Exchange Rate Factors
When meeting with financial advisors and clients, the question often arises: “What do you think the Rand is going to do this year”. The simple answer is, no one knows! I believe that anyone who tells you that they do know is not giving you an honest answer. Taking a long- term view, however, provides a clearer picture.
When looking at the factors that determine the exchange rate, one should first consider the period you wish to define. In the short term, (daily, weekly or monthly), exchange rate movement is influenced by a nearly infinite range of factors, including but not limited to, economic data, politics and expected monetary policy, or critical events within the country, government stability and last but not least, sentiment and speculation. If speculators believe the Rand will rise in the future, they are likely to hold more of it now to make a future profit. Quite often, government reserves of a foreign currency are relatively low and therefore speculators can move the price significantly in the short term.
Over the longer term, however, things become clearer as fundamentals come into play and long term trends play out, rather than short term events. Similarly, to share prices, the exchange rate is determined by supply and demand: how much are you willing pay for a US Dollar and how much is someone willing to buy your South African Rand from you.
1. The South African current account (also known as balance of payments).
When South Africa has a larger value of imports then that of exports, we have a current account deficit. Simply put, we sell more Rands to buy international goods than the international market buying Rands to pay South African exporters. This results in net negative flows and demand for our currency. When this is coupled with a lack of capital inflows to finance the deficit, the Rand is expected to weaken. When looking at the South African current account balance over the past three years in the below graph, it is clear that recent history has demonstrated a negative account balance.
2. Government Debt
Evidence has shown that at times, the level of government debt may also have an impact on the exchange rate. If international markets are concerned with the government’s ability to repay its debt, either now or in the future, global investors may choose to sell their South African bonds which will negatively impact the Rand. Notably, the South African government debt has been on a steady rise over the past 10 years, as depicted by the below graph.
When considering transferring funds offshore, there are some key factors to consider. Exchange Control Regulations in South Africa govern the flow of cross-border transactions. As a result, there are particular requirements when sending funds abroad.
3. Interest Rates
Generally, inflation rates, interest rates and exchange rates have a strong correlation. If South Africa has a higher interest rate, the South African bond market usually provides a better yield and will consequently, attract more international investors to buy our bonds. The bonds need to be purchased in Rands, thus international investors need to buy Rands and the demand for the currency increases and therefore strengthens. However, it should be noted that, if inflation rates in South Africa are much higher than in other countries, investors will have a lower real return and on a risk-adjusted basis prefer not to buy or even sell South African bonds, which tends to weaken the currency.
4. Inflation Rates
As mentioned above, inflation rates impact the currency due to either decreasing or increasing the real return of a South African based investment compared to that of another country and therefore they have a significant impact on the exchange rate.
The second significant aspect to configure when considering how the inflation rate impacts the exchange rate is purchasing power parity (PPP). This is potentially the one of the most significant long-term determinants of how exchange rates fluctuate. The Dictionary of Economics defines PPP as a theory which states that the exchange rate between one currency and another is in equilibrium when their domestic purchasing powers at that rate of exchange are equivalent. We know that this is usually not the case as exchange rates often differ quite substantially. How then does the inflation rate differential between two countries affect the exchange rate in the long term? Let’s take a simple example to illustrate this. Let’s assume a two litre soft drink in South Africa costs R18.50 and the same soft drink costs $1 in the USA. Let’s then also assume South Africa has an inflation rate of 5% and the USA 0.5%. What is the cost of the two litre soft drink in 20 years from now?
Based upon the above assumptions, a two litre soft drink will cost R49 in South African Rands and $1.10 US Dollars in 20 years. This allows for an assumed exchange rate of R44 to 1 US Dollar.
Although there are numerous factors that influence the exchange rates between countries and no analyst has been able to predict precisely where the South African Rand will be trading in the future, especially in the short- to medium-term, we believe that on past performance, indicators and fundamentals there is a reasonable expectation that the Rand will weaken against most major currencies, especially where their inflation rates are lower over the long term.
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