Have you stopped to wonder why the rand is so strong?

Gareth Stokes, FAnews Online Editor

Every investment guru you speak to will tell you the rand is going to trend softer against the US dollar over time. And over time they usually prove right. Right now the rand is unusually strong. I decided to find out why. The first observation I’d like t

As soon as we look at wider periods – five or 10 years for example – the long-term declining trend becomes more pronounced. Draw a line from the 1980s to today and the rand devalues at around 10% per annum – from R2.50/$ in 1990, to R3.50/$ in 1995 and R6.30/$ in 2006. (I chose to ignore the ridiculous plunges in rand value witnessed in December 2001 and October 2008). The point I’m trying to make is the rand can strengthen against the US dollar for periods as long as three years without breaking the long-term declining trend. And we’re in one of these ‘rand strength’ periods right now. Since July 2009 the rand has bounced between support at R7.90/$ and resistance at R7.30/$, with enough macroeconomic support to keep the short-term trend in place for some time yet.

Massive foreign inflows underpin our currency

What’s behind these brief periods of rand strength? I found a simple answer in my first year economic textbook. Prices – whether they relate to goods, services, equities, commodities (hard or soft) or currencies – hinge on the outcome of the supply versus demand battle. What this means is the rand will find an acceptable level based on the total demand (value of ‘rand’ market participants want to buy) and supply (value of ‘rand’ market participants want to sell). Reserve Bank interference aside, the bulk of this rand / dollar currency exchange is due to importers, exporters and foreign investors. The latest bout of rand strength is attributed to the latter.

Money has been streaming into South African bonds and equities this year. Anyone still disputing the impact of the 2010 FIFA World Cup ™ on the domestic economy need only look at recent capital inflows to the country. During the week of the World Cup final weekly foreign net inflow surpassed the peaks achieved in April 2008 and October 2009 respectively. “Foreign investors were net buyers of South African bonds worth R11bn and South African equities worth R2.7bn for the week ending 16 July 2010,” says Dr Prieur du Plessis, Plexus group chairman. “To put these figures into perspective, bonds have seen a net inflow from foreigners just short of R50bn and equities just under R21bn year to date.”

There are a number of theories as to why so much capital is flowing into the country. Du Plessis says it could be due to expectations of another interest rate cut. Remember – bond prices have an inverse relationship with interest rates – when interest rates fall bond prices rise. Developed market fund managers might be betting on one ‘last gasp’ rate cut to keep South Africa’s economy firing. The Monetary Policy Committee may have decided to leave interest rates unchanged on 22 July 2010, but given the latest inflation numbers, could certainly surprise the market in September. So don’t expect a capital outflow any time soon.

Emerging market versus developed world

Peter Brooke, head of Macro Strategy Investments at Old Mutual Investment Group SA reckons the strong rand is a consequence of a low-return world. “Today’s major global economic and financial trends all point to significantly lower returns across asset classes, possibly over the next decade,” observes Brookes. Investors from developed countries are replacing the appalling yields on US Treasuries with the attractive yields on offer in South African government bonds. Some circles say international fund managers are finally prepared to ‘back’ emerging economies like South Africa, even keeping a portion of their income portfolios permanently invested in the domestic bond market. If this happens we will see a significant reduction in rand volatility.

A great way to ‘predict’ the rand is to closely monitor foreign fund flows. “A Plexus study of the monthly correlations between foreign transactions and the FTSE/JSE All Share Index, the BESA All Bond Index and the rand/US dollar exchange rate since January 1999 shows they are all positive,” observes Du Plessis. The more money foreign investors plunge into our bond and equity markets, the stronger the rand becomes.

A strong currency is a double-edged sword. It makes imports cheaper and would certainly reduce the billion rand price tag on Eskom’s proposed electrical infrastructure upgrades. But it makes life difficult for exporters who struggle to remain price competitive in developed markets. The ‘cash is trash’ tag is firmly in place in the US, UK, Europe and Japan. For as long as low returns dominate developed world economies, fund managers are going to shift to riskier asset classes and different geographies in search of yield. They’re finding this yield in South Africa’s bond market right now. And if they have an appetite for risk they’ll love Du Plessis’ final prediction: “While some caution is still warranted in the next month or two, equities, and especially emerging-market equities, remain Plexus’ preferred asset class in the longer term!”

Editor’s thoughts: The rand has a nasty habit of collapsing on us. I was in the UK when it fell close to R14/dollar in December 2001. Back then I though the end was nigh – but the rand recovered nicely. Nowadays the debate centres on whether the rand is too strong. Trade unions say at current levels it’s impacting on the economy’s ability to create jobs – and exporters say they’ll never produce competitively at current levels. Are you in favour of government intervention to weaken or strengthen the level of the rand against foreign currencies? Add your comment below, or send them to gareth@fanews.co.za