ZAR: Looking Vulnerable, But Bad News Priced In

Short-Term Outlook

The South African rand's movements continue to be dictated by swings in global risk appetite, and specifically sentiment regarding the likelihood of the US Federal Reserve tapering its asset purchases. At present, emerging market (EM) and commodity currencies - including the rand - are on a losing streak amid growing expectations that the Fed will begin tapering in March 2014, a move which will result in a drying up of global investment flows into high-yielding EMs. However, as outlined below, we believe that the risks are largely priced into the rand already, and provided that key support at ZAR10.5000/US$ holds firm, the currency should continue to range-trade between ZAR9.7000-10.5000/US$ over the short term.

Core View

Current Account Deficit Barely Covered
South Africa - Capital & Financial Account By Component and Current Account Deficit, % of GDP

Short-Term Outlook

The South African rand's movements continue to be dictated by swings in global risk appetite, and specifically sentiment regarding the likelihood of the US Federal Reserve tapering its asset purchases. At present, emerging market (EM) and commodity currencies - including the rand - are on a losing streak amid growing expectations that the Fed will begin tapering in March 2014, a move which will result in a drying up of global investment flows into high-yielding EMs. However, as outlined below, we believe that the risks are largely priced into the rand already, and provided that key support at ZAR10.5000/US$ holds firm, the currency should continue to range-trade between ZAR9.7000-10.5000/US$ over the short term.

BMI South Africa Currency Forecast
Spot 2014 2015
ZAR/US$, ave 10.4451 10.1500 9.2620
ZAR/EUR, ave 13.9724 12.8481 11.4346
Policy Rate, % eop 5.00 5.00 5.00
Source: BMI, Bloomberg, November 12 2013
Key Support At ZAR10.5000/US$
South Africa - Exchange Rate, ZAR/US$

Core View

Our core view on the rand is that a range of negative fundamentals, both economic and political, are already priced in, so we expect the currency to remain weak but not depreciate significantly in 2014. Thereafter, we see scope for the rand to appreciate gradually as domestic growth picks up and investor sentiment regarding EMs makes a tentative recovery.

In terms of the negative fundamentals weighing on the rand currently, these are manifold. South Africa is widely regarded as one of the more vulnerable emerging markets that will suffer 'when the tide goes out'. In other words, if global investor appetite for emerging market assets dries up following a rise in US treasury yields, portfolio inflows may be insufficient to cover the current account deficit, resulting in a depletion of reserves and a general rise in macroeconomic instability. The deficit equaled 6.5% of GDP in Q213, and we forecast that it will remain wide over the medium term at 5.8% of GDP in 2014 and 5.4% of GDP in 2015. Although consumer demand for imports will likely weaken alongside a general slowdown in consumer spending, capital imports should remain elevated owing to state-led infrastructure developments. Moreover, weak commodity prices will weigh on export revenues.

Current Account Deficit Barely Covered
South Africa - Capital & Financial Account By Component and Current Account Deficit, % of GDP

The fiscal deficit is also a key concern for investors, reinforcing the notion that South Africa is particularly vulnerable to capital flight. Based on the Medium Term Budget Policy Statement delivered by Finance Minister Pravin Gordhan in October 2013, we expect the budget deficit to remain fairly wide over the medium term, at 4.4% of GDP in fiscal year 2014/15. In light of the tepid economic environment (we are forecasting real GDP growth of just 2.5% in 2014 and 3.0% in 2015), the Treasury intends to maintain an accommodative stance (see 'Accommodative Fiscal Policy To Continue', October 28) and boost long-term growth via the National Development Plan.

Last but not least, South Africa's political risk profile is unfavourable, adding to investor concerns. Industrial action has diminished recently, but will likely flare up again given the high degree of unionisation. Furthermore, national elections are approaching in 2014 (the date has not yet been announced). Although the outcome of the polls is not difficult to predict given the dominance of the African National Congress (ANC), the polls will inevitably shed some light on the trajectory of South African politics, potentially causing some ructions for the rand.

Rate Hike Expectations Misplaced?
South Africa - 6x9 FRA, %

In spite of the above, our core view is for the rand to remain relatively stable, rather than depreciate significantly. The risks are widely recognised among investors, and we therefore believe that they are more or less priced in. Although we do see some scope for foreign investors to withdraw portfolio flows when the Fed begins tapering, this will likely be gradual rather than sudden. In the interim, South Africa will likely continue to attract investment into the bond and equity markets, keeping the rand supported. Bond yields are attractive in a global context and the equity market remains in a strong uptrend. However, one caveat to this view is that we think interest rate expectations are too high. We expect the repo rate to stay on hold at 5.00% over the medium term because the central bank will be reluctant to hike amid weak economic growth, while the forward rate agreement (FRA) markets indicate that consensus expectations are for rates to be hiked by at least 50 basis points in 2014.

Risks To Outlook

Given that the rand is vulnerable to swings in global risk appetite, a surprise announcement from the Fed signaling earlier-than-expected tapering could easily cause the rand to sell off sharply. From a technical perspective, a break through ZAR10.5000/US$ would be a very bearish signal, potentially presaging a move to ZAR11.0000/US$.

Another key risk stems from the domestic political scene. As mentioned above, industrial unrest could easily flare up, with negative implications for output in key sectors, mining in particular. Furthermore, we believe that President Jacob Zuma is becoming increasingly unpopular and although it is not our core scenario, a sudden ousting would create policy uncertainty and associated instability for the rand.

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This article is tagged to:
Sector: Country Risk
Geography: South Africa
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