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  The rand during commodity cycles ‘’The three to four decades of free floating exchange rates around the world show that most commodity currencies only hold their own over the period during the last up...  

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SA financial markets during the commodity super cycle

Part 4 of Mike Schüssler’s commodity super cycle series.

Read Schüssler’s three previous articles in this series:

 

The rand during commodity cycles

The three to four decades of free floating exchange rates around the world show that most commodity currencies only hold their own over the period during the last upward phase of the commodity cycle.

The currency is the job market shock absorber for the commodity-based economy during times of weak commodity prices. In nearly all cases when major commodity prices decline, the currencies of those commodity exporters devalue.

It makes sense as those countries will get less in earnings from their major exports and may not be able to finance all their imports anymore. So a weaker currency slows imports – if not even causing an absolute decline in them as the current accounts would have bigger deficits if not for currency declines.

There is no doubt that the rand will fall steeply and more permanently during this downward phase than most expect. During the last downward phase the rand lost 88% of its value between 1981 to 2000.

By the end of 2015 the rand had lost over 55% of its value since the commodity peak in 2011 and it’s likely to lose more. Already at the time of writing the rand had lost a further 8% since the start of 2016. (See chart further down).

Currently just under six American cents buy a rand, down from over 12 cents in 2011. (Remember that another 50% fall will now only bring the total fall to just over 75%. ) In fact the rand lost 2.2 American cents just in 2015 as it cost Americans 8.65 American cents to buy a rand at the end of 2014 and only 6.45 at the end of 2015.

Since then the rand declined again and currently 5.95 American cents buy a rand. A decline of less than 1 US cent will therefore take the rand to R20 to the dollar. It is really that simple for the trader in New York at present.

A 3 US cent rand would translate into over R33 per dollar and this is more than likely by the end of the downward phase in 2030 or so. If the rand has the same percentage decline as during 1981 to 2000 then the currency would be over R70 to the dollar or less than 1.5 US cents per rand!

Rand performance over the decades against the dollar

Screen Shot 2016-01-21 at 12.09.01 PM

 

Source: Economists.co.za

Remember too that for most of the 1980s the country constrained imports, which seems unlikely now and currency liquidity is much higher now than in the last cycle so more downward pressure on the currency can be expected.

The decline in the rand will however save much of South African mining and manufacturing and allow the country to explore new options for growth – as long as the hand is a guiding hand and not an oppressive hand and unrest is limited.

This will however keep commodity prices low as other commodity currencies will also decline and help keep the oversupply of many commodities intact far longer than anyone currently expects.

Inflation during the long downward phase

As the currency has a significant influence on the inflation rate and most of the fall in commodity prices will be muted for South Africans, expect inflation to exceed the average of the past decade. One can expect single-digit inflation but above 6% on average, probably now closer to 8%.

I do expect inflation at a higher rate than from 2000 to 2010 in total as we are a small open economy, but I also think that with lower barriers to entry in many fields because of technology we should not have double-digit inflation overall but possibly for a short period of a year or two.

The previous first part of the downward phase of the commodity cycle saw consumer prices rise 240% over the decade. This was driven not by low commodity prices of course but by the weaker currency and our need at the time to make things ourselves.

The rand will drive inflation more than commodity prices. The demand side inflation may remain low but any extra buying of imported good will increase the current account and the country will have very little to sell back – so demand will have to remain subdued for a period or the inflation impacts could be higher.

Inflation in SA over the decades

Screen Shot 2016-01-21 at 12.21.45 PM

Source: Economists.co.za

Interest rates will also increase a little and remain there for quite a while

At first, interest rates remained low as the world exited the early 1980s but then inflationary pressures resulted in higher interest rates and South Africa went from negative real rates to a positive real rate by 1986. Much the same seems to be happening now as inflation slips out of the bag due to currency declines and, at present, the drought.

It is clear that the policy stances have moved on from the mid-eighties so one does not expect high double digit interest rates but one can expect rates to gradually increase to a repo rate that will be higher than inflation (which I estimate could go to 8% or so for a longer period of time)

This will result in interest rates such as the prime rate going closer to 12% or even 13%.

Government yield has already increased and is likely to remain elevated for a period until budget deficits are well below 3% and the current account is also closer to that number – both as a percentage of GDP.

The second phase of the down cycle seems to suggest lower interest rates and smaller increases in inflation as most of the adjustment happens in the first decade. Nonetheless for South Africa and others in a similar boat this will be because adjustments are forced upon us.

I would expect a period of at least half a decade of higher interest rates than now for both the prime rate and government bonds. Probably much lower than the 1980s but nonetheless higher than now partly due to higher inflation and partly due to risk increases brought about by the lower commodity prices in the long wave down phase.

I do not have a strong view on the JSE at present on the commodity cycle

You may ask about the JSE and I would have to say that it will be ruled more by factors outside the country as most revenue now comes from outside the country. The trend of looking for investments outside of South Africa will continue and should be a strong suit in the rand over time, but with large dividend outflows cancelling foreign profit inflows I suspect that they would cancel each other out.

So the JSE will act independently of the SA economy but mining shares and others will obviously be influenced by the commodity cycle. But their role will remain very small for a long time to come. (This excludes gold shares which are outside of the commodity indices)


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I wish you used the same colours for the same periods in the two charts. Otherwise a very informative and interesting series of articles.

The rand during commodity cycles

‘’The three to four decades of free floating exchange rates around the world show that most commodity currencies only hold their own over the period during the last upward phase of the commodity cycle”

“’The currency is the job market shock absorber for the commodity-based economy during times of weak commodity prices. In nearly all cases when major commodity prices decline, the currencies of those commodity exporters devalue.”

Very good article again Mike but I don’t really agree with the two abovementioned statement as:
• I tested the 14 years (just after the fixed exchange rate and gold price) and the Gold/Rand price was trading at ZAR 2189
• I then tested the exchange rate and gold price when the ANC took office in 1994 and the gold rand price went slightly UP to ZAR 2275, when the Gold Price fell and the USD/ZAR exchange rate weakened.
• During the Mbeki reign, the ZAR weakened to USD/ZAR 6.80000 in 2007 despite the fact that the US $ gold price went up. The Gold/Rand price rose to ZAR 5032
• During Zuma’s reign, the Gold price rose to US$ 1.060 and the Dollar /Rand weakened substantially to USD/ZAR 17.50 in 2016. The Gold/Rand price rose nicely to ZAR18, 550 per fine ounce.
The Dollar Rand therefore did not hold when its own over the last upward phase of the commodity cycle.
I also always believed that the ZAR will strengthen when the US $ gold prices rises but there were clearly other forces (political?) as the Gold Rand prices went through the roof to ZAR 18.550 when it should have fell.

The USD/ZAR exchange rate in the beginning 1980: USD/ZAR 1.1000

The Gold Price in the beginning of 1980 US$ 1990
AU/ZAR price during this period ZAR 2189
The USD/ZAR exchange rate in the beginning 1994: USD/ZAR 3.5000
The Gold Price in the beginning of 1994 US$ 650
AU/ZAR price during this period ZAR 2275
The USD/ZAR exchange rate in the beginning 2007: USD/ZAR 6.8000
The Gold Price in the beginning of 2007 US$ 740
AU/ZAR price during this period ZAR 5032
The USD/ZAR exchange rate in the beginning 2016: USD/ZAR 17.5000
The Gold Price in the beginning of 2016 US$ 1060
AU/ZAR price during this period AU/ZAR 18,550

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