eBusiness Weekly
Managing exchange rate exposure is a perennial problem for South African investors and businesses.
It is an equally big headache for foreign investors. In very simple terms, the rand is one of the most volatile currencies around, something we experienced again in 2020.
In fact, last week saw more sizeable swings after the US Federal Reserve painted a bleak picture of the health of the American economy. In response it expects to keep interest rates near zero at least until the end of 2022, and will continue buying bonds and other securities in record numbers. An uptick in new coronavirus cases in the US further unnerved investors who were betting on a speedy recovery. The rand was but one casualty.
The mighty dollar
When they talk about ‘the rand’, most people refer to the rand-US dollar exchange rate. It is by far the most important currency pair for South Africans. Our commodity exports are priced in US dollars, as is oil, our main import. More than 50 percent of global equity market capitalisation is also in dollars, meaning that it has an outsized role in portfolios too. Other notable currency pairs are rand-euro, rand-pound and rand-yen.
To state the obvious, an exchange rate has two moving parts, the rand and the dollar, for instance. When global sentiment towards emerging markets improves and commodity prices rise, capital flows increase, and the rand will tend to appreciate with its peer currencies. The opposite is also true.
The rand experienced a classic blow-out in the first few months of 2020, as global Covid-19-related risk aversion gripped the world. Investors pulled money out of emerging markets at a record pace and sought the safety of the US dollar, Japanese yen and Swiss franc. Commodity prices also came under pressure.
Similar blow-out episodes were experienced in 1985, 1998, 2001, 2008 and 2015. What they have in common is the general backdrop of a strong dollar and the more particular backdrop of a global risk-off episode.
The short-term noise (the waves) that is often the focus of media attention adds to volatility but little else.
Where to next?
So what is the shorter-term outlook? There are three reasons to believe that the US dollar could pull back. Firstly, in times of financial stress, the US dollar tends to strengthen as a safe haven asset. As investors breathe out, they tend to look for opportunities elsewhere, and the dollar eases.
Secondly, the interest rate gap between the US and other major economies has virtually disappeared. The difference between US and German (and other eurozone) short-term interest rates was almost 2 percent at the start of the year.
Thirdly, the recent dollar rally has come on top of a nine-year bull market which put it above its long-term average value. As chart 2 shows, there have been three big cycles in the dollar when it became a free-floating currency after US President Richard Nixon broke the gold peg in 1971. It tells us nothing about timing, but suggests it is more likely to revert to mean than to strengthen further.
A currency that is too strong for too long tends to adjust eventually, because it can cause distortions in the economy by suppressing inflation and hurting export competitiveness. A currency that is too weak will similarly adjust.
A fourth regular argument is that a complicated US political outlook with elections looming in November, coupled with massive Federal government borrowing and central bank money creation, is negative. However, it is not as if other major economies don’t have big problems of their own. For the dollar to fall, the euro, pound and yen have to rise, and each of these economies has major weaknesses. Nonetheless, on balance, it looks like the odds are stacked for a somewhat weaker dollar.
One obstacle is lower short-term rates in South Africa. Though the Reserve Bank’s interest rate cuts have been fewer than in previous cycles, it has been able to cut more than the US Fed (which has hit zero). The gap between SA and US short-term rates is the smallest since 2007, though it is still reasonably attractive at around 4 percent.
Another is that, unlike in 2009 when the world emerged from the financial crisis, emerging markets do not appear to be set for a particularly strong recovery, nor are they in better financial shape than developed markets, nor is there the prospect of a renewed surge in Chinese demand for commodities. Still, the rand appears somewhat oversold at current levels.
Benefits of being weak
This is not a bad thing. South Africans have more assets abroad than foreigners have here. Our net international investment position is positive, to use the technical term, suggesting that the economy as a whole should benefit from a weaker rand.
Export revenues (values) will also increase, all else being equal. But the boost to export volumes is much more muted. Half of the global trade is in the form of interlinked value chains, where trade is in inputs, not final goods. Suppliers in these value chains are not chosen based on exchange rate movements.
At any rate, exporters (and importers for that matter) have learned the hard way that what the rand gives it can take away. Its volatility is a serious hindrance for long-term planning.
Perhaps more active intervention from the Reserve Bank would be useful. If the rand does appreciate, it should use the opportunity to build forex reserves (widely seen as inadequate). This will prevent the currency from becoming too strong.
Meanwhile, higher forex reserves could ward off at least some speculators, and reduce future disorderly depreciation. This is not an argument for a managed currency, such as China’s. The flexibility of the exchange rate is a key strength, but it can be a bit too flexible, and in particular, it can get too strong. When it is too strong, imports surge and domestic producers suffer. The Reserve Bank has resisted doing so because it insists, probably unnecessarily, on ‘sterilising’ the associated increase in money supply (a technical discussion for another day) and because it quite likes a strong currency as it assists with bringing inflation down.
Portfolio positioning problems
So how should investors think about exchange rate volatility in their portfolios?
The first thing to remember is the short-term unpredictability. For all the reasons listed above as to why the rand could appreciate, a sudden turn in risk appetite could toss them out the window. Investors can hedge out volatility with futures contracts, but it not always cheap or straightforward. It is better, therefore, to place any investment with exchange rate exposure in the long-term growth portion of a portfolio, since anything can happen in the short term. The problem is that the same conditions that lead to the rand appreciating and giving a better entry point [offshore] also tend to cause global markets to rally.
What you gain on the currency, you might lose on more expensive global markets. The reverse is also true. We saw this year that the rand fell along with global markets. It happened again last week.
Of course, there is a difference between asset allocation and asset location. We know some investors want to take some money offshore not on a tactical basis, but because they are worried about the future of the country. In such a case, the exchange rate shouldn’t matter that much nor should global market valuations. These investors are not trying to generate a rand return now; they are seeking protection against a catastrophic political or economic outcome in South Africa, however unlikely that is.
For the rest of us, it all comes down to building balanced portfolios that could do well when the rand strengthens or weakens. Because ultimately our living expenses are in rand.
It is often noted how poor South Africans have become in dollar terms over the years, but unless you plan on emigrating, your purchasing power should be measured in the currency that you do most of your purchasing in.
It makes sense to match shorter-term spending needs with SA interest-bearing assets, particularly with high local long bond yields.
Putting your entire portfolio offshore might work over the very long term, and would have worked over the past few years, but there have been uncomfortably long periods when this would not have worked (most notably between 2002 and 2006). And it would miss out on attractive local investment opportunities.
The thing is, ‘attractive’ investments tend to be unpopular, unwanted and unglamorous, priced for doom and gloom, the kind of investments that anxious investors believe can never recover. Like junk status South African bonds, or beaten up bank shares or pummelled property companies. Or, for that matter, the rand itself.— Moneyweb.
