The right perspective is required.
It is interesting how the value of the rand can influence our perception of the value of our country. A strong rand, when compared to the US dollar, often makes us feel better about the state of affairs in South Africa. When the value of the rand climbs, so does our optimism about the growth and recovery of the country, while a weak currency fires up all the negative sentiment we read about in the press. We have no shortage of problems in our country – whether it be concerns about rising food and fuel prices, subdued growth, unemployment, electricity shortages, political infighting, a weak fiscal outlook, and social unrest.
With that said, it is not all doom and gloom and South Africans can find some reprieve in knowing that the value of our currency is only partially affected by South African specific factors. In the following article, we discuss the different factors that can influence the value of our local currency.
To set the scene, the below chart shows the performance of emerging market currencies relative to the US dollar, indexed to 100, since July 2020. Some emerging market currencies can be extremely volatile over time, with the performance of the Turkish Lira over the past two years being a case in point. What is evident is that the rand has actually held up relatively well against the US dollar, when compared with most other emerging market currencies.
The US dollar has actually been extremely strong against most major developed market currencies over the past couple of years. This has been exacerbated by the willingness of the US Federal Reserve to hike interest rates in 2022 in response to rising inflation, while other major global developed market central banks have been rather dovish in comparison. As an example, with inflation in the Eurozone at 8.9% and interest rates still at 0%, it is difficult to argue that the European Central Bank is not behind the curve in its response to rapidly rising prices.
This has impacted the performance of the Euro, which has recently broken through parity against the US dollar.
A research report[1] was written by the International Monetary Fund (IMF) wherein it looked at the main drivers that impact the rand/dollar exchange rate since the onset of the global financial crisis and the results are very interesting.
Rand volatility could be attributed to global macro-economic factors
The IMF’s research showed that the main driver behind the movement of the rand relates to global factors and macro-economic events in the US. In other words, the level/value of the rand is often influenced and determined by the US dollar movement (strength and/or weakness). Roughly 30% of all rand volatility could be attributed to global macro-economic factors which influenced the US dollar and hence the rand.
As a small, open, emerging market that makes up less than 1% of the world economy, we are more likely to be affected by what is happening globally rather than in our own country. This is further exacerbated by the fact that the rand is one of the most liquid and tradeable currencies when compared to other emerging market currencies globally. Often when there is global risk aversion (better known as a “risk-off trade”) and investors flock to safe-haven assets, the rand acts as a proxy for all assets perceived to be risky by global investors. This can often lead to the rand depreciating.
Commodity price volatility is a key factor
A second finding was that commodity price volatility was a key factor that influenced rand/dollar volatility. Roughly 30% of the volatility of our currency was a result of commodity price volatility. In the first half of the year, the rise in commodity prices has largely benefited South Africa. This is due to the fact that we are a net exporter of commodities including base metals and gold, and rising prices have resulted in South Africa’s current account moving into a surplus, which has supported the exchange rate over this period.
Recently, commodity prices have started to fall from their peaks, largely as a result of concerns around the global growth outlook and the increased possibility of a recession in some major geographies, particularly those in close proximity to the Russia/Ukraine conflict in Central and Eastern Europe. The concerns around global growth have been exacerbated by interest rate hikes from central banks in response to stubbornly high inflation.
Impact of domestic factors on the rand
The IMF’s research also looked at the impact of domestic factors on the currency. They found that neither domestic macro-economic surprises nor those originating from other emerging markets are statistically related to rand volatility. However, they did find that local political uncertainty is positively associated with rand volatility.
So, how should we go about working out a fair value for the rand?
Currencies can deviate significantly from fair value over time, however, over the long term, movements between currencies should reflect inflation differentials between two countries. Due to the relatively higher inflation environment in South Africa (especially compared to most developed markets), we would expect the rand to depreciate against most developed currencies in the long term.
Currencies can frequently deviate from purchasing power parity (PPP) over time. Extreme examples include the height of the commodities boom in 2005 and 2006, when the rand reached R6 to the US dollar. Following the removal of previous Finance Minister Nhlanhla Nene (in late 2015 and early 2016), the rand reached around R16 to the US dollar. Just a year later the rand had strengthened to just over R12.50 to the US dollar.
What should be apparent, however, is the movement in the exchange rate following these events. In almost all cases, the exchange rate moved back to a value that would be regarded as fair when judged according to PPP. That is not to say that currencies do not stay cheap or expensive for long periods of time. Idiosyncratic events may cause currencies to deviate from fair value for extended periods, however, currencies tend to move back to levels reflective of inflation differentials in the long term.
As can be seen in the below graph, the rand is currently slightly undervalued on a Purchasing Power Parity basis.
Where does that leave us?
We are often asked the question, “Is this the time to be taking money offshore given where the rand is?” In our view, the decision to invest offshore should be taken as part of a holistic financial plan, taking into account all investment opportunities at that particular point in time. While the value of the currency does play a role, we would encourage investors not to try to time the currency.
Notwithstanding the recent inflation spikes that we have seen across the globe, South Africa typically will have higher levels of inflation when compared to major developed market countries. We would, therefore, expect the rand to depreciate against these currencies over the long term, regardless of the short-term moves based on global economic factors, the commodity cycle, or local political developments.
In conclusion
The above factors once again emphasize the need for investors to remain patient, stay the course and avoid making investment decisions in a panic due to gloomy news headlines. This would include articles forecasting which direction the rand is heading.
Previous experience has taught us that these forecasts are seldom accurate. It is during these challenging investment times that we should remove emotions from our investment decision-making process and focus on the fundamentals.
Over decades of evidence
and through the investment literature there is one golden thread –time in the
market remains superior to timing the market. We believe that investing is a
long-term pursuit, patiently allocating to assets that will help you achieve
your investment goals.
[1] Source: International Monetary Fund (IMF) “Surprise, Surprise: What Drives the Rand / U.S. Dollar Exchange Rate Volatility?” Data as at October 17, 2016.
