Like other emerging market currencies, the rand has seen periods of prolonged fluctuation since September 2018 but has remained relatively stable over time. Linda Kallis explores the factors that impact the rand’s movements.
Often referred to as the world’s most volatile currency by market commentators, the rand is unpredictable and a continuing source of anxiety for South Africans. With growing uncertainty and anxiety about global politics and business conditions, capital flows into emerging markets are likely to be volatile, as will be the rand exchange rate.
South African debt has been rated sub-investment grade by both S&P and Fitch, leaving Moody’s alone among leading ratings agencies in maintaining an investment grade rating. At least one investment grade rating is required if South Africa is to continue to be included in the World Global Bond Index (WGBI). Much attention is given to the possibility that Moody’s will downgrade South Africa’s rating thereby triggering a significant capital outflow as certain institutional investors adjust their portfolios to comply with their mandates which require WGBI membership. However, Moody’s has indicated publicly that an imminent downgrade is unlikely because South Africa’s institutional framework remains robust. Barring an unexpected adverse development, any change in the rating will await the outcome of Government’s present efforts to achieve fiscal stability. It will require some time before a definitive judgement can be made as to whether these will be successful.
The carry trade
The ebb and flow of foreign capital into the South African capital market is of critical importance in determining the rand exchange rate. The pronouncements of ratings agencies are only one of many factors that determine such investment decisions. Among the most important is US monetary policy. At the beginning of this year the US Federal Reserve abandoned its well-communicated strategy to further increase interest rates. This has important consequences for currency markets. The prospect of lower dollar interest rates makes emerging markets where interest rates are high significantly more attractive to international investors. The carry trade is on again. This involves investors seeking to profit by accessing capital in the currencies of countries where interest rates are low, such as Japan or Europe, and redeploying these funds into currencies paying high interest rates, such as the rand. Such flows are a significant contributor to the relative stability of many emerging market currencies.
The impact of domestic South African issues
Driven by negative reports about Eskom and South Africa’s economic woes, investors sold-off the rand during August. However, this once-off adjustment may be behind us. With global price stability and a weak domestic economy, domestic inflationary pressures are increasingly benign, and inflation continues to surprise the market and the South African Reserve Bank (SARB) on the downside. In August CPI inflation was 4.3%. Accordingly, South Africa’s real rates are high by global standards, which should encourage further capital inflows and help stabilise the rand.
South Africa’s current account deficit is approximately 4% of GDP or R200bn per year. Provided that there are no further shock announcements and we remain an attractive investment destination for foreigners, it should be possible to fund this deficit and the rand should then track the movements of its emerging market peers. The dollar is likely to continue to edge stronger against emerging market currencies, but not dramatically.
Currencies act as shock absorbers
One reason exchange rates are so difficult to predict is that they tend to act as shock absorbers which enable economies to adjust to unexpected events. Given the frequency of economic surprises, it is impossible to make confident predictions about exchange rates. This is particularly true of South Africa whose currency trades freely without official intervention. Therefore, while we may predict a relatively stable outlook for the rand, this can be totally undermined by an unexpected event.
Other factors that influence the rand
There are various domestic factors that influence the rand’s behaviour over the short and long term, consideration of which contributes to the formulation of exchange rate predictions.
- Inflation rate differentials
In the longer run exchange rates adjust to compensate for inflation rate differentials between countries. Over time the currency of a country with a high rate of inflation will depreciate against one enjoying price stability. Our long history of rand weakness is a direct consequence of a high inflation rate relative to our trading partners. Adjusting for the longer-term impact of inflation differentials permits the calculation of a purchasing power parity, which is the theoretically correct level at which a currency should be priced. In practice actual exchange rates can depart significantly from this theoretical fair value, and one can talk about a currency being either expensive or cheap, principally because of capital flows. Currently, on its long-term history the rand is cheap. One of the reasons why emerging markets currencies are becoming more stable relative to their developed economy peers is a global convergence of inflation rates towards less than 3%. There are few exceptions to this trend, notably Venezuela, Zimbabwe and Argentina. South African inflation is also heading downwards, which promotes rand stability.
- Interest rates
South Africa is widely regarded as having high real interest rates. However as yet this view is not shared by the Monetary Policy Committee of the South African Reserve Bank, which sets short-term rates. Its caution is reinforced by concerns about fiscal stability and a hesitation to embark on monetary easing until there is more certainty as to the direction of fiscal policy. High real rates promote rand stability because they make South Africa an attractive target for carry trade investors. However the attractiveness of high real rates is significantly reduced by rand volatility. A single day’s movement in the exchange rate can eliminate all the returns arising from high interest rates.
- Economic growth
A general rule is that a fast-growing economy will attract capital inflows and unless the government acts to depress its currency by accumulating foreign reserves its currency will appreciate. It is no coincidence that during the emerging market boom of the first decade of this century many countries enjoyed appreciating currencies. South Africa also benefitted from this virtuous cycle. While it might seem logical that in stagnant economies the opposite will apply this is not always the case. When domestic demand is weak import demand declines which has a positive impact on the current account which promotes currency stability. In the past year South Africa’s external balance has benefitted from declining imports.
- Political stability and performance
The political climate can significantly influence investor sentiment. A positive surprise may strengthen the rand and a negative event can have the opposite effect. Events that have had a rallying effect on the exchange rate in the recent past include Ramaphoria, the 2018 cabinet reshuffle and the annual budget speech. The biggest immediate threat to the rand is the possible failure of the Treasury to formulate a budget for 2020 that can allay the market’s fears about South Africa’s fiscal trajectory. However, in recent years shifts in global capital flows driven by events totally unconnected with South Africa have often far outweighed the consequences of local difficulties. For example, during the final year of Jacob Zuma’s administration the rand appreciated.
- Global events
South Africa is dependent on continuing capital inflows from abroad to compensate for its shortfall in domestic savings. As discussed above, anything that disrupts the flow of investment into emerging markets is bad for South Africa and bad for the rand. However, the secular trends within the global economy favour such flows. The majority of accumulated capital lies in developed economies, but increasingly rapid economic growth is only to be found in emerging markets. There is a natural tendency for capital to migrate from the first world into the third world. In the long run, emerging market currencies including the rand should benefit from this reality.
Bearing all the above in mind, it is clear that it is impossible to accurately and consistently forecast the movements of the rand: there are just too many factors at play that we can’t control – from the mood and actions of local politicians, to foreign investor sentiment, and the daily noise in global markets. A better strategy than trying to predict what will happen next with the currency is to consider the outcome of various scenarios and make sure your portfolio is well diversified, so that you minimise the impact any one outcome has on your returns.