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Rand Overvaluation & Undervaluation
From FNB - Dr. Cees Bruggemans
10 October 2006
It took only five short months since May to go from a 15%-20% Rand overvaluation to a similar undervaluation.
If fair Rand value is 7.00:$, bolstered by productivity improvements of recent years, the Rand's 5.80-6.20:$ trading area of early this year has been swapped for a 7.80-8.20:$ trading post today.
One can argue 7:$ hasn't been fair value for a long time, with the CAD (current account deficit) deteriorating within three years from nil to 6% of GDP.
To maintain balance on the current account, domestic demand shouldn't be growing much faster than potential output, savings should be roughly in line with investments and potential producers in export sectors need to be pulling their weight.
Manufacturing hasn't been doing so on account of the Rand (and domestic-related issues, such as regulatory burdens, labour cost and productivity). More seriously, mining went missing in action, apparently mostly on account of regulatory issues and infrastructure bottlenecks.
If mining had been able to respond more vigorously to the global commodity boom of recent years (instead of cutting its real fixed investment expenditure by 35% these past three years), a much stronger export performance could have prevailed, and Rand breakeven would after all have been nearer 7:$.
But that's academic. Mining has mostly been AWOL, matter of factly. Such handicapping isn't in our interest, but it has been a reality and may remain so until evidence to the contrary surfaces.
It suggests a weaker Rand breakeven, possibly nearer 8:$. It also suggests modestly higher inflation and interest rates and reduced household consumption and import growth, closer to potential output.
Thus the move from 5.60-6.00:$ towards 8:$ (a 30%-40% shift) gives a much clearer sense of the unsustainable overvaluation of recent years.
What ended the overvaluation?
The proximate cause was the May global wake-up call that the Fed meant business, with risk needing more realistic repricing. Also, there was the June revelation that our CAD had jumped the fence to 6% of GDP.
Between them these two factors turned the global mindset. That was the ultimate cause of the Rand's rapid repricing. Foreign banks changed their trading positions, with the Rand losing support. Global portfolio managers became more cautious after their headlong inward rush of recent years (also bolstered by a few mega corporate deals). And local companies presumably followed suit, as is their traditional wont, with their foreign trade leads-and-lags reversing direction, now weighing on the Rand rather than supporting it.
Two interest rate hikes of 0.5% weren't enough to turn this tide, and weren't intended as such.
Instead, policy tightening was aimed at containing inflation expectations, in case future expectations might want to move outside the 3%-6% target zone, setting in motion unwanted second-round pricing accelerations, also in the labour market.
Importantly, the interest rate tightening was also aiming to neutralize the stimulatory boost imparted by the weakening Rand to the economy.
With the Rand having so far put 30% on the clock, and a 1% interest rate tightening being necessary (roughly) to neutralize a 10% trade-weighted Rand deterioration over a one-year time horizon, it gives an indication of how much of an interest rate tightening will be needed to keep things in check. If so far 1% higher interest rates has been absorbed (in two steps of 0.5%), prime moving to 11.5%, another 2% may be coming (in four steps of 0.5% or two steps of 1%).
The saving grace is oil, hugging $60 and possibly testing $50 by yearend (but potentially doubling or tripling some time next year, depending on global events).
How far may the Rand's undervaluation go? In 2001 it halved in real trade-weighted terms before snapping back in a matter of 18 months.
So far we have done only five months and have done 30% against the Dollar from an overvalued condition.
Though retracements are to be expected, Rand momentum is on the downside, with little sense of fatigue just yet.
This could perhaps trigger SARB urgency, going to 1% interest rate hikes, starting this week, in order to get ahead of the curve. The state of the daily capital flow will presumably be an important consideration.
In 2000-2001 it took exactly two years to go from 6.05:$ to 13.85:$. But that was with few foreign reserves in the kitty and an oversold forward book of $25bn, still cutting interest rates while buying Dollars to augment the reserves, and verbal intervention of the worst (encouraging) kind.
This time things look and feel differently. But trade disappoints, the capital flow is wobbly, foreign sentiment doubtful, the locals excitable and the Rand has already done 30%.
It will be for value-seeking contrarians to call the end of this rout. Whether they will make an early or late call will be up to ... them. Not the SARB.
As for the Rand, it is now in 7-9:$ trading territory. And interest rates will rise further.
Original articles published at www.fnb.co.za.
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