Rand Vulnerable to Depreciation due to Offshore Factors say Commerzbank

-Rand to driven mostly by offshore factors through rest of 2018.

-Domestic political and economic risks remain a threat to the Rand.

-USD/ZAR to rise 4% before year end while GBP/ZAR steadies.

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The South African Rand has seen its best days for 2018 and is now set to depreciate, according to analysts at Commerzbank, who flag a range of domestic and offshore factors likely to push the currency lower before the year is out.

This call comes hard on the heels of a strong start to the year that saw South Africa's Rand gain high single-digit percentage returns over developed world currencies such as the US Dollar and Pound Sterling.

However, a Federal Reserve set to continue raising interest rates in the US and elevated tensions over international trade and geopolitics all bode ill for the South African currency during the months ahead.

"The rand rally has been stopped for now; since the end of March the currency has devalued somewhat. In addition to the central bank's rate cut and its remark that the rand is slightly overvalued, global factors such as fears of a trade war or the Syrian conflict are the main reasons for this," says Elisabeth Andreae, an analyst at Commerzbank.

Moreover, since President Cyril Ramaphosa came to power in February, all of the low-hanging fruit has been picked in terms of economic and political reforms.

This means optimism over the Rand will soon run out of oxygen in the absence of further meaningful reforms, which are likely to require time to implement and take effect, leaving the currency at the mercy of conditions on global markets.

"Ramaphosa has started with a promise to revive the economy, restore political stability and fight corruption within the state – not easy tasks by any means. The cabinet reshuffle in late February, with two renowned former finance ministers taking key positions, highlights that a priority is to put in order and consolidate public finances as well as state-owned enterprises," says Andreae.

To date, President Ramaphosa has replaced the board of troubled state power utility Eskom, whose weak balance sheet and poor governance was a threat to the government's own financial position, and unveilled a budget that stops a rising deficit in its tracks over the coming years.

These reforms, combined with a cabinet shake up that routed many of the more controversial Zuma-era party grandees from office, enabled the country to cling to its investment grade soveriegn credit rating that had been threatened by a weakening fiscal position.

The cumulative effect of these events enabled the South African Reserve Bank to cut interest rates from their crisis-level of 6.75% while also supporting a continued recovery of the Rand. However, Andreae and the Commerzbank FX team have warned that this doesn't mean political risk is now off the table.

"This does not mean that political risk is off the table, as parliamentary elections are due in May 2019. Controversial issues such as the land expropriation without compensation show that the government has to walk the tightrope if it wants to win the majority of voters and at the same time the investors’ confidence," the analyst writes, in a recent note.

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. It is far frm clear how this situation will develop over coming months and what the long term economic and political consequences might be.

"While the recent improvement in business sentiment should continue to support investment, the tax hikes and spending cuts announced by the government should constrain growth. This is exacerbated by lingering political uncertainties, such as the planned land reform," says Andreae.

South African business confidence was boosted in the first quarter of the year as companies and consumers took heart from President Ramaphosa's ascent and the decision by Moody's to leave the country's investment grade credit rating intact.

Losing the rating would have forced many international investors to dump their South African government bonds, which would have raised the cost of borrowing, increased the deficit and put pressure on the Rand as capital fled the country.

However, the price of retaining the rating was a budget that raised VAT taxes and sought to reduce expenditures in all areas where it was politically viable to make cuts, which also means an automatic hit to demand, and so the economy, during the months ahead. This could be bad for the Rand.

"Besides possible global risk-off moves, we consider the Fed’s forthcoming rate hikes and a continuing correction of the USD weakness to be the biggest risks for the rand. Risks also remain on the domestic front," says Andreae, circling back to uncertainties around the land reforms.

The Federal Reserve is expected to raise interest rates a three times or more in 2018. This could help to reverse some of the US Dollar's weakness from the last 12 months, which would be bad for the South African Rand due to the negative correlation between emerging market currencies and those of the developed world.

Nevertheless, we consider the risk of a drastic rand devaluation to be limited. This is mainly based on our assumption that confidence in the SARB’s stabilityoriented monetary policy will remain intact. Should global risks worsen and the rand depreciate more sharply, the central bank will probably take countermeasures by raising interest rates," says Andreae.

Andreae and the Commerzbank FX team forecast the Rand will fall steadily toward the 12.50 level against the US Dollar before year end, which implies a 4% fall from the 11.98 that prevailed Tuesday.

For the Pound-to-Rand rate, they predict Sterling will actually cede a small amount of ground to the Rand so that the exchange rate finishes the year at 17.0. This would a fraction from the 17.13 that prevailed Tuesday.

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