South Africa: The mysterious weakness of the rand

By Eric Uhlfelder, Investing Across Borders

For the Financial Times, January 24, 2002

Currency-driven investments are inherently risky. Even foreign exchange traders are lucky if they guess right half the time. But opportunities occasionally arise that merit a closer look. The sudden collapse of the South African rand late last year is such an event.

While the country is off most investment managers' radar screens, South Africa is among the most compelling emerging market stories around. The country enjoys a relatively open market economy that has become increasingly integrated in world trade since the apartheid system ended. And its government is generally applauded for sound fiscal management, negotiating the demands thrown up by extensive poverty and the need to spur domestic and foreign investment.

Between 1995 and 2000, the South African Reserve Bank reports that gross fixed capital formation increased annually by 3.8 per cent. Real gross domestic product growth has averaged 2.7 per cent. Consumer price inflation has been brought under 6 per cent. A current account deficit that reached Dollars 2.29bn in 1997 fell to Dollars 469m in 2000, while foreign-exchange reserves have soared from Dollars 942m in 1996 to over Dollars 6bn in 2000. And in November, Moody's upgraded the country's credit rating.

South African equities have enjoyed an impressive run over the past five years, with annualized total returns in rands of 16.6 per cent through 2001, according to FTSE. Recent performance has been even more impressive, with the trailing 12-month returns of 21.7 per cent and three-year returns of 37.9 per cent.

But foreign exchange has been the weakness. Dollar-based returns over the last five years are down an average of 3.3 per cent. Three-year annualized returns have netted 10.8 per cent. And last year's strong performance actually translated into a 18.1 per cent loss for a US investor, highlighting the rand's sudden collapse during 2001's fourth quarter.

The rand was the worst-performing currency in 2001 measured against the US dollar, falling from R7.60 to R12.11, a loss of 60 per cent.

"Behavior of the rand defies ordinary explanation," says Brian Kantor, analyst at Investec Securities, one of South Africa's main banks. "There is no banking or liquidity crisis, no emerging market crisis, no foreign or local debt default or balance of payments crisis, no political crisis, no economic crisis and no stock market bubble just burst, to provide a clue to behavior."

John Morris, a Merrill Lynch analyst in Johannesburg, says that over the past 20 years the real value of the rand has been closely correlated with the Australian dollar, since both economies rely significantly on natural resources, with substantial exposure to commodity prices. But from July last year the two currencies decoupled, with early signs of the Australian dollar's recovery having had no effect on the rand.

Mr. Morris does not believe sharply declining platinum prices explain the low rand. Troubles in Zimbabwe probably do not account for more than 5 per cent of the rand's value.

There are factors working against the rand, but none are new or of great magnitude. The government has been slow to privatize assets, which has hindered foreign investment and helped corporate performance. A number of important South African companies have now listed on the London Stock Exchange, shifting demand from the rand to sterling. Exporters, who have been enjoying windfall gains from the tumbling currency, have delayed repatriating hard currencies in hopes of realizing additional gains, thus further reducing demand for the rand. And in October, the government's attempt to curb speculation resulted in reduced trading volumes, exposing the rand to greater downward volatility.

Jos Gerson, senior Merrill Lynch economist, believes an exchange rate above R9.40 cannot be justified. For dollar-based investors, reversal to that rate would reflect nearly a 20 per cent appreciation. But Mr. Gerson warns that even over the medium term, fundamentals do not necessarily drive value.

Not surprisingly, last year's strong equity returns were helped by resources groups which profited from products whose costs are in rands but which generate hard-currency revenues. South African mining companies all did well in local currency terms, led by Gold Fields, whose shares soared 124.6 per cent. Sasol, the oil and gas concern, rose 115.3 per cent, while the forestry and paper company Sappi gained 121.8 per cent.

Domestic banks generally fared poorly as interest rates declined, hurting margins, and the declining rand hurt investment activity. Nedcor declined 27.4 per cent and FirstRand Holdings lost 39.1 per cent. Standard Bank, however, managed a gain of 2.3 per cent while the Absa Group pushed up 22.7 per cent.

However, investors may see a reversal of sector fortunes this year if the rand is able to stabilize and reclaim a portion of its value, as most analysts expect it will.

Raphe Herrmannsen, an analyst at the brokerage Barnard Jacobs Mellet in Johannesburg, says "periods of currency collapse always result in outperformance by the resources sector followed by underperformance once the rand stabilizes".

Financial stocks work in the the opposite way to resources, he notes, underperforming when the rand is collapsing. This has left them trading at a 32 per cent discount to the overall market, their lowest for nine years. While Mr. Herrmannsen admits that valuation is not a good timing tool, "contrarian and value-oriented investors should be intrigued by financials".

As for the rand's future, Mr. Herrmannsen believes it will rebound, just as it did in 1996 and 1998 after it lost 18 and 21 per cent, respectively. The rand looks oversold, especially in comparison with these last two sell-offs and relative to the commodity cycle, which appears to be turning around as big global economies show signs of recovery.

But he warns "a speculative assault on a thinly traded currency like the rand, especially one where the psychology of perpetual weakness is so deeply ingrained, builds a momentum of its own over time, regardless of the fundamentals".