Two measures show the rand is undervalued

Determining the value of the rand exchange rate is tricky at the best of times but the exercise is not a superfluous one. With the scrutiny banks are facing and the accusations of currency manipulation and price fixing of the rand exchange rate, there could not be a better time to consider what may be its fair value.

It is not the actual value of a currency’s trading in the open market but its stability that concerns the treasurers hedging currency exposures. This is where purchasing power parity (PPP) models are rather useful — they are anchors of stability when spot exchange rates are excessively volatile.

Over long periods of time, PPP calculations have been regarded as generally accurate. A deep data series, longer than 30 years, is needed. The rand meets this criterion.

But the data series have some limitations. One is that the local exchange rate was hamstrung by a two-tier exchange rate — the financial rand and the commercial rand — which was abolished in 1995. There were other instances when the introduction and abolition of capital restrictions distorted the market value of the rand.

Knowing which economic variable to choose in a PPP calculation is a lot easier for a currency such as the rand.

SA is largely regarded as a commodity-linked country, so producer price inflation is an obvious indicator of choice.

This simplicity, however, has limitations. An obvious one is the use of only one set of economic variables. Another is the comparison of a developing economy (SA) with a developed one (US). Local prices are also distorted by adjustments in administered prices that exceed the inflation target and, more recently, also by the effect that adverse weather conditions had on the prices of goods monitored at the factory gate — although the high base that followed may technically encourage lower readings in annualised growth rates of inflation readings over the next 12 months. Theoretically, this should also assist in moving the spot rand exchange rate towards its PPP.

The Big Mac index allows market participants to realise that the mechanics of these currency calculations are broadly the same. The extent to which a currency is under- or overvalued can broadly be determined by comparing the price of a hamburger in Johannesburg, where it is more than 60% cheaper than it is in New York, with the same burger in Switzerland, where it is more than 30% more expensive than it is in the US.

Take a hamburger out of the equation and put an inflation variable in its place and people soon realise why the rand is considered to be grossly undervalued against the dollar on a PPP measurement.

It is, of course, not as simple as that. A base year has to be chosen for the PPP calculation to work. For SA 1994, makes sense, not only because seismic political change took place then, but also because it was the year when the country got its first credit rating. Until then, SA’s political pariah status had prevented US pension funds, for example, from investing in government bonds.

After these variables are plugged into the PPP model, the outcome is a valuation estimated to be R10.65/dollar. (See figure 1.) But this is a theoretical valuation.

Referencing this value against the spot exchange rate of about R12.97/dollar, the local exchange rate is considered to be grossly undervalued against the US dollar.

For confirmation that the rand is undervalued on the basis of its PPP, look no further than the real effective exchange rate of the rand — an inflationadjusted basket of 15 currencies monitored by the Reserve Bank. The weightings of its components are determined by international trade in manufactured goods.

This basket of currencies is dominated by the eurozone, which has a weighting of 34.82, suggesting that where the European unit goes, the rand should, by default, follow. Other doubledigit weightings go to the US (14.88), China (12.49), the UK (10.71) and Japan (10.12).

This diversity in weightings suggests why local monetary policy makers emphasise time and again that it is not only the value of the rand exchange rate against the US dollar that matters but rather the performance of the rand against a basket of currencies — especially when deliberating gear changes in the direction of the policy rate. Figure 2 corroborates the view that the rand is undervalued, being at below 100, a key threshold.

The South African unit is off its historic intraday low of almost R17/dollar, which it reached a year ago following the controversy in changes made — and later reversed — in the finance ministry.

But it is important to recognise that while it appears there may be room for the rand to strengthen further towards its PPP, the weaker level it got to did not happen overnight. It was caused by shifts in political and economic risk factors not only in SA but elsewhere, especially in the US. The rand is not a one-way bet.

The one thing PPP and the real effective exchange rate have in common is the effect that inflation has on their outcomes. They both suggest that the South African currency’s exchange rate is undervalued, not only against the US dollar, but also against a basket of key currencies, even at current levels.

It would be shortsighted to condemn the rand to a path of perpetual weakness, especially if the track-record of these models is used as a yardstick.

WHILE THERE MAY BE ROOM FOR THE RAND TO STRENGTHEN, THE WEAKER LEVEL DID NOT HAPPEN OVERNIGHT