Economic Thoughts: Thinking about the Rand

What is top of mind when thinking about Rand prospects, near term and far? It isn’t all daily randomness. There is structure, some of it obvious, some of it requiring more digging, giving us a better probability of getting the levels right where the Rand may be residing over time. Even if we cannot pin it down in the very short-term.


The Rand defines our relationship with other countries and systems. That has its own rules about what flies and what doesn’t. It allows a sketch to be made of the main forces that drives the Rand over time.


We may select the Rand/Dollar relationship as the one to examine, with other Rand exchange rates obtained from these currencies to the Dollar.


The first reality that defines the Rand is our inflation differential with other countries. To the extent that our inflation is higher, longer term nearer 6% as compared to near 2% for the US, the Rand needs to depreciate by an average 4% annually to keep our trade relationships (export, import, capital flows) balanced.


The second reality is that no currency is necessarily at all times at its fair value, meaning the level at which its balance of payments can be sustained in a stable manner, exports matching imports. Informally defined, fair value is a currency level neither too comfortable for most companies (too many making super profits and managers starting to take up golf) nor too uncomfortable (too many businesses failing under the impact of foreign competition).


Yet, few currencies ever find themselves for long anchored at their fair value, under- and overshooting being the order of the day, as many forces impact on the currency, with capital (investment) flows as their main conduit.


For the Rand, current fair value on Purchasing Power Parity is about 9-10:$. Instead, we find ourselves at 15.50:$ (or 60% over fair value), having started 2015 at 11.50:$ (already undervalued but only mildly so).


In December 2001, Rand fair value was near 7:$ and the actual Rand peaked near 14:$ (100% over fair value). Under present circumstances, the Rand needs to reach 20:$ for a similar degree of real under-shooting.


Yet there is no law that defines how far a currency may under- or overshoot. The 2001 experience isn’t even a benchmark, merely a (bad) experience. On future occasions, things can turn out even worse (or better), a matter of very specific circumstances.


The only relevant observation is that the bigger the undershoot, the greater the export advantage & import-penalty, inviting shifts in investment and trade, making for a shift in current account balances, impacting capital flows and thus influencing the level of the Rand, naturally correcting under- and overshoots, given enough time.


This, though, takes time. Often other processes are faster to correct for the currency under- or overshoot. During 2002-2005 something like that certainly took place, with the Rand firming from an extreme 13.85:$ back to 5.60:$ (by then overshooting fair value by 30%).


At least five forces made this positive trend possible.


Firstly, favourable shifts in trade, driven by the period of Rand under-shooting. Secondly, the SARB increasing interest rates by 4% in 2002, constraining domestic growth & imports while increasing returns for foreign capital inflows. Thirdly, the onset of the Chinese-driven commodity supercycle also driving our key commodity prices higher. Fourthly, favourable global liquidity conditions setting in motion large capital inflows to many Emerging Markets (EMs) looking for higher returns. Fifthly, the onset of faster domestic SA growth (boom conditions) making us more attractive to foreign capital inflows.


So whereas we currently at the start of 2016 find the Rand at 15.50:$, and thus deeply undershooting, the question is whether this undershoot will still (severely) deepen, or whether it will start to shortly reverse, as it did after 2001?


What forces can we identify driving this process? Here I have before identified our Big Five Game Changers. The global growth cycle, commodity cycle, capital flow cycle, any windfall conditions and our internal political cycle.


Global growth this decade has been slowing down, but may be stabilizing, in some parts already recovering (America, Europe), in others bottoming out (China?). Even so, in yet others recessions may still be further deteriorating (many, though not all, commodity producers).


The downswing in the global commodity cycle may turn out to be deeper and more prolonged, with talk of oil prices for many years below $40 and now also iron ore projected below $40 for some years still, a function of weak demand and oversupply. This may delay the revival of the commodity price cycle beyond 2016, but will ultimately not prevent it.


The Fed liftoff has begun, with markets mostly orderly, though the Dollar is expected to firm more, with more currency weakness elsewhere. This transition should not end capital flows towards EMs, even if their cost increases. Once the Fed has normalised interest rate levels (2018?) and the world has adjusted thereto, these pressures on EMs should become less stressful.


The bigger game changers for SA, with the biggest risk (of happening or not), concerns windfalls and any change in the political cycle. If shale gas turns out to be a major viable proposition, it will change SA 2020s prospect deeply. Similarly if we can look beyond the short-term Zuma presidency. Either there awaits worse or reform of some kind is to be expected, in turn impacting business confidence and contribution positively.


All these forces have been negative this decade, may still worsen (somewhat?) over the next two to three years, but may then start a longer term revival.


We also have ultra-short term effects, such as the Nene firing and Gordhan reappointment as finance minister, with an orgy of wild market selling over two days, and since then a partial asset price clawback. Some more clawback may follow, but much will depend on the credibility of policy in coming months, not quite a given with an “incomplete restoration” (see my earlier Africa Brief), the Rand this past week again giving up more of its limited clawback since mid-December. Poor yearend liquidity and the trend-is-your-friend doing the driving, with credibility severely dented, and questioned at every turn, with the proof of evidence to be delivered by the politicians, and not relying on market gullibility. 


Translation: we may not have seen the decade bottom for the Rand at 15-16:$, but we won’t necessarily from here onward “collapse” further (unless our politics surprise badly or an unforeseen global surprise catches us badly).


More weakness for longer, a wider Rand undershoot by all means, but a turning point before decade end as our big game changers at some point start to reverse, after which a gradual narrowing of the Rand undershoot relative to fair value is feasible (which itself will keep rising at 50 cents yearly because of the inflation differential). The Financial Times carrying an article this weekend asking whether this year is the moment to (slowly) re-enter bombed out EM valuations. Been there, done that?


This decade outcome as sketched would not rate as the end of the world. Instead, a difficult decade, laid low by many coinciding forces, giving us yet another deep Rand undershoot (of which so many in recent decades), after which (partial?) recovery into the 2020s, certainly in real terms inflation-adjusted (and, who knows, at some point another overshoot, in the nature of these big cyclical things).


For never say never in this game, as the historic record suggests (but much also hinging on us making our own luck, alternatively digging our own grave ever deeper).