Is the recovery of the rand for global or SA reasons? Whatever the explanation, it is surely very welcome.
A recovery of the SA economy needs a stronger rand. A stronger rand will mean less inflation to come and lower interest rates. Unfortunately a weaker rand leads interest rates in the opposite direction making it just about impossible for the business cycle to turn higher. A combination of higher prices on the shelves and the petrol station forecourts following rand weakness, depresses household spending. And the higher interest rates that follow add to the inability of households to spend more – and to borrow more. Household spending, which accounts for over 60% of all spending, leads the economy in both directions. Without a recovery in the propensity of households to spend more, the best the SA economy can hope to do over the next 24 months would be to avoid recession.
The foreign exchange value of the rand responds to both global forces – that is global risk appetites that drive emerging markets and currencies lower or higher (including the rand) – and SA-specific risks that encourage capital flows to and from SA.
An obvious example of SA-specific risks driving the rand weaker and interest rates higher was provided by President Jacob Zuma in December. The week of Zuma interventions in the Treasury saw the rand sharply weaken and sent long term interest sharply higher. These interventions added about R2 to the cost of a US dollar – according to our model of the rand – and about 100bps or more to the cost of raising long-dated government debt.
Our model of “fair value” for the USD/ZAR relies on two forces, the USD/AUD and the emerging market risk spread. Had Zuma not acted as he did, the US dollar might well have cost no more than R14 in early December 2015. With the recent recovery in the USD/AUD and emerging market bonds, the current fair value for the rand would be closer to R13 than R14. This suggests that the Zuma danger to the rand has not left the currency or bond markets. And that the welcome recovery of the rand is mostly attributable to global rather than SA forces. We attempt below to isolate the impact of global from SA-specific risks on the exchange value of the rand and show that the recovery of the rand is mostly global rather than SA specific.
If indeed the recovery of the rand is mostly attributable to global rather than SA forces, there is the possibility that a revived respect for SA’s fiscal conservatism – demonstrated in the Pravin Gordhan Budget for 2016-17 – can still prove more helpful to the SA bond market and the rand, global forces permitting.
In the figure below we compare the performance of the rand to other currencies including a basket of emerging market currencies. The rand weakened against all currencies in 2015 – including other emerging market currencies. Furthermore the significant recovery of the rand in 2016 is in line with that of other commodity and emerging market currencies. This suggests again that global rather than SA forces explain the recent rand recovery.
A similar impression of predominant global forces is provided by the bond market. The spread between RSA 10 year bond yields and US Treasury Bond Yields of similar duration have stabilised at more than 7% p.a. having widened dramatically in December 2015. These spreads are significantly wider than they were in early 2015. This spread may be regarded as a measure of SA specific risk, or more particularly as a measure of expected rand weakness. The rand has weakened – and is expected to weaken further. An alternative measure of SA specific risk is provided by the CDS spread paid to insure SA US dollar denominated debt against default. This spread has moved very much in in line with the interest rate spread.
The recent narrowing of this insurance premium has however also been accompanied by a narrowing of the more general emerging market CDS spread, reflecting global forces at work. The gap between the higher emerging market CDS spread and the lower RSA spread narrowed sharply in December 2015, indicating a deterioration in SA’s relative credit standing. This relative standing has not improved much in 2016, as may be seen by a difference in spreads of only about 120bps. Note that the wider this spread, the better SA’s relative standing in the global credit markets.
The spread between RSA rand yields and their US Treasury yields of similar duration are by definition also the average rate at which the rand is expected to depreciate over the next 10 years. The fact is that the rand has weakened and is expected to weaken further – despite the wider interest carry in favour of the rand.
Given these expectations of rand weakness it is not surprising and entirely consistent that inflation compensation provided by the RSA bond market being the difference between an inflation linked yield and a nominal yield. This is a very good measure of inflation expected and has also risen and remains above 7% p.a.
The Reserve Bank pays particular attention to inflationary expectations, believing that these expectations can drive inflation higher. But without an improvement in the outlook for the rand, it is hard to imagine any decline in inflation expected. It is also very hard to imagine how higher short term interest rates can have any predictable influence on the spot or expected value of the rand and therefore on inflation to come. As we have emphasised the risks that drive the rand are global events or SA political developments, for which short term interest rates in SA are largely irrelevant.
The only predictable influence of higher short term interest rates in SA is still slower growth in household spending. Less growth without any predictably less inflation is not a trade off the Reserve Bank should be imposing on the SA economy, even though but may well continue to do so. The only hope for a cyclical recovery is a stronger rand – whatever its cause, global or South African.
