Real value of the rand 

The rand should be trading much stronger than it is, with its real value closer to R15/$. However, South Africa’s poor economic performance and deteriorating government finances have resulted in investors undervaluing the currency. 

This is feedback from Old Mutual’s chief economist, Johann Els, who said South Africa suffers from a confidence crisis, with investors and companies hesitant to invest in the local economy. 

Els explained that the rand’s value in comparison to the US dollar can be seen as a proxy for investors’ attitudes toward South Africa. 

And so, while the rand has strengthed post-election, its consistent depreciation over the past two decades reflects that investors are losing confidence in the local economy.

The local currency has always been volatile, acting as a proxy for investor sentiment towards emerging markets and commodities more generally. 

This results in extreme swings in value depending on economic data from South Africa’s major exports and, most importantly, investors’ risk appetite. 

These impacts, however, tend to be short-term as the rand consistently returns to its trend of losing value relative to the dollar.

Els estimated that the rand loses around 5.5% of value annually to the US dollar, significantly increasing the cost of importing goods into South Africa and reducing the global purchasing power of local consumers. 

This trend is driven by economic fundamentals, particularly GDP growth and the state of government finances. 

As these have deteriorated over the past two decades, the rand has weakened to the point where it is now undervalued.

This undervaluation occurs as investors lose confidence in the local economy and government to boost economic activity and improve business conditions. 

According to Old Mutual’s calculations, the rand should be trading far closer to R15 to the dollar based on purchasing power parity. 

The actual value of the rand compared to the implied value of the currency on a purchasing power parity basis is shown in the graph below. 

The Bureau for Economic Research (BER) outlined the rand’s consistent decline in value versus the dollar since 1994 as part of its 30-year macroeconomic review of South Africa. 

It explained that the currency’s weakening was driven by South Africa’s relatively high inflation rate compared to its peers and, in particular, the US. 

Over the long term, this requires a degree of currency depreciation to ensure the country’s exports remain competitive in the global marketplace.

As inflation raises the cost of producing exports, they become less attractive than cheap alternatives. To counteract this, a currency is deliberately weakened to make the country’s exports relatively cheaper on the global marketplace.

The BER also flagged South Africa’s current account deficit – the country imports more than it exports – as another major reason for the rand weakness.

Consistently running a current account deficit results in money flowing out of the country and less demand for the local currency, which in turn weakens it.

A major driver of this has been the declining output from South Africa’s mining sector, which is traditionally the country’s biggest exporter.

A weaker rand compounds this problem by increasing the cost of imports, causing inflation, and eroding South Africa’s export competitiveness.

Efficient Group’s chief economist, Dawie Roodt, and his team have created a barometer to depict how the rand’s value represents investors’ perceptions of South Africa.

“This barometer or graph shows us whether the rand’s exchange rate is accurate,” said Roodt.

When the rand is marked as ‘expensive’ on the barometer, it indicates that the market undervalues it, whereas if it is marked as ‘cheap,’ the market overvalues it.

A currency is expected to stay around its ‘fair’ value range and eventually return to it.

However, influences like geopolitical tensions, weak economic performance, improper fiscal policies, and inflation can keep a currency outside this range for long periods.

“The current pricing of the rand at about R18.50 to the US dollar shows it is very expensive, meaning it is significantly undervalued,” he noted.

Roodt’s calculations suggest that the rand should trade at a rate better than R17 to the US dollar.

“The rand’s current value signals that foreign investors are increasingly worried about South Africa,” he said.

Previously, Roodt estimated the rand’s fair value at around R16.50 to the US dollar by using Purchasing Power Parity (PPP) and factoring in the currency’s historical undervaluation.

To estimate the fair value of the rand, Roodt utilizes a basket of goods to measure its purchasing power, similar to The Economist’s Big Mac Index.

He then incorporates the historical average undervaluation of the rand against the dollar with its PPP to find the rand’s fair value.

Currencies rarely trade exactly at their fair value. The rand often trades below its fair value, so its undervaluation must be included to get an accurate fair value.

Typically, the rand trades about 50% weaker than its fair value.