Jac Laubscher, Group Economist: Sanlam Limited

6 August 2008

Is the rand overvalued?

During the past month the rand again caught the eye with its sharp and unexpected appreciation, not only against the US$ but also on a weighted basis against South Africa's trading partners. The fact that this has occurred against the backdrop of a worrying current account deficit, falling commodity prices and a weakening global economy, makes it all the more remarkable.

The question that arises is whether the rand is currently overvalued and whether it is necessarily set to depreciate sharply.

According to South Africa's ASGI-SA economic strategy document released in 2006, the level and volatility of the rand are one of the major obstacles in the way of higher economic growth. The so-called Harvard panel of economists that advised the SA government agreed and recommended that SA should aim at an undervalued exchange rate in order to boost exports of manufactured goods and curb unemployment. Unfortunately their ideas on how SA should go about achieving and maintaining an undervalued exchange rate were pretty ineffective.

The report on the SA economy published by the OECD approximately two weeks ago adopted the opposite view. According to this report the rand is not overvalued at current levels, and the volatility of the rand is mainly a function of the volatility in commodity prices. The report consequently proposed a different development strategy for the SA economy, although still within the context of ASGI-SA, with greater emphasis on education, competition, trade reform and the functioning of the labour market.

When one looks at any currency's exchange rate level, one needs to realise that no individual exchange rate is determined in isolation. The current set of exchange rates of all currencies is the collective outcome of the current equilibrium between global balance of payment flows, and these will be relatively stable only if there are no inconsistencies.

Any change in the current account balance of a particular country must of necessity mean a similar collective change in the balances of other countries. However, there could be more than one set of exchange rates that meets this requirement.

An interesting study in this regard recently released by the Peterson Institute for International Economics in Washington is an attempt to answer this very question. In this study the author, William Cline, tries to determine which adjustments in exchange rates worldwide are necessary to correct the international imbalances in current account balances.

The idea is not for all surpluses and deficits to be eliminated, but for them to move to fundamentally sustainable levels in response to the appropriate adjustments in exchange rates. In other words, what would a set of global fundamental equilibrium exchange rates look like at present?

Cline first considers the adjustments required in countries' real effective exchange rates (that is against a trade-weighted basket of currencies, adjusted for inflation differences). He then calculates the required adjustment specifically against the US$.

Cline looks at the exchange rates of 34 countries, including South Africa. His premise is that, in the light of its history, the current account deficit of a country such as South Africa should not exceed 3% of gross domestic product (GDP).

Nevertheless it is interesting to note that he is of the opinion that, judging by the past, countries such as Australia and New Zealand could cope with a deficit of up to 6% of GDP. That obviously leaves the possibility that SA's history is not the right criterion for sustainability - if, like these countries, SA had gained permanently improved access to international capital, a deficit of more than 3% of GDP might be sustainable.

Cline then determines the exchange rate adjustments required to establish an international equilibrium in current account balances, with February 2008 as basis. As far as South Africa is concerned, Cline's premise is that SA's current account deficit should be reduced by $15,5 billion. In order to do so, SA's real effective exchange rate will have to depreciate by between 9,2% and 14,6%, depending on different assumptions, including the exchange rate elasticity of SA's exports.

With regard to the rand exchange rate against the US$, the required depreciation is only between 1,8% and 6,7%. Compared with the average R/$ exchange rate (R7,66/$) that prevailed in February 2008, this implies a rand value of between R7,80/$ and R8,21/$.

If one accepts Cline's methodology, it means that at its current exchange rate the rand is moderately overvalued. However, if one starts meddling with his assumptions, for example that SA could sustain a current account deficit of more than 3% of GDP given indications that its access to international capital flows has improved steadily, the current rand exchange rate is by no means excessive.

At present, investors in particular are asking themselves whether the strength of the rand is not an ideal opportunity to increase their exposure to foreign assets.
In this regard I believe that one should never base a decision on investing offshore purely on exchange rate considerations. The main question should be whether the foreign asset concerned will yield a higher return than SA assets. And as far as this is concerned, the most important considerations are the comparative outlook for growth and current valuation levels.

In my previous commentary I expressed the view that, given its current policy framework, SA's sustainable potential growth rate is no more than 4,5%, while a number of countries are offering more. Then there is the OECD's view that profit margins in SA are generally too high and that a more active competition policy is required to rectify this situation. (An opinion that SA's Competition Commission has embraced for some time.)

Should company earnings grow more slowly in the future, it is an open question whether the current valuation levels of SA equities are not too high.

For me this would be enough reason to increase the foreign exposure in a portfolio - at an exchange rate that can fairly safely be regarded as not undervalued.

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