This morning I was faced with having to make a fairly significant (for me) exchange rate trade decision. With everything that has been happening in this fair country of ours recently, I was very uncertain as to whether it was a good time to trade or not. Whilst there has been more than average political turmoil, the Rand is actually strengthening. What to do?
Before I go on, ask yourselves what would you do right now; would you be buying or selling Rands? I would anticipate that all of you have a view about the South African currency right now. Further more, many of you probably feel quite strongly about your position. However certain you are, always remember that, every time you trade in anything; shares, Rands or even your old car, there will be a willing buyer on the other side of the trade who is willing to take the opposite view on what you think your item is worth. And only time will show who was right.
Over the last two exchange rate newsletters I have introduced the concept of a fair value exchange rate that is significantly stronger than the actual exchange rate that we experience as South Africans. We’ve discussed how the Rand can trade away from its fair value rate as a result of market forces; supply versus demand. The market forces in question get given their direction and force (a vector in mathematical terms) as a result of news flow that effects the expectations of future inflation rate differences between the two countries for which the exchange rate is quoted.
It is therefore worth highlighting the most important economic factors that drive future inflation expectations. We can then reflect on how these might be impacting the Rand and for that matter, the US$. In no particular order
- Actual Inflation Differentials; like it or not, historical trends are widely used as predictors of the future and thereby influence investor expectations in a self-fulfilling manner.
- Interest Rate Differentials; interest rate policy set by central banks can attract or deter international capital flows. High relative interest rates can increase the demand for local currency compensating for differences in inflation.
- Current Account Balance; a country that imports more than it exports is effectively over-supplying local currency with its trading partners on a net basis.
- Public Debt; a country that needs to borrow money (rather than using tax receipts) for public spending is effectively increasing the supply of its currency.
- Political Stability & Economic Performance; the world is becoming a global investment platform. A country with high economic growth and political stability will attract foreign capital through investment flows.
So how does South Africa score against the US?
Core inflation 6.0% 1.5%
Official Interest Rate 7.0% 0.5%
Current Account Balance (% of GDP) -4.4% -2.7%
Public Debt (% of GDP) 50% 104%
Political Stability & Economic Growth -ve? +ve?
When we look at South Africa versus the US$ we see that inflation is higher but that our interest rate policy is supportive and effectively balances this. We see that our Current Account Balance is worse but that our Public Debt as a % of GDP is better so maybe that’s ok. One might therefore reasonably conclude that the reason for our structural undervaluation to the US$ is due mostly to the last consideration; the outlook for political stability and economic growth.
When President Zuma fired Finance Minister Nene on the 9th December last year, he effectively signaled to the market a significant increase in the risk to South African inflation expectations. A more compliant Finance Minister in the form of David van Rooyen might have approved such unconstrained and ill-conceived public spending as the bailout of SAA, a multi-billion US$ nuclear program, etc. This was at a time of weak economic growth and a deteriorating Current Account associated with low commodity prices. It was no wonder that the Rand fell to almost R17.00/US$ having started the year at R11.40/US$.
The outlook is better now and we see this in the recovery of the Rand, currently at R13.50/US$. Finance Minister Gordhan has prevailed, President Zuma faces possible recall by the ANC, the weak Rand has stimulated exports and improved the Current Account balance. In contrast, risk in the USA appears to be increasing with the possibility of a Trump presidency.
Domestic risk has not gone away however. In December, rating agency Standard & Poor’s will decide whether or not to downgrade the credit standing of South African Government debt having posted a negative outlook in June. President Zuma still wields enormous influence though grass-roots support in KwaZulu-Natal and via an association of certain powerful Provincial leaders allied in the interests of self-preservation. Commodity prices remain low. Economic growth is weak and unemployment remains high. South African universities are in lock-down
So, the time has come to make the trade. Hopefully I have been able to highlight the main drivers to movements in the Rand. Given this understanding, would you buy or sell Rands right now? The Rand, even at R13.50/US$, is at a meaningful discount to its fair value. This implies that a considerable amount of the risk that we have discussed is already in the price. It’s not an easy decision in the short term; it really could go either way from here.
If you accept that you don’t know for certain then consider your decision from the point of view of diversification. Take a look at your overall portfolio. South Africa is tiny, less than 1%, of the global financial market. Consider how exposed your wealth is to the fortunes of the South African Rand. If you are uncomfortable with the level of exposure that you have, then your decision should be an easy one. Why assume so much risk in such a small, volatile financial market?