S.A. Rand's 'Overvaluation' Predicted to Persist, "Reforms" Need Monitoring

- USD/ZAR to fall to 11.50 by December 2018 and 11.0 before end of 2019

- Overvaluation can persist for extended periods; no barrier to further gains 

- Reforms, including those on land expropriation, need close monitoring

© Natanael Ginting, Adobe Stock

The South African Rand continues to hand back its 2018 gains over the Pound and US Dollar during March, as recent good news has already been priced by the market and doubts over the new leadership are now beginning to emerge.

Nevertheless, foreign exchange strategists at UniCredit Bank, Italy's largest lender and a prominent European investment bank, say the South African currency is still likely to see new highs in 2018. 

UniCredit strategists wrote Thursday that South Africa's currency has reached overvalued levels in recent months but that this shouldn't prevent it from posting further gains during the month ahead. Few would argue with the former part given the Rand's meteoric rise over the last three months. 

South Africa's currency has risen by nearly 10% against the Dollar and 5% against the Pound over the last three months alone as markets cheered the election of now-President Cyril Ramaphosa to lead the African National Congress and his subsequent installation into the Mahlamba Ndlopfu following the resignation of Jacob Zuma. 

The Naational Prosecuting Authority said Friday it will prosecute former President Zuma on 16 charges relating to corruption.

"The cycle of overvaluation still appears to be at a relatively nascent stage compared to past episodes of overvaluation. These episodes have tended to be more persistent, lasting for at least another four quarters," says Kiran Kowshik, an emerging market FX strategist at UniCredit. 

"There is some tentative evidence that such cycles coincide with strong (or improving) global trade growth, as is the case at present. So, assuming that macro fundamentals in South Africa remain static, there is scope for overvaluation to persist."

USD/ZAR was quoted 0.36% higher at 11.93 during morning trading in London Friday while the Pound-to-Rand rate was quoted 0.56% higher at 16.67.

The market's excitement over Ramaphosa's election was the result of hopes he would set South Africa on a path toward more sustainable public finances, which is neccessary for the country to avoid a downgrade of its local currency sovereign credit rating that would be catastrophic for the Rand. 

"The budget has been delivered, including the first hike in value-added tax since 1993 showing some commitment to get the fiscal house in order. Market-friendly and credible staff have been appointed to key posts in the Ministry of Finance as well as the Minister for Public Enterprises," notes Kowshik.

Reforms to public spending and governance at state owned enterprises were both key to the positive Rand narrative and, as far as the budget and governance go, the Ramaphosa administration has made some key market-friendly reforms in its very early days. Most analysts now expect South Africa to avoid a downgrade when Moody's reviews its rating later in March.

However, changes to the cabinet have still left some of the old Zuma guard in key government positions, some of which have been implicated in corruption probes, while other measures taken by the government have proven a cause for outright concern.

This appears particularly apparent when considering South Africa's economic success story over coming years will be dependent, in large part, on its ability to draw in foreign investment.   

President Ramaphosa and the ANC passed a resolution in South Africa's parliament on February 28 that, in part, reads; "With the concurrence of the National Council of Provinces (NCOP) instruct the Constitutional Review Committee to review section 25 of the Constitution and other clauses where necessary to make it possible for the state to expropriate land in the public interest without compensation.”

The Expropriation Act was designed to placate the radical Economic Freedom Fighters grouping of the parliament but will require wholesale constitutional change that not only casts Ramaphosa's grip on power in a much weaker light, but also places a question mark directly over South Africa's commitment to private property rights.

"Developments related to the reform of state-owned enterprises, the mining charter and the land-expropriation act (among other things) will need to be monitored," Kowshik noted Thursday. 

The confiscation of property, in whatever form and under any guise, sends a clear signal to investors. Your investments in South Africa may not be safe. 

Coincidentally, the renewed and ongoing weakness of the Rand began on February 28, with the South African currency slipping 2.5% against both the Pound and US Dollar during the subsequent two and a half weeks to March 16. 

However, all of that said, for now UniCredit strategists say improving financials, economic momentum and only a modest overvaluation are grounds to think the Rand can regain the initiative and push higher during 2018 and 2019. 

"Taken together, we do not believe that valuation concerns will become a barrier to a continued appreciation of the rand. We remain comfortable with our existing USD-ZAR forecast for 11.50 and 11.00 by the end of 2018 and 2019 respectively," says Kowshik.

"The currency should remain well-supported, even after its recent stellar gains. Any dips ahead of Moody’s scheduled update of its ratings (23 March) will present buying opportunities (we assume Moody’s will hold off from lowering its ratings)."

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