by Ian Marsberg
Towards the end of 2001, the South African rand went into a near freefall, losing more than 30% of its value against the major currencies of the world. However, from around October 2002, the currency staged an uncharacteristic comeback, from which it has not looked back. Although it could have been expected that the rand would stage somewhat of a comeback following the overshooting episode of 2001, the extent of the comeback caught most analysts, including us, off guard. The rand’s appreciation was underpinned by a number of factors, including general dollar weakness, an improvement in global commodity prices, particularly gold and platinum, favorable real interest rate differentials, improved investor sentiment toward emerging markets, and the elimination of South Africa’s net open forward currency position. The South African rand continued its appreciation in 2004, with the nominal effective exchange rate—an exchange rate index consisting of a basket of the 13 currencies of South Africa’s most important trading partners—appreciating by nearly 10% since the beginning of the year (around 40% since October 2002).
Is the rand currently over- or undervalued? There is still considerable debate among economists and analysts on that question. Some argue that the currency is overvalued given the cost structures of the South African economy. However, our belief is that the rand is still somewhat undervalued. Based on our purchasing power calculations, it seems as if the currency was undervalued by around 18% in March 2004, a view that seems to be supported by The Economist’s Big Mac Index, which suggests that the rand was undervalued by more than 30% when this index was published in May 2004. Perhaps a better indicator of South Africa’s competitiveness is the real effective exchange rate, which shows that the real trade weighted rand was still close to 10% below its neutral level in March 2004.
Considering the cost structures in the South African economy, some might argue that the aforementioned indicators are not a true reflection of where exchange rate should be. The proponents of this view would probably favor South African Reserve Bank intervention in the foreign exchange market to bolster foreign reserves, thereby promoting a currency depreciation. Although limited action might be justifiable to push up the overall level of foreign exchange reserves, Global Insight does not believe that intervention should be aimed at weakening the currency, as there is some research that suggests that such action could cause more harm than good. One should rather ask: Is it the strength of the rand that is the problem, or is it the cost structures in the South African economy? If it is the cost structures, one should consider addressing the factors that contribute to these costs rather than use the currency as a way of, arguably, promoting further inefficiencies.
If one looks at the factors that have been supportive of South African rand strength up to now, it appears as if the rand is likely to remain strong over the short-term—levels considered to be overvalued by a number of analysts. Firstly, the U.S. dollar is expected to remain under pressure given the huge current account deficit, as well as the worsening federal budget deficit. Secondly, although South African real rates are no longer rising, and may even start to fall in the not-too-distant future, their current levels should still provide some support for the currency over the short-term. Thirdly, overall global commodity prices seem to be losing steam, and considering that the South African currency can be viewed as a commodity-linked currency, it may find less support from this factor over the short-to-medium term. This said, the gold price, which found considerable support from the weakening dollar, may contribute to rand-strength for as long as U.S. dollar weakness persists. Fourth, the elimination of South Africa’s net open forward currency position (NOFP) may provide long-term support for the currency. Since the SARB is no longer forced to purchase foreign exchange in an attempt to eliminate the NOFP, the perceptions that the rand is a one-way bet have been eliminated. Add to this, generally positive investor perceptions toward the country and it becomes increasingly likely that the currency will find long-term support from these factors.
Given the aforementioned factors, what is our overall currency view? On balance, it appears that the currency is likely to remain stronger for a longer period of time, and there is a real possibility that the rand moves below the 6.00/U.S dollar over the short term. However, over the long-term, the fact that South Africa’s cost structure is higher than industrialized countries will come into play, leading to our belief that the currency will return to its long-term depreciating path.
