Mystery of the stronger rand

THE South African rand is rallying in the midst of a grave political crisis, confounding many of the experts who expected a disaster after Pravin Gordhan's axing.

What is happening in Wonderland?

After then finance minister Nhlanhla Nene was axed in December 2015, the rand weakened dramatically. This time around, however, despite the even worse news of Pravin Gordhan's axing and SA's downgrade to junk status, the rand has proved remarkably resilient.

How do we square this? Are the markets getting so used to bad news coming out of SA that they have stopped reacting to it? Or is there some other factor at play?

Before President Jacob Zuma's cabinet reshuffle on March 30 the rand was trading at R12,40 against the US dollar.

In the following two weeks it weakened by roughly R1,50 against the dollar. But at the time of writing, it had reversed almost one-third of its losses, firming by USc50 to trade at R13,40 against the greenback.

What is evident is that the local news flow - dominated by mass protests against Zuma and a growing clamour for his resignation - certainly doesn't justify the biggest rand rally in six months.

"Total rand losses of a mere R1 seem remarkably limited given all that has happened," says Rand Merchant Bank currency strategist John Cairns.

Dollar weakness and better Chinese trade data appear to have triggered the latest rand gains, but far more interesting is the currency's longer-term outlook.

Surprisingly, given how much South Africa's prospects have darkened, Cairns has not downgraded his rand forecast of R13 per dollar for the year-end. Of course, the situation remains in flux and RMB could still change its rand forecast. But for now, Cairns says there are two positive factors RMB believes might offset the negatives.

First is the significant narrowing of South Africa's current account deficit.

This has been caused mainly by slowing imports due to falling domestic demand and firmer exports following the recovery in commodity prices.

RMB expects the deficit to average 2,8 percent this year compared with an average of 3,3 percent in 2016 and 4,4 percent in 2015. This will take significant pressure off the rand.

Second, a more positive growth outlook in advanced economies has contributed to a more favourable environment for emerging markets and commodity currencies as a whole. As a result, foreign capital inflows into South Africa's bond market have held up remarkably well.

The favourable external backdrop helps to explain why the market reaction to South Africa's recent downgrades has been more benign than experienced by other countries when they lost their investment-grade status.

"We continue to feel that the external backdrop is restricting far bigger losses on our local markets," says Cairns.

"It seems a rising tide lifts even half-submerged boats."

Efficient Group chief economist Dawie Roodt is also sticking to his year-end rand forecast of R13 per US dollar.

Both Roodt and Cairns are assuming that Zuma will stay on as president this year and that there will be no further dramatic political negatives or further downgrades to South Africa's local currency rating.

Like Cairns, Roodt made this forecast many months before Zuma reshuffled his cabinet and caused many to wonder if South Africa's democratic project had permanently run aground. So the fact that he hasn't lowered his forecast also bears scrutiny. Roodt has a remarkably successful track record in correctly predicting the rand, having won the 2016 Sake24 economist of the year award for the accuracy of his forecasting against that of more than 30 other economists. His forecast that the currency would average R13 per dollar in the final quarter of 2015 was the closest to the actual figure of R13,09.

Roodt looks set to be closest to the pin again this year, with a forecast of R14 against the dollar for the final quarter of 2016 compared with the actual figure of R13,91. In January 2016, when he made this forecast, the rand rose to a new record high of almost R18 per dollar during intraday trading as the markets battled to digest the axing of Nene.

"Everyone said I was crazy," chuckles Roodt.

"Some said the rand would be R20 per dollar by the year-end."

He bases his rand forecasts on the observation that on a 35-year view (1980-2015), the rand has on average been roughly 50 percent undervalued against the US dollar on a purchasing power parity basis.

The easiest way to understand the theory of PPP is to use The Economist's Big Mac index. It was invented as a light-hearted tool to make it easier to compare the misalignment of exchange rates between countries. It was never intended as a precise gauge, explains the magazine, but rather a fun way of explaining PPP.

In January 2017, the price of a Big Mac burger in the US was USS$5,06. In South Africa it was R26,32. At the prevailing exchange rate of R13,95 per dollar at the time, a Big Mac in South Africa cost only US$1,89.

So according to the "raw" Big Mac index, the rand was undervalued by almost 63 percent against the US dollar on a PPP basis. This made the rand the fourth-most undervalued currency against the US dollar among 44 countries surveyed, after Malaysia (64,6 percent undervalued), the Ukraine (-69,5 percent) and Egypt (-71,1 percent).

Roodt bases his study of PPP not just on the Big Mac, but on a more representative basket of goods published as a series by Oxford Economics, one of the world's largest data providers. By this yardstick, the rand at R13 against the dollar would be 54 percent undervalued, making Roodt fairly confident the currency will move back towards this level over time.