

Most long-term lump sum investors target portfolio returns of CPI + 6% – so we investigated these as our base case. Our results are similar to those of other researchers – the optimum offshore exposure for a CPI + 6% portfolio is anywhere between 30% and 40% of the total portfolio.

At 30% offshore exposure, the long-term asset allocation from the models is depicted in Figure 1, as follows:

Figure 1: Offshore exposure at 30%

Source: Ninety One.

A similar risk/return profile can be obtained with higher offshore exposures as well. Figure 2 contains an extract of some of the results when increasing the offshore exposure to 45%.

Figure 2: Offshore exposure at 45%

Source: Ninety One.

The results have been surprising – when allocating up to 30% offshore, the model suggests that all the offshore assets should be invested in global equities (Figure 1). But once the offshore exposure exceeds 30%, the model starts looking at other offshore asset classes as well (Figure 2).

This is a key takeaway – in portfolios with substantially more than 30% of their assets invested in foreign markets, the offshore component needs to include a wider range of offshore asset classes than just global equities.

Are there any significant portfolio construction implications for living annuities because of the increased foreign allowance?

Readers might be familiar with the series of articles we published over the course of 2018 and 2019 regarding the ‘rules of thumb’ for the safe management of living annuities.¹ For those interested in exploring these ‘rules of thumb’, the managing retirement income  hub on our website contains all the details. The good news is that none of these key living annuity rules has changed because of the increased foreign exposure limit for living annuities.

However, amid the COVID-19 uncertainty, particularly in 2021, we saw a marked increase in the offshore allocation for many advised living annuity portfolios. This development made us turn again to our living annuity model to investigate an increasingly important question: is there significant risk of too much offshore exposure for a living annuity investor retiring in South Africa?

We ran the model for several different income levels, and Figure 3 summarises the failure rates for different exposure levels.

Figure 3: Can a living annuity investor have too much offshore exposure?

Source: Ninety One.

Figure 3 highlights annuity failure probabilities for different levels of offshore equity exposure (horizontal axis) and for different levels of income (different colored lines) over a 30-year period. Please note that these failure rates assume that the pensioner lives in South Africa with living expenses in South African rand.

Here are some key takeaways:

• The first takeaway is that an annuitant can invest any proportion of a 2.5% income annuity offshore, even up to one hundred percent, without taking on a material risk of failure.
• The second key takeaway from Figure 3 is that there is a ‘safe zone’ (the highlighted area of the graph) of between 25% and 55% for offshore equity exposure in living annuities. Anywhere in this safe zone, living annuities with responsible income levels have more or less the same failure risk.
• The third key takeaway is that there is a risk of too much offshore equity – offshore equity exposure of more than 60% to 65% materially increases the failure risk of a living annuity.
• Very high offshore exposures (more than 65%) only really make sense for pensioners who have emigrated, or will shortly emigrate, and who wish to limit their currency risk. However, for South African pensioners living in South Africa, very high offshore equity exposures represent a real risk.

What are the implications of the new offshore limits for asset allocators such as discretionary fund managers (DFMs) and financial advisors?

DFMs and advisors face an interesting challenge dealing with the implications of the increased offshore allowance. Depending on whether they follow a multi-asset blend or a specialist approach to portfolio construction, they will face different challenges.

Allocators who use multi-asset portfolios will probably leave it to the portfolio managers to increase the offshore exposures to the new limits. But as we have seen in our modelling work, this requires portfolio managers to consider adding new asset classes such as offshore bonds, emerging market debt and infrastructure, and employing currency hedging strategies. The key question is whether the portfolio managers that asset allocators use for their multi-asset portfolios have demonstrable skill in these areas?

Allocators employing specialist building blocks will have to find specialist global managers for asset classes other than global equities. This will require the DFM/advisor to assess manager skill in these areas of expertise.

And finally, once these new offshore asset classes have been incorporated at a portfolio level, DFMs/advisors will need to monitor and manage their impact on portfolio risk/volatility and liquidity.

What are the implications of the new offshore limits for South African asset managers?

The changes to the offshore limits will drive South African fund managers to critically evaluate their current offshore capabilities and investment strategies. Asset managers lacking demonstrable skill and a track record of managing global assets will increasingly find themselves competing for an ever-shrinking domestic investment market.

Increasingly, this development will force large South African fund managers to set up integrated global investment teams, or to potentially partner with a global investment management firm, to credibly expand their offshore product capabilities. At Ninety One, we are excited about this development, as we have built a fully integrated global investment firm over more than 30 years.

Conclusion

We will likely look back at the February 2022 increase in foreign exposure limits as a tipping point in the development life cycle of the South African wealth and asset management industry. Every single component of the wealth management value chain will have to adapt to the increased foreign asset holdings in client portfolios. These changes will drive innovation in financial advice strategies, impact how portfolios are constructed and monitored, and ultimately determine how product manufacturers and asset managers strategically adapt their businesses. Advice firms should take care not to underestimate the long-term implications of these changes on their business models.

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¹ Managing retirement income