Category: The Rand

Inflation in SA has nearly halved since June. From 5.1% p.a then to 2.8 in October. Indeed average consumer prices have hardly risen at all since June. In October they fell marginally, and over the past three months the CPI has hardly budged, and price increases were close to zero.

Inflation and the SA CPI; Monthly Data

One observation that one can make is that such price stability could not have occurred without a very strong rand. A rand that has gained value against a range of low inflation currencies. This year to date the rand is worth four per cent more USD, can buy six per cent more Euros and seven per cent more Aussie dollars. The year before the rand had weakened VS these currencies by over 10%. Its surely no surprise that inflation in SA accelerated in 2023 and has sharply decelerated this year.

The ZAR Vs the USD, the Euro and the Aussie Dollar. Daily Data (2024=100)

One can also conclude that the exchange value of the ZAR drives the direction of prices in SA – rather than the other way round. SA is a very open economy. Flows of exports and imports account each for about 30% of GDP- of total supply and demand in the economy. What we pay in rands for imports and receive for exports helps determine all prices in a systematic way. You can tell as much at the petrol pump.

And so how then can SA achieve currency strength and low inflation? The answer would also seem obvious enough. Form a government of national unity that is expected to raise growth rates, improve the outlook for SA bonds and equities and so more capital will flow in more than out leads to less rand weakness and inflation expected in the future.  Lower long term bond yields, lower costs of capital generally, all reinforce the growth momentum. And with lower inflation short term interest rates decline just as predictably, as they can be expected to rise with rand weakness. Yet expectations of faster growth have to be reinforced with consistent growth enhancing actions. Investors can be encouraged, they can as easily be disappointed.

It is not only in South Africa that politics and the economic policies and outcomes associated with a change in leadership drive the direction of the exchange rate. And depending on the degrees of openness to foreign trade that will then drive the direction of all prices. The exchange rate leads and prices follow, and the exchange moves in response to changes in expectations of returns in the capital market. The exchange value of the USD,  the essential reserve currency, is subject to large changes in direction, persistently so, that have little to do with differences in inflation between the US and its principle trading partners. And everything to do with expected returns on capital invested. But will have a significant impact on the profits and growth prospects of businesses that engage in foreign trade.

The DXY is a weighted Index of the exchange value of the USD Vs the major currencies, the Euro, Yen etc.. It gained nearly 50% additional exchange value between 1995 and 2000. It then declined from an Index value of 120 to 70 by the time of the Global Financial Crisis. The dollar since has been on a mostly upward tack since and clearly has received a boost from the Trump ascendancy. From which the ZAR has not be immune but has behaved broadly in line with all other currencies. Dollar strength will be far more easily managed provided the ZAR holds its own with the other low inflation currencies, as it has been doing.

But for the Trump administration the impact of the potentially stronger dollar on trade flows may be far more important than the impact of higher tariffs on imports and the retaliation that may follow and on prices US consumers will pay. The unpredictability of exchange rates, despite low rates of inflation in the developed world, especially of the exchange value of the USD, is a fundamental flaw of global trade and finance that all economies including SA have to cope with.

The exchange value of the US dollar

Brian Kantor and David Holland

A great deal of commercial, domestic, and speculative energy is spent pondering the future of the rand (ZAR). The foreign exchange value of the rand will remain highly variable and unpredictable. The best prediction for tomorrow’s exchange rate is today’s rate but with a high level of variance that increases with time. As in the past, the rand is unlikely to be a one-way bet. It will experience periods of negative and positive turbulence. On average, persistent rand weakness is expected in the currency markets due to the higher inflation and sovereign risk of South Africa relative to the US dollar (USD) and other hard currencies. The rand cost of a US dollar is priced to rise at an average rate of 5.5% p.a. over the next five years and by about 4.5% this year. Yet, for all its volatility, changes in the foreign exchange value of the rand can be almost fully explained by but two persistent influences on its value. These are the exchange rates of other emerging market currencies with the dollar and the dollar prices of industrial metals that SA exports. 1

Since 2010, daily movements in the EM currency basket explain 54% of daily movements in the ZAR/USD exchange rate. This is a highly significant association. If you had a crystal ball that foretold future EM basket to USD rates, you could make confident and profitable bets on the trajectory of the rand’s exchange rate. Unfortunately, exchange rates are random walk processes that are impossible to precisely predict. And commodity prices also follow a random walk process. Your best guess for tomorrow’s ZAR/USD exchange rate is today’s rate plus or minus 1% (and ±2.2% if you’re looking a week ahead).

Knowing why the rand behaves as it has may however not help much to predict where it is heading. Forecasting the USD/ZAR demands an accurate forecast of the dollar value of other EM currencies and metal prices. A clearly formidable task. A strong dollar, as measured vs its developed economy peers, will clearly force EM and ZAR weakness and probably also weigh on metal prices, when expressed in USD – and vice versa. Though the major force acting on metal prices will be the state of the Chinese economy- the major destination for industrial metals – and so another known unknown with relevance for the ZAR.

The other forces acting on the rand are South African specific events. Political shocks and own goals that move the rand irregularly and unpredictably one way that then may be reversed. These shocks account for up to 46% of the movement in the rand relative to other emerging markets.

This is where wise economic policy and effective implementation of those policies can positively influence the exchange rate. The persistently weaker bias of the rand when compared to not only the US dollar, but also when compared to other emerging market currencies, is due to the failure of the South

African economy to deliver meaningful growth and attractive returns. The rand is riskier than the emerging market basket to a significant degree. A drop of 1% in the EM basket typically translates into a 1.5% drop in the rand. Government’s job is not only to shoot fewer own goals, but to convince through positive coordinated action that South Africa is not significantly riskier than other emerging markets. The potential gains are a less risky rand, a lower cost of capital, greater investment, job creation, and more wealth for the country to share.

Exchange Rates and Metal Prices (USD) Daily Data (July 2010=100)

The ZAR and the EM basket. Higher number indicate rand weakness.

The rand has recovered strongly this month – by about 7% against the US dollar, and has performed similarly Vs the Aussie dollar and an index of EM currencies. The rand had weakened through much of 2023. It weakened by a further 3% when the SARB increased rates unexpectedly sharply by 50 b.p. on May 25th. Since June 1st the ZAR has recovered – as interest rates in SA have fallen away. arply.

The ZAR Vs The USD, the AUD and the EM Currency Index. (Daily Data January 2023=100)

Source; Bloomberg and Investec Wealth and Investment
Long term RSA bond yields have declined significantly and helpfully by between 50 and 70 basis points this month. The Yankee Bond, a five year dollar denominated claim on the RSA, now yields a lower 6.4% p.a. compared to the 7% p.a. offered on June 1st. Moreover, the spread between the RSA dollar bond and a US Treasury of the same duration has narrowed significantly from 3.6% p.a to 2.8% p.a. This interest rate spread provides a very good indicator of the risks of default attached to SA bonds. More important perhaps for the direction of the rand and the economy has been the recent inflection in short-term interest rates. When the SARB raised rates on the 25th May, the money market, as represented by the forward rate agreements of the banks, immediately predicted a further one per cent hike in short rates over the next six months. The SARB is now expected to be much less aggressive. The market is now expecting short rates to rise by a quarter per cent.

RSA Dollar Denominated (5 year Yankee Yield) and the SA Sovereign Risk Premium (Daily Data 2023)

Source; Bloomberg and Investec Wealth and Investment

Why have surprisingly lower short term interest rates helped the rand as surprisingly higher rates clearly weakened the rand last month? There is much more than coincidence at work here. Higher short-term rates – higher overdraft and mortgage rates- combined with the higher prices that follow a weaker rand – are expected to further depress spending in SA and the growth outlook for the economy. The weaker the outlook for the economy, the weaker the growth in incomes before and after taxes, the more government debt is likely to be issued. And the graver becomes the eventual danger a of a debt default. For which still higher interest rate rewards have to be offered to investors to compensate them for the additional risks implied by a deteriorating fiscal condition. These higher interest rates then raise the cost of capital for SA business – making them still less likely to undertake growth encouraging capex.
The Reserve Bank is ill advised to react to exchange rate shocks in ways that further threaten the growth outlook – and can prove counterproductive by weakening the rand that then lead to still higher prices. Interest rate increases make sense when excess spending – excess demand – is putting pressure on prices. Which is not the case for the SA economy today. The right response to exchange rate shocks is to ignore them as their temporary impact on the price level falls away. Absent any additional consistent pressure on prices from the demand side of the economy, over which the SARB will always have strong influence. The notion of self-perpetuating inflationary expectations, as promoted by the Reserve Bank when explaining its interest rate reactions to a weaker rand, is supported neither by evidence nor is it consistent with self-interested economic behaviour. It is poor theory and even poorer practice.
But this leaves open the question- why then have interest rates come down in SA? The answer can be found offshore. The Fed has found good reason not to push its own rates higher. The pause on rate increases in the US became widely expected and was confirmed yesterday gives the SARB even less reason to raise its own interest rates. The Fed by dealing effectively with a surge in inflation (which has not been self-perpetuating) has improved the outlook for interest rates, the SA economy and the rand.

Update on US Inflation – to May 14th 2023.

Both CPI (4.0%) and PPI headline inflation fell more than expected in May. Monthly moves were low – 0.2% for CPI and negative for PPI. The only proviso was the elevated rate 0.4% m-m for core CPI- CPI excluding energy and food. But core has a very large rental weight- over 40% which was up 8% y/y – but rentals are clearly heading lower and core may not be the most useful leading indicator for CPI – PPI- now strongly lower may do much better in predicting CPI.
The Fed paused but member dot plots indicated further increases to come. But the Chairman says the Fed will remain data dependent and my view is that the Fed panic about inflation is over. Because demand pressures on inflation are largely absent- thanks to higher interest rates and negative growth in money supply and bank credit. The global pressure on interest rates in SA is therefore abating. As discussed in my commentary above

US Headline Inflation Y/Y growth in Index

US Inflation over the past three months – % per 3 months annualized. CPI now running at a quarterly rate of 2%. PPI inflation – headline and quarterly- is now negative

Monthly % move in CPI Seasonally Adjusted. Latest April-May 2023=0.12%.

Graham Barr and Brian Kantor

16th May 2023

In early 1980 the Rand reached a peak of 1.32 US$ to the Rand; yes, the Rand then bought more than one dollar! This was the time of a very high gold price of $820 per oz. when Russia invaded Afghanistan and WW3 looked like a real possibility. It was but 35 dollars an ounce in 1970. Things have not been as rosy on the exchange rate front since. The exchange rate is currently around 19.2 Rand to the $. This means that in purely nominal terms the Rand is currently 1/25th (against the dollar) of what it was in those heady days of 1980! If the ZAR merely adjusted for differences in SA and US inflation since 2000 the dollar would now cost less than R13. In a relative sense- the ratio of the market to the Purchasing Power Parity was only wider in 2002 when the ZAR was nearly 80% undervalued. At current exchange rates it is about 50% undervalued. Or in other words the rand buys roughly 50% less in NYC than it does in SA as SA visitors will testify. The great deals will now be realised by tourists to SA –until the rand sticker prices in the stores and on the menus are marked higher. See figure 1

Figure1. The USD/ZAR and its PPP equivalent.1 Monthly data to April 2023.

Source; Federal Reserve Bank of St.Louis, Stats SA and Investec Wealth and Investment

In the seventies as the gold price took off- more in USD than ZAR, SA was the largest gold producer in the world and gold mining was hugely lucrative for shareholders in the gold mines and for the SA government who collected much extra revenue from taxes, and royalties paid by the gold mines. Platinum mining was only then getting going and subsequently got a huge boost from the widespread use of catalytic converters in the exhausts of motor vehicles. Coal exports got going after the construction of the huge export terminal at Richard’s Bay, and the rich Sishen iron ore deposit was still to be exploited.

South Africa is now merely the eighth largest producer of gold in the world, producing but a sixth of the gold delivered in 1970. And gold production is now a relatively small part of the South African economy that in the seventies accounted for 60% of all exports from SA and about 16% of GDP. The link between the gold price and the exchange rate

is now correspondingly weak and has done little to save us from facing the second weakest Rand on record and ever higher long-term interest rates.

The strength of the Rand is still much influenced by the state of the commodity-price cycle, as South Africa remains a commodity-based and exporting economy. It is also determined in large part by perceptions of South Africa’s economic future and the associated safety of investing in SA. Foreign and local investors require a return that compensates for the perceived risk of investing in SA- including the risk of rand weakness. These perceived risks influence flows of capital to and from SA and can strongly influence the foreign exchange value of the ZAR, as they have this year. As an emerging market, South African risk generally follows the average emerging market risk, but SA specific risk has recently risen dramatically in the face of income destroying load shedding and more recently for reputation destroying toenadering with the reviled Russians. This year the rand has weakened by about 13% vs the Aussie dollar and 11% Vs the EM basket. Much of the relative weakness occurred in January and February in response to load shedding. With additional exchange and bond market weakness (higher yield spreads) on the 10th May in response to the Russian revelations. (see figures 2,3 and 4)

The ratio of the USD/ZAR exchange rate to the USD/Emerging Market (EM) average provides a useful indicator of SA risk. This ratio indicates that SA is again in economic crisis territory. The hope is that this time is not different- and the USD/EM ratio recovers to something like normal, as it has done after all the other crises that have damaged the ZAR and the SA economy. Relative to an average EM currency the ZAR has never been weaker than it is now. The outlook for the SA economy, judged by this ratio, has never been as bleak as it is now.

Fig.2: Identifying SA specific risks- comparing the behaviour of the USD/ZAR exchange rate to that of a basket of EM currencies. Daily Data 2000=1

Higher ratios indicate relative rand weakness

Source; Bloomberg and Investec Wealth and Investment.

Fig.3; Relative performance in 2023 ; ZAR VS AUD and EM Index; Daily 2023 to 15th May 2023. Higher numbers indicate relative rand weakness.

Fig.4; Rand Weakness, Inflation expected and the RSA Sovereign Risk Premium. 5 year yield spreads. Daily Data 2023 to May 16th 2023.

Source; Bloomberg Investec Wealth and Investment

In response to this exchange rate shock – for reasons specific to SA – the SA rate of inflation is very likely to trend higher, independently of by how much the Reserve Bank raises short-term interest rates to further reduce spending pressures on prices. Yet raising short-term rates is almost certainly negative for growth in incomes and employment of which the SA economy is already so sorely lacking, given load shedding and a general loss of confidence in the competence of the SA government. The forces that have given us this latest exchange rate shock are completely out of the Reserve Bank’s control. The

Governor needs to recognise this and do little additional harm to the economy and its growth prospects- by not reacting to the exchange rate shock.

It seems evident that the surging rand prices for our mineral exports may not help the Rand this time. A working Transnet to ship the metals and goods out the country would help – as even more important would be a consistent supply of electricity. But it is hard to be optimistic about such immediate responses and investors shared this pessimism earlier in the year and well before our damaging Russian connection came to light to add further to relative rand weakness.

Unfortunately, we do seem saddled for now with a weak Rand and a near-term uptick in inflation. Yet the weaker rand is not an unmitigated disaster. Exporters and firms competing with more expensive imports will benefit from higher rand prices for their production. Their extra rand costs of production will lag higher rand revenues until local inflation catches up with the inflation of the rand prices, they will be able to charge on foreign and domestic markets. The window of extra profitability will be supportive of extra output, incomes and employment. And of the rand values of the exporters and global plays (e.g. Richemont or Naspers) listed on the JSE. Sectors of the JSE that face abroad can provide a very good hedge against rand weakness that occurs for SA specific reasons, as they are predictably doing.

The rand cost of petrol and diesel will play an important role in influencing the inflation rate in the months to come. A saving grace for the inflation outlook is that the dollar price of oil and gas has fallen away- by more than the ZAR has weakened against the USD. (see figure 5)

Fig.5; Brent Oil price – per barrel in USD and ZAR

Source; Bloomberg and Investec Wealth and Investment

The biggest danger to the local economy is that the Reserve Bank will raise interest rates further (the money market already expects increases of over 100b.p. in the next few months) The most recent attempt to support the ZAR raising interest rates by 50 b.p. at the last Monetary Policy has been a conspicuous failure. It has not helped, could not support the rand in the circumstances, but has further depressed spending and the growth outlook. And helped push long term interest rates and the cost of capital higher.

The best approach to rand shocks – that have nothing to do with monetary policy settings- is surely to ignore them – and let the inflation work itself out without higher interest rates. One has long hoped that SA had learned the lesson to not interfere with the currency market. Interest rates can have little impact on the ZAR in current circumstances. The best support for the rand will come from faster economic growth that raises incomes and tax revenues for the state.

Long term interest rates in SA are now punishingly higher than they were last week and the rand is now expected to weaken at an even more accelerated rate than was the case a week ago. This is because SA remains at greater risk – given the even more depressed outlook for growth – of not easily balancing its fiscal books. The expectation of even slower growth to follow still higher borrowing costs, as is widely expected, has added to these risks.

The only way out of the mess SA has got itself into is to surprise investors by delivering surprisingly faster growth- even an extra one percent higher GDP would be helpful. The Reserve Bank has a crucial role to play in this by ignoring the exchange rate shock. Eliminating load shedding and delivering more exports are even more important to improve the growth outlook and reduce SA risks.

The latest shock to the SA currency and bond markets is of a large scale, similar to those of 2001, and of 2008-9, that was linked to the Global Financial Crisis, also to the Zuma-Nenegate shock of 2015-16, and the Covid shock of 2020. This shock is entirely of our own making. It is the punishing result of a failure to keep the lights on and choose our friends more carefully. We can assert this not only by reference to the abruptly higher rand costs of a USD or Euro, but by the poor performance of the ZAR against other emerging market (EM) and commodity currencies. A weakness that was pronounced earlier in the year as load shedding increasingly hurt the growth prospects of the economy and that was accentuated on the news of our arms business with Russia. The ZAR this year to the 24th of May, after a further burst of weakness on the 10th May, is about 10% weaker Vs the Aussie dollar and 12% weaker Vs the JPMorgan Index of EM exchange rates.

Fig.1 Relative performance in 2023 ; ZAR VS AUD and EM Index; Daily 2023 to 24th May 2023. (2023=100) Higher numbers indicate relative rand weakness.

The ZAR compared to a basket of seven EM currencies – the ZAR/EM ratio – has never been weaker than it is now. The ratio very easily identifies the periodic shocks to flows of capital to and from SA since 1995. One can only hope that this time will not be different and that the ZAR bounces back- at least relative to our peers.

Fig.2. Identifying SA specific risks- comparing the behaviour of the USD/ZAR exchange rate to that of a basket of EM currencies. Daily Data 2000=1 to 15th May 2023

Higher ratios indicate relative rand weakness

Source; Bloomberg and Investec Wealth and Investment.

The RSA bond market could not escape similar punishment. Yields on long dated RSA Rand and USD denominated debt rose by about 60 b.p. between the 9th and 15th of May having all tracked higher through much of 2023. The case for investing more in SA plant and equipment has become that much harder to make. And the rand -judged by the wider carry- the difference between interest rates in SA and the USA- is now expected to weaken at an even faster rate- despite recent rand weakness. All bad news for our economy

Fig.3 Interest rate movements in 2023. Daily Data to 24th May

Source; Bloomberg and Investec Wealth and Investment.

The weaker rand is not an unmitigated disaster. Exporters and firms competing with more expensive imports will benefit from higher rand prices. Their extra rand costs of production will lag higher rand revenues and until local inflation catches up with the higher rand prices they will be able to charge on

foreign and domestic markets. The window of extra profitability will be supportive of extra output, incomes and employment. And of the rand values of the exporters and global plays (e.g. Richemont or Naspers or the International Mining Houses) listed on the JSE and who account for more than half its market value. The JSE is not in shock- it is well hedged against SA specific shocks.

How quickly inflation rises in the months to come will depend on the rand price of imported oil. A saving grace for the inflation outlook is that the dollar price of oil has fallen by more than the rand- hence a lower rand price of a barrel of oil.

Fig.4; Brent Oil price – per barrel in USD and ZAR

Source; Bloomberg and Investec Wealth and Investment

The interest rates set by the Reserve Bank will make no difference to the rand or the inflation rate. Hopefully they will react to an exchange rate shock by not reacting to one. And do what little they can not to slow down growth any further.

The Treasury could help –by keeping the peak loading generators on for longer. And pay for the extra diesel or LPG. Every hour of load shedding not only means less income and output generally – it means lower tax collections. Every rand spent on diesel by the public or on replacing Eskom means less tax revenue in proportion to the company and personal income tax rates and the conversion to solar

allowances. Spending taxpayers rands on diesel will pay for itself. And possibly produce the growth surprise that could turn, only can turn around the rand.

The rand has consistently declined by more than its purchasing power parity equivalent rate against leading currencies over the years. Strong action is needed to change this.

South Africans travelling abroad should not blame the rand for their lack of purchasing power, at least not lately. In mid-January 2016, a US dollar exchanged for R16.80, a British pound then cost R24. Observers of the gyrations of the foreign exchange value of the rand should know that its exchange rate has had very little to do with the differences in inflation between SA and its trading partners. The rand has consistently bought less abroad than it has at home.

The exchange value of the rand with the US dollar or sterling has been weaker than its purchasing power parity (PPP) equivalent rate of exchange ever since 1995, when SA’s capital market was opened up, though with varying degrees of weakness. Had the rand simply followed the ratio of the SA consumer price index (CPI) to the US CPI since 1995 a dollar would now cost a mere R8. Similarly, since 1995 the difference between SA and UK inflation has been an average of 3.3% a year while the pound on average has cost an average 8.2% extra a year in rands since 1995.

Rand exchange rates against the US dollar (1995-2022)

Source: Federal Reserve Bank of St Louis, Bloomberg and Investec Wealth & Investment, 17/08/2022
 

Yet not only has the rand depreciated by more than the differences in inflation over the past 27 years, it is also expected to carry on weakening by more than the expected differences in inflation. The rand is expected to lose its dollar value by an average rate of 7.6% a year over the next 10 years and at an average 6% rate a year over the next five years. This is known as the interest carry: the current differences between the market established rand yields on an RSA bond and the dollar yields on the US Treasury bonds of the same duration. While helpful to exporters and import replacers competing in the home and foreign markets (and to incoming tourists) this expectation of further consistent rand weakness has a damaging downside. It raises the cost of funding rand-denominated debt, increasing the required return on securities. Expected rand weakness sharply reduces the expected return from the RSA (government) 10-year bond to under 3% a year (10.4% nominal yield less 7.6%). This is less than the same return in US dollars offered by a US Treasury.

The expected rate of inflation can be accurately estimated or implied in the same bond markets. It can be measured as the difference between a vanilla government bond and an inflation-protected alternative of the same duration. The compensation to investors in the US accepting inflation risk is an extra 2.65% a year for a five-year bond and 5.91% a year extra for rand investors in RSA bonds. This difference in expected inflation of 3.2% a year is significantly less than the 6% rate at which the rand is expected to weaken against the dollar over the same five years. PPP does not only not hold, but it is not expected to hold in the future. Sadly therefore, even reducing expectations of inflation may not much improve the outlook for the rand – a major issue if the cost of raising foreign or domestic capital is to be reduced.

Inflation compensation in SA and US 10-year bond markets and differences in expected inflation

Source: Bloomberg and Investec Wealth and Investment, 17/08/2022

The interest carry (difference in nominal yields) and the difference in inflation expected (2010-2022)

Source: Bloomberg and Investec Wealth and Investment, 17/08/2022
 

The full explanation for the exchange value of the rand is thus not to be found in the PPP rate but much more in the varying flows of capital into or out of emerging markets generally and to or away from the dollar. SA-specific risks move the ratio of the rand to other emerging market currencies about this long-term one-to-one ratio. Both the rand and the other emerging market currencies respond similarly to the same degrees of global risk tolerances that drives the US dollar stronger or weaker.

The task for SA lies in promoting capex (and so economic growth) by improving the outlook for the rand. It could do so by adopting policies that would make SA a superior emerging market attracting a much lower risk premium. SA’s recent impressive successes in the competitive businesses of international rugby and cricket, provide the case study to be emulated widely.

The exchange value of the rand vs other emerging market currencies (1996-2022)
(Higher numbers indicate rand weakness)

Source: Bloomberg, Investec Wealth & Investment, 17/08/2022

South Africans travelling abroad should not blame the rand for their lack of purchasing power- at least not lately. In mid-January 2016, a USD exchanged for 16.8 rands, the pound then cost R24. Observers of the gyrations of the foreign exchange value of the ZAR should know that the ZAR rate has had very little to do with differences in inflation between SA and its trading partners. The rand has consistently bought  less abroad than at home.

The exchange value of the ZAR with the US dollar or UK pound has been weaker than its purchasing power parity (PPP) equivalent rate of exchange ever since 1995 when the capital market was opened up. Though with varying degrees of weakness. Had the rand simply followed the ratio of the SA CPI to the US or UK CPI since 1995 a USD would now cost a mere R8. Since 1995 the difference between SA and UK inflation has been an average 3.3% p.a. while the pound on average has cost an average 8.2% p.a. extra in rands since 1995.   

Exchange rates with the US dollar. 1995-2022. Monthly Data

Yet it is not merely that the ZAR has depreciated by more than differences in inflation – it is expected to continue to weaken by more than the expected differences in inflation. The rand is expected to lose its dollar value by an average rate of 7.6% p.a. over the next 10 years and at an average 6% p.a. rate over the next five years. Known as the interest carry – these are the current differences between the market established rand yields on an RSA bond and the dollar yields on the US Treasury bonds of the same duration. While helpful to exporters and import replacers competing in the home and foreign markets – and to incoming tourists – this expectation of further consistent rand weakness has a damaging downside. It raises the cost of funding rand denominated debt, increasing the required return on securities that are expected to lose their dollar value at a rapid rate. Expected rand weakness sharply reduces the expected return from the RSA 10 year bond to under 3% p.a. (10.4 nominal yield less 7.6) Less than the same return in USD offered by a US Treasury.

The expected rate of inflation can be accurately estimated or implied in the same bond markets. It can be measured as the difference between a vanilla government bond and an inflation protected alternative of the same duration. The compensation to investors in the US accepting inflation risk is an extra 2.65% p.a. for a five-year bond and 5.91% p.a. extra for rand investors in RSA’s. This difference in inflation expected of 3.2% p.a. is significantly less than the 6% rate at which the USD/ZAR is expected to weaken over the same five years. PPP does not only not hold- it is not expected to hold in the future. Sadly therefore even reducing inflation expected may not much improve the outlook for the ZAR- essential if the cost of raising foreign or domestic capital is to be reduced.

Inflation compensation in SA and US bond markets and differences in inflation expected

The interest carry (difference in nominal yields) and the difference in inflation expected. Daily data- 2010-2022.

The full explanation for the exchange value of the ZAR is to be found not in PPP but much more in the varying flows of capital into or out of emerging markets generally and to or away from the dollar. SA specific risks move the ratio ZAR/EM about this long term one to one ratio. Both the ZAR and the other EM currencies respond very similarly to the same degrees of global risk tolerances that drives the USD stronger or weaker.

The task for South Africa hoping to promote capex and so economic growth by improving the outlook for the ZAR. It could do so by adopting policies that would make SA  a superior emerging market attracting a much lower risk premium. SA’s impressive success in the highly competitive business of international rugby, provides the case study – to be emulated widely.

The exchange value of the ZAR compared to other EM currencies. Higher numbers indicate rand weakness. Daily Data 1995-2022

Higher metals prices in previous times have been good for the SA economy. There is little reason to believe this will not be the case again, even if global inflation rises.

Inflation is busting out all over the world. The US dollar prices of industrial metals traded in London are up 30% and commodity prices are up 20% this year. These higher prices are not a cause of inflation. They are inflation. Larger amounts of money have stimulated demand and supply is struggling to catch up. Too much money chasing too few goods is the obvious explanation of higher prices.

Rising prices and interest rates absorb excess holdings of cash and, sooner or later, will slow down demand and the pace of growth. Governments might respond to this slowdown with yet more money and spending. If that happens, a temporary phase of rising prices will morph into a much longer phase of continuously rising prices. The US jury is out on this and when they return, South Africans should hope for a guilty verdict – guilty of causing more inflation and the rising metal prices that come with it.

Good times for the SA economy follow when metal prices rise much faster than prices in general – as they are doing now. The extra income earned by mining in SA, the profits earned, the dividends, wages and royalties and taxes paid, rise faster and (conversely) fall further with this cycle. In the 1970s, the real price of SA metals, the ratio of the metal price index over consumer prices, increased by nearly five times. Between 1981 and 1996, it then more than halved, damaging the economy severely in the process.

The one genuine recent SA boom between 2003 and 2008 followed a doubling of SA’s real metal prices.  Real national incomes grew on average by 5% a year over these six years, until interrupted by the GFC. Chinese stimulus helped hold up metal prices until 2011 but their decline until 2016 made for more difficult local economic conditions. A degree of relief came from a recovery in metal prices after 2016, a prospective recovery that was overtaken in turn by the lockdowns of 2020. The advances on the metal front make the outlook for the coming years promising for the SA economy.

The exchange rate takes its cue from the global forces that drive metal prices. And the inflation rate in SA, with variable lags depending on global prices (especially the oil price), follows the exchange rate.  Interest rates follow inflation – in both directions. These forces strongly reinforce the metal price effects on the direction of the SA economy.

Much of what drives the SA business cycle, metal prices, our international terms of foreign trade and the exchange rate is unpredictable and beyond our control. What matters is how we react to such circumstances. Our policies should be anti-cyclical and focus on moderating the direction of spending.

Exchange rate strength both stimulates domestic demand and dampens prices, led by the price of imports. Exchange rate weakness does the opposite. It weakens demand by pushing up prices.

Interest rates should not respond to exchange rate shocks on inflation in either direction: they work themselves out over a year or two. The stagnation of the economy post-2014, the depressing effect of lower metal prices and a weaker rand, was intensified by exchange rate weakness. This weaker rand led to higher prices and to higher interest rates, which in turn were kept consistently too high, given the weakness of demand.

The cause of higher prices was a weak rand and the effect was to depress spending and interest rates. This placed further pressure on demand. The economy paid a high price for countering an inflation rate that had nothing to do with the demand side of the price equation, in fighting so-called second round effects of inflation for which there is no evidence. Economic actors are more than capable of differentiating between temporary and permanent increases in inflation. The permanently higher rates of inflation come from too much demand, not too little supply. They are waiting to make that judgment about inflation in the US.

Hopefully the next phase will be one of faster growth with low inflation that will accompany a strong rand. The risk then may then be of interest rates being kept too low for too long. This was possibly a monetary policy error committed between 2005-2008, a case of too much rather than too little stimulus. It will however be a much higher-level problem to have to deal with in the years to come. Let us hope for such a challenge.

https://www.businesslive.co.za/bd/economy/2021-05-04-watch-will-rand-strength-last/

In goods and services as well as in currencies, it’s the relative price that matters

When it comes to prices, what matters is whether a good or service has become relatively more or less expensive, rather than the absolute price. Relative prices can change a great deal even as prices in general rise consistently or remain largely unchanged.

For example, the prices of food and non-alcoholic beverages in SA have risen much faster than the price of clothing. Since 1980, the prices of the goods and services bought by consumers have risen on average (weighted by their importance to household budget) by 31 times. Clothing and footwear prices are up a mere 8 times over the same 40 years. And food prices have increased 43 times since 1980, making food about 5.4 times more expensive than clothes.

Consumption of goods and services
LHS: Deflators for different categories (1980 = 100)
RHS: Multiple increases (1980 – 2019)

Source: SA Reserve Bank Quarterly Bulletin, Investec Wealth & Investment
Inflation rates: All consumption goods and services, food and beverages, clothing and footwear (2010 – 2019)

Source: SA Reserve Bank Quarterly Bulletin, Investec Wealth & Investment
Other relative price movements are worth noting. Over the 10 years 2010 to 2019, furnishings and household equipment became 20% cheaper in a relative sense, while education has become 25% more expensive. Utilities consumed by households (water, electricity) have increased by only 6% more than the average consumer good. Health services (surprisingly perhaps) have only become 3% more costly in a relative sense. More powerful pharmaceuticals and less invasive surgical procedures may well have compensated for these above average charges. Communication services have become about 37% cheaper in a relative sense, helped of course by the price of many a phone call falling to zero.

Relative prices (individual price deflators / consumption goods deflator) (2010 = 1)

Source: SA Reserve Bank Quarterly Bulletin, Investec Wealth & Investment

Businesses that serve consumers (retailers and service providers) are likely to flourish when passing on declining real prices. Producers are likely to suffer declining profitability as the prices they are able to charge decline, relative to the costs they incur.

It will be the changing supply side forces that will dominate real price trends. Temporary surges of demand in response to changes in tastes that force real prices higher will tend to be competed away. Constantly improving intellectual property or technology can give producers the opportunity to consistently offer competitive real prices, yet sustain profit margins and returns on capital to fund their growth.

The dominance of China in manufacturing has been an important supply side force acting on real prices, for example on the real prices of clothing, household furnishings, equipment and communication hardware. Having to compete with lower real prices has decimated established manufacturers everywhere, including in SA though often to the benefit of consumers.

Predictably low inflation makes for more easily detected real price signals that consumers and producers should respond to. Unpredictable inflation rates make it harder for businesses to separate the real forces acting on prices from what is merely more inflation, common to all buyers and sellers.

There is however one important real price that shows no sign of stabilising. That is real value of the rand, in other words the rand after it has been adjusted for differences in SA inflation and inflation of our trading partners. The real, trade-weighted rand is now about 30% below its purchasing power parity level. SA producers exporting or competing with imports must hope that it stays as competitive, but there would be no reason to expect it to stay so. It is an important real price given that imports and exports are equivalent to 60% of SA GDP.

The real value of the rand moves in almost perfect synch with the market rates of exchange, which tend to be highly variable. The real and the nominal rand exchange rates have been almost equally variable. The average three month move in the real exchange rate calculated each month since 2010 has been 2.03% with a wide standard deviation of 19.8%.

For an economy open to foreign trade, this real exchange rate volatility adds great uncertainty to business decisions. It disturbs the price signals to which businesses must react. Until SA gets a higher degree of exchange rate stability, the price signals will remain highly disturbed, regardless of the inflation rate.
Quarterly percentage movements in the nominal and real traded-weighted rand exchange rate

Source: SA Reserve Bank and Investec Wealth & Investment

A shorter version of this essay was published in the Financial Mail (Special Edition 1959-2019) October 24^th– October 30^th 2019

A full version is available here: Understanding the past and future of the rand

The rand (USD/ZAR) has not been a one-way road. Yet SA portfolios are more likely to be adding dollars when they are expensive and not doing so when the rand has recovered.

The rand cost of a dollar doubled between January 2000 and January 2002 – but had recovered these losses by early 2005. The USD/ZAR weakened during the financial crisis, but by mid-2011 was back more or less where it was in early 2000. A period of consistent rand weakness followed between 2012 and 2016 and a dollar cost nearly R17 in early 2016. A sharp rand recovery then ensued and the USD/ZAR was back to R11.6 in early 2018. Further weakness occurred in 2018 and the rand has been trading between R15 and R14 since late 2018. Weaker but still well ahead of its exchange value in 2016. The rand in March 2019, had lost about 20% of its dollar value a year before. It has recovered strongly since and t on July 5^th at R14.05, the rand was a mere 4% weaker Vs the USD than a year before

The USD/ZAR exchange rate; 2000-2019 (Daily Data)

Source; Bloomberg, Investec Wealth and Investment

Two forces can explain the exchange value of the rand. The first the direction of all other emerging market currencies.  The USD/ZAR behaves consistently in line with other emerging market (EM) currencies. And they generally weaken against the USD when the dollar is strong, compared to its own developed market currency peers.

When the USD/ZAR weakens or strengthens against other EM currencies, it does so for reasons that are specific to South Africa. Such as the sacking of Finance Ministers Nene in December 2015 and Gordhan in March 2017. These decisions that made SA a riskier economy, can easily be identified by a higher ratio of the exchange value of the rand to that of an EM basket of currencies. The reappointment of Gordhan as Minister of Finance in late December 2015 improved the relative (EM) value of the ZAR by as much as 25% through the course of 2016.  His subsequent sacking in March 2017 brought 15% of relative rand underperformance. The early signs of Ramaphoria was worth some 15% of relative rand outperformance – and its subsequent waning can also be noticed in an increase in the  ratio ZAR/EM.

The rand compared to a basket of emerging market exchange rates (Daily Data)

Source; Bloomberg, Investec Wealth and Investment

This ratio has remained very stable since late 2018- indicating that SA specific risks are largely unchanged recently. Emerging market credit spreads have also receded recently – as have the spreads on RSA dollar denominated debt. The cost of ensuring an RSA five-year dollar denominated bond against default has fallen recently to 1.62% p.a. from 2.2% earlier in the year. The USD/ZAR exchange rate -currently at R14 – is very close to its value as predicted by other EM exchange rates and the sovereign risk spread. It would appear to have as much chance of strengthening or weakening.

The exchange rate leads consumer prices because of its influence on the rand prices of imports and exports that influence all other prices in SA. A weak rand means more inflation and vice versa. And given the Reserve Bank’s devotion to inflation targets, the exchange rate therefore leads the direction of interest rates. Despite a renewed bout of dollar strength and rand weakness in 2018 import price inflation – about 6% p.a. in early 2019 -has remained subdued.

Import and Headline Inflation in South Africa (Quarterly Data)

Source; SA Reserve Bank, Bloomberg, Investec Wealth and Investment

This has helped to subdue the impact of rand weakness against the US dollar that might have brought higher interest rates and even more depressed domestic spending. The dollar prices of the goods and services imported by South Africans has fallen by 20% since 2010 and by more than 10% since early 2018. This has been a lucky deflationary break for the SA economy.

SA Import Prices (2010=100)

Source; SA Reserve Bank, Bloomberg, Investec Wealth and Investment

Given that the rand is driven by global and political forces largely beyond the influence of interest rates in SA, it would be wise for the Reserve Bank to ignore the exchange value of the rand and its consequences. And set interest rates to prevent domestic demand from adding to or reducing the pressure on prices that comes from the import supply side. The SA economy can do better than merely hope for a weak dollar.