Rand’s fair value is between R8 and R12 to the US dollar

The rand has strengthened remarkably over the past few weeks, extending gains versus the dollar since South Africa’s national elections at the end of May. 

This has led some to think the currency is finally trading at its fair value against the dollar. However, economists disagree and calculate its fair value to be much stronger, towards R8 to R12 per dollar. 

While many have attributed the rand’s recent gains to optimism surrounding the Government of National Unity (GNU), international factors have a far larger impact on a currency’s value. 

In particular, interest rates in the US and the performance of the Chinese economy dictate the value of the rand more than local politics. 

“The rand is beginning to unwind its depreciation experienced under the US interest rate hike cycle, with the domestic currency running below R15.00/USD before the US started hiking interest rates in early 2022,” Investec chief economist Annabel Bishop said. 

Crucially, the US Federal Reserve aggressively entered its interest rate-cutting cycle last month with a 50 basis point cut. Typically, when the Fed cuts rates, the dollar weakens. 

A day after the Fed cut rates, the Reserve Bank followed with a 25 basis points cut. This widens the interest rate differential between the two countries. 

As a result, South African fixed-income assets are now relatively more attractive than their US counterparts as they offer a higher risk-adjusted rate of return. 

This differential will likely widen further as the US cuts again in November and December, while South Africa’s MPC has only one meeting left in November.

Bishop expects the differential to be another 25 basis points wider by the end of 2024, supporting the rand versus the dollar. 

Chinese stimulus has also boosted the rand in recent weeks as it is expected to drive increased demand for South Africa’s commodity exports, bolstering foreign exchange earnings. 

More supportive stimulus measures are expected to follow from China, while in US markets, the implied Fed funds futures are currently pricing in about a 40% chance of another -50bp cut. 

In South Africa, improving economic activity has also positively affected the domestic currency, along with reduced political risk after forming a centrist government and increased foreign appetite for local assets. 

The substantial movement in the rand since the US interest rate cut this month has brought it towards R17.70/USD more quickly than a -25bp cut would have done. 

Bishop said the last quarter is therefore likely to be significantly stronger for the rand, averaging around R17.20/$. 

The rand’s fair value

The rand’s rapid strengthening versus the dollar and then halting its progress at just above the R17/$ level has led some to question whether it has overextended and strengthened below its fair value, with a pullback on the horizon. 

However, economists revealed that their fair value calculations showed that the rand should be trading at R8 to R12 to the dollar. 

The fair value of a currency can be calculated in various ways. The most common method is purchasing power parity (PPP).

The Big Mac Index is an example of such a calculation, which shows the rand should be trading at R9.12/$ on a PPP basis. 

Renowned economist Dawie Roodt does a similar calculation using a basket of goods and reaches a similar fair value of around R8 to R9 to the dollar. 

“But, if you look over time, the rand is always undervalued based on PPP. The extent of the undervaluation differs over time, but it hovers around 50%,” Roodt explained to Daily Investor. 

This means the rand is currently trading within its historical range based on PPP at between R16 and R18 to the dollar. 

“I have noticed recently that the historic 50% undervalued rule has been breached. Over the past few years, the rand has traded worse than 50% undervalued to the dollar to reflect South Africa’s high risk premium.” 

Roodt warned that this could mean the rand, at current levels, is overstrengthening and could pull back. 

The reason for the consistent undervaluation of the rand is due to South Africa’s elevated risk premium as its economy has stagnated, government debt has skyrocketed and increase policy uncertainty. 

“As far as I am concerned, the single biggest risk affecting the currency’s value in the short term is sentiment. That is why you see it strengthening recently, but its long-term trajectory is determined by economic performance.”

Unlike Roodt, Old Mutual’s Johann Els used inflation differentials to calculate the fair value of the rand, in particular, the difference between producer price inflation in South Africa versus in the US. 

Els uses this method as the rand will naturally adjust to ensure South African exports are priced competitively around the world in US dollars.

Thus, as local inflation is higher than in the US, the rand should depreciate by the difference to make the exports competitive. 

“My fair value, at the moment, is R11.90/$. I do not think it will go back to R11.90 in this cycle, but that is my fair value calculation,” Els told Daily Investor. 

He said the rand tends to swing between being undervalued and overvalued as it is a relatively volatile currency used as a proxy for investor sentiment towards emerging markets and is buffetted by global forces. 

A currency should always return to its fair value. The only question is when that will happen. 

“This cycle is similar to what was seen in 2020 to 2021. During the Covid-19 lockdown, the rand hit R19/$. It then went from R19/$ in April 2020 to R13.50/$ in June 2021,” Els said. 

“People do not think the rand can trend like that, and it has in the past when the climate was right.” 

Such an extensive gain versus the dollar is often driven by global factors, in particular, the US interest rate cycle and the Chinese economy. 

While these two forces appear to be positively impacting the value of the rand, Els does not think they will be enough to bring the currency down to R11.90/$. 

“So, this time around, I also think the rand can come back quite substantially because of lower US interest rates combined with increased risk appetite from investors. All of that will benefit the rand.” 

However, the only way it can reach R11.90/$ is if the local economy shows sustained growth and the government can begin chipping away at its debt pile. 

“I think the rand can strengthen substantially over the next three to six months and, with economic growth, can become more stable in the medium term,” Els said.