LONDON South Africa faces the risk of a huge exodus of foreign investors who are seeing the plunge in the rand's value rapidly erode their stock and bond returns.
Africa's largest economy has sucked in huge investments in the past two decades, but also has one of the world's biggest balance of payments deficits - over 6 percent of its economy - and depends almost fully on portfolio capital to plug the gap.
Now a combination of domestic policy fears and structural problems along with a poor global trade and investment climate is weighing heavily on the country's currency.
South African stocks and bonds have been a magnet for foreigners who now own a third of the bond market and up to half the equity free float in Johannesburg .JTOPI, which is home to multinationals like SabMiller and Anglo-American and remains close to record highs.
A record 93 billion rand ($10 billion) flooded into the country last year, when South Africa became only the fourth emerging economy to enter Citi's key global bond index.
But a ballooning deficit, sluggish 2-3 percent growth and fears of erratic policy before 2014 elections are weighing heavily on the rand which has lost 8 percent this year versus the dollar and a fifth of its value since early-2012.
Investor exits tend to pick up when returns turn negative and the rand is now perilously near the 9.30 per dollar rate, that analysts at UBS reckon is the "pain threshold" at which longer-term bond returns will tip into the red.
"You are seeing rand weakness eating away investors' returns," says Manik Narain, who co-authored the UBS report.
He estimates the average rand exchange rate was 7.70 per dollar over the past four years when most bond investors entered the market. Cumulative returns during this time amounted to 20 percent according to UBS calculations.
"Another 1-2 percent loss on the rand could see them exit positions altogether," Narain adds.
Rand weakness also ties the hands of the Reserve Bank of South Africa (SARB), preventing it from offering the economy vital monetary stimulus. The SARB left interest rates on hold this week, noting the currency's propensity to "overshoot".
EXTERNAL AND DOMESTIC HEADWINDS
Undoubtedly some funds are in for the long run, irrespective of currency swings. Others will also have put in hedges against currency depreciation.
HSBC currency strategists are among those arguing that even at current levels the rand can be hedged. They note that inflows are continuing, albeit at a less robust pace than last year.
Stock exchange data indeed shows net year-to-date inflows of 7.3 and 14 billion rand respectively.
But Narain says that if a currency keeps depreciating, it can become harder to roll over the hedge. And the rand's moves are being driven by bad policy and worsening macro economics rather than short-term problems or global issues.
"Indeed it is very possible also that despite sitting on strong cumulative aggregate profits investors would choose to stop adding to a market, or exit from it, if they believe there are structural shifts for the worse in that economy," he says.
Chronic labor unrest has slashed mining and power output, depressing corporate profits and economic growth.
Soaring wage costs have kept productivity weak - data from the World Economic Forum for instance ranks South Africa 97th out of 139 countries in terms of labor flexibility.
The global trade slowdown led by China and Europe, along with waning demand for emerging markets, is making things worse.
STOCKS A SEPARATE STORY?
So how does this macro-economic gloom square with the fact that the Johannesburg stock market is at record highs?
First, much of this gain is locally-driven. Unlike many emerging markets, South Africa has a powerful local investor base which is less likely to take fright from currency weakness. A weak rand can in fact be a plus for export-focused mining companies whose income is in dollars.
Second, Johannesburg-listed stocks are often the best way for overseas investors to get exposure to fast-growth markets in the rest of Africa.
Mark Livingston, investment director for emerging markets at Fidelity Global Investments notes that the top 60 South African firms derive about half their revenue from overseas. That according to him, provides a natural hedge to currency weakness.
"Of all the emerging markets...South Africa stands head and shoulders above the rest for the way companies are run on behalf of shareholders," Livingston says.
Yet many are uneasy, noting the sluggish domestic demand story which contrasts so starkly with other emerging peers.
And in dollars, equity returns this year are minus 8 percent, with only Cairo and Prague doing worse. A net 80 percent of global fund managers are underweight South African stocks, Bank of America/Merrill Lynch's latest survey finds.
"Investors have lost progressively as the rand has fallen. At the end of the day, a lot will depend on where the rand goes," says John Lomax, head of emerging equity strategy at HSBC who advises clients to underweight South African stocks.
"For that we need more political clarity and for the current account to start turning around."
(Reporting by Sujata Rao; editing by Ron Askew)