South African Rand: Still below Fair-Value, Should Rise in 2017

The South African Rand is looking poised for further gains in 2017 as the latest analysis from one of the world's largest foreign exchange dealers confirms the currency is undervalued and should catch up to its fair value.

Analysts at Deutsche Bank’s argues that after being one of the most vulnerable emerging market currencies to external shocks - such as higher interest rates in the United States - the Rand has become more resilient.

According to analyst Gautam Kalani, the factors contributing to this performance include, “an improving trade balance, some reduction in political uncertainty, avoidance of a ratings downgrade in December and most importantly a pick-up in activity”.

“The recent data suggest that we could be at the start of an economic turnaround. As such we expect this resilience to continue and remain bullish on ZAR,” says Kalani.

One signal that something is afoot is rebelliousness of the Rand in the face of US Dollar appreciation since the election of Donald Trump.

Unlike most other emerging market currencies which have declined sharply versus the Dollar the Rand has remained relatively strong.

Yields are a major driver of currencies, with higher yields indicating the likelihood of higher interest rates in the future and therefore a stronger currency.

Following the election of Donald Trump, US yields rose markedly versus EM yields (also referred to as Beeta’s or Ex ante Beeta’s by Kalani) and this was a major driver for USD appreciation, in the case of the USD/Rand however, the relationship broke down.

“While the betas would have implied a large ZAR sell-off, the currency has held up well since the election (slightly outperforming vs. USD),” said Kalani.

Economic Upturn

Dr. Kalani’s thesis rests on the emergence of an economic recovery in the country.

Leading indicators for the South African economy turned positive in mid-2016 and pointed to a “turn in the business cycle” in early 2017.

Coincident Indicators – those which lag or come out ‘coincidentally’ with economy activity, and include Vehicle Sales and Retail Sales - have also now improved.

Manufacturing PMI is back in expansionary territory, which is above 50, and the detail showing that New Orders are now higher than inventories, revealing greater demand.

Data also shows an increase in “Inventory Restocking”, as well as a recovery in the Trade Balance to almost zero.

Kalani dismisses a common argument that the recovery in ZAR is mainly due to the rise in industrial metal prices of which the country is a large exporter.

The 17% rise in industrial metals in the second half of 2016 was offset by a decline in the value of precious metals which are an even bigger export for South Africa.

Also, Oil, of which South Africa is a net importer, rose during that time, further offsetting the contribution to the trade balance by the rise in industrial metals.

The small trade surplus which was thus generated from industrial metals was insufficient to account for the 20% rise in ZAR (in a trade-weighted basis) during that period.

Nevertheless, Kalani also states that according to one of their model's called the DBeer model, ZAR is still 8% below its estimated fair value based on the trade balance, which could suggest a disproportionate effect and could explain the outsized gains in 2H.

“While ZAR has appreciated over the past 6 months, it still remains 8% undervalued on our fundamental DBeer model, which accounts for terms of trade (in addition to productivity and inflation) – in other words, ZAR has room for ‘catch up’ appreciation even at current terms of trade levels,” said Kalani.