Category Investments

On the local front

08 December 2004 Angelo Coppola

According to Shaun le Roux at Alphen Fund Managers, a weaker dollar has resulted in further gains by the rand…

While Mr Manuel would prefer a little less confidence in the currency, Messrs Mbeki and Mboweni have stressed that the level of the currency must be determined by the market and no level is being targeted.

That said the Reserve Bank has clearly stepped up the rate at which it is accumulating foreign reserves of late, a clear message that they see the currency as being on the overvalued side and that currency strength has moved inflation comfortably into the targeted 3% to 6% inflation band.

Had the Reserve Bank not been buying dollars, the rand could have gone a lot stronger!

Trying to forecast short-term movements in the currency is like trying to catch a furry toy with a claw at the amusement arcade, the hit rate is dismal.

What is of more value is to unpack the reasons for currency movements to try to get a feel for the medium term outcome given the various scenarios that could unfold.

There are several factors that have driven the rand stronger over the past three years.

These include:

* a very strong commodity cycle;

* a lack of yield worldwide has raised the attraction of local interest rates;

* a reversal of the panic by SA corporates and residents to externalise their assets;

* an increase in the global appetite for risk;

* the increased demand and strong performance by emerging markets as an asset class;

* the improving confidence around SA as an investment destination given the stability of government and sound fiscal regime;

* a booming local economy raises the attractiveness of SA equities;

* low inflation rates have given rise to lower interest rates raising the attractiveness of SA bonds;

* significant dollar weakness and support for currencies that benefit from dollar weakness (commodity currencies in particular).

What the above list should be telling you is that a number of factors have been running strongly in the rand's favour.

This has coincided with a marked deterioration in the trade balance and current account that have to date been financed by inflows of capital.

The problem lies in the fact that the bulk of the capital flows over the last few years have been short-term in nature and this leaves the currency vulnerable to a reversal in such flows in the event of rates going up or the currency losing ground.

The government's pro-growth stance, with R165 billion budgeted to be spent on infrastructure alone, as well as the improving economic situation bode well for the outlook as regards attracting foreign direct investment.

However, a strong (in my opinion overvalued) currency, decreases the appeal of investing in local operations that manufacture or export. That leaves the local players that are inwardly focussed and an investment here is an investment in a company that is already having a great time of it all and may run out of road to expand locally. The investment by Barclays in Absa would fall into this camp.

It is foolhardy to look only at the rand/dollar cross in assessing the performance by the rand, given the fact that the dollar has depreciated massively against a basket of currencies.

Rand/euro shows signs of the rand struggling to extend the gains of recent years and technically it looks like a topping formation. Remembering that some of our key exports, and precious metals, in particular, gain in dollar terms as the dollar weakens.

Currency gains can be offset by improvement in dollar commodity prices, meaning our terms of trade hold up and earnings pressure on resource companies stabilises. This implies a shift from rand strength to dollar weakness as the main theme and this is what we believe is currently unfolding.

The possible future scenarios are threefold.

In the first place, sustained rand strength on the back of capital inflows will nudge inflation to the lower end of its target range and will force further interest rate cuts.

This would add impetus to spending by local consumers and an increase in demand for credit could become a major concern remembering the outfall from the credit bubble of six years ago.

The second scenario would involve a gradual depreciation of the rand, though this would be limited to other currencies in the event of further dollar weakness, as global interest rates edge upwards and the momentum in the commodity cycle slows.

The correction would likely not be severe as protection would come in the form of the solid economic outlook.

In our view this is the most likely scenario. The third scenario sees a sharp downwards correction in the rand as capital flows reverse and a weakening rand sees foreign investors running for cover.

This could be attributed to a political or external event or a collapse in commodity prices and has risky implications for interest rates. The further the rand moves into an overvalued situation the greater the chance of a rand blow-off as the ultimate outcome.

What is clear is that currency movements will remain the key determinant of inflation levels, interest rates and investment returns.

Having taken so long to shrug off their bearish mindset as far as the rand is concerned, is it possible that South Africans are now getting overly bullish?

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