Rand’s evaluation: A comparative analysis of economic indices

The view that the rand is too weak relative to so-called hard currencies gets a fair amount of attention every few months, as does the view that the exchange rate should improve. A few brave souls even venture that the rand can recover every time it plunges on the back of bad news.

An update of The Economist’s Big Mac index recently indicated that the rand is undervalued relative to the dollar by as much as 46%.

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The Big Mac index is a simple and straightforward comparison of the price of the popular McDonald’s hamburger in different countries in local currencies, assuming that the burger is exactly the same everywhere and can be used as a benchmark to calculate a ‘correct’ exchange rate.

According to this, the rand should be at R9.31 per dollar compared to the actual R17.25 per dollar at the time of the analysis, indicating that it can recover significantly.

In reality, the currency declined further. It is now sitting at nearly R19 per dollar.

IMF

The Economist always warns that the Big Mac index is not the ultimate guide to purchasing power parity (PPP) for any currency but merely an indication of currencies worldwide.

However, according to PPP data published by the International Monetary Fund (IMF) – data that should be more robust as it is based on overall PPP – our exchange rate is even further from where it should be.

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At the beginning of 2024, the IMF calculated the exchange rate at R7.17 per dollar on a PPP basis.

Yet here we are, flirting with R19 and with fears of R20.

Nedbank chief economist Nicky Weimar says it is not surprising that the rand looks weaker than PPP data suggests.

“Purchasing power parity rarely holds in the short to medium term and is also heavily influenced by the chosen base year. However, inflation differentials tend to reassert themselves over the longer term, but deviations can be prolonged and dramatic.

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“In the case of SA, the rand’s weakness mainly reflects a sharp rise in the country’s risk premium after SA lost its investment grade status by all major rating agencies in 2020, which was further reinforced by the country’s greylisting by the Financial Action Task Force in 2023, the sharp deterioration in our fiscal metrics and some lingering concerns about SA’s geopolitical alignments in the context of a more fractured world,” she says.

“At the same, investors are pricing in structurally weaker economic growth relative to SA’s emerging market peers, with economic activity likely to be constrained by the electricity shortage, collapsing rail infrastructure, worsening port inefficiencies and deteriorating public service delivery.

“The rand, therefore, reflects foreign investors’ assessment of SA’s relatively higher risk and lower returns than other key emerging markets,” says Weimar.

Sentiment

Nedbank’s economists list several factors that will influence the exchange rate.

“In the short term, the rand is heavily influenced by global risk sentiment,” says Weimar.

“In a risk-on environment, the US dollar tends to weaken and high-risk currencies tend to experience more robust capital inflows, buoying their currencies.”

Global risk sentiment, in turn, is influenced by a complex interaction of a variety of factors:

• Geopolitical tensions, conflicts or shocks usually trigger risk-off sentiment, driving investors to safe-haven currencies, largely the dollar.
• Foreign exchange markets are also sensitive to market expectations on the likely trajectory of US monetary policy and interest rate differentials between countries. Tighter US monetary policy implies higher US interest rates, and, therefore, the world’s ultimately low-risk destination offers a higher return or yield to investors, which usually results in capital outflows from high-risk countries and placing pressure on their currencies.
• Poor global growth prospects benefit the US dollar, strengthening its safe-haven appeal.
• Global growth prospects also weigh on commodity prices and impact sentiment towards commodity-based currencies like the rand. If the world economy is strong and expanding, commodity prices tend to rise, and commodity-based currencies tend to strengthen.

Weimar says specific factors in SA also impact the rand.

“Domestic political developments could either enhance or weaken the country’s risk and return outlooks.

“If a country is on a fiscally unsustainable path, with widening budget deficits and mounting public debt, then it raises the country’s risk premium, increases the risk of further sovereign risk rating downgrades and clouds the economic growth outlook.

“SA’s worsening fiscal outlook has weighed heavily on the rand over the past year, as reflected in higher credit default swap spreads and the steep domestic yield curve. Our poor growth prospects in the face of our weak fiscal position and serious infrastructure constraints undoubtedly also contributed to the rand’s slide over the past two years,” says Weimar.

She says Nedbank’s view is that the rand will remain weak and volatile in the first half of the year, with sentiment heavily influenced by the country’s worsening fiscal story and the uncertainties around the outcome of the general election.

“However, the rand should regain some lost ground in the second half of the year as the US dollar softens against the backdrop of US monetary policy easing and global risk sentiment improves in anticipation of an upturn in global demand and international commodity prices into 2025,” according to Weimar.

“The net effect of weakness in the first half of 2024, followed some appreciation in the second half, is that the rand ends the year around R18.10 to the dollar.

“The rand tends to overshoot on the way up and down,” she adds.

“So, when the key risk events are done and dusted, the rand could strengthen more than we currently anticipate.”

Other factors

Michael Keenan, senior foreign investment and foreign exchange strategist at Absa Corporate and Investment Banking, says the PPP school of thought assumes that exchange rates are driven exclusively by the inflation differentials between two countries.

“Hence, the current deviation between PPP fair value and the spot rate implies that other factors such as capital flows and trade flows have pushed the rand to weaker levels and/or the market expects SA’s inflation differentials to deteriorate sharply,” he says.

In theory, a PPP exchange rate strips out sentiment, such as political risk, economic outlook and capital flight, and only considers yield differentials, while the actual (weak) exchange rate takes these and other factors into account.

Keenan says Absa’s analysis suggests that SA’s economic growth and interest rate differentials are critical drivers of the exchange rate over the medium to longer term.

“This is because when either of these two differentials improves significantly, investors are likely to feel adequately compensated for holding rand-based assets and vice versa.

“For example, when commodity prices climb, the rand tends to strengthen because the net export component of GDP improves. Alternatively, when interest rates in SA are said to have peaked, foreign investors tend to buy SA bonds before the yield differential becomes eroded by policy rate cuts.

“Hence, investors should also always consider the growth and interest rate implications of a given news item or data release when trying to decipher what these events imply for the future performance of the exchange rate,” says Keenan.

He notes that the rand has been oscillating between R18.10 and R19.60 per dollar in recent months.

“Given that all rand valuation models suggest that the rand is currently undervalued, we remain of the opinion that the rand will be able to breach R18 per dollar (strengthen) over the next few quarters,” he says.

This article was republished from Moneyweb. Read the original here