South African financial assets have recently enjoyed strong gains on the back of the election of the perceived market reformist Cyril Ramaphosa as the new president of the country’s ruling political party, the African National Congress (ANC), in December. The country’s currency, the rand, in particular appreciated strongly in December, gaining more than 10% against the US dollar for calendar 2017. Since making a cyclical bottom in January 2016, the iShares MSCI South Africa ETF (NYSEARCA:EZA) has nearly doubled.
However, in our view, the outcome of the ANC elective conference will not meaningfully change the long-term structural impediments faced by the South African economy. The country’s high unemployment rate and the parlous state of its finances (particularly those of state-owned entities) cannot be remedied overnight. Furthermore, as the policy resolutions adopted at the conference by the broader ANC body show, the fundamental “social mood” in South Africa is one that is increasingly gravitating towards populist thinking.
As an example, ANC delegates by a majority voted to amend the country’s constitution allowing for land expropriation without compensation. Given that South Africa’s third-largest political party (the EFF, or Economic Freedom Fighters) already has this position as a key pillar of its policy platform, one can easily argue that a plurality of voters in the country are in favour of such a policy shift. Local and foreign investors that have rejoiced at the outcome of the ANC conference have missed this crucially important point and are at risk of substantial disappointment in the years ahead when a potential Ramaphosa presidency fails to deliver on hoped-for market reforms, constrained by political forces beyond his control.
Yes, overall governance may improve, but if policy remains rooted in statist or populist thinking, the Ramaphosa economy will do little better than what has been the case over the past 10 years. In fact, the micro and macro policy disconnect, which has been a feature of the South African economic landscape over the past two decades, may become even further entrenched under a Ramaphosa presidency. What do we mean when we allude to a policy disconnect between micro and macro policy? Well, at a macro level, and particularly with regard to monetary policy, South Africa has been remarkably successful at maintaining a fairly “laissez-faire” and pro-market policy framework.
The country’s central bank, the South African Reserve Bank (SARB), has been relatively disciplined in adhering to its mandate (to protect the value of the rand) and maintaining a real policy rate for much of the past two decades. The SARB has also shied away from large-scale intervention in the foreign exchange markets. However, at the same time, the ANC’s desire to run a “mixed” economy with a large and interventionist public sector (via numerous state-owned entities) as well as inflexible and rigid labour laws has substantially eroded the competitiveness of the country’s supply-side sectors, thus impeding the ability of the economy to raise its potential rate of growth and substantially increase overall employment levels.
So, although inflation has generally remained within the central bank’s target band and the rand remains at levels that are not meaningfully different from 16 years ago (2001), South Africa’s average GDP growth rate has been poor and the unemployment rate has returned to levels last seen in 2004. Therefore, we would suggest that the rand, viewed in the context of the country’s poor structural dynamics and micro policy choices, has been fundamentally overvalued for much of the past two decades.
The SARB, although admirably adhering to its mandate, has unfortunately been one of the culprits or "actors" in the country’s economic demise. As an example, the SARB has, since 2011, chosen not to intervene in the foreign exchange market to accumulate more foreign exchange reserves and maintain the currency’s value at a level more consistent with the impaired structural competitiveness of the South African economy.
In part, the rand’s resilience in the face of the country’s deteriorating economic performance has also been a function of the extraordinarily accommodative monetary policy which has been in place in most of the major developed economies over the past decade. In fact, in the context of nominal GDP growth which has averaged between 9% and 6% over the past seven years, the SARB’s policy rate has, if anything, modestly been on the low side of what one would consider “fair value”.
South Africa: Nominal GDP y/y growth rate
Nevertheless, despite the fact that domestic interest rates have not been excessively elevated, the rand has, apart for a brief period between late 2014 and early 2016, been fairly resilient, and certainly when viewed in the context of the country’s deteriorating economic performance and sustained current account deficits.
This would suggest that at a fundamental level, the SARB should have been far more aggressive in intervening in the foreign exchange market and building foreign exchange reserves, maintaining the rand at a more appropriate level, and dampening some of the extreme price volatility in the currency over the past 15 years. Undoubtedly, allowing the rand to appreciate by almost 50% between late 2008 and 2010 likely constituted a policy mistake. We would add that the elevated volatility of the currency that stems from allowing such periodic large appreciations has also acted as a key structural impediment to greater investment and growth. The key question is whether the SARB is going to repeat its mistake in 2017 and 2018. Regardless of the composition of the country’s leadership or policy agenda, the rand is now substantially overvalued, at least in our opinion.
Unless there is a substantial and rapid reform of the country’s micro policies, the SARB’s current mandate is simply not consistent with achieving anything near full employment or above-trend economic growth and will further accelerate, not reverse, the country’s slide towards populism, perhaps making Ramaphosa a "one-term" ANC president. Even in the event substantial reform at the micro policy level does materialise, the currency will still need to adjust for “past” input cost increases and inefficiencies before reaching a more stable equilibrium.
Many analysts continue to use purchasing power parity (PPP) ratios, such as The Economist’s "Big Mac Index", as support for their view that the currency is, in fact, undervalued. As we have detailed in prior commentary, PPP is simply not relevant for a country with commodity-intensive exports. South Africa does not export “Big Macs”, or in other words, PPP does not capture export competitiveness accurately in the case of the South African economy.
Some analysts point to the country’s trade surplus as evidence that the current level for the Rand is sustainable.
Firstly, even taking into account the trade surplus the country has managed to produce in 2017, a large services and income deficit has still meant that its overall current account balance has remained in deficit (projected at 2% of GDP in 2017). Secondly, South Africa’s trade balance arguably reflects an unsustainable position given that the volume of imports (as a result of depressed consumption and fixed investment) is below normal, while oil imports (a major component of the country’s import bill) have also been below normal as a result of a depressed oil price (this appears likely to change in 2018).
South African inflation and, by implication, input cost inflation in the country’s mining sector continues to average around 5-8%, with upside risk in terms of future electricity price inflation. At a currency exchange rate of 13 to the US dollar or lower, a substantial portion of the country’s precious metal mining sector is loss-making. Precious metal exports account for roughly 20% of the country’s total export revenues, or around 5% of GDP. If 50% of these exports are not sustainable at an exchange rate below 13 to the US dollar (assuming current US dollar prices for these same precious metals), then the country is arguably not running a “real” or sustainable trade surplus.
The trade surplus for 2017 is expected to amount to roughly 1% of GDP, a figure easily eliminated if just 20% of the country’s precious metals production is taken off-line. As such, our work continues to suggest that fair value for the currency lies somewhere between 14 and 16 to the US dollar, rising by at least 5% per year. The sooner the SARB becomes cognizant of this reality and chooses to broaden its set of policy tools to include the more aggressive accumulation and management of foreign exchange reserves (an acceptable policy tool for small, open economies in a world of large and volatile capital flows), the better.
In fact, given the country’s growth imperative in order to avoid a further drift towards populism, one can make the argument that the currency should, in fact, trade at even weaker levels than what would normally be considered “fair value”. This undervaluation would need to be sustained for several years until such time as the necessary market reforms have been implemented and have started to address and improve the country’s structural dynamics. Should global interest rates rise further in coming years, the rand may eventually weaken substantially once again and alleviate some of the pressure on the SARB.
However, equally, in this event, the SARB’s failure to build a more substantial level of foreign exchange reserves may come back to haunt the central bank, as was the case briefly in late 2015 and early 2016. Although the SARB cannot prevent a sustained depreciation of the currency when global capital flows turn from being a friend to a foe, with much larger reserves, the volatility in the currency can undoubtedly be somewhat dampened - a worthy objective in itself.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in EZA over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.