Last week’s correction in the dollar, which contributed to the rand weakening to its worst level since November 12, came on expectations of future rate hikes in the United States, which pushed the country’s twin deficits out of the spotlight.
Economists are divided, however, about how long the dollar’s correction will last and what effect US rate hikes will have on the greenback.
Last week’s correction saw the euro weaken from a highest-to-date $1,3668 seen just before New Year to $1,3024 — its weakest since November 23. During the week, the rand depreciated from just less than R5,62 per dollar on Monday to a worst level above R6,14 per dollar on Thursday.
Prospects of US rate hikes knocked high-yielding currencies such as the rand particularly hard because such increases would dent the carry trade, which involves borrowing in low interest rate environments and investing in those with high rates.
Rate increases unlikely to help dollar
However, Absa Treasury economist Chris Hart said the dollar’s current correction will last another two to three weeks at most.
He said that the dynamics driving the dollar will be the US’s current account and fiscal deficits. Concerns about these deficits saw the dollar weaken to multi-year lows in 2004. He also argued that US rate increases are unlikely to help the dollar.
“I think the [twin] deficits are going to come to the fore again fairly soon. US rate hikes are going to create dollar weakness going forward because the economy is going to slow down. Therefore, the investment merits of the country are going to decline,” he asserted.
Hart explained that while the rate hikes will help resolve the deficits, as the economy slows down there will be an investment strike. Once rates are high enough and the current account gap has closed to a sustainable level, the need to hike rates further will end and the economy will start to recover again.
However, this would likely take two to four years rather than a few months, he said.
By the third quarter, Hart expects the rand to be trading at about R5,50 to the dollar, and the dollar to have weakened to $1,42 to $1,43 per euro.
Dollar rebound almost over
T-Sec economist Mike Schussler said the dollar rebound will probably only last about a month and that it is for the most part already over.
“I think we are likely to see a weaker dollar in a range of $1,35 to $1,40 to the euro in a year’s time,” he said.
Schussler sees the rand firming slightly against the greenback and expects a rand-dollar exchange rate of R5,50 to R6 at the end of the year. He sees the rand weakening slightly against the euro, however.
“I have doubts about R5 per dollar forecasts at the moment because I think we can’t afford it. At that stage, labour rates and price levels would make us a lot more expensive than other countries.”
Brait economist Colen Garrow, however, said higher US rates could continue to support the dollar in the second half of the year.
“I think we have to bear in mind the bigger picture. US rates are moving up, which will be a stabiliser for the dollar at some stage. With global events being uncertain, the dollar should be viewed as a safe haven, which should also be a dollar-supporting factor.
“This year we should be careful about the dollar. The US has twin deficits that need addressing, one of them being the current account deficit. But that deficit is manageable as long as the US gets capital inflows.”
Garrow said legislation to cut taxes on money held of offshore could see the repatriation of US funds, which are kept predominantly in Europe. If that happens, there will be some financing of the US current account deficit.
“I’m not saying that we must ignore the current account deficit, but these things are only important if they can’t be financed,” he asserted.
Higher rates to provide capital financing
He said higher US rates should also provide some form of capital financing.
“For the rand, [the dollar’s correction] ought to mean some weakness, but there are other issues. Higher-trending GDP [gross domestic product] is positive in attracting foreign direct investment and the banks’ stories [such as Barclays buying a controlling stake in Absa] are also positive. Portfolio flows are highly significant.”
He noted that in 2004, foreigners purchased R32,868-billion-worth of shares — the highest since 1999.
“We are likely to be affected by dollar strength, but only in the second half of the year. The rand has been hugging purchasing power parity [PPP] for some time. We have had some deviation from PPP now — the rand is sitting at R5,61 if we use 1994 as a base.
“There is still a bit of potential for the rand to strengthen, but we can’t ignore the fact that the dollar may strengthen in the second half of the year and that the South African current account is getting large and may need financing. The wider deficit is an issue the rand will have to face at some stage.”
Caution still necessary
Garrow said the US federal open market committee is likely to keep increasing US rates until they become positive in real terms. Investors will then start shifting funds back to the US.
He emphasised that there is still a need to be cautious because the US twin deficits are large. Rate increases might buy the dollar some time, but at some stage, if the deficits are not reduced significantly, one would have to ask if there is not a major structural problem in the US economy.
However, this is more likely to become an issue next year than this year.
Schussler said the rand’s deprecation last week is unlikely to change the outlook for interest rates and he still expects a cut when the South African Reserve Bank’s monetary policy committee meets next month.
Said Hart: “While there are doubts about the US economy — there are question marks all over the show — the South African economy looks like it is surging ahead, but there are some risks because rates aren’t aligned internationally. It is very difficult for the supply side to cope with the demand side, so there could still be further rate cuts.”
Hart said he is definitely looking for a cut in February. — I-Net Bridge