The rand: fractured or fragile? Looking beyond the rating concerns



Dr Adrian Saville, Chief Strategist at Citadel, finds that the rand could still diverge further from fair value, but it is not a one-way bet

adrianSouth Africa may have been given a temporary reprieve in terms of a maintained investment grade sovereign rating, but what is the underlying trend for the rand?

South Africa is a small, open economy. Export industries, including agriculture and resources, make up the economic bedrock, which makes the country reliant on the world economy. About a third of GDP is made up of imported goods and services, making South Africa vulnerable to imported inflation; about two-thirds of JSE earnings are influenced by currency conversion; and other economic elements, such as foreign capital and foreign tourism, highlight the importance of international exposure to the South African economy. As such, the economy is influenced by currency fluctuations and is vulnerable to sudden or sharp price moves away from “fair value”.

This context helps underscore the point that all businesses face three types of risk, namely:

  1. Macroeconomic risk or country risk, which embraces factors such as currency moves;
  2. Mesoeconomic risk or industry risk, which references elements such as technologies that transform the way in which companies do business and, as such, bring new opportunities whilst creating fresh threats, such as the infamous “Kodak moment” in the photographic film industry; and
  3. Microeconomic risk or business risk, which refers to company-specific risk, such as BP’s Deepwater Horizon disaster or the failure of Lehman Brothers in 2008.

Notably, of these three forms in which risk parades, most business decisions anchor on operational risk. Yet, by far the greatest risk all businesses face is macroeconomic, or country risk, the impact of which is most often manifested in currency fluctuations. To illustrate this point, imagine creating and building a highly profitable business, staffed by exceptional people with good products and loyal customers in a fast growing economy, only to be told at the end of this short thought experiment that the year is 2014 and your business is based in the Ukraine, which is on the edge of a currency collapse.

Whilst the example is dramatic, it helps underscore the point that the principal risk all businesses face is macroeconomic risk. In turn, this helps emphasise the importance of currency to businesses in all geographies, but especially those that are based in small, open economies that are vulnerable to currency fluctuations. This is the case for South African firms, and the situation is exacerbated by the fact that we have a developed and highly active financial market. This financial sophistication comes with some positives. South Africa punches well above its weight in currency markets: it is the world’s 33rd largest economy, yet the rand is the 18th most traded currency. This helps to advance the sophistication and global competitiveness of South Africa’s banking industry. In the same breath, South Africa’s financial sophistication means the rand is often used as a proxy for other emerging markets. Consequently, daily turnover in the rand currency market amounts to some $60 billion, which dwarfs the country’s foreign exchange reserves of $50 billion.

However, rather than being seduced by emotion which clouds judgement, it befits us to interrogate from an objective stance the status, stature and strength of South Africa’s primary business risk: the rand. In short, whilst emotion and popular sentiment suggest the rand is a fractured currency, is this the case, or is the rand simply fragile, and in need of time – or some other catalyst – to allow the currency to recover?

Drawing on a raft of country experiences and empirical evidence from the last three decades, it is evident that there are essentially three currency drivers:

  1. External reliance and dependency of the economy, which considers the degree to which an economy is open, dependent on commodities and vulnerable to current account deficits or crises.
  2. Management and vulnerability, which recognises the proficiency with which an economy is managed in terms of fiscal and monetary policies, and their result, in the form of structural economic growth.
  3. Absorptive capability, which considers the ability of an economy to weather economic storms or setbacks, whether self-imposed, such as policy shifts, or the result of external shocks, such as a commodity price collapse.

To assess the status and stature of the rand, we conducted a study of various metrics within each of these drivers to arrive at a ranking for South Africa. All the data inputs that we used are based on five-year numbers for as many countries as we could source reliable information. While this means the universe was different across the various metrics, it also means we have a rich and reliable data set on which to base the analysis. The table below shows the three pillars identified above and the underlying factors used to score each of the pillars.

Currency Drivers & South Africa’s Rank
External Reliance & Dependency Management & Vulnerability Absorptive Capability

Economic Openness

Government Budget Deficit

Import Cover (Reserves)

Commodity Reliance

Money Supply Growth

Short-Term Debt Cover

Government Debt-to-GDP

Structural Growth Rate

Minimum Reserves

Current Account Deficit


In considering the factors in the first pillar, it needs to be recognised that at least one of the drivers, in the form of economic openness, can be a double-edged sword. Economies need to be open to benefit from trade, but too much openness, combined with a lack of competitiveness, makes an economy vulnerable to external influence. Ideally, one wants an economy that is both open and competitive, without being overly dependent on commodity exports. In this instance, South Africa fairs modestly in most regards. The South African economy is open (ranking 47/185), and quite reliant on commodity exports (60/179), putting the country at some risk to Dutch disease which occurs when high foreign inflows into one sector (largely commodities) raises the value of the currency causing a misallocation of resources that renders other sectors uncompetitive. Although government debt-to-gross domestic product is in an acceptable position (30/72), the economy is being foreign funded, evidenced by the large, and arguably unsustainable, current account deficit (106/187) which puts further pressure on the rand.

In terms of the second pillar, South Africa is making some significant, but not fatal, policy missteps. With a fiscal deficit that is budgeted to amount to 3.2% in the current cycle (129/191), and government debt to GDP at 45%, we are perhaps not overly debt funded. But the efficiency of expenditure is not optimal resulting in inadequate infrastructure capacity to fuel the growth that the country requires. It’s not surprising therefore, that South Africa’s economic growth rate, hovering just in positive territory, ranks 121 out of 195 countries on a five-year through-the-cycle basis.

South Africa’s absorptive capacity – the third currency driver – scores modestly, which is concerning given the size and liquidity of the rand currency market. With a three-month rule of thumb for import cover (foreign reserves/imports), South Africa’s cover is four months (81/177). The short-term debt cover relative to exports – a measure which shows the ability of an economy to repay the debt with export revenue and thus its creditworthiness and vulnerability to economic shocks – is at 20% for South Africa (83/108) while the country’s level of reserves compared to the minimum reserve requirement places South Africa at 75/114.

Taking South Africa’s relative position for each metric into account, we found that the country is ranked in the 49.9 percentile across all the countries. The inference from this is that, while much needs to be done to bolster the structure and stature of the South African rand, the currency enjoys a structural strength that could be conveniently described as “halfway there”.

What does all of this mean? Although South Africa is vulnerable in some areas, the results of our analysis on the rand suggest that this is by no means the picture of a country – or currency – that is in the business of falling over. South Africa is doing what it has done for decades: it is muddling along, escaping disaster but avoiding a miracle.

At present, a “perfect storm” of factors have converged to weaken the rand: the dollar has been strong, commodity prices have been weak and we have seen some policy slipups. Nervousness ahead of the June S&P rating announcement caused further weakness. But these all are transient and each has the propensity to turn. To this end, the dollar has shown weakness in 2016, while commodity prices are off their lows.

We are making progress in areas of policy, on which the ratings agencies offer important insights. On this front, perhaps the most notable component in the ranking table is South Africa’s position (37/158) in money supply growth, and with the firm hands of Pravin Gordhan and Lesetja Kganyago on our policy tillers, and sound monetary policy, these factors should conspire to help the rand recapture its purchasing power parity, which translates into the rand being a stronger currency than recent experience – and current prices – suggest.