FX Valuation: ZAR appreciation justified but difficult to sustain

  • Impressive appreciation for the ZAR has confounded many who felt that SA's fundamental risks did not justify this
  • SA's weak domestic consumptive and investment demand contrasts starkly with the sharp rise in SA's terms of trade
  • Such surpluses manifest in ZAR supportive cross border flows and explain how the ZAR has remained resilient

Bottom Line:

  • Since the previous report in mid-March, there has been a steady and impressive appreciation in the ZAR that has confounded many who felt that SA's fundamental risks did not justify this. Closer inspection of some of the drivers of the ZAR, however, reveals that the appreciation may indeed be justified.

  • SA's weak domestic consumptive and investment demand contrasts starkly with the sharp rise in SA's terms of trade that have been driven by an increase in the prices of commodities that SA exports. The result has been that the rise in these exports has more than offset the increased cost of oil imports to assist the SA economy produce record trade surpluses.

  • Such surpluses are good news from a growth and tax revenue perspective. They also manifest in ZAR supportive cross border flows that go a long way to explaining how the ZAR has remained resilient and even appreciated in the face of a seemingly endless river of bad news on state failure and corruption. But, unfortunately, these appreciative forces will not be sustainable to the same degree when domestic demand recovers and focus shifts back to SA's unsustainable fiscal position, which remains the ZAR's biggest Achilles Heel over the longer term.

BASELINE VIEW: ZAR appreciation and resilience has been impressive and can extend a little further. However, over the longer term, this move will not be sustained once the trade surpluses moderate, global financial markets become fully priced and focus turns back to SA's fiscal position later this year and the start of next.

Real Effective Exchange Rate (REER) Trade Weighted

Since the last valuation report six weeks ago, there has been a substantial appreciation in the ZAR across the board. Without exception, the ZAR has made background against its major trading partners, rendering this a clear example of ZAR strength more than weakness in any of the majors.

Most developed economies do appear to have lost ground on a trade-weighted basis, but even that only explains only part of the move. QE efforts, substantial monetary and fiscal stimulation combined with improved levels of risk appetite have shifted investors away from safe-haven currencies towards emerging markets and other higher-yielding destinations.

The ZAR has been one beneficiary of this trend. Still, it is also important to note that the ZAR has gained ground because its internal fundamentals have generated a ZAR supportive environment. At a real economy level, a reduction in consumption and investment has cratered importer demand. On the flip side, some of the strongest terms of trade in a decade have bolstered exports.

USD still overvalued but reversing

 Reasons to remain bearish on the USD are well entrenched. Despite calls that the magnitudes of the twin deficits are known and should be priced in, the bias in the market, driven by real money flows, remains bearish, and speculators are choosing to ride the wave rather than fight it.

Furthermore, with the tide of monetary stimulation expected to extend as the Fed recommits to its QE programme and governments around the world double down on their stimulus efforts, it makes sense that their underlying currencies will be undermined and debased.

It was not by accident that the cycle affecting developed market currencies has turned. A historical comparison shows that developed market real-effective exchange rates could shift overvaluation to undervaluation. Suppose the cycle had to complete in the way that previous cycles have. In that case, it could imply that the median of all developed market currencies could depreciate by as much as 20-25%, which would play a significant role in emerging market currency performance.

Dissecting the drivers of the ZAR's strength

Domestic consumption and investment are weak, and there is a correlation between the demand they exert on the imported component of the trade account and the trade balance. The chart of household consumption expenditure clearly shows the trade balance's behavior that shifted sharply into surplus just when consumption cratered. Before that SA ran an almost permanent trade deficit.

Gross Fixed Capital Formation, otherwise known as fixed investment, also dropped off sharply, as reflected in the right-hand chart to again highlight the dearth of demand for imports. That this happened at the same time when SA recorded the strongest terms of trade in a decade helps explain how real money flows turned sharply positive for the ZAR.

Terms of trade and the trade balance

While the charts above reflect the drivers of SA's weaker importer demand, the chart below and to the right shows why SA's exports have held up. SA's terms of trade, the rise in the oil price notwithstanding, have risen to the strongest levels seen in a decade. The crosshairs show when last the terms of trade were at these highs and how it also coincides with a ZAR trading at much stronger levels. With the global business cycle heating up and likely to accelerate through H2 2021, it is quite possible that the terms of trade that have helped the ZAR recover and remain resilient will remain strong.

Based on the charts above and the rise in SA's terms of trade, it becomes understandable that the trade account as a % of GDP has risen to near-record levels. Dissecting the current account shows that the trade surplus in goods and services has singlehandedly driven the current account to the strongest surplus in almost two decades and why the reduced portfolio flows into SA have not translated into ZAR weakness many expected.

The ZAR's resilience at a real economy level is therefore very much a function of the weakness of the domestic economy, as well as the recovery in global growth and commodity prices. Nevertheless, there is substance to the ZAR's resilience and an argument for the ZAR to appreciate further and remain resilient through the remainder of the year.

Adjusting the ZAR's valuation for fiscal risk

It is only when one starts to unpack the structural and fiscal risks that a very different picture for SA emerges.  The country's fiscal position has steadily deteriorated through the past decade and has left the economy vulnerable to shocks.

SA's fiscal trajectory is unsustainable and a default episode of sorts may well follow. As it stands, the credit rating agencies are downgrading SA and the tradeable market most likely to reflect the deterioration in fiscal rectitude will be the ZAR.

When adjusting for SA's troubled fiscal position, the valuation picture changes dramatically from one where the ZAR is undervalued to one where it is overvalued by as much as 20%.

It implies that there may be a discount of around 20% that is needed to attract foreign inflows to keep the trade and current accounts well-funded. The important point to note, however, is the timeframe.  This fiscally adjusted valuation offers perspective over the next 2-3 years, and is not meant to offer perspective on the current trading valuation.

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