Headwinds at Home and Abroad Weaken South African Rand

The South African rand fell to its lowest level on record early last month, having shed over 45% of its value against the greenback since the start of 2015. While the rand was caught up in a historic sell-off of global commodities and emerging market assets, it has also been suffering from a long list of unique domestic economic headwinds that have made it one of the worst performers among EM currencies. Like Turkey’s lira and Brazil’s real, the rand is suffering from a perfect storm of mounting domestic economic woes and a broader market that is struggling to come to terms with the rebalancing of China’s economy and the prospect (albeit fading) of higher borrowing costs in the U.S. The combination has resulted in a historic sell-off of the rand.

There was an uptick in the value of the rand a few weeks later. However, this was mainly due to a decision by the South African Reserve Bank to raise its interest rates by an aggressive 50 basis points in late January, sending the currency to a three-week high. Combined with a surprise overnight rate cut by the Bank of Japan, which added to the overall improved tone in global markets and helped lift risk assets across the board, the rate hike in South Africa has strengthened the rand. However, given the chronic problems in South Africa’s economy and the weakening demand for commodities in world markets, especially in China, the rand’s woes are not likely to abate anytime soon.

Global Economic Storm Clouds on the Horizon

While the rand has been trending lower against the dollar for the better part of the last five years, its losses have truly accelerated over the past 12-18 months. A key driver of the massive sell-off of the rand has been the absolute pummeling of EM assets over the past year. By any measure, risk assets have tumbled over recent months, with selling accelerating in early 2016. MSCI’s broad emerging equity market index is down by nearly 35% from January 2015, thanks to the same wholesale de-risking among global investors that has driven many EM currencies to record lows against the greenback. Worries about the health of China’s economy, the world’s second largest (and by no coincidence, South Africa’s biggest export market), have driven investors to sell EM assets across the board.

As Beijing tries to engineer a soft landing for its economy and a shift from its traditional manufacturing/export-driven growth to a more services/consumer-driven growth, the necessary adjustments to its currency and its capital controls have rattled investors’ confidence and sparked concerns about a broader currency war among major Asian exporters. A slowing Chinese economy, which in 2015 posted its worst annual growth in 25 years, has generated a key headwind that is impacting demand for South Africa’s key commodity exports.

China’s declining demand for commodities, which was previously (along with historically easy money in much of the developed world) a key driver of elevated resource prices, has sparked a dramatic bursting of what many have characterized as a decade-long commodities bubble. Major industrial metals like copper and iron ore, key South African exports, have plummeted to near seven-year lows amid concerns about slowing demand from China. Meanwhile, gold, South Africa’s largest export, also saw its prices fall last year to levels not seen since 2010 before the most recent safe-haven buying helped revive some of the precious metal’s long-lost sheen. The downtrend in industrial commodities, which industry experts do not expect to run its course anytime soon, will continue to be a major drag on South Africa’s economy and on the rand.

Falling oil prices are a major cause of the end of the “commodity supercycle.” In addition to worries about global demand, oil markets are suffering from a historic glut in supply thanks to U.S. fracking, OPEC’s stubbornness about cutting production and the fact that millions of barrels of Iranian oil are set to come online in the very near term. And while South Africa is a net importer of oil, which means that it suffers little direct impact from falling crude prices, further declines or weakness in oil prices will keep broader commodities pressured, thus adding to the headwinds facing the rand.
Fragile Domestic Backdrop Leaves Rand Vulnerable

The global economic backdrop has undoubtedly been a major driver of the massive selling of the rand over the past year and a half. In fact, nearly all EM currencies have been pummeled because of the wholesale unwinding of risk in global markets due to the worries about China, the fall in the value of the yuan, sliding commodities and the possibility of higher Fed rates. This, in turn, makes much of the household and corporate debt in EMs, which is often priced in dollars, more expensive to service. At the sovereign level, South Africa enjoys a small level of dollar-denominated debt (compared with other EMs), so the nation’s balance sheet is shielded, to some extent, from the falling rand. That’s where the good news ends.

At November’s review, S&P kept its rating of South African government bonds at BBB-, which is one notch above “junk” status, but it did downgrade the country’s outlook to negative. Fitch cut its rating in December to just one notch above “junk” status. The agencies cited South Africa’s near 25% unemployment rate; the steady rise in inflation to what is expected to be around 6.0% (year-on-year) in 2016, thanks to the falling value of the rand; a widening current account gap that reached 4.1% of GDP in Q3 2015; and a measly growth outlook of 0.7% in 2016 (according to the International Monetary Fund). The IMF slashed its 2016 forecast of GDP growth from 1.3% back in October to 0.7 %, and sees Africa’s largest economy growing at a rate of just 0.3% in 2017.

Against this particularly challenging backdrop of plummeting demand for the country’s key resource exports, a collapse in its mining industry, near stagnant GDP growth, rising inflation and a near 25% unemployment rate, there would appear to be little room for any policy missteps. Unfortunately, policy mistakes have recently characterized the performance South Africa’s President Jacob Zuma, who sacked two finance ministers in one week in December, sending the rand, stocks and government bonds tumbling. Zuma’s third choice for finance minister in a week, Pravin Gordhan, did calm the markets and instill some degree of confidence in the management of South Africa’s economy, but his appointment will not likely do much to offset the very long list of domestic and global economic headwinds that have converged to send the rand to a record low against the dollar.

The unique combination of global market turmoil and domestic economic challenges has kept the consensus view on the rand decidedly negative. And while the short-rand, short-EM, short-commodity trade is looking increasingly crowded, the fundamental arguments for staying short continue to keep the rand and its risk asset counterparts a sell on any rally.

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