Explaining the poor performance of the rand

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By Kevin Lings

In the first six months of 2008, the rand exchange rate weakened by 12.6% against the dollar. This makes the rand one of the worst-performing currencies in the world for the year to date. In fact, looking at a list of the 22 most important emerging markets in the world (see attached chart), the rand was the worst performer! The second worst was the South Korean Won, down 10.9%, while the best-performing currency was the Czech Koruna, up 19.9% against the dollar.

Obviously, the dollar itself has been under pressure. In fact, during the first half of the year the euro gained 7.9% against the dollar. This implies that the rand has weakened significantly against a currency that itself was under pressure. Not great news. So why has it weakened?

Trying to understand why currencies change value is notoriously difficult, especially emerging-market currencies such as the rand. The typical explanations include a widening current account deficit, interest rate differentials, economic growth differentials, commodity prices, inflation differentials, political turmoil, credibility of the central bank, risk aversion, etc. Naturally, while all these factors do play a role, it is not always easy to determine the influence of each factor at any point in time. Hence analysts struggle to forecast currency movements with any meaningful consistency. And in that regard, the rand is one of the most difficult currencies to forecast in the world.

In order to illustrate this point, I have looked at two key economic variables that would normally help to explain currency movements. The first is the current account deficit and the second the interest rate differential. Very simply, I compared the current accounts of all 22 emerging-market currencies with the movement in their currency during the first half of year. Similarly, I compared the interest rate differential between each of the 22 emerging markets and the US with the performance of their currencies. In both instances, the analysis could not in any meaningful way explain the movement in the emerging-market currencies. It is noteworthy that out of the 22 countries analysed, South Africa has the worst current account deficit and the worst-performing currency. However, this relationship does not hold up well for other emerging markets. Also, South Africa has one of the largest interest rate differentials among the emerging markets when compared with the US, but the worst-performing currency.

I think the reason for this lack of universal explanation is that each emerging market has its own unique set of circumstances that impact its currency. For example, SA’s electricity outages in January and February clearly had a significant impact on the rand.

Lastly, I looked at the relationship between net foreign buying of SA equities on the JSE and the performance of the rand. The reason is that the impact of many of the variables mentioned above is ultimately reflected in foreign investors’ decisions to either buy or sell SA equities. As it turns out (see attached chart) this relationship is extremely helpful in explaining the movement of the rand in the first six months of the year. In fact, it is probably the best fit I have seen for any key economic variable, although it is over a very short period of time. Hopefully, this will provide some insight into what has been impacting the rand this year.

Of course, it is impossible to accurately forecast net foreign buying of SA equities. However, it should be possible to provide at least a basic direction to expected future foreign buying (see previous e-mails).

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Source: Kevin Lings, Stanlib, July 2, 2008.

 

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