Currency Elements – Deciphering the Rand

With ongoing political and economic uncertainty both locally and globally, Rand volatility has become the norm rather than the exception. When looking at the chart below, one is able to visualize the significance of the instability in our local currency, from a short-term perspective. Over the past three years, the Rand has taken us all on an emotional roller-coaster, oscillating between weakness and strength.

Data Source: SARB

However, when looking at the Rand since 1980 (see chart below), a far clearer picture emerges – one of consistent depreciation.

 Data Source: SARB

For a long time, it has been believed that the Rand is driven by differences in inflation. The widely-accepted fundamental theory is explained as follows:

“The difference between inflation rates in South Africa and the United States is often used as a gauge of how much the Rand should depreciate against the US dollar to maintain purchasing power parity (to ensure that the cost of, for example, a hamburger here remains the same relative to the cost of a hamburger in the US over time)”.

However, as Professor Brian Kantor ( notes, if differences in inflation were the only force driving the Dollar/Rand exchange rate we would now (in August 2018) be paying less than R10 for a dollar. Clearly this is not the case. Since 1980 until now, the annual trend rate of depreciation of the Rand against the Dollar has been approximately 7.8%. This is not in line with standard economic rationale that the Rand should depreciate by the difference between South Africa’s long-term average inflation rate of 6% p.a. and the global inflation rate of 2% p.a. (based on the US inflation rate), known as the inflation differential.

So, if exchange rates are not adjusting to account for inflation differentials, then what is driving the exchange rate of the Rand?

Emerging Market Sentiment & Capital Flows

As can be explained by Professor Brian Kantor’s blog, a big component of the fluctuation in the exchange rate is driven by capital flows in and out of South Africa. This is the trend across Emerging Markets, with the Rand often influenced by actions taken by its Emerging Market peers, such as Turkey and Argentina for example. There are, however, cases when the Rand behaves independently of its peers, explaining risks specifically relating to the South African economy. This is shown by comparing the blue and red lines in the graph below.

A big driver of Emerging Market weakness is the normalization of rates in developed economies. The flow of capital from Emerging Markets becomes significant, as money managers can achieve real returns in hard currency and do not have to take on the liquidity and sovereign risk that comes with Emerging Markets. It all comes down to the risk-on, risk-off nature of capital inflows and outflows from Emerging Markets.

Globally, markets have in recent weeks become nervous of Emerging Markets amid expectations that the US may raise interest rates more aggressively than initially expected, thus leading to capital outflows from Emerging Markets. In addition, the political and economic challenges in Turkey and Argentina have also sapped demand appetite for Emerging Markets. Recently, South Africa has been subjected to a sharp burst of unwelcomed Rand weakness, which has been a reaction to the shocks that have overwhelmed the Turkish Lira and Argentine Peso.

In August, the Turkish Lira hit a record low, losing 40% of its value against the Dollar year to date. This was primarily due to President Donald Trump doubling tariffs on Turkish steel and aluminum imports, and President Recep Tayyip Erdogan pressuring the country’s central bank to keep interest rates low. The Argentine economy on the other hand has been hindered by a sharp increase in inflation. Through July, the country’s inflation rate is up more than 30% on a year-over-year basis. Towards the end of August, they raised the overnight (borrowing) rate to 60 percent, the highest in the world.

“The EM contagion risk is front and center,” said Mark Esposito, CEO of Esposito Securities. “If these countries can’t pay their debts, that’s not good.”

Weakness in other emerging market exchange rates has been part of the collateral damage, as can be seen from the iShares MSCI Emerging Markets ETF graph above, where there has been a gradual decline in Emerging Markets Year to Date.

When talking about a depreciating Rand, one should always try and identify the sources of Rand weakness, recognizing the difference between global forces and SA specific sources.

South Africa Specific Risks for the Rand
Business Confidence

Locally, business confidence is low. The RMB/BER Business Confidence Index takes the percentage of respondents that rate prevailing conditions as satisfactory as a proxy of business confidence. The composite RMB/BER Business Confidence Index (BCI) is the unweighted mean of five sectoral indices, namely that of manufactures, building contractors, retailers, wholesalers and new vehicle dealers. Business confidence can vary between 0 and 100, where 0 indicates an extreme lack of confidence, 50 neutrality and 100 extreme confidence.

As can be seen below, business confidence has teetered around 40/50 index points for several years. “Ramaphoria” inspired a jump in the RMB/BER Business Confidence Index (BCI) to 45 in Q1 of 2018, sentiment fell back to 39 in the Q2 and 38 in the Q3. Although confidence rose marginally in two of the five sectors covered in the survey, not a single sector in the Q3 had a number above the neutral level of 50 – an infrequent and worrying development.

Poor Fundamentals – GDP

The South African economy shrank a seasonally adjusted annualized 0.7% for the quarter from April to June of 2018, following a 2.6% contraction in the prior period, making it the second consecutive period of contraction, as output fell for agriculture, transport and trade. GDP Growth Rate in South Africa has averaged 2.78% per annum from 1993 until 2018, coming in well below par when compared to its Emerging Market peers.

The IMF have forecasted a Real GDP growth rate for South Africa of 1.8% per annum for 2022, compared to 3.3% for Argentina, 2.2% for Brazil, 3.6% for Turkey and 8.1% for India.

Credit Outlook

In general, a credit rating is used by sovereign wealth funds, pension funds and other investors to gauge the credit worthiness of South Africa, thus having a big impact on the country’s borrowing costs. Standard & Poor’s credit rating for South Africa stands at BB with stable outlook. Moody’s credit rating for South Africa was last set at Baa3 with stable outlook. Fitch’s credit rating for South Africa was last reported at BB+ with stable outlook. The ratings agencies have indicated that GDP growth is the main driver for a potential downgrade.

With an unreliable power supply, the imminent ‘strike season’ and widespread corruption, the GDP growth rate may continue to come under pressure. On the back of a repeat of low GDP figures and a contingent liability due to Eskom, another downgrade would see the rand once more sell off against hard currencies.

Country-Specific Concerns

The following country specific concerns, highlighted by Sasfin Wealth, affect the above-mentioned factors and impact the outlook of the Rand:

  • High unemployment rate of 27.2%
  • Divergence from robust global economic growth in 2018 and 2019
  • Intensifying regulatory uncertainty:
    • Land reform, Mining charter, telecommunication regulation, BEE legislation
  • Serious underperformance of State-owned Companies (SoCs)
  • Major fiscal constraints – expanded free tertiary education and higher public sector wage agreement will cost an additional R30bn
The Rand on your Investment Decisions: Stay Objective

Taking into consideration all the above, consider the following (courtesy of Investec):

  1. South Africa’s equity market now makes up less than 1% of the world’s market capitalization.
  2. South Africa’s GDP comprises less than 0.5% of the world’s GDP.
  3. Naspers and Richemont, two of the largest shares in the FTSE/JSE All Share Index, together make up a quarter of the market by capitalisation. Add BHP Billiton Limited and the trio comprise one-third of the market.
  4. It often seems that the strength of our equity market is dependent on the revenue of computer and mobile games (Honour of Kings and League of Legends) via Naspers, and the sale of luxury goods via Richemont.
  5. The cumulative weight of the top ten shares is 55% of the index, making for a highly concentrated market.
  6. More than 30% of the shares on the JSE are owned by foreigners and more than 70% of the revenue earned by the top 40 companies listed on the JSE is from foreign sources.
  7. Overall, cyclical rand hedges make up just over 50% of the market by weighted contribution.

With a consistently depreciating Rand (as is evident from 1980), an understanding of why the Rand has consistently become weaker over the years and how the local market really operates from a global perspective, it is necessary and worthwhile considering diversifying a portion of one’s wealth offshore. WellsFaber’s house view is that 50% of discretionary money should be invested offshore.

Many South African investors, contrary to sound advice, invest offshore at times like these when the Rand is weak and either the economic or political outlook is negative. This is not ideal as one should invest offshore when the Rand enables you to buy more units in a foreign currency.

The Rand is notoriously difficult to forecast and extremely volatile over the short-term, so timing your investment offshore can be tricky. This should not discourage investors as your motivation for investing offshore should be to benefit from the diversification that offshore markets can offer, such as geographical, sectoral, and currency diversification. If you are worried about investing your whole contribution into the market on a single day, with the possibility of market prices being less favourable than at another time, you can phase your contribution instead. This type of strategy enables you to ‘drip-feed’ your money into the market over a given period, smoothing out the effects of market movements.

It is all too easy to get caught up in the emotional talk around the Rand, the state of the economy, and the strange dynamics that play out in our local market. The fact of the matter is, if you are sufficiently diversified in your investment portfolio, there is less reason to be concerned. The best approach to a fluctuating Rand is to be sufficiently diversified and to remain objective throughout the periods of panic. If you have optimally diversified your portfolio and are able to stick to your long-term strategy through volatile times, the market will reward you.

Compiled by: Kelly Marais