For a few years Dynasty has utilised a “currency decoder” model developed by Dr Lance Vogel (a member of our investment committee), which is based on metrics such as the level of the US dollar relative to its developed market peers; how emerging market currencies are priced relative to the dollar; and what difference in the exchange rate of the rand against the dollar can be ascribed to South African-specific risks. These factors are combined to determine a fair value for the rand which is updated dynamically on a weekly basis.
The “currency decoder” has proven a very useful guide as to when clients should or should not be externalising funds, as the actual exchange rate relative to this fair value graphically illustrates the extent of the premium or discount in the prevailing exchange rate.
However, to gain a fresh and independent perspective, we have taken the approach of also looking at the Relative Purchasing Power Parity (“RPPP”) to determine an alternative fair value. This methodology suggests that the change in an exchange rate between two countries can be expected to correlate to the differential in their respective inflation rates over time. That is, if the prices of goods increase at a faster rate in one country than another, their respective currencies should adjust to ensure the relative purchasing power is retained across the two.
Using the South African and US inflation differential to calculate our estimated RPPP valuation from a base of 1990, it is interesting to note, per the chart below, that according to RPPP the fair value would currently be R9.28/$*, whereas the current exchange rate of R19.71/$* is at a substantial discount to this fair value.
*(Both as at 31 May 2023 as the June inflation figures are not yet available for the US and SA.)
The rand has weakened against the dollar by 6.31% per annum on average over the last 33 years, while the inflation differential has been 4.06% on average over the same period. The differential does not appear that significant, but when compounded over such a long period, it leads to a very substantial divergence, to the point where the rand price of a dollar is more than twice what it would have been had the rand followed the inflation differential.
Chart since 1990
When the same exercise is repeated with base exchange rates of 2000 and 2010 the outcomes follow a similar trend:
Chart since 2000
Implied fair value: R12.58/$ (as at 31 May 2023) is still at a substantial discount to the current exchange rate of R19.71/$
Average exchange rate weakness: The rand has weakened against the dollar by 5.00% per annum on average over the last 23 years.
Average inflation differential: 3.07% on average over the last 23 years.
Chart since 2010
Implied fair value: R10.80/$ (as at 31 May 2023) is at a significant discount against the current exchange rate of R19.71/$.
Average exchange rate weakness: The rand has weakened against the dollar by 7.38% per annum on average over the last 13 years.
Average inflation differential: 2,71% on average over the last 13 years.
Deductions
Our observation is thus that the risk premium applied to South Africa has been widening over the entire 33-year period and the depreciation of the rand cannot solely be attributed to the inflation differential.
It is interesting to note, however, that per the 33-year chart, the rand rate reverted to its fair value in February 2011. This implies that for the 21 years from 1990 to 2011, even though the rand had spent most of its time at a discount to this fair value, by the end of the period the rand’s deprecation was equal to the differential between the South African and US inflation rates. Consequently, all of the discount accruing from the fair value of R9.28/$ to R19.71/$ has occurred in the last twelve years, where the rand last lost 9.16% per annum and the SA/US inflation differential was only 2.76% per annum.
A few contributing factors have been:
- Political – During Jacob Zuma’s tenure from May 2009 to February 2018 one could safely say that this State Capture era was an influential contributor to the rand’s demise. However, Cyril Ramaphosa’s time as President has not been fundamentally unblemished. His inability to act on the findings of the Zondo Commission State Capture report, for example, has not helped investor confidence. Continuing to pursue policies which are economically unviable, such as National Health Insurance (NHI), have also reduced faith in the prospect of improved fiscal metrics going forward. In general, the capacity of the state to execute efficiently on service delivery has been severely diminished.
- Economic Growth – Loadshedding started in 2008 and the unreliability of the power supply has not only had significant direct impact on GDP growth of late, but has also been detrimental to confidence and investment for most of the last fifteen years. This is only one aspect of our pronounced infrastructure bottle necks that are inhibiting economic growth.
- Credit Rating – South Africa’s Sovereign credit rating has been downgraded to multiple notches below “Junk” status.
- Ideologies – more recently, South Africa’s persistence with the neutral stance on Russia/Ukraine, for example, has placed major trade relationships under pressure.
The effect of the divergence between the exchange rate and the inflation differential is that South African assets (including residential property) and incomes have become worth significantly less over time in global terms and, unless South African residents have a significant portion of their assets offshore, they have become substantially poorer on a relative basis. This is obvious when one travels abroad.
The upside of the currency depreciating at a faster rate than the inflation differential is usually that export industries – mining, manufacturing, and agriculture – as well as inbound tourism, become more competitive on a relative basis, partly as a result of the real cost of labour declining. However, our inability to take advantage due to our capacity constraints – most evident with Eskom and Transnet – implies that these industries are losing out on this opportunity.
Given the uncertainty around the 2024 national and municipal elections; the ongoing rhetoric around NHI, the Employment Equity Act and the proposed changes to water legislation; the lack of consequences for those accused of corruption; cadre deployment; and ANC ideologies that are not necessarily in the national interests, we cannot see any significant reason why the trajectory of the exchange rate will revert towards the inflation differential in the foreseeable future.
Our conclusion is that we see the rand continuing to depreciate at a higher rate than the inflation differential would suggest, even though it may strengthen in the short-term due to it trading at a small discount to that trajectory at present and due to factors such as a weaker dollar.