* Offshore investors drop $800 million of local debt
* Forward markets pricing in September rate hike
* Dollar liquidity squeeze, local factors weigh
By Mfuneko Toyana
JOHANNESBURG, Aug 24 (Reuters) - South African bonds suffered twice the outflows of the next worst-hit emerging market at the height of the Turkey crisis as foreign investors scrambled to reduce volatility in their portfolios against a backdrop of rising economic risk.
Even with forward markets now heavily pricing in interest rates hike this year, which would boost the potential yield on local bonds, investors are dumping Pretoria's debt with increasing speed.
The Turkish lira has plunged nearly 40 percent this year over investor concern about Tayyip Erdogan's influence on monetary policy and a deepening row with the United States, sparking a wave of selling across emerging market assets.
Data from the International Institute of Finance (IIF), an authority on global portfolio flows, this week showed $800 million (12 billion rand) bled out of South African bonds from the start of the month up to Aug. 17, more than any other emerging market, including Turkey.
Between January and June foreign investors sold $2.5 billion worth of South African bonds, the highest sell-off on record, before a brief respite in July as investors gave in to the lure of a carry yield second only to Russian debt.
"Higher interest rates would make bonds attractive, however the return adjusted for volatility also plays an important role," said strategist at Nedbank Mehul Daya.
The benchmark 1-month implied volatility contract rose 10 vols to a 7-year high last week as the rand spot rate rapidly collapsed to its weakest in 24 months.
"A squeeze in global dollar-liquidity also makes the carry-trade expensive. A stronger dollar means tighter financial conditions meaning higher CDS spread, which works into the S.A. bonds," Daya said.
On Friday forward markets were pricing-in a 100 percent chance of a 25 basis points (bps) increase to benchmark rates at the bank's September meeting, and a 65 percent probability of a hike by the same margin in November.
The Reserve Bank said in July it was ready to tighten policy if rand weakness translated into higher second-round inflation, a message it has reiterated more recently. It also said it was concerned about the exchange rate's volatility.
The benchmark 2026 bond currently yields 8.9 percent, but market watchers say investors are likely to want a return of 9.2 percent or above to compensate for higher risks.
"When you look at candidates for contagion from Turkey, South Africa stands out," said Kiran Kowshik, EM FX strategist at UniCredit.
"It has quite a liquid currency and... investors have quite a lot of South African bonds – they own well over 40 percent of that market. (So) when people want to hedge their EM exposure they may sell South Africa," Kowshik said.
On Friday ratings firm Moody's cited the high wage settlements and uncertainty about the implementation of land reform as factors that would exacerbate the selloff in South Africa's debt. With economic growth set to barely top 1 percent this year and public debt close to a third of gross domestic product, analysts see financial stresses mounting, taking the sheen off the hoped-for recovery following Cyril Ramaphosa's election as state president.
And while the crash of the Turkish lira triggered an exodus from EM's across the board, South Africa's high current account deficit and the fact that foreigners hold nearly half of state debt has ensured added pain.
"You might not be willing to sell the ones with the big losses, but rather sell the more liquid holdings, so there could have been pressure for funds to sell some South Africa," said Trieu Pham, emerging markets sovereign debt strategist at ING. (Additional reporting by Claire Milhench in London Editing by James Macharia and Toby Chopra)