The rand is being bashed again, but unlike at the end of May — when it weakened within a whisker of R20/$ on acute load-shedding, persistent inflation and South Africa’s diplomatic fallout with the US — this time it’s hostage to concerns about global growth.
Markets have been perplexed by the currency’s rapid change in direction. It strengthened to about R18.70/$ after the failure of the US Federal Reserve to hike rates at its September federal open market committee meeting, but by midweek had slid to R19.27/$, before recovering to R18.90/$ in the past few days.
The expectation was that as soon as the Fed reached the end of its hiking cycle, the dollar would weaken, allowing the rand to recover as foreign investors piled back into emerging market assets. However, though initially cheered by the Fed’s failure to hike, financial markets have subsequently started to worry about the underlying message from all major global central banks that interest rates are likely to remain higher for longer.
This has pushed out the prospect of rate cuts deeper into 2024 or even 2025.
South African Reserve Bank governor Lesetja Kganyago sang from the same hymn book as other central banks at the monetary policy committee meeting last week, noting that while the Bank is holding rates steady for now, “the job of tackling inflation is not yet done”.
The fear is that, if overdone, central banks’ hawkishness could torpedo global growth. At the same time, concern over China’s collapsing property market has resurfaced on the news that the country’s distressed property developer, Evergrande, has missed a $547m debt payment.
The slowdown in the Chinese economy is suppressing commodity prices and dampening the global and South African growth outlook. All this has increased global risk aversion, benefiting the dollar.
“The combination of a strong dollar and weak demand out of China is a toxic mix for commodity prices and currencies,” says Absa currency strategist Mike Keenan, “and at the moment the rand is tracking fellow commodity currencies very closely.”
HSBC currency strategists Murat Toprak and Charlotte Ong expect global forces to continue to exert downward pressure on the rand going into 2024.
“While the US economy displays some resilience to higher rates, eurozone cyclical indicators have gone from strength to weakness and China continues to face growth and balance-sheet problems,” they argue in a research note. “Such a panorama does not bode well for the rand, which is one of the most sensitive currencies to global growth dynamics.”
In addition, HSBC expects the rand to be undermined by a worsening of South Africa’s domestic fundamentals. Only, unlike the first half of the year, when the currency was driven mainly by domestic growth fears due to acute electricity shortages and higher interest rates, HSBC now expects structural factors to take over.
Specifically, HSBC believes that a further deterioration in South Africa’s current account deficit (because of softer commodity prices and faltering export growth), combined with rising fiscal risks ahead of the 2024 election, could cause the country’s twin-deficit problem to become the dominant driver of the rand.
These forces are likely to push the unit back to R19.5/$ by the year-end, HSBC forecasts, and could even propel the rand to a record high of R20.5/$ next year. (In real terms, its worst level in previous blowouts was the equivalent of about R21/$ now.)
The rand could spike to R22/$ next year or it could recover to R16/$ — it does not need to be weakness all the way
— What it means:
HSBC is not alone in noting the potential for another rand blowout. RMB strategist John Cairns thinks a spike to R22/$ is possible if there is a US recession in the coming year, particularly if it is combined with financial stress.
“The rand always has the ability to weaken very sharply and very far,” he adds. “While it is already very weak, remember that, historically, US recessions have caused extreme rand weakness.”
However, this is not RMB’s core view. In fact, it expects the rand to end this year at R18.50/$ on the basis that it is much weaker than its fair value and must eventually recover some lost ground. But RMB assumes a proper rand recovery will occur only once South Africa’s fundamentals start to improve, potentially in 2024 and 2025. By the end of 2025, it has the currency trading back at about the R17/$ level, in line with its estimated long-term fair value.
So, is there a plausible scenario under which the rand could pull all the way back to R16/$ over the coming year, or is it going to be a slam dunk with weakness all the way?
Though South Africans have quickly become used to extreme rand weakness, a recovery to R16/$ is, in fact, “quite plausible”, according to Cairns. He points out that the average recovery after previous blowouts in 2001, 2008, 2016 and 2020 was about 35%.
One of Absa’s valuation models puts the rand’s fair value at R16.75/$ based on South Africa’s prevailing GDP growth and yield differentials with the US, implying that the prevailing spot rate is offering investors a substantial risk premium. (With the repo rate at 8.25% against inflation of 4.8%, South Africa is one of the few emerging market countries offering positive real rates at present.)
Even so, given South Africa’s very poor economic fundamentals, and the time it will take to fix things such as the electricity and logistics crises, Keenan doesn’t expect the rand to recover to more than about R18/$ by the end of the year.
Still, this is a relatively constructive view, considering that the medium-term budget policy statement (MTBPS) due on November 1 is expected to be an absolute shocker.
The combination of a strong dollar and weak demand out of China is a toxic mix for commodity prices and currencies
— Mike Keenan
Keenan takes heart from the fact that the tone of the Bank’s September monetary policy committee statement remained hawkish. He also notes that the significant risk premium investors were demanding to hold in rands relative to peer currencies in the first half of the year has narrowed.
Moreover, the fact that the rand is still trading at a significant premium to its fair value suggests that foreign bond investors are already pricing in South Africa’s challenging fundamental backdrop, including a significant deterioration in the fiscal metrics this year.
“Call me an eternal bull, but there’s a lot of bad news already priced into the rand, including big fiscal deficits and a widening current account deficit,” says Keenan. “Everyone is expecting the MTBPS to be very negative, but investors are being handsomely compensated for South Africa’s challenging fundamental backdrop.”
Also on the upside, Absa expects load-shedding to become less acute as South Africa moves into the summer months and some of Kusile’s power station units that are under repair come back online.
The recent confirmation that South Africa will still host the African Growth & Opportunity Act forum in November should also help to reduce some of the geopolitical premium that was priced into the rand in the wake of the Lady R allegations during the second quarter.
But to pull back all the way to R16/$ would, Keenan thinks, require a really big catalyst — like the Fed quelling the idea of any further rate hikes and engineering a soft landing for the US economy, or China announcing a fresh economic stimulus package.
Neither is far-fetched.
“Were China’s data to get worse it would have to provide stimulus, and the same applies to the Fed. If the data gets too weak too quickly, they’ll take their foot off the brake,” says Keenan. “Both countries’ ability to pull levers mustn’t be discounted, and South Africa is likely to benefit from that.”
But even if the worst were to happen — our fundamentals weaken further, the US enters a recession and China’s growth outlook deteriorates — Keenan still doesn’t see the rand weakening much beyond R19.50/$. That is because, at this point, local asset managers are likely to have to reduce their offshore exposure levels to stay within prudential limits. This would strengthen the currency.
Specifically, regulation 28 of the Pension Funds Act prohibits domestic asset managers from investing more than 45% of their assets under management offshore. The unit trust industry has about 34% of its holdings offshore at present. But when the rand weakens, the industry’s offshore component increases proportionately because these shares are worth more when translated back into the South African currency.
Absa estimates that at about R19.50/$, the unit trust industry would be within 5% of its upper limit, forcing a lot of players to reduce their offshore exposure.
This is what appears to have happened at the end of May, when the rand rose rapidly to R19.98/$ but then quickly pulled back to closer to R18/$ in just a few weeks.
“Granted, load-shedding subsided a bit and South Africa posted a good current account figure, but the speed of the pullback told me it was more of a regulatory-driven recovery,” says Keenan.
This doesn’t mean the rand couldn’t spike up to R20/$, or even run further next year on some bad headline news, but it does make it unlikely that it would stay there for long.
Would you like to comment on this article?
Sign up (it's quick and free) or sign in now.
Please read our Comment Policy before commenting.