There is some light at the end of the tunnel for South African importers
This year the rand experienced its third major blowout.
Over the past two decades, the rand has on average depreciated by 3% against the dollar per year. This rate of depreciation is broadly in keeping with purchasing power parity (PPP) exchange rate theory, given that South African consumer inflation has on average exceeded US inflation by 3.5% since January 2000. However, on three specific occasions, rand depreciation has been particularly dramatic and far exceeded South Africa’s inflation rate differentials.
More specifically, in the wake of the September-11 attacks in 2001, the rand weakened by 39% to R13.84 (that is, 3.6 standard deviations above the long term rate of deprecation) in only three months. Then during the Global Financial Crisis of 2008, the rand weakened by 40% to R11.87 (that is., 4.1 standard deviations) also within a three-month period. Then again during the first quarter of this year, the rand depreciated by 28% to R19.35 (that is 3.4 standard deviations) in four months in response to the COVID-19 pandemic (Figure 1).
Being a free-floating liquid emerging market currency, with no capital controls for foreign investors, the rand is particularly vulnerable when these global event shocks rapidly erode investor risk appetite. The fact that foreign investors sold around R50bn worth of South Africa government bonds (SAGBs) in March, after a sub-investment sovereign downgrade from Moody’s Ratings effectively ejected SAGBs from the World Government Bond Index, merely aggravated the extent to which the rand weakened during the latest bout of global risk aversion.
However, the cost of hedging exchange rate risk is cheaper on this occasion.
It took the rand between 12-15 months to get back to its 5-year depreciating trend after the 2001 and 2008 crises. This implies the rand may only return to its long-term trend around mid-2021. Such a sluggish rand recovery bodes ill for domestic importers, especially because in the current economic downturn it will be even more difficult to pass on the higher input costs associated with the weaker exchange rate.
In response to the 2001 and 2008 rand selloffs, the South African Reserve Bank (SARB) hiked policy rates by 575bp and 125bp respectively. However, despite this year’s dramatic rand depreciation, the SARB has actually cut policy rates by 275bp to a record low of 3.75%. At this month’s Monetary Policy Committee meeting, the SARB reiterated that it would only respond to second-round inflationary effects. In other words, until there is clear evidence that this year’s dramatic rand depreciation is actually starting to fuel inflation expectations, the SARB is unlikely to increase interest policy rates.
In fact, inflation expectations are declining at present, partly because this year’s collapse in oil prices has been proportionately greater than rand depreciation. Moreover, in more recent years, the pass-through effect from exchange rate depreciation into overall imported inflation has halved, because weak economic growth has ensured that producers have less pricing power to pass on higher imported costs to consumers.
Meanwhile, US policy rates have only declined by 150bp this year to 0.25%, which means that SA’s interest rate differential over the US has narrowed to a 13-year-low of 350bp (Figure 2). Given that a forward exchange rate contract is equal to the spot exchange rate multiplied by the interest rate differential of the two countries concerned, the cost of hedging currency risk in South Africa has declined due to the SARB’s relatively aggressive cutting cycle.
Therefore, unless US policy rates move into negative territory and/or the SARB starts hiking policy rates, local importers will be able to lock in the cost of their future dollar commitments at levels that are relatively close to the prevailing spot exchange rate. During 2001 and 2008, even if importers wanted to hedge themselves against a rapidly depreciating currency, the premium they needed to pay to secure those dollars was well above the spot rate at the time, which merely added to the overall cost of the respective imported good.
Conversely, when SA’s interest differential over the US compresses, local exporters have to sell future dollar proceeds at lower levels relative to the spot exchange rate. As a consequence, exporters are likely to convert their dollar earnings sooner rather than later and in so doing, cap extended rand weakness, which would also be beneficial to the importer community. We conclude by highlighting that the current level of rand volatility is not as high as it was during 2001 or 2008, which means that the cost of hedging exchange rate risk in the options markets is also not as expensive as it was for importers in the previous two rand blowouts.
Michael Keenan is a Fixed Income and Currency (FIC) Strategist at Absa
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