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The Future of the Rand

Annabel Bishop

17-Oct-2012

SA has seen the rand weaken on a recent slew of bad news ranging from Moody’s rating downgrades of both SA’s and its key corporates’ debt (see “Ratings update: Moody’s indicates further downgrades may follow yesterday’s downgrade of SA government bonds”, 28th September 2012, contact details below), S&P’s downgrade, violent strike action and increased political tensions, to worsening global economic activity and renewed concerns over the euro zone debt crisis.

Figure 1: Industrial disputes: working days lost per 1000 inhabitants per year

Sources: World Competitiveness Report

SA has seen the rand weaken on a recent slew of bad news ranging from Moody’s rating downgrades of both SA’s and its key corporates’ debt (see “Ratings update: Moody’s indicates further downgrades may follow yesterday’s downgrade of SA government bonds”, 28th September 2012, contact details below), S&P’s downgrade, violent strike action and increased political tensions, to worsening global economic activity and renewed concerns over the euro zone debt crisis.

The rand depreciated across key currencies to R14.00/GBP in early October from R12.50/GBP in August and approached R11.50/EUR from R10.00/EUR two months ago.

The negative impact on foreign investor sentiment has seen foreigners sell R11.8bn worth of equities since the deaths at Marikana (the strike of Lonmin workers at Marikana reached a head in the week of 16th August 2012), which has caused the rand to weaken significantly.

Citi Bank’s recent inclusion of SA bonds in its World Government Bond Index (WGBI) prevented a similar selloff in sovereign debt, with the rand weakening by less than it would have if the timing of SA’s inclusion in the WGBI had not been so fortuitous.

A breakdown between trade unions and management, along with intra-union tensions, spurred the conflict in the mining sector. In particular, NUM points to the changing profile of union membership, i.e. younger, more militant individuals who are deemed to have had a loss of faith and respect with traditional wage negotiation processes. The resultant illegal strikes spread from the platinum sector through the mining industry and into the transport sector, with loss of life and property.

It is reported that out of the 273 people arrested at the Marikana strike in August, 133 did not work at Lonmin. The community joined in as social unrest merged with mining industry wage complaints, giving vent to disappointment at the perceived inadequate level of service delivery of the North West economy. For those with garnishee orders, which can reduce decent wages to a figure inadequate to meet a family’s needs, the demands have become desperate.

SA is likely to record GDP growth closer to 2.5% this year compared to the 2.7% initially forecast as the productivity of the mining sector is afflicted by the strikes, and the manufacturing sector remains in recession due to the weakness of global demand.

Figure 2: Forecasts - probability given for each scenario, scenario one is the expected case.
    Q3.12 Q4.12 Q1.13 Q2.13 Q3.13 Q4.13
Scenario 1: Expected case 48% 8.25 8.35 8.30 8.65 8.90 8.75
  Slow economic growth domestically and globally, flux between risk-on and risk-off
Scenario 2: Down case 42% 8.25 9.50 8.85 8.60 8.40 8.15
  Recession either globally led by credit market freeze, US fiscal cliff or domestic work stoppage
Scenario 3: Extreme down case 9% 8.25 11.00 10.50 10.00 9.00 8.50
  Scenario two turns into global depression, central banks can’t provide sufficient stimulation
Scenario 4: Up case 1% 8.25 7.20 6.00 5.95 6.80 6.65
  The return to the boom period before the 2008/2009 global recession

Source: Investec

Figure 3: Foreign net purchases(+) /sales(-) of SA equities

Source: I-net Bridge

While the rand has tracked back from its recent worst level of R8.90/USD and R14.23/GBP, it is still well off levels experienced before the strike in Marikana.

While we expect the rand will pull back further, and indeed continue strengthening toward, but not reach, its projected fair value of R8.00/USD for Q4.12 (see figure 4), ongoing strike action and contagion into other sectors would result in a weakening trend instead.

The strike in the platinum sector spread through the mining sector and entered the transport sector via the trucking subsector, then threatened to spread to rail and port workers.

Municipal workers also threatened action as the strike season got underway late this year, proving to be more violent and disruptive than usual. With close to 40% unemployment using the expanded definition that takes into account those who wish to work but have not looked recently as they cannot afford the transport money to do so, SA urgently needs jobs. Instead many workers involved in illegal strikes are losing their jobs.

A resolve is required across labour, business and government to make wage negotiations work, be inclusive and have broadly acceptable outcomes for all so individuals can either work peaceably or strike peaceably.

Lack of the latter peace accord will result in more deaths over and above those killed at Marikana. SA needs to return its mining sector to growth and repair its reputation problems of unemployment, poverty and inequality.

Figure 4: Foreign net purchases(+) /sales(-) of SA bonds

Source: I-net Bridge

Figure 5: EMBI+ and the rand: risk aversion levels drive rand

Source: I-net Bridge

SA is ranked worst in the world (out of 144 countries) on labour-employee relations by the World Economic Forum’s Global Competitiveness Report (see figure 1) and among the five worst in the world on flexibility of wage determination and hiring and firing regulations.

Indeed, the Institute for Management Development in Lausanne also ranks SA worst in the world in terms of labour relations in its survey, and worst in the world in terms of worker motivation and availability of skilled workers, while the number of working days lost in SA are recorded as the second highest in the survey.

Labour rigidities need to be urgently reduced as they contribute to SA’s high unemployment rate. The barriers to entry to the jobs market for the youth, such as the opposition to the youth wage subsidy and poor quality of education need to be urgently overturned, while appointees to government positions need to be made on the basis of meritocracy, not political connections.

Additionally, policy uncertainty must be removed as companies need to be able to price risk when deciding to invest. In particular, government must demonstrate firm leadership in an environment of improved property rights, regulatory efficiency, reduced state intervention and open markets to promote economic freedom and the right to self determination (to work or strike) in South Africa.

Figure 6: PPP value of ZAR/USD vs ZAR/USD – rand undervalued , fair value forecast at R8/USD for Q4.12

Sources: I-Net Bridge, Investec

Figure7: Rand vs metal commodity price index: driving the ZAR weakers

Sources: I-Net Bridge, Investec

Strikes and high wage settlements (above inflation) are in no doubt partly related to the significantly higher cost of living South Africans now face due to steep increases in electricity and water tariffs, rising rates and taxes for home owners (or higher rentals), along with the high debt burden, and now sharp increases in transport and food costs.

In South Africa it is middle income earners who go on strike for higher real wages, while the country’s 24 million low income earners (less than R50 000 per year) lose out on employment prospects as the real incomes of the middle class increase. With close to four times as many low income earners compared to those in the middle class, it is crucial for South Africa’s future stability that more low income earners get drawn into a level of employment that provides a decent wage.

Equally important is more, as opposed to less, labour flexibility. More labour flexibility will improve hiring rates, less will make firms think twice about anyone they were thinking of taking on.

With food prices already on a sharp upward trajectory due to high international grain and edible oil prices, while transport costs are climbing due to high oil prices, the rand’s weakness will exacerbate the cost of living for the remainder of this year, coming at a time when tensions are already high over wage demands.

We do expect the rand to continue to pull back toward R8.00/USD this quarter, which is its estimated fair value (see figure 6), but not average R8.00/USD as lingering strike action in some sectors and the overhang of the risk of further deterioration of the sovereign debt crisis in Europe cause it to have an added risk premium (see figure 2). We forecast an average of R8.35/USD for Q4.12, but it should be noted that an escalation in strike action will pull this forecast toward the down case in figure 1.

Figure 8: Exchange rates forecasts - averages
  Q4.12 Q1.13 Q2.13 Q3.13 Q4.13 Q1.14 Q2.14 Q3.14
USD/ZAR (Av) 8.35 8.30 8.75 8.90 8.75 8.70 9.05 9.30
GBP/ZAR (Av) 13.35 13.02 13.32 13.64 13.41 13.33 13.87 14.25
EUR/ZAR (Av) 10.48 10.13 10.29 10.50 10.33 10.27 10.68 10.97
ZAR/JPY (Av) 9.34 9.40 9.02 8.88 9.26 9.54 9.39 9.35
GBP/USD (Av) 1.60 1.57 1.54 1.53 1.53 1.53 1.53 1.53
EUR/USD (Av) 1.26 1.22 1.19 1.18 1.18 1.18 1.18 1.18
USD/JPY (Av) 78 78 78 79 81 83 85 87

Source: Investec

  Current Previous
  2012 2013 2012 2013
Global growth 3.3 3.6 3.5 4.1
Advanced economies 1.3 1.5 1.4 2.0
 European Union -0.2 0.5 0.0 1.3
 Euro Area -0.4 0.2 -0.3 0.9
 United States 2.2 2.1 2.1 2.4
 Germany 0.9 0.9 0.6 1.5
 France 0.1 0.4 0.5 1.0
 Italy -2.3 -0.7 -1.9 -0.3
 Spain -1.5 -1.3 -1.8 0.1
 Japan 2.2 1.2 2.0 1.7
 United Kingdom -0.4 1.1 0.8 2.0
 Canada 1.9 2.0 2.1 2.2
 Other Advanced Economies 2.1 3.0 2.1 3.0
Newly Industrialized Asian 2.1 3.6 3.4 4.2
Emerging and Developing 5.3 5.6 4.7 5.1
 Russia 3.7 3.8 4.0 3.9
 China 7.8 8.2 8.2 8.8
 India 4.9 6.0 6.9 7.3
 Brazil 1.5 4.0 3.0 4.1
Middle East and North Africa 5.3 3.6 4.2 3.7
Sub-Saharan Africa 5.0 5.7 5.4 5.3
 South Africa 2.6 3.0 2.7 3.4

Source: IMF

The nominal trade-weighted rand is around 10% weaker on the year (see figure 10) which does not bode well for inflation.

The SARB is unlikely to cut interest rates at its next meeting, with the rand weaker and inflation likely to experience greater upward pressure than previously expected (see figure 11).

However, the IMF has recently revised it forecasts for global growth down (see figure 10), which is of concern, and could cause the Monetary Policy Committee to consider a 25bp cut. The moderation in metal prices has also contributed to the rand’s weakness (see figure 7), and a further slowdown in the global economic outlook would cause greater metal price weakness, and so further rand depreciation given the close relationship between the domestic currency and international metal prices.

Figure 10: Nominal trade-weighted rand

Source: I-net Bridge

Figure 11: CPI inflation not yet peaked

Source: I-net Bridge

The slowdown in the global economic outlook has negatively impacted other emerging market currencies, with the result that the rand is no longer the worst performing EM currency (see figure 12).

The advent of QE3 has yet to strengthen emerging market currencies as the take up in the US housing market has not been rapid.

The down case remains one of recession for SA, either led by a credit crisis in the euro zone or the less likely manifestation of the fiscal cliff in the US (sharp spending cuts and tax hikes).

The down case precipitated by domestic events are currently most likely economy wide work stoppages as the violent strikes in the mining sector spread virulently throughout the economy.

While this is relatively unlikely (i.e. the probability is below 50%, see figure 2), the rand forecast in the down case should be used as a mark toward which the rand will depreciate as the strike action intensifies on a sustained basis across the economy (not our central forecast) as opposed to eventually subsides (our baseline or expected view).

Figure 12: Volatility index for selected emerging market currencies

Sources: I-Net Bridge, Investec

Annabel Bishop
Group Economist
Investec South Africa

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