Grey-listing: what are the implications for the financial sector and the greater economy?

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The following content is extracted from an article by Casey Delport, investment analyst: fixed income at Anchor Capital.

The results of global empirical studies of the impact of grey-listing or black-listing by the Financial Action Task Force (FATF) are mixed.

A recent IMF study estimates that capital inflows typically decline by 7.6% of GDP at the time of a grey-listing (with a typical range of 4.5% to 10.5%).

In contrast, two empirical studies found that black-listing had no significant and enduring impact on banking flows and tax havens.

Falling between these results is a Latin American study that found a small (0.3% to 0.4% of GDP) impact on foreign direct investment but no consistent impact on other flows.

Two further studies found a 10% and 15% decline in cross-border receipts and growth in bank inflows, respectively.

Essentially, these divergent empirical findings demonstrate the difficulty in accurately estimating the economic impact of the FATF’s grey-listing and/or black-listing. This is arguably at least partly because, unlike the specific event of an adverse listing, the fundamentals that inform such listing typically deteriorate or become greater over time. Thus, investors would typically react to these fundamentals independently and not only to the listing status itself.

For example, global investors would already have been more cautious about their transactions with South Africa during the state capture era rather than waiting for an adverse listing of the country by the FATF. Plainly speaking, many international investors would have already priced in the risk of transacting with and within the South African financial system. This mirrors the same dynamic as that of a sovereign credit rating downgrade, which does not necessarily cause a material and persistent economic and/or market reaction, because the relevant, weak fundamentals are typically discounted well in advance.

Nonetheless, it is safe to assume that landing on the grey list will be detrimental to the integrity of the South African banking system and jeopardise the country’s relationships with overseas banks.

Regulators from some of South Africa’s main trading partners – such as the US, the UK, China and Japan – may restrict their banks from transacting with South African banks. Of those able to transact, the associated costs will be raised significantly. This, in turn, may have a material adverse impact on capital flows and subsequent growth, as well as on the currency and bond markets. Furthermore, it will become increasingly difficult to invest offshore, even for the wealthiest investors.

Although one cannot rule out an adverse impact on South Africa’s economy, bonds and currency if the country is grey-listed, at this stage, it would be premature to adjust our macroeconomic forecasts on the assumption that at least some of South Africa’s deficiencies are already being discounted by high idiosyncratic risk premia and, if placed on the grey list, the reasonable probability of authorities making adequate progress in addressing these deficiencies to be removed from the list.

How do we get out of this mess?

Significant progress would have to be made in a short period to avoid such an adverse outcome of the FATF process currently under way.

Positively, the FATF assessments lend substantial weight to any demonstrable effort by policymakers, such as interventions by the South African Reserve Bank (Sarb) and National Treasury, to address South Africa’s shortcomings.

However, aside from the typical uncertainty surrounding the timeframes to complete specific actions (such as regulatory changes), the FATF assessments also embody inherent subjectivity, which clouds estimating any probability that South Africa can make enough progress timeously to avoid being grey-listed.

Nonetheless, an adverse outcome is not inevitable, but at this point, recent assessments by Treasury and the Sarb of a “high” probability of such an outcome appear pertinent.

Regardless, in an urgent move to help prevent South Africa from being grey-listed, cabinet approved a raft of new amendment bills in late August. The omnibus bill amends the Financial Intelligence Centre Act, the Non-profit Organisations Act, the Trust Property Control Act, the Companies Act and the Financial Sector Regulation Act.

The amendments included in the bill aim to respond to the deficiencies identified during the peer review of the country conducted by the FATF and address about 14 of the 20 areas in which the FATF found South Africa deficient.

The Protection of Constitutional Democracy against Terrorist and Related Activities Amendment Bill, currently before Parliament, will address two other deficiencies. The remaining technical deficiencies will be addressed through various regulatory changes.

Although it is indeed plausible (even if unlikely) that Parliament will be able to process these legislative reforms by the end of this year, other aspects of the FATF review will require a broader political response to correct. In particular, the authorities will need to assure the FATF that, collectively, South Africa is more capable of giving effect to this legal framework than it has been in the past and governance institutions can hold to account those responsible for past and inevitable future transgressions.

Regarding the upcoming review, above all, the authorities will need to restore confidence in South Africa’s capacity to deliver accountability for state capture crimes and its ability to recoup the funds looted from state institutions by those implicated in high-level state capture offences.

Could this be the wake-up call that SA needs?

Although no country would want to wind up on the FATF’s grey list, doing so could kick-start and accelerate much-needed reforms to counter fraud, corruption and terrorism financing in South Africa. Such was the case for Mauritius – the country was able to get off the grey list in under two years, much to its longer-term economic benefit.

South Africa might not be as lucky as Mauritius was to get off the grey list so quickly – as countries tend to spend several years on the list tackling the various identified deficiencies – but it is possible. Mauritius took a concerted effort to exit the grey list, and it is now fully compliant with 39 of the 40 FATF recommendations.

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Disclaimer: The views expressed in this article are those of the writer and are not necessarily shared by Moonstone Information Refinery or its sister companies.