The South African rand could see more strength over the next few months on the back of a weak dollar, which has been the main driver of the rand since early 2002, Nedcor economist Dennis Dykes said in a commentary this week.
“The United States dollar’s breach of the $1,30 [per euro] level in November 2004 has important implications for the rand and economic prospects. If the pattern of the past three years continues, then the local unit will at least remain stable, but could even gain against a basket of currencies.
“This would be good news for inflation, interest rates and domestic spending, but could be the last straw for certain export and import-replacement industries,” Dykes wrote.
Dykes forecast that if recent trends hold, a 10% dollar depreciation will lead to roughly a 10% rise in the trade-weighted rand. This means that a fall in the dollar to $1,47 per euro will imply a rand at R5 per dollar. Even if the rand remains stable against the basket, it will move to about R5,35 to the dollar.
A 20% dollar depreciation will imply a rand at about R4,27, or R4,90 if it remains flat in trade-weighted terms.
He noted that in early 2002, the dollar traded at about $0,86 to the euro and has since progressively weakened to current levels of about $1,33 per euro — a depreciation of more than 35%.
Dykes said that forecasters are now generally predicting a euro of about $1,40 by the end of 2005.
Commodity prices have improved disproportionately to the dollar’s decline over the same period, helped by the recovery from the global slump in 2001.
This has helped commodity currencies such as the rand and the Australian dollar, which have enjoyed the added advantage of having relatively high interest rates, making the decision for investors even easier, he said.
According to Dykes, the rand’s fortunes look set to remain tied to the dollar’s in the short to medium term. With the market’s attention focused on the massive further deterioration in the US trade and current account deficits, questions of sustainability have started to grip market sentiment.
The US current account deficit has risen to more than 6%, or more than double the mid-1980s levels that were seen as high back then, he said.
He asserted that the US current account deficit will return to more sustainable levels — generally considered to be about 2,5% of gross domestic product — only if the dollar’s fall becomes so significant that it forces adjustments to exports and imports, or the rest of the world grows faster than the US so that export volumes grow quicker than import volumes.
“At present, it appears as if the US authorities are happy to allow the dollar to depreciate in order to force this adjustment, even though other developed countries are trying to resist this policy of benign neglect.”
The rand is likely to remain a key beneficiary of dollar weakness, even if this is only moderate.
“The markets will continue to be attracted by the inverse relationship between the two currencies, interest rate differentials and other emerging factors,” he said.
Dykes cautioned, however, that a weakening dollar and strengthening rand are not inevitable.
“Some believe that the dollar will instead stage a pullback, either on economic fundamentals or as a result of concerted intervention. Dollar optimists point out that US growth prospects still appear more favourable than European prospects and a currency correction is therefore quite possible.
“The European authorities are also clearly dismayed at the recent strength of the euro and could decide to intervene actively in the markets to try to prevent a further loss of competitiveness. However, most analysts think that such a policy will not succeed unless supported by the US, which is considered unlikely.”
He added that the rand could also depreciate at the same time as the dollar depreciates.
“If the global economy nosedives in 2005 and commodity prices correct, currencies such as the rand could fall out of favour. Such a scenario would also negatively affect emerging market currencies as risk premiums widen, putting further downward pressure on the local unit.”
A significant change in domestic circumstances could also alter the rand’s course, he said. This could result from the market starting to focus on current account deterioration or possibly from a radical change in policy direction.
While aggressive intervention and a relaxation in foreign-exchange controls would help to ease strengthening pressure, intervention has been consistently rejected by the South African Reserve Bank, despite relatively low levels of foreign-exchange reserves, said Dykes.
Despite months of accumulation, official reserves now cover only about three months of imports, making a more concerted approach justifiable, he asserted.
According to Dykes, a further strengthening of the rand will intensify the trends already established in 2004. Exporters will clearly suffer further, especially if global growth eases slightly, as is generally expected.
He noted that a recent survey by the Bureau of Economic Research suggested that many manufacturers have moved out of the export markets, some permanently, largely as a result of the rand’s effect on competitiveness.
“Others may make the same decision if the rand’s strength appears to be entrenched, as will probably be the case in early 2005.”
However, a strong rand will benefit importers, not only boosting imports directly, but also encouraging spending through its effect on inflation and interest rates.
“As a result of the expected firmer trend of the rand, the short-term outlook for inflation has clearly improved, removing the chances of what earlier seemed to be a probable breach of the upper limit of the 3% to 6% target range in 2005.
“As a result, interest rates could well stay flat in 2005 despite growing credit and spending pressures.”
This scenario does hold longer-term dangers, Dykes warned.
“Excessive spending in the short term and a rising current account deficit increase the potential for volatility in both the rand and interest rates in the future. At some point the market may become concerned over evidence of excesses, but in the meantime consumers will continue to experience enticing conditions.” — I-Net Bridge