This year hasn’t been a good one for the South African rand. Granted, 2013 still has a long way to go but unless something unexpected happens, the rand will probably end the year as the world’s most volatile and worst performing currency.
In reality, it has been vulnerable for some time and, while many economists and analysts have been warning of the possible consequences of this vulnerability, they have been ignored in the euphoria of a consumer-fuelled spending boom and a currency sitting at a respectable R7-R8 to the US dollar.
To use a simple analogy from everyday life, it has been like a teenage biker riding around without a helmet. He’s susceptible and vulnerable. But that doesn’t mean he’s definitely going to have an accident and could carry on this way for years; looking calm, seemingly in control and perhaps wondering why everyone else feels it’s necessary to wear a helmet. However, if he does crash, he’s going to get hurt and it will inevitably end badly for him.
WHY ARE WE VULNERABLE?
Why is our currency vulnerable? Or, to turn again to our young biker, why has it been likely that, despite the bravado, at some point he’d suffer an unpleasant accident?
The vulnerability in the rand has come about because South Africa has been systematically importing more than it has been exporting for a long time and, as a consequence, has been running constant and ever-increasing trade deficits. Normally these are a result of large purchases of equipment and machinery to be used in manufacturing and infrastructure development – a ‘good news’ trade deficit because, ultimately, it benefits the economy.
But now things have changed. We’re running ‘bad news’ trade deficits – so called because they’re not improving fixed investment or production capacity, but result from excessive consumer spending on imported goods.
On top of this, our exports are down. This is partly due to slow global growth and partly because of our own infrastructural problems, like difficulties in efficiently transporting goods to our ports and poor handling capacity at the ports themselves. The combination of high consumer goods imports and low exports means a current account deficit is inevitable.
The international guideline is that a current account deficit should not exceed 3% of GDP, yet the South African figure is a very substantial 6% of GDP. Given that our GQP is over R3 trillion, this equates to a huge amount of money leaving the country on a monthly basis!
Adding to this vulnerability is strong foreign investment into our stock and bond markets – in other words, investment. South Africa has attracted foreign investment partly due to money being cheap and partly because of the constant search for yield. Foreigners look at what they can earn in Europe – less than 1% – and would rather invest in South African government bonds at 7%-8% annual return. As a result, we are now at a point where foreigners own 30%-40% of our stock and bond markets.
So at the same time as South Africa has been running increasingly large trade deficits, we have been in the fortunate situation of attracting a huge amount of foreign investment and currency. Up to now, this has offset the currency outflows and allowed the rand to remain strong; in effect compensating for (and masking) our excessive consumer spending and low exports.
However, we have been vulnerable to changing foreign investor sentiment for a while. If these foreigners decide they are no longer going to invest, or worse still, withdraw their investments even in part, then foreign currency flows out of our country and the rand weakens.
This has now happened. Our teenage biker has been involved in a crash … without his helmet.
THE CAUSES OF THE PROBLEM
Why has foreign investment slowed? There are a number of reasons, but the most obvious is that the world has, for the past six months or so, been systematically bombarded with bad news coming out of South Africa.
It started with the Marikana shootings in August last year, which on their own, would probably not have triggered the vulnerability because it would have been seen as an isolated event. But a combination of bad news factors has evolved, stemming the inflow of foreign investment and, in some cases, seeing investors taking their money out of the country.
At the same time, we are still importing consumer goods, still paying dividends to foreign investors, and continuing to pay interest to them too. But, because we have lost the masking effect of a strong inflow of foreign investment to offset this, the rand has weakened.
Unfortunately, the bad news around labour issues isn’t the only problem we face. There are also question marks around the politically-based policies that the government is following and a lack of clarity over important issues such as nationalisation, land rights, economic growth strategies, and the like.
Then there’s the country’s credit rating, which has been downgraded by all three of the major rating agencies. South Africa remains on negative watch, indicating there’s a risk of a further downgrade to come. This tells investors that we’re vulnerable and it makes them nervous.
Also making investors wary is a GDP growth number of only 0.9% annualised, reported for Q1 2013. While South Africa is not in a recession or about to go into one, the number sounds too close to being recessionary to inspire confidence in our economy.
Lastly, there is the historic social dynamic in this country: high unemployment, large income inequality, service delivery protests and flare-ups of social tension.
So it’s a combination of all five factors that have highlighted our vulnerability and sparked the weakness in the rand. While economists predicted it could happen at some point, no one knew when. The timing of our teenage biker’s accident couldn’t be accurately forecast, but a combination of adverse factors has conspired to make him crash now.
COULD THINGS GET WORSE?
Unfortunately things could still get worse before they get better. While the rand is technically undervalued and its fair value is closer to R8.60 to the US dollar, there is no guarantee that this will happen soon, simply because the currency’s weakness has now been exposed and exploited. At R8 to the dollar nobody wants to take their money out of the country, but at R10 to the dollar a great many do, and that causes even greater weakness and vulnerability.
We have to hope that in the short term the currency weakness doesn’t become exaggerated. This can be crippling to a country, particularly if it happens quickly and the costs of critical items like fuel, medicine and essential infrastructure projects (e.g. ports and power stations) rise dramatically. Inflation will then increase, wage demands will rise, unemployment will surge and greater social unrest results. You can end up in a downward spiral where the rand grows ever weaker and more vulnerable.
The problem is not so much the rand weakening, but the speed of that weakening. With a slow drift the economy can adjust, but a rapid weakening is destabilizing to a country.
CAN THINGS IMPROVE?
If the currency remains weak for a prolonged period then, paradoxically, there are factors that could begin to work in our favour. As imports become increasingly expensive and unaffordable to consumers, the retail sector will need to source more products locally because they would be cheaper. This should help local manufacturing and the clothing sector in particular, where the current default position is to source from China or other Asian countries. When that happens, imports will slow and help to reduce the trade deficit.
Similarly, South African-made products will become cheaper for international buyers and we could see a rise in exports, once again with a positive impact on South Africa’s balance of trade figures.
The third positive factor is that a weak local currency makes us more affordable as an international tourist destination –something we’ve witnessed previously when the rand was weak. A consumer in Europe or Asia who has always wanted to go to a game reserve, now has the means to afford their dream – and our economy benefits.
The problem is that these things don’t happen immediately. It takes time for retailers to identify new local suppliers and it takes time for South African companies to gear up to find new export markets. In the meantime, the rand will remain under pressure.
But in the medium term if we can reduce imports, grow exports and attract more tourists, then we are starting to address some of the fundamental vulnerabilities of the economy. Our rider is back on his bike, but this time with a helmet, leather gloves, knee pads and a new appreciation of the potential dangers.
WHAT CAN BE DONE IN THESHORT TERM?
Unfortunately there’s not much that can be done in the short term. The rand is an actively traded global currency and more than 50% of the trade happens offshore between foreign institutions, like banks. That money doesn’t come near South Africa, so there is no way to control it.
There are some restrictions on South African residents in terms of foreign exchange, but many of these have been lifted over time and that control is far from extensive.
As for the Reserve Bank intervening to strengthen the currency, its options are limited. The amount of money the Bank would need to spend to achieve a change in the rand’s value probably exceeds the total amount of foreign exchange it has available. Other central banks around the world have tried this in the past, but invariably it doesn’t work and ends up costing the country a fortune. In my view it would be futile.
WHAT ABOUT LONG-TERM SOLUTIONS?
The current situation is another signal that, in the long term, South Africa must maintain sound economic and labour policies, become more productive and have better policies in relation to competition. These are not new messages but they need to be reinforced.
A problem in this country is that we tend to wait for something to manifest as a crisis before we are called to action. There may be some response to the situation from government, but I am not convinced it is going to be effective, seeing as we are heading into an election year and there are plenty of political sensitivities – around the labour market, in particular.
WHAT SHOULD MY INVESTMENT RESPONSE BE?
Given that we can expect South Africa to remain an open economy with ongoing exposure to world markets and therefore vulnerable, our advice to investors is the same as if the currency was at R7 to the dollar: the vulnerability dictates that you diversify and ideally 30% of your investment portfolio should be offshore.
While a very weak rand may suggest a greater percentage would be appropriate, logic dictates that if a country is good enough to live in and work in, then you should have around 70% invested in that economy and the remainder elsewhere.
Given exchange control and each individual’s circumstances, this exact split may not always be achievable. However, there are ways of getting foreign exposure, other than via the often complex route of taking your money offshore. SAB, for example, is a local investment whose earnings benefit from international exposure. So too are luxury goods company Richemont, media giant Naspers, and cellular technology giant MTN.
At certain times you may benefit from this 70%-30% investment strategy and at other times not. But, over an extended period of time, our view at STANLIB is that it will be beneficial in terms of protecting you against a weakening rand and South Africa’s economic vulnerability. Our teenage biker then has a quality helmet, leathers, gloves and padding … as protected as possible from the dangers ahead.