The rand’s strength over the past two years might have been more as a result of the currency’s association with other emerging market and commodity-based currencies than with South African specific fundamentals, according to research published by South African commercial bank Absa.
During 2002 and 2003 the correlation between the rand and other major emerging market currencies was high due to general United States dollar weakness.
However, some of the safe-haven emerging market currencies showed an exceptionally high positive correlation to the rand.
These currencies include the Hungarian forint (90,8% correlation), the South Korean won (74,8% correlation) and the Polish zloty (71% correlation).
Foreign investors’ risk-averse investments in safe-haven emerging markets explain a great deal about the rand’s strength, especially in 2002.
The movements in the Hungarian, South Korean and Polish currencies explained 86% of the movement in the rand during 2002.
The strong relationship broke down in 2003, with the explanatory value dropping to 37% and the sign (changing from a positive to a negative correlation) of the Polish zloty turning negative as investors shied away from Poland due to political uncertainty and fiscal problems.
If one drops the zloty from the equation, the explanatory value of the equation drops to a mere 11,4%.
Absa chief strategist Matthys Strauss believes that the safe-haven factor in 2002 was replaced by the commodity-based factor in 2003.
South Africa is seen as one of the four primary commodity-based currencies in the world — in other words, countries that are highly dependent on their exports of commodities (both soft and mining commodities) and commodity-related products.
Given South Africa’s diverse commodity exports — in contrast to the country’s dependence on gold exports in the 1980s — the rand is often categorised together with the Australian, New Zealand and Canadian dollar.
The New Zealand dollar was ignored for the purposes of this study because of the currency’s significant dependence on soft commodities in contrast to the rand, which is primarily reliant on mining-commodity exports.
The rand’s correlation with the Australian dollar was a very high 93% for the period January 2002 to November 2003. With the Canadian dollar it was 88,5% over the same period.
The strong performance of commodity-based currencies in 2003 can be explained by the anticipated and actual rise in global commodity prices as a result of improving economic conditions.
This time around, the world commodity price cycle has not only benefited from the improved global economic outlook, but also from the general dollar weakness, which saw most commodity prices soaring in US dollar terms.
The explanatory power of the Australian and Canadian dollar to clarify the movements in the rand during 2002 and 2003 is an astonishing 89%.
Interest rate policy and the coinciding earnings potential through interest rate differentials are often seen as an important driver of currencies worldwide.
South Africa entered into an upswing in its interest rate cycle in 2002 (to counter the adverse inflationary impact of the currency crisis of 2001) while the developed countries were still relaxing monetary policy — that is, cutting interest rates quite aggressively.
A number of analysts believed that this increasing positive interest rate differential in favour of South Africa was the most important driver of the currency in 2002.
The theory became slightly more difficult to defend in the latter part of 2003 when South Africa started to cut interest rates aggressively (South African interest rates were cut by 500 basis points between June 2003 and October 2003) in an environment where investors became concerned about possible interest rate increases in developed countries.
So far three important reasons that resulted in the rand strengthening in 2002 and 2003 were analysed individually. These factors include the emerging market status of the rand, the commodity-based nature of the currency and interest rate differentials.
The relative importance of these factors (compared against each other) still needs to be clarified.
By integrating all three factors through a regression process, one can determine which factors were the most important drivers during a certain period.
Through a process of elimination, the best-fit equation was developed. All three factors discussed earlier played an important role in driving the rand stronger during the past two years.
Strauss concluded that the shift of the rand towards mimicking other commodity-based currencies holds important implications for forecasting the currency in the near future.
Although South Africa is and will continue to be an emerging market, it seems that the immediate future of the rand will be determined more by the international attractiveness of commodity-based currencies.
Currently, the upward trend in the commodity price cycle also tends to override any domestic developments in South Africa. — I-Net Bridge