The rand’s fair value
The rand’s fair value on a purchasing power parity basis is around R15.70 to the US dollar, with the continued inflation differential between the two countries resulting in the local currency consistently weakening versus the greenback.
This is feedback from Old Mutual Wealth investment strategist Izak Odendaal, who explained that analysing a currency’s fair value is more art than science.
Since the formation of the Government of National Unity (GNU) in early June, the rand has strengthened significantly against the dollar.
This rally has been halted in recent weeks due to increased geopolitical tension, which has pushed investors to the relative safety of the dollar and US-based investments.
However, some have questioned whether the rand has approached its fair value range and has pulled back after over-strengthening versus the dollar.
Odendaal said that while the rand is significantly stronger than the R20/$ that it was in May last year, it is still far off its fair value.
He also pointed out that the road has been as strong as R11.57 against the dollar in 2018, less than a decade ago.
One way to calculate a currency’s fair value is using purchasing power parity (PPP). This method assumes that the exchange rate will reflect inflation differences between the two countries over time.
Since higher inflation will erode one country’s competitiveness relative to the other, its currency will fall to adjust for this. A PPP estimate suggests a fair value range of around R15.70.
Another way to think about it is simply that the rand was battered by several storms in recent years.
Most notably, the US dollar has been globally strong, up 25% on a trade-weighted basis over ten years.
Commodity prices, particularly platinum and palladium, have been relatively weak, and thus, South Africa has lost out on valuable foreign exchange earnings.
Emerging markets have also generally fallen out of favour with global investors. South Africa has done little to convince them otherwise through load-shedding, logistics crises, and policy and political uncertainty.
Some of these headwinds are now easing, and some are turning into tailwinds, Odendaal said.
The graph below, courtesy of Odendaal, shows the rand-dollar exchange rate in comparison to its fair value calculated according to PPP.
Old Mutual’s chief economist, Johann Els, takes a different approach than Odendaal, focusing on inflation differentials rather than relying on purchasing power parity theory.
Specifically, Els calculates the fair value of the rand by comparing producer price inflation in the US and South Africa.
He explains that this method is based on the idea that the rand will adjust to ensure South African exports remain competitively priced in US dollars.
As inflation in South Africa exceeds that of the US, the rand should depreciate by the difference to maintain this competitiveness.
“My fair value, at the moment, is R11.90/$. I do not think it will go back to R11.90 in this cycle, but that is my fair value calculation,” Els told Daily Investor.
Els noted that the rand is a volatile currency, often fluctuating between being undervalued and overvalued due to its use as a proxy for investor sentiment toward emerging markets, as well as its exposure to global forces. Despite these swings, a currency should eventually return to its fair value—the only question is when.
“This cycle is similar to what was seen in 2020 to 2021. During the Covid-19 lockdown, the rand hit R19/$. 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 large gains against the dollar are typically driven by global factors, particularly the US interest rate cycle and the performance of the Chinese economy. While both seem to be supporting the rand, Els doesn’t expect these factors alone to push the currency 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.”
“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.
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