RMB February 2010 How Strong is the ZAR and What Can Be Done About It

8/14/2019 RMB February 2010 How Strong is the ZAR and What Can Be Done About It

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John Cairns and Nema Ramkhelawan

RMB FICC Research

February 2010

How strong is the ZAR and what can be done about it?


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2Fixed Income, Currency and Commodities

Background

People are complaining about the strength of

the ZAR and are calling for it to be weakened

There is a lot of anecdotal evidence that the

strong ZAR is impacting negatively on the

South African export sector

Is the ZAR really that strong?

Is it really affecting the economy?

And can anything actually be done about its

strength?

This presentation aims to address these

questions

Source: Reuters, RMB FICC Research

USD/ZAR fell sharply in 2009

5.00

7.00

9.00

11.00

13.00

15.00

2004 2006 2008 2010


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How strong is the ZAR?

Is the strong ZAR affecting the South African economy?

What can be done about its strength?

A look at the underlying issues


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USD/ZAR is only now back to last years

ranges and is still much higher than previous

years


USD/ZAR

5.00

7.00

9.00

11.00

13.00

15.00

2004 2006 2008

USD/ZAR

Back to last years ranges


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Back to last years ranges

USD/ZAR is only back in last years ranges

and still much higher than previous years

EUR/ZAR has fallen even further but is still

much higher than previous years


USD/ZAR and EUR/ZAR

5.00

7.00

9.00

11.00

13.00

15.00

2004 2006 2008

USD/ZAR

EUR/ZAR


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Adjusted for inflation

After adjusting for inflation, USD/ZAR is

strong but not unduly so

Source: Bloomberg, RMB FICC Research

USD/ZAR adjusted for inflation

4.00

6.50

9.00

11.50

14.00

16.50

1990 1995 2000 2005 2010


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The complete picture adjusted for inflation and all currencies

Look at a weighted average of all the ZAR

exchange rates adjusted for inflation (the real

effective exchange rate)

The ZAR is stronger than the average

exchange rates this decade but not as strong

as in 2005

But there are also complications

Source: I-Net Bridge, RMB FICC Research

Real effective exchange rate

60

75

90

105

120

135

2000 2002 2004 2006 2008

Actual Post-1998 averageIndex

Up = rand

appreciation


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Suffering a competitive shock

Our export sector is electricity intensive

The mining industry contributes 10% of

GDP but consumes 15% of electricity

The manufacturing sector contributes

18% of GDP but consumes 26% of

electricity

Sharp price increases imply a shock tocompetitiveness

Do we need a weaker exchange rate to

maintain competitiveness?


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Suffering a competitive shock

Export sector is labour intensive

Labour costs are rising rapidly; 12.8% in 2008

and around 10% in 1H09

2.8m combined working days lost to industrial

action in first three quarters of 2009

Do we need a weaker exchange rate to

maintain competitiveness?


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Conclusions: How strong is the ZAR?

Strong but not overly so

ZAR is stronger than historical averages when adjusted for inflation

But the ZAR has been at even stronger levels in the past

SA exporters are suffering a competitive hit from labour and Eskom price hikes

-Maybe this means we need a weaker ZAR to keep us competitive?

-Maybe labour and electricity are the problems, not the exchange rate


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Is the strong ZAR affecting the economy?

What can be done about the strength?

A look at the underlying issues


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SA exports not sensitive to the exchange rate in the short term

Various studies have found that SA exports

are not very price sensitive

This can be seen in the adjacent graph

Changes in exports and USD/ZAR

-30

-15

0

15

30

45

1995 2000 2005 2010

Exports USD/ZAR

Change y/y %, 4qmave

Source: I-Net Bridge, Bloomberg, RMB FICC Research


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SA exports very sensitive to global activity

Studies have found that SA exports are

sensitive to global economic activity

This can be seen in the adjacent graph

Changes in exports and global activity

-30

-20

-10

0

10

20

1995 2000 2005 2010

Exports

Global activity (4 quarter lead)

Change y/y %, 4qmave

Source: I-Net Bridge, Bloomberg, RMB FICC Research


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Local manufacturing driven by global factors not the ZAR

SA manufacturing performance is driven by

the global economy

ZAR has had no discernable impact on local

manufacturing

Our manufacturing sector continued to

perform well in 2004 2006 despite the

strong ZAR

Our manufacturing sector is picking up

as expected, just with a delay to the

international economy


SA and US purchasing managers indices

20

30

40

50

60

70

2000 2002 2004 2006 2008 2010

SA PMI

US ISM

Index


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SA exports doing just fine

Despite the strong ZAR, South African

exports have bounced back in line with global

exports


SA and world exports invalue

terms

0

100

200

300

400

500

2000 2002 2004 2006 2008

South Africa

World

USD terms, Indexed (Jan-00 = 100)


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Yet to see an improvement in volume terms

The growth in SA exports has mostly come

about because of a rise in export commodity

prices

In volume terms, SA exports are starting to

turn the corner merely lagging the global

cycle


SA and world exports involume

terms

0

40

80

120

160

200

1990 1995 2000 2005

World South AfricaIndex


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SA exports doing just fine

After declining massively in the 1980s and

early 1990s our export performance has been

quite adequate since 1998 despite the ZAR

volatility


SA exports as a percent of total global exports

0.0

0.2

0.4

0.6

0.8

1.0

1980 1985 1990 1995 2000 2005

Percent


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A longer-term impact?

Exports might be insensitive in the short term

because of the nature of our exports

For example: mines will not simply open or

close because the exchange rate moves

they have large sunk investments and long

project start-up time

The strong ZAR might impact on exports over

the longer term


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A positive side to the strong ZAR lower inflation

A stronger ZAR feeds through into lower

inflation

Lower inflation allows for rate cuts


USD/ZAR and headline consumer inflation

0

3

6

9

12

15

2000 2002 2004 2006 2008 2010

Inflation USD/ZAR


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Would a weaker ZAR help?

A weaker ZAR would help boost exports and

employment

But it will only help if it is not deflated away by

inflation

This implies wage restraint and higher

interest rates

Historically we have not reaped the benefitsof a weaker ZAR for very long we have

allowed inflation to eat away the gains!


USD/ZAR and inflation differentials

0.00

2.50

5.00

7.50

10.00

12.50

1970 1980 1990 2000

Actual Cumulative inflation differential


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Conclusions: Is the strong ZAR affecting the economy?

There is significant anecdotal evidence that the strong ZAR is negatively impacting our export

sector and economy

This is not evident in the data our exports seem to be doing fine

Our export sector seems not to be very sensitive to the exchange rate, it is more sensitive to

global demand

Dont forget the positives: the strong ZAR is bringing inflation down and has allowed interest

rates to drop to current low levels

Mixed view


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A look at the underlying issue


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Options to consider


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Confronting the impossible (or unholy) trinity

The impossible trinity

In theory a country can only have two of the

following:

Control over interest rates,

Control over the exchange rate, and

An open capital account

Think about it, if USD/ZAR was pegged

then you could borrow at close to zero in the

US and invest at close to 7% in SA free

arbitrage

Open capital account

Control overinterest rates

Control over theexchange rate


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Implications of the impossible trinity


If we want to control the exchange rate then

we need to either:

1) Impose draconian exchange controls to

keep capital from flowing in and out

2) Allow interest rates to float





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Making the choice


Very poor countries keep government

control over interest rates and the exchange

rate

Most developed countries choose to open

their capital accounts and let the currency

float

South Africa has the developed market

model, which is sensible considering that:

Draconian exchange controls would

have major perverse implications for

the economy

We have tried and failed to control the

exchange rate in the past




Developing countries

US,UK

,EU

,SA

etc

.

HongK

ong,Denm

ark,N

amibia,

Singapo

re


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We tried and failed to control the ZAR in the 1990s

The SARB was very aggressive in trying to

control the ZAR in the mid 1990s, specifically

1996 and 1998

Even selling almost US$10bn over two

months failed to stop the 1998 ZAR

weakness

Source: I-Net Bridge, Reuters, RMB FICC Research

SARB reserve activity and USD/ZAR

-6,000

-4,000

-2,000

-

2,000

4,000

6,000

1994 1996 1998

0.00

1.25

2.50

3.75

5.00

6.25

7.50

SARB reserve activity

USD/ZAR (RHS)

US$m USD/ZAR


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A pegged ZAR would imply massive fluctuations in interest rates

Attempts to control the ZAR in the 1990s and

early this decade saw sharp interest rate

increases in response to currency pressure,

e.g. in 1996, most particularly in 1998 andwith a delay in 2002/2003

To truly control the ZAR we would need

massive interest rate fluctuations

At present this would imply rates moving

towards zero

At times of pressure, such as in October

2008, rates would have to move to 20%

or perhaps even 30%


USD/ZAR and the repo rate

0

5

10

15

20

25

1995 1997 1999 2001 2003 2005

0.0

2.5

5.0

7.5

10.0

12.5Repo rate USD/ZAR (RHS)%


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The bottom line for South Africa


We have made the right choice

An open capital account is a necessity for a

developing country

We cannot peg the ZAR

Even our ability to control the ZAR is limited





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More on capital controls


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Why we shouldnt do the same


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Options to consider


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We could ease exchange controls

The easing of exchange control limits on

offshore investments by residents historically

generated capital outflows

Offshore investment limits and flows

-7.5%

0.0%

7.5%

15.0%

22.5%

30.0%

1990 1995 2000 2005 2010

-1.5

0.0

1.5

3.0

4.5

6.0

Unit trust limits

Institutional limits

Outflows (RHS)

As % of assets % of GDP

Source: I-Net Bridge, SARB, RMB FICC Research


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We could ease exchange controls

The relaxation of exchange controls

internationally has often caused currencies to

strengthen

The local experience has been the exact

opposite

Foreign investors face very little restrictions

so they would not be encouraged to invest

more by further relaxation

We missed our chance to abolish controls in

2004 and 2005

We should use this opportunity

Source: I-Net Bridge, SARB, Reuters, RMB FICC Research

Offshore investment limits and USD/ZAR

-7.5%

0.0%

7.5%

15.0%

22.5%

30.0%

1990 1995 2000 2005 2010

0.0

2.5

5.0

7.5

10.0

12.5

Unit trust limits

Institutional limits

USD/ZAR (RHS)

As % of assets


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Options to consider


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Should the SARB intervene on the currency?

SARB has been building up reserves since

1998

Should they accelerate their reserve

purchases by buying USD more aggressively,

thereby putting pressure on the ZAR to

weaken?

Source: I-Net Bridge, RMB FICC Research

SARB foreign reserves

-30,000

-15,000

0

15,000

30,000

45,000

1990 1995 2000 2005

Gross reserves

Net reserves

US$

S


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SARB has been relatively inactive

Authorities have tried to talk the ZAR weaker

The SARB was very inactive in the market

despite the ZARs appreciation in 2009

Only Octobers reserve data suggests any

real reserve purchases

This activity is a lot less than in the past cycle

Should they be more aggressive currently?


Reserve accumulation and USD/ZAR

-500

0

500

1,000

1,500

2,000

2005 2006 2007 2008 2009

5.00

6.50

8.00

9.50

11.00

12.50Reserve accumulation

USD/ZAR (RHS)

Trigger level (RHS)

US$m

Th d t d


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They dont need more reserves

The SARB might be unwilling to act because

reserves are already at adequate levels

By an adequate level we mean they meet the

normal international ratios

Reserve adequacy ratios

Ratio Standard

Guidotti ratio 1.45 1.00

Augmented Guidottiratio 1.05 1.00

Reserves to foreign currency debt(percent) 101% -

Import cover (months) 6.4 6.0

Import and service payment cover(months) 5.5 6.0

Reserves to M2 (percent) 19% -

Reserves to GDP (percent) 12% -

Source: I-Net Bridge, SARB, RMB FICC Research

Th SARB i th t i t ti i ht b i ff ti


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The SARB worries that intervention might be ineffective

Older historical evidence suggests that

intervention on currencies is generally

ineffective

Evidence of the attempts to control the ZAR

in the 1990s is not very encouraging

More recent international evidence is more

favourable

Note: acting to stop appreciation is easier

(there is no limit on the maximum size of

reserves) than acting to stop depreciation

(you run out of reserves to sell)

Intervention can never control the ZAR it can

only slow or smooth its adjustment

Confronting the issue of sterilisation


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Confronting the issue of sterilisation

If the SARB buys USD it must sell ZAR

This boosts the money supply

The SARBs policy is to sterilise (remove from circulation) this money

They do so by selling bonds or debentures

As such, the SARB is left with a USD asset, paying close to zero, and a ZAR liability, costing 7% or so

It is argued that this sterilisation cost limits how much they can buy from the market

Sterilisation and uncovered interest rate parity


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Sterilisation and uncovered interest rate parity

Uncovered interest rate parity argues that the

ZAR should weaken in line with interest rate

differentials

As such, capital gains on reserve holdings

should offset the cost of sterilisation

E.g. SARB pays 7% sterilisation cost but

the value of reserves would rise 7% if

USD/ZAR rose by the same amount

The sterilisation costargument is overplayed!

Uncovered interest rate parity

If SA rates = 7% and

US rates = 0% then

USD/ZAR should rise by 7% peryear

An incoherent argument: We should use unsterilised intervention


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An incoherent argument: We should use unsterilised intervention

If sterilisation has a cost, why just intervene

but not sterilise?

The problem is that the ZAR created by

reserve purchases would be left in the market

This would drive money market rates

downwards its like printing money!

Eventually the SARB would have to stop

intervening and let the currency float or it

would lose control over local interest rates (it

all comes back to the impossible trinity)

Reserve accumulation and USD/ZAR

An incoherent argument: SA doesnt have enough reserves


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An incoherent argument: SA doesn t have enough reserves

It is often argued that the SARB cant

intervene to stop ZAR appreciation because it

does not have enough reserves

But stopping appreciation requires that you

buy reserves, not sell them

Having low levels of reserves is no problem

whatsoever

When would intervention be more effective


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When would intervention be more effective

The ZAR moves in line with other high

yielding and commodity currencies if policy

makers also act to stop appreciation in those

currencies then local intervention will be more

effective

Evidence shows that intervention is generally

only effective when its consistent with

general; monetary policy objectives i.e.intervention to stop appreciation is more

effective in a rate cutting cycle and ineffective

in a hiking cycle


Currency rates versus the USD

50

70

90

110

130

150

Jan-08 Jul-08 Jan-09 Jul-09 Jan-10

ZAR AUD NZDIndex

weakness

strength

Options to consider


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Options to consider

Should we use interest rate cuts to weaken the ZAR?


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Should we use interest rate cuts to weaken the ZAR?

Our monetary policy regime uses interest

rates to target inflation

If interest rates are also used to target the

currency then we potentially have a conflict

To some extent a strong or weak ZAR does

impact on policy anyway a strong ZAR

lowers inflation and hence allows rate cuts

One can see from the graph that interest

rates follow the ZAR


Interest rates and the ZAR REER

0.0

5.0

10.0

15.0

20.0

25.0

1995 2000 2005 2010

65

80

95

110

125

140

Repo rate REER (RHS)%

Would cutting interest rates weaken the ZAR?


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0

5

10

15

20

25

1980 1985 1990 1995 2000 2005

South Africa

Global median

Percent

ou d cutt g te est ates ea e t e

ZAR driven by carry trade flows

Reduce rates would take some of the shine

off the attraction of the ZAR

But even with aggressive cuts local rates

would still look very attractive

Remember also that the gains from ZAR

weakness would only be temporary unless

inflation was contained

Consider that Australia and New Zealand

have also seen sharp inflows even through

there rates are significantly lower

Bottom line: rate cuts would help only a little


Global and local interest rates

How about creating a sovereign wealth fund?


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g g

If we created a sovereign wealth fund it could

take money offshore to invest, which would

weaken the ZAR

But where would the cash come from?

Our government does not have the excess

wealth (sustained budget surpluses)

necessary to invest in a fund

The idea is a non-starter

Options to consider


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p


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A look at the underlying issue

The underlying issue is that the ZAR swings massively in value


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The problem now is of ZAR strength

In 2008 it was of ZAR weakness

We need to address the issue of ZAR

volatility


USD/ZAR fell sharply in 2009

5.00

7.00

9.00

11.00

13.00

15.00

2004 2006 2008 2010

The ZAR is the most volatile currency in the world


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Source: Bloomberg, RMB FICC Research

Volatility against the USD since 2008

The ZAR has experienced the highest

volatility of any of the liquid global currencies

on the USD cross in recent years

0.0 5.0 10.0 15.0 20.0 25.0 30.0

ZARBRLAUDKR

PLNTRYNZDCZKSEKNOKMXNCADJPY

CHFGBP

ILSEURDKKIDR

RUBINRPHP

SGDMYRTHBTW

ARSCNY

Volatility %

Volatility has been rising


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0%

10%

20%

30%

40%

50%

60%

1990 1995 2000 2005

Volatility

Source: Reuters, RMB FM Research

90-day rolling USD/ZAR actual volatility

Volatility has been rising

Contrasts with other markets that, until the

recent crisis, had seen volatility reduce (the

great moderation) The reasons for this rise in volatility has not

been studied as far as we are aware

Why is the ZAR so volatile?


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Source: BIS, RMB FM ResearchNote: Currency volatility is defined as annualised standard deviation of

real effective exchange rates. 52 countries in sample. Period: January1994 September 2008. SA marked as the red dot.

Inflation and currency volatility

Why ZAR volatility is so high:

High inflation

Low income levels

Commodity exporter

Sophisticated financial markets

Export sector relatively insensitive to

exchange rate movements

High inflation = high interest rates =

exposure to carry trades = high currency

volatility

R2

= 0.4917

0%

5%

10%

15%

20%

25%

0 1 10 100 1,000Inflation (log scale)

Volatility

If we want to stop the massive

swings in the ZAR we need tobring down our inflation rate!

Conclusions: What can be done about ZAR strength?


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We cannot peg the ZAR

Reducing interest rates sharply would weaken the ZAR but rampant inflation would mean any

gains are fleeting

The SARB could be more aggressive in building reserves the sterilisation cost argument is

overplayed

We could and should ease exchange controls

Any weakness in the ZAR is meaningless unless inflation is also controlled

The only real solution is a longer term one: bring down our inflation rate to that of the developed

world thereby reducing huge swings in ZAR value

Only a little

A reputation for product excellence


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2009:Fixed Income: Interest rate swaps

Inflation

Currency

Overall category winnerCross currency swaps (USD/ZAR)

Currency options (USD/ZAR)

CommoditiesOverall category winner

2008:Inflation

Currency options USD/ZARCross-currency options USD/ZAR

Forward rate agreementsRepos

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Disclaimer

Whilst all care has been taken by FirstRand Bank Limited, Registration No. 1929/001225/06 (acting through its Rand Merchant Bankdivision (the Bank)) in the preparation of the opinions and forecasts and provision of the information contained in this report, the Bankdoes not make any representations or give any warranties as to their correctness, accuracy or completeness, nor does the Bank assumeliability for any losses arising from errors or omissions in the opinions, forecasts or information irrespective of whether there has been any

negligence by the Bank, its affiliates or any officers or employees of the Bank, and whether such losses be direct or consequential. RandMerchant Bank (a division of FirstRand Bank Limited) is an Authorised Financial Service Provider.

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RMB February 2010 How Strong is the ZAR and What Can Be Done About It