It’s interesting how the value of the rand can influence our perception of the value of our country. A strong rand, when compared to the 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.
With that said, it’s 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.
In recent years, the South African rand has been on the back foot against major currencies, with investors being extra cautious due to the many headwinds and political infighting that frequently dominates news headlines. Investors simply can’t ignore that the country has subdued growth, a weak fiscal outlook, rising industrial and social tensions, and external vulnerabilities associated with the current account deficit, all of which support a weaker currency.1
A research report2 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 U.S. In other words, the level/value of the rand is often influenced and determined by 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.
1 Source: International Monetary Fund (IMF) “Surprise, Surprise: What Drives the Rand / U.S. Dollar Exchange Rate Volatility?” Data as at October 17, 2016.
2 Source: International Monetary Fund (IMF) “Surprise, Surprise: What Drives the Rand / U.S. Dollar Exchange Rate Volatility?” Data as at October 17, 2016.
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. Over the past year, we have seen a sharp rise in commodity prices of which South Africa has been a beneficiary.
South Africa is a net exporter of resources, and local exporters benefit from the rand weakness in that it makes the goods and services that we produce cheaper for foreigners and more attractive when compared to the goods and services available in other markets.
South Africa also imported a lot less in 2020, which has impacted our current account balance positively which, in turn, has been a factor causing the recent Rand strength.
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.
Purchasing Power Parity’s part
Of the many metrics used to determine the valuation of the rand against other major currencies, is the Purchasing Power Parity Index (PPP). PPP is an economic theory that compares the different currencies from countries across the globe through a “basket of goods” approach.
In 1986, The Economist created the Big Mac Index 3 to create a lighthearted way of showing PPP and whether currencies were cheap or expensive. The Big Mac Index uses a price of a Big Mac burger in the US (as a base) and then compares the price of a Big Mac burger in every other country (in its native currency) and then looks at the price differential.
According to the latest Big Mac Index data, the rand is very cheap compared to the US dollar. A Big Mac costs R33.50 rand in South Africa and US$5.66 in the United States. The implied exchange rate is 5.92. The difference between this and the actual exchange rate, 15.52, which suggests the South African rand is 61.9% undervalued.4
With that being said – it should also be pointed out that we do not believe the Rand to be 62% undervalued – this is merely a fun way of looking at relative currency strength or weakness versus the US dollar.
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 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 R17 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 undervalued on a Purchasing Power Parity basis.
Work done by the capital markets team at Morningstar supports the view that the Rand remains undervalued compared to the US dollar. It is also worth remembering that the rand never really trades at fair value. Historically, the rand moved in big swings from being expensive to being cheap and each time shooting through fair value.
Where does that leave us?
While the rand (at roughly R14/$) is undervalued/cheap, we don’t believe the economic data supports a materially stronger rand. Over time the inflation and growth differentials between South Africa and our developed counterparts support a depreciating currency. While the commodity cycle and US economic factors favour a firmer rand for now, we do expect that in a 10-year horizon the rand is likely to depreciate from these levels.
We are often asked the question, “Is this the time to be taking money offshore given where the Rand is?” and the best way to answer that is to quote Howard Marks who said, “This is not the time but it is a time”. The decision to invest offshore should be based on the investment opportunity. While the value of the currency does play a factor, we would encourage investors not to try to time the currency.
The above factors once again emphasise 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.
Ask yourself this: “Given where I am now, what actions move me closer to my long-term goals?” “Would an investment change align with the original investment plan for reaching well-defined goals?” These are different questions than, “What do I wish I had done last month?”.
We believe that investing is a long-term pursuit, patiently allocating to assets that will help you achieve your investment goals.
Morningstar Investment Management South Africa
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