KIM SILBERMAN: Interest rates can protect the rand for only so long
Longer term, the currency reflects structural shift in fundamentals and risk
Between 2000 and 2013 the rand averaged R7.80 against the dollar. Over the next two years, from 2013 to 2015, it fell to R15.50/$ and hasn’t looked back.
From 2015 until 2019 it traded around a new average of R14/$. According to our analysis, though SA’s economy deteriorated over this time, this structural shift weaker was largely due to the dollar, which strengthened from $1.30 to the euro in 2013 to $1.12 in 2015, around which it has since traded. We estimate that the strong dollar accounts for about R1.50 of the depreciation in SA’s fair value exchange rate over that period.
The second structural shift weaker in the rand caused it to trade around an average of R16.40 between 2019 and 2022. This coincided with SA’s downgrade to non-investment grade and falling out of the World Government Bond Index.
We are now experiencing a third structural shift weaker, which has played out over the past 12 months, during which the currency has traded around an average of R18.20. Using a fair value model of the currency, the rand/dollar fair value is unlikely to appreciate from its current trading range as long as SA’s systemic economic issues continue to worsen.
A currency’s fair value is usually measured using the difference in the rate of inflation between two nations to estimate the exchange rate that results in parity regarding purchasing power (the purchasing power parity, or PPP, approach). Using this measure, the rand/dollar fair value is R14.20, and accounting for the strong dollar takes it to R15.70.
SA has been very successful at controlling inflation thanks to the independence of the Reserve Bank. Unfortunately, the rand is statistically less and less sensitive to inflation (see chart 1) and increasingly a function of sovereign risk, distilled over time in GDP per capita. SA’s per capita wealth adjusted for inflation has declined from $5,895 a year in 2015 to $4,640 in 2022, and is projected to decline to $4,100 by end-2024.
A chart of SA’s GDP per capita relative to US GDP per capita (chart 2) shows this persistent decline since 2015. This decline has already added about R2.50 to the rand/dollar fair value, taking it to R18.20/$.
Central banks generally hike policy rates to protect the value of their domestic currency. The theory behind this is based on the PPP principle: higher rates mean lower inflation and a lower inflation rate will support the exchange rate. However, due to the reduced sensitivity of the rand to inflation, the Reserve Bank needs to run a higher policy rate and target lower inflation to get the same results.
We estimate that SA’s interest rate needs to increase potentially to 2.5 percentage points above inflation, which is prohibitive if economic growth remains below 1%. For example, if inflation returns to the Bank’s target of 4.5%, this means the Bank could cut rates, but only to 7%.
We note that higher policy rates can assist in protecting the currency in the short to medium term by making it more expensive to sell the rand and buy dollars in the forward market (hedge the currency), and offer more reward for borrowing in dollars and investing in rand, also known as the carry trade.
However, over the longer term the rand reverts to expressing the structural shift in SA’s fundamentals and greater risk premiums.
The above provides a context for the effects of load-shedding and the collapse of logistics infrastructure on the currency and interest rates. Load-shedding raises inflation and lowers growth, that is it results in stagflation. Stagflation raises the risk associated with SA’s bond and equity returns, especially for foreign investors, who have reduced their exposure to SA assets.
Domestic investors have also reduced their holdings of domestic assets from 70% of assets under management to 63% by the first quarter of the year. In addition, SA’s widening trade and budget deficits make it more vulnerable to these reduced exposures due to increased reliance on foreign flows to fund these deficits.
SA’s sensitivity to geopolitical tensions has also increased, while these tensions are heightened. This was evident in May, during which SA’s five-year sovereign risk premium rose about 70 basis points and the rand weakened about 80c on fears that sanctions could be imposed on SA.
Risks to the currency may rise over the next 12 months if there are increased episodes of sabotage leading up to national elections in the first half of 2024, the outcome of which also is extremely uncertain.
If SA’s economic risks continue to worsen in line with consensus expectations over the next two years the rand/dollar fair value exchange rate will shift weaker again.
• Silberman is economist and macro strategist at Matrix Fund Managers.
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