THROUGH THE RABBIT HOLE
The mystery of the stronger rand
The rand is rallying in the midst of a grave political crisis, confounding many of the experts who expected a disaster after Pravin Gordhan’s axing. What is happening in Wonderland?
After then finance minister Nhlanhla Nene was axed in December 2015, the rand weakened dramatically. This time around, however, despite the even worse news of Pravin Gordhan’s axing and SA’s downgrade to junk status, the rand has proved remarkably resilient.
How do we square this? Are the markets getting so used to bad news coming out of SA that they have stopped reacting to it? Or is there some other factor at play?
Before President Jacob Zuma’s cabinet reshuffle on March 30 the rand was trading at R12.40/$. In the following two weeks it weakened by roughly R1.50 against the dollar. But at the time of writing, it had reversed almost one-third of its losses, firming by 50c to trade at R13.40/$.
What is evident is that the local news flow — dominated by mass protests against Zuma and a growing clamour for his resignation — certainly doesn’t justify the biggest rand rally in six months.
"Total rand losses of a mere R1 seem remarkably limited given all that has happened," says Rand Merchant Bank (RMB) currency strategist John Cairns.
Dollar weakness and better Chinese trade data appear to have triggered the latest rand gains, but far more interesting is the currency’s longer-term outlook.
Surprisingly, given how much SA’s prospects have darkened, Cairns has not downgraded his rand forecast of R13/$ for the year end. Of course, the situation remains in flux and RMB could still change its rand forecast. But for now, Cairns says there are two positive factors RMB believes might offset the negatives.
First is the significant narrowing of SA’s current account deficit. This has been caused mainly by slowing imports due to falling domestic demand and firmer exports following the recovery in commodity prices.
RMB expects the deficit to average 2.8% this year compared with an average of 3.3% in 2016 and 4.4% in 2015. This will take significant pressure off the rand.
Second, a more positive growth outlook in advanced economies has contributed to a more favourable environment for emerging markets and commodity currencies as a whole. As a result, foreign capital inflows into SA’s bond market have held up remarkably well.
The favourable external backdrop helps to explain why the market reaction to SA’s recent downgrades has been more benign than experienced by other countries when they lost their investment-grade status.
"We continue to feel that the external backdrop is restricting far bigger losses on our local markets," says Cairns, "It seems a rising tide lifts even half-submerged boats."
Efficient Group chief economist Dawie Roodt is also sticking to his year-end rand forecast of R13/$.
Both Roodt and Cairns are assuming that Zuma will stay on as president this year and that there will be no further dramatic political negatives or further downgrades to SA’s local currency rating.
Like Cairns, Roodt made this forecast many months before Zuma reshuffled his cabinet and caused many to wonder if SA’s democratic project had permanently run aground. So the fact that he hasn’t lowered his forecast also bears scrutiny.
Roodt has a remarkably successful track record in correctly predicting the rand, having won the 2016 Sake24 economist of the year award for the accuracy of his forecasting against that of more than 30 other economists.
His forecast that the currency would average R13/$ in the final quarter of 2015 was the closest to the actual figure of R13.09/$.
Roodt looks set to be closest to the pin again this year, with a forecast of R14/$ for the final quarter of 2016 compared with the actual figure of R13.91/$.
In January 2016, when he made this forecast, the rand rose to a new record high of almost R18/$ during intraday trading as the markets battled to digest the axing of Nene.
"Everyone said I was crazy," chuckles Roodt. "Some said the rand would be R20/$ by the year end."
He bases his rand forecasts on the observation that on a 35-year view (1980-2015), the rand has on average been roughly 50% undervalued against the US dollar on a purchasing power parity (PPP) basis (see graph).
The easiest way to understand the theory of PPP is to use The Economist’s Big Mac index. It was invented as a light-hearted tool to make it easier to compare the misalignment of exchange rates between countries. It was never intended as a precise gauge, explains the magazine, but rather a fun way of explaining PPP.
In January 2017, the price of a Big Mac burger in the US was $5.06. In SA it was R26.32. At the prevailing exchange rate of R13.95/$ at the time, a Big Mac in SA cost only $1.89.
So according to the "raw" Big Mac index, the rand was undervalued by almost 63% against the US dollar on a PPP basis.
This made the rand the fourth most undervalued currency against the US dollar among 44 countries surveyed, after Malaysia (64.6% undervalued), the Ukraine (-69.5%) and Egypt (-71.1%)
Roodt bases his study of PPP not just on the Big Mac, but on a more representative basket of goods published as a series by Oxford Economics, one of the world’s largest data providers.
By this yardstick, the rand at R13/$ would be 54% undervalued, making Roodt fairly confident the currency will move back towards this level over time.
"I’m pretty sure the rand will come back. It always does, very strongly, but it never resets to purchasing power parity. It is always about 50% undervalued on average. So if it stays at R14/$, and inflation remains where it is now, then this would be an exception," says Roodt.
Roodt, in fact, considers the rand at R14/$ to be a "screaming buy", given that SA’s 10-year bond yield is highly attractive at 9% and that SA’s bond market is exceptionally liquid and well-integrated, so investors can get out quickly.
"Where can you get such an attractive yield with an undervalued currency at the same time?" he asks.
This explains foreign investors’ continued appetite for SA bonds, despite the highly uncertain political environment.
Based on Roodt’s PPP estimates, the rand has fared remarkably well during the current crisis compared with previous episodes.
In nominal terms, the rand dropped by just 12% in the first two weeks after Gordhan’s axing before pulling back sharply. In PPP terms the rand at its recent worst of R13.95/$ was just 56% weaker than parity.
By comparison, in 1985 after then president PW Botha’s famous "Rubicon" speech, in which he failed to announce the dismantling of apartheid, the rand nose-dived by 66% in nominal terms. It was the sharpest nominal decline in the history of the currency.
At its worst, the rand was 72% undervalued against the dollar but it recovered shortly thereafter, mostly because inflation accelerated.
During the 2002 rand crisis, contagion from the Asian financial crisis caused the rand to collapse by 47% in nominal terms. It reached an undervaluation low of 73% but again bounced back quickly, mostly because of a nominal exchange-rate correction, helped by some inflation.
The rand suffered another huge blow when Nene was axed. At its worst level of R18/$ it was 69% weaker than parity. The reasons for the rand’s fall were mostly political but, unlike now, unfavourable international forces were also at play.
At the time, fears were growing that China was heading for a hard landing. The deteriorating growth prospects of emerging markets, particularly for commodity-producing countries such as SA, caused persistent capital outflows from these markets.
Had the same global conditions been in place now, there is little doubt that the fallout from Gordhan’s axing and SA’s downgrade to junk would have been far more severe. This doesn’t mean the political and economic implications aren’t deeply worrying — only that Zuma’s timing was excellent.