While many local banks have been surprised by the South African rand’s resilience in recent days, given the June 12 repo rate cut and Wednesday’s better-than-expected producer inflation (PPI) data, investment bank Merrill Lynch disputes that the local unit is overvalued and estimates fair value for the currency at between 6,50 and 7,00 per dollar.
“There is a common perception in the market that the rand is now overvalued. As we have long noted, this is not a perception that we share. The currency is now fairly valued on a fundamental basis,” Merrill Lynch economists Jos Gerson and Nazmeera Moola say in a research report.
The report says that using a simple purchasing power parity model of the Aussie dollar and the rand bilaterally with the US dollar, the rand is “still significantly undervalued”.
“A fair-value estimate of the USD-ZAR exchange rate is roughly 6,50 or an AUD-ZAR rate of R4,30,” it asserts.
The report adds that according to the IMF model of the real effective equilibrium rand, the fair value for Q1 would be estimated at 7,80.
“Taking into account the decline in the trade-weighted USD, the slight decline in industrial commodity prices and the rise in real interest rates stemming from the revisions in inflation, the IMF model would probably produce a fair value estimate for the USD-ZAR that is fractionally below 7,00.”
The report cautions that this is not equivalent to a forecast and that the nominal counts far more than the real interest rate differential. Furthermore, the South African economy is slowing and the strong rand is squeezing profits in the tradable goods sector.”
“Nonetheless these cursory exercises cast doubt on the conventional view that the rand is overvalued and can only depreciate from here.”
On the issue of favourable interest rate differentials, which have often been cited as a reason for the rand’s strength in recent months, the report says that there is no doubt that foreign funds have flowed into South Africa in order to take advantage of the high level of nominal interest rates.
However, estimates of the amount of ‘hot money’ that has entered the country in the last nine months vary from five-billion rand to R50-billion.
“Despite the obvious logic for these inflows to occur, it is difficult to find evidence for the presence of large amounts of ‘hot money’ in South Africa,” the report says.
Players in the local currency market were caught on the wrong side of the rand when the South African Reserve Bank (SARB) cut the repo rate by a bigger-
than-expected 150 basis points. Players had been expecting the rand to weaken in
the wake of the cut, but instead it firmed fairly sharply.
Then, on June 25, May PPI came in at 1,1% compared to a consensus forecast of 2,6%. Again the rand surprised players by firming despite the implications of the data for consumer inflation and interest rate cuts down the line.
The Merrill Lynch report notes that according to the Balance of Payments data, Other Investment Liabilities — including foreign deposits in the banking system — fell by R5,8-billion in Q1. Non-resident deposits in domestic banks also fell slightly in Q1.
The report says that because many of the more bearish forecasts for the rand are based on the rapid outflow of this ‘hot money’ in the near future, and if the size of these inflows has been overestimated, “then the risk to the currency in the future may also be less than previously thought.”
Gerson and Moola say that while foreigners sold a net R3,2-billion of South African bonds in Q1, they turned net buyers in Q2 and have purchased R1,4-billion of local bonds so far this quarter. It expects continued foreign participation in the bond market going forward, particularly considering that the bull run in developed bond markets appears to have slowed. They see the yield on both the R153 and sort-dated 150 at 8.5% at year-end from Wednesday’s close of 8,910% and 8,890% respectively.
The report concludes that the rand does not appear to be overvalued and questions the magnitude of fund that have flowed into South Africa to take advantage of the ‘carry trade’.
However, it sees attractive albeit declining interest rate differentials as providing support for the rand, together with stable to increasing commodity prices and continued portfolio inflows, particularly into the bind market.
“Our year-end USD-ZAR target remains at 7,00 and we still recommend holding
on to long ZAR call spreads.” – I-Net Bridge