The rand: No surprises

The recent strength of the rand should not have come as a surprise. The rand has continued to follow very closely the day to day the direction provided by emerging equity and bond markets.

A simple regression equation linking emerging equity markets (represented by the benchmark MSCI EM Index) to the rand explains over 95% of the daily value of the rand as we show below. This model predicted a value of R6.80 on Wednesday 27 July, slightly weaker than the R6.70 at which the rand traded that day.

This relationship seems obvious and persistent enough and very likely to continue: where emerging market (EM) equity markets go and where global growth and risk appetite take them, the rand will follow.

The explanation for the strength of the relationship is perhaps less than obvious. That the JSE All Share Index, especially when converted to US dollar, also follows the EM Index very closely, is part of the explanation. This connection that makes the JSE so highly representative of the average EM is by no means accidental. As we have pointed out, JSE earnings in US dollars follows average EM Index earnings as closely as does the Index. This is because the major companies listed on the JSE have a global and emerging market economy reach, rather than being dependent on the SA economy. And so capital tends to flow into and out of the JSE and the SA bond market, depending on the simultaneous direction being taken by the EM equity and bond markets generally.

It should moreover be recognised that the market in rands is a large, active and liquid global market. Each day up to US$20bn worth of rands is now being traded according the SA Reserve Bank. Much of this trade is conducted between third parties not directly engaged in SA trade or finance; they are presumably trading the rand because they can easily do so and are doing so because presumably the buying and selling of rands enables traders and investors to hedge exposure to Emerging Markets and their currencies that cannot be traded as easily.

This makes the rand much more of an emerging equity market currency and much less influenced by the direction of SA foreign trade and the implications that inflation differences, or purchasing power parity (PPP), can have for this trade. Exports are encouraged when the rand is undervalued – that is exchanged for the US dollar at a lower rate than its PPP equivalent; while imports are encouraged when the US dollar is cheaper and can be bought for less than its PPP equivalent value.

It all depends on where you start

The history of the rand relative to its PPP value, that is, its value explained by the difference between higher SA inflation and lower US inflation alone is shown below. In the decade of the 1990s the rand stayed close to PPP until 1995. Thereafter it depreciated at a much faster rate than PPP until the rand blew out in 2001. By then the rand was substantially undervalued relative to PPP. However by 2011, the rand was back to its 1990 PPP equivalent.

Thus if we begin the calculation of PPP in 2000 and carry it forward until now, the picture becomes very different. By 2011 the rand, compared with its PPP value, is substantially overvalued compared to its undervalued position in 2000 and 2001. The PPP value for the rand today (with January 2000 taken as the starting point) would be about R9 to the US dollar. But the strength of the rand over the last decade was due to the recoveries from two major shocks: the 2001 shock was almost completely domestic in origin – it was linked to the initiation of the asset swap facility. The shock in 2008 and the recovery thereafter represent the impact almost entirely of global forces (that is the impact of the global financial crisis on all emerging market currencies) including the rand and the subsequent recovery from this crisis.

As indicated, the rand cannot be well explained by PPP. Capital flows explain these differences from PPP and will continue to do so whatever the SA Reserve Bank might hope or try to do about this by interventions in the currency market. The market is just too big for the Bank to hope to muscle in one or other preferred direction.

These flows and their influence on the rand were severely restricted by exchange controls before 1995. Capital flows were captured within the financial rand pool and the financial rand exchange rate insulated the (commercial) rand. These controls were lifted for foreign investors in 1995 and gradually for SA investors ever since. The relief of the exchange control log jam after 1995 and panic demand for asset swaps by individuals in 2001 explains most of the persistent weakness of the rand between 1995 and 2001 (just as the global financial crisis explained the weakness and recovery in 2008-2010). By 2002 global forces had taken over the exchange value of the ZAR.

It should be appreciated that with the almost complete lifting of exchange controls and the trading appetite for rands abroad, the rand is no longer a one way bet. It is much more a bet on emerging markets. Those who like to believe that rand weakness (given higher SA inflation) is a fact of economic life should think again. And they should also appreciate that a stable rand helps to reduce inflation pressures in SA.

To view the graphs and tables referred to in the article, see Daily Ideas in the Daily View: Daily View 29 July