directions
What is the rAnd
going to do?
This is a frequently asked question among South African
investors. In this article, David Knee, Head of Fixed
Income at Prudential, shares some valuable insights about
how to think about the valuation of the rand.
ImAgeS: geTTy ImAgeS
When and how quickly could the
rand depreciate?
There are different views about how
much the rand needs to depreciate in
order to return to its true value. We can
use the long-term difference between
inflation rates in South Africa and the
United States as a measure of how much
the rand should depreciate against the
US dollar to maintain purchasing-power
parity; in other words, to ensure that
the cost of, for example, a can of Coke
22 consider this winter 2011
The extent to which the rand is over-valued
14
12
90% limit
10
rand/$
PPP
8
rand
6
90% limit
4
here remains the same relative to the
cost of the same can in the US over time.
Since 2000, South African inflation has
exceeded that of the US by 44 percent,
while the rand has depreciated by just
over 10 percent, which means that
goods in South Africa are now over 30
percent more expensive for Americans
than they were 10 years ago. While it is
impossible to know when the rand might
depreciate to return to its true value,
the past decade has seen two bouts of
severe rand weakness, both connected
Jun-10
Dec-10
Jun-09
Dec-09
Jun-08
Dec-08
Jun-07
Dec-07
Jun-06
Dec-06
Jun-05
Dec-05
Jun-04
Dec-04
Jun-03
Dec-03
Jun-02
Dec-02
Jun-01
Dec-01
Jun-00
Dec-00
0
Source: I-net Bridge
2
Dec-99
The rand is currently over-valued
South Africa has a number of trading
partners and none of them accounts
for more than 10 percent of total trade
with South Africa. This means that if
you focus on a single exchange rate,
such as the rand to the US dollar, it
can be misleading. But an analysis of
the rand’s exchange rate to a basket of
the currencies of the country’s major
trading partners shows that the rand is
over-valued relative to these currencies.
The rand exchange rates and inflation
differences of South Africa’s trading
partners are combined in what is known
as the real trade-weighted exchange rate.
At the end of April, this exchange rate
was 13 percent above its average since
the end of 1995.
to developments in the global economic
cycle. With cycles averaging about five
years in length, this seems to us to be
reasonable time over which to assume an
unwind back to fair value but there are
no hard-and-fast rules. Five years would
mean a depreciation in the rand-US dollar
exchange rate of about seven percent
a year from current valuations. The real
effective exchange rate referred to earlier
implies somewhat less, perhaps five
percent per annum, against the basket of
South Africa’s trading partners.
winter 2011 consider this 45
directions
The rand and the current account
Do we want a strong or weak rand?
12.0
7.0
6.0
11.0
10.0
current account as % of GDP
4.0
POSITIVE
• Lower inflation
• Lower interest rates and bond yields
• Increases disposable income = higher
consumption
• Cheaper servicing of international debt
9.0
2.0
8.0
0.0
7.0
6.0
–2.0
5.0
4.0
–4.0
3.0
–6.0
2.0
1.0
–8.0
NEGATIVE
–9.0
0.0
81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
• Weaker export activity as exports become
more expensive
• Weaker tourism as SA goods and services
become more expensive
• Weaker employment creation in
manufacturing
• Lower GDP growth overall (weaker
exports are partially balanced by higher
consumption)
• Rising current account deficit
Source: I-Net Bridge
What drives the rand?
Many factors are alleged to influence the
rand, including:
• the gold spot price;
• interest rates;
• the difference between our exports and
imports (known as the current account);
• foreign investment.
The reality is that no single factor in
isolation causes the rand to strengthen
or weaken against other major currencies
consistently. At times, markets appear
to focus on specific factors but there
is no discernable pattern in terms of
which factor is in favour when, nor
when a factor will fall out of favour. The
What does the future hold?
While the strength of the rand seems to
indicate that it should depreciate in the
future, we can’t forecast when this will
happen and by how much, because the
factors that drive the strengthening or
the weakening of the rand have been
inconsistent over time.
0
30 000
2
20 000
4
10 000
6
0
8
–10 000
12
rand is
weakening
–20 000
rand is
strengthening
–30 000
net foreign flows into bonds and equities (r’m)
rand/US$ exchange rate
The importance of foreign portfolio flows
10
–40 000
Jun-10
Dec-10
Jun-09
Dec-09
Jun-08
Dec-08
Dec-07
Jun-07
Jun-06
Dec-06
Jun-05
Dec-05
Jun-04
Dec-04
Jun-03
Dec-03
Jun-02
Dec-02
Jun-01
Dec-01
Jun-00
Dec-00
Dec-99
14
24 consider this winter 2011
rand vs US dollar exchange rate
While this is a hotly debated economic
and political issue, the table below
summarises some of the positive and
negative outcomes of a strong rand.
Source: I-Net Bridge
implication is that short-term currency
forecasting is extremely problematic and
why at Prudential we prefer to take a
medium-term view based on valuation.
There is no clear cause-and-effect
relationship between:
Interest rates and the rand
For example, in 2000 the rand weakened
despite increases in interest rates. And
as rates decreased in 2003, the rand
continued to strengthen.
2 The rand and the current account
The rand weakened sharply between
1995 and 2002 despite a current account
that was almost balanced. From 2002
to 2007, the current account moved
into significant deficit while the rand
strengthened sharply (chart above). This
indicates that the level of the current
account does not necessarily affect the
rand although there may be a tipping
point when the deficit approaches double
digits and suddenly foreign investors
decide they are no longer prepared to
support South African investment.
3 Foreign investment inflows
and the rand
The chart on the left shows that strong
inflows in the second half of 2009
and 2010 coincided with significant
strengthening of the rand. In the period
from 2003 to 2007, inflows appeared
to be less important in driving the value
of the currency.
1
You therefore can use the
current strength of the rand to
your advantage
As shown in the chart below right, based
on current valuations, we expect offshore
developed market equities to be the bestperforming asset class over the next three
to five years. If the rand does weaken,
your rand returns from global equities
could increase by as much as five percent.
The rand is
one of the most
volatile currencies
in the world.
If we accePt that...
• The rand is widely regarded as
overvalued on all the measures used by
economists and analysts;
• Broader-based measures of the rand
give a better picture of what the
currency is doing;
• The drivers of the rand vary over time
and therefore it is unwise to look at
single catalysts;
• The rand is one of the world’s most
volatile currencies;
So, is there any merit in trying
to forecast the short-term
movements of the rand?
In short – no. You cannot identify
catalysts that will accurately predict
what the rand will do. While
you can always tell a compelling
story for whether the rand should
strengthen or weaken, the rand is
one of the most volatile currencies
in the world and history shows no
factors that have an enduring effect
through time.
Potential prospective returns % per year over 3-5 years
25
Asset returns
rand impact
20
15
then we can exPect...
• The rand to depreciate in the medium
term;
• Volatility to continue – especially in the
short-term, and;
• Non-rand assets to play an important role
in rand portfolios to diversify risk – with
very compelling international equity
valuations – which bodes well for returns.
10
5
0
cash
Government
bonds
US Government
bonds
Property
equities
world equities
Source: PPMSA
winter 2011 consider this 25