Currency depreciation highlights diversification benefits of offshore investment

With the rand sliding down the slippery slope of industrial action sweeping the country, the longer term prospects for the currency will have a major impact on decisions about whether to invest outside of South Africa, or not.

Francois van der Merwe, Head of Macro Research at Novare Investments, noted that industrial action had negatively impacted on sentiment towards South African assets with the result that the rand has been the worst performer amongst emerging market currencies over the last month, and the third worst performer over the past year.

“Other related factors impacting on the rand include sovereign ratings downgrades, the negative news flow from South Africa and the current account deficit that rose to 6.4% of gross domestic product in the second quarter, from 5.9% in the first quarter. The continuation, or reversal, of the rand’s declining trend will have a fundamental impact on offshore investment decisions,” said van der Merwe.

Looking back, he said that during the nineties, the rand was a one-way bet for domestic investors wanting to get offshore exposure. The currency depreciated from R2.50 to the US dollar at the start of that period to a record high of R13.84 against the greenback in December 2001.

Many investors, however, missed the early depreciation and only invested in offshore assets closer to the rand’s weakest point. They were subsequently hurt as the rand’s trajectory reversed and it appreciated in the following three years to as low as R5.60 in January 2005.

Although it has depreciated since then, the rand’s movement against the US dollar has been characterised by swings in either direction, complicating decisions on investing money offshore. This begs the question whether now is an appropriate time to allocate part of your portfolio offshore?

Said van der Merwe: “During times of risk aversion, the rand is often one of the worst performing currencies due to its healthy liquidity profile compared to other emerging market currencies. Investors first withdraw assets from South Africa before other emerging markets.

“Against that background, risks are currently still stacked against the global economy, given fears of a hard landing for China, the looming US fiscal cliff, and the ongoing European crisis. A continued flight to safety would cause the rand to keep depreciating, which would contribute positively to offshore investment returns.”

Over the longer term, growing imbalances within the local economy will also put the rand under pressure. South Africa’s terms of trade ratio has been deteriorating with a resultant widening in the current account deficit.

A country’s terms of trade is the ratio between the prices of its exports and the prices of imports. South Africa’s export prices have been weakening due to declining commodity prices and dwindling commodity export volumes. Mining-related exports make up two-thirds of South Africa’s total exports. In contrast, imports have been growing at a faster pace than exports on the back of a consumption-led economic recovery over the last few years.

This situation is not expected to turn around in the near future given the Reserve Bank’s recent interest rate cut and expectations of further rate cuts that will fuel spending and discourage savings.

The current account deficit for the first quarter of this year was the widest it has been in the last three years. Thus far, foreign portfolio flows into the country have financed the current account deficit, but a reversal of this trend could see a sharp depreciation in the rand.

“It is already a concern that the domestic bond market received record amounts of foreign purchases since June, yet the rand has weakened. Bond purchases have been supported by news that South African bonds have been included in the key Citi World Government Bond Index, providing a boost in interest.

“Part of the diversification benefits of an offshore portfolio allocation is that deterioration in global risk appetite is likely to result in currency depreciation. In addition, growing imbalances in the domestic economy could result in additional rand weakness. Investors should, however, make sure that the offshore assets they invest in, match their risk and return profile,” said van der Merwe.