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Does the rand-dollar PPP actually tell us anything?

For starters, there isn’t consensus on what the purchasing power parity level actually is.
Over time, the rand has weakened more than just inflation differentials would suggest. Image: Waldo Swiegers, Bloomberg

Views on the rand seem to be inherently controversial. This is not only because forming a view on the currency’s direction inevitably seems to be a fool’s errand, but it is a topic that South Africans find emotive.

So, when Methodical Investment Management’s fixed income portfolio manager Jean-Pierre du Plessis posted a rand-dollar purchasing power parity (PPP) chart on social media last week, he must have known he was courting a response.

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Du Plessis’ chart showed that, for the first time since 2013, the rand was below its PPP level. This he calculated as R14.16 at the end of April.

Source: Methodical/Bloomberg

However, calculating the ‘fair value’ of the rand is not an exact science. As PSG Wealth portfolio manager and strategist Schalk Louw pointed out in response, the starting point you chose for your calculation matters.

Different periods

Essentially, a PPP calculation is showing an inflation differential. In the case of the rand-dollar exchange rate, that would be inflation in South Africa minus inflation in the US. All else being equal, the rand should trend on that line.

But countries go through very different periods and inflation regimes. As a result, where you start the calculation could make a significant difference to the outcome.

“As an example, I used the last time the rand was trading at R1 to the dollar as a starting point, because then, in theory, your inflation differential should have been more or less the same,” Louw said in an interview with Citywire South Africa. “Using actual inflation differentials from that point on to date, and actual rand movement, you could a very different picture.”

Source: PSG Wealth

On this view, the rand is still well above ‘fair value’, and in fact has never traded meaningfully below it.

Louw acknowledged that this isn’t an entirely serious calculation. In the 1980s, South Africa was under sanctions and exchange controls were in place. The value of the rand was not therefore being set in an open market.

However, it still raises the question of the usefulness of PPP as a measure. Louw’s preference is to use the below graph, showing the rand relative to PPP.

Source: PSG Wealth

“I use this as a guideline,” Louw said. “It’s just to show us those really overly-negative or overly-positive environments where the rand really overshoots. We saw it in 1986 with the Rubicon speech, in 2001 when rand was manipulated, in 2016 when Zuma played with his ministers of finance, and we saw it when the rand blew out last year after the downgrade to junk.”

Rolling start date

Methodical’s Du Plessis takes a different approach. His preferred PPP calculation is a rolling 10-year geometrically weighted calculation, which is what is reflected in the first chart above.

“This gives you a weighted start time,” Du Plessis said. “I’m by no means saying that makes it 100% accurate, but I think it gives a good sense of whether the rand is historically cheap or expensive.”

He added that using a rolling 10-year geometrically-weighted average for inflation provides a better picture, in his view.

“If you use the differential over a very long term, the risk is that you end up with something that loses its relevance. I’m not suggesting that you are going to day-trade the rand versus its PPP, but you do want something that is relative to something that exists today, rather than something that was the case 50 years ago.

“That’s why I think it’s a better model to have a rolling start date. Whatever start date you have with PPP is going to be a problem because of the way it works. But if you have a rolling start date, and weight that towards the most recent past, then you do end up with something that is more anchored.”

Necessary, but insufficient

With these varying takes on PPP, then, how much does it really tell investors?

John Cairns, head of research at Rand Merchant Bank (RMB), said that the consensus from economists is that “PPP probably holds in the long-term”.

“The theory is a strong one, but the evidence is very mixed,” he added. “In South Africa’s case, I would argue that PPP is a necessary but insufficient explainer of the rand in the long-term.”

This is because, over time, the rand has weakened more than just inflation differentials would suggest.

“This you might think could be explained by South Africa’s low growth – the Balassa-Samuelson effect. But, in practice, the rand’s underperformance has not matched well with the ups and downs on the country’s long-term growth prospects.”

Cairns added that RMB runs various fair value estimates for the currency, with the chart below being one he finds particularly useful.

Source: RMB

In this case, they have used the real effective exchange rates of both the dollar and the rand (the trade weighted exchange rate adjusted for inflation) and made a further adjustment for the rand’s tendency to depreciate faster than inflation. This model puts the PPP level on USD/ZAR in May 2021 at around 14.65. Like Du Plessis’s chart, it therefore shows the currency having now slipped into the expensive side of fair value.

Cairns added that RMB uses this PPP model as a useful tool to understand the valuation of the rand, although their forecasts are built on more complex behavioural models – which, he said, “go by the favourably termed behavioural effective exchange rate, or Beer”.

Patrick Cairns is South Africa editor at Citywire, which provides insight and information for professional investors globally.

This article was first published on Citywire South Africa here, and republished with permission.

COMMENTS   17

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There are two main factors that support the RAND right now – supply and demand. Capital expenditure became something of the past in sunny SA -no more big imports.

Exporters are now forced to convert their dollar export proceeds very fast now, hence the strengthening of the rand. The rand has always been a ”order market”, and the orders are mainly on the export side now.

The second and very important factor for the Rand is the Yield due to very favorable interest rates for Global investors.

The US rates are kept down ”artificially” which benefits most emerging market currencies, all over the globe.

I have been calling this strengthening bias of the rand for the last couple of years – it has now reached my target of 13 ish…The Rand is on its way to 10 right now (maybe a bit of a breather first)and you sell the rand at your peril.

In my FX Trading days we always watched the ”rand sentiment” – the sentiment is very strong pro-rand now, but I also believe there are only two people in the world that knows where the rand is heading – problem is, they don’t agree.

And volatility wouldn’t be such a problem if we didn’t import so many consumer and business products or exported so many HNWI and skilled folks. Everytime the rand blows out the whole economies business confidence goes in the toilet. Tricky to make long term investments in those situations.

Lots of volatility was/is created when the USD/RAND trends directional (like now), and leads and lags kicks in, as the market (importers and exporters) dynamics change.
I think the ZAR has now reached levels where it’s cheaper to manufacture locally – hence imports are replaced and non-competitive. I have become very anti-globalisation (as an emerging marketer) as these globalists drains African resources.
One of the biggest currency outflows on a contingent basis is dividend payments and accrued ”interest” on all the ”carry trades”. Vodacom Group is majority owned by Vodafone (64.5% holding), and one of the world’s largest communications companies by revenue. Massive profit payments are done annually . Thank goodness Barclays PLC sold out of Absa !

“I have become very anti-globalisation (as an emerging marketer) as these globalists drains African resources.”

Start studying economics at university level. Australia gains $130bn a year from exporting iron ore. That’s just from iron ore…$130bn.

Nobody is draining Africa’s resources. The business environment has to attract foreign investment, the level of business taxes have to be attractive to LOCAL and FOREIGN investors.

A weak currency is NO INCENTIVE for foreigners to invest in a country, otherwise they would be lining up, standing queue in order to invest in Zimbabwe, Zambia and all the countries with Mickey Mouse currencies and cheap labor costs.

No the business costs, the level of infrastructure, the technological development is what counts: ports, railways, computers, bulldozers, universities… and not your labor costs are Karl Marx believes …

STABILITY. FINANCIAL STABILITY. Singapore attracts more foreign investment than South Africa! 4 times more! Meanwile there’s not even 12 hours of sustained electricity production in Zambia a day! How can you mine even in such an environment!?

And no the carry trades is not weakening South Africa’s Rand: Google South AFrica saw FDI inflows of R51.1-billion for all 2020, down from inflows of R74.0-billion in 2019.

Stop listening to Buddy Wells and the rest of the saxophone players on Twitter pretending they went to university, technicon and are qualified economists, business peopl and stop relying on MMT theories…. look at the US dollar dropping Buddy Wells…. Not even the savings of 200 countries can’t prop up the crashing dollar.

Any other strong views – I never knew that Australia was an emerging market!

No need to get personal – In my Corporate FX trading days, I worked with a lot of University ”whizz kids” – they didn’t last as nothing in the FX market are learnt faster and better than the practical experience – only the ones that studied”financial markets”, survived – ask me I know!

I’m sick and tired of some people giving foreign investors the blame for the weak Rand. The Rand is not weak because of foreign investors. The Rand is weak, historically, because we have the HIGHEST business and personal income taxes in the developing world. Our labor productivity is at a 70 year low – people are not motivated to work in such a high tax business environment. We have bankrupt municipalities. Bankrupt SOEs. Our infrastructure is crumbling. Our life expectancy is one of the lowest in the developing world. Our crime is one of the highest in the world. Our fuel prices are some of the highest in the developing world. We have a corrupt government that controls most of the economy. DESPITE that … foreigners invest, hoping to help us sink another mine shaft, start up new businesses, expand our business operations despite a lack of electricity… our militant unions want 15% salary increases during a global economic pandemic! No it’s the not the foreigners that are to blame for the weak Rand.

It’s our poor attitudes towards business! It’s also the disgusting discrimination that exists in labor and business relations … and the hatred of foreigners, the xenophobia, the violent attacks. That’s the reason the Rand is weak. Paris, the world’s top tourist destination, attracts 30 million visitors a year. People want to visit Paris? Why? Because that multicultural country welcomes foreigners and foreign investment and the French people are FAR richer because they have successfully created millions of restaurants, businesses, many foreign owned, they have created a super business environment where everyone wants to visit. The MOST expensive real estate on earth is the Champs Elysees. Paris. France. Millions of restaurants, millions of businesses, foreign investment all compete and that creates wealth and competition for employees driving up wages and employment.

It tells us nothing. It’s about the over-orinted US Dollar, not so much about the Rand.

100%

30% more US Dollars printed since Jan 2020, that is why the Rand went up plus the Gold price stayed steady.

Eskom is going to hit the Rand like a train today!

What does it matter? There is no thing such as an overvalued currency. As Peter Schiff has said: what is more important than the value of a country’s currency? Nothing. It is the ultimate price in an economy. It determines the value of everything in the economy… and your country can’t raise its production by 20% a year if the currency drops by 20% a year. Production and sales generally increase by a mere 2% to 4% a year. So if your currency depreciates by more than 4% a year vs other currencies in the world, your economy will struggle to pay for the products available for import from 200 countries! And South Africa desperately needs oil, computers, electronics and machines.

“I used the last time the rand was trading at R1 to the dollar as a starting point, because then, in theory, your inflation differential should have been more or less the same.”

Astonishing statement. How does it come out of the mouth of someone who works in finance, and why is it allowed into the article by someone who writes about finance?

As for “2001 when the rand was manipulated”, please, both of you, go read the report of the Rand Commission. There was no manipulation.

https://www.justice.gov.za/commissions/comm_rand/final%20report.htm

…..not if you don’t call Central Bank Intervention – exports?

PPP is a theory, but agree with Patrick’s assessment. USD/ZAR currently only based on dollar weakness and demand for commodities, thanks to the Fed’s easy money policy. Further rand rally expected over the short term and will only turn around once monetary tightening happens. This is when the party will end and asset bubbles will burst!

Where are those who called R25/$ last year and advised investors to invest offshore?

Maybe Nasdaq7 was one of them – ask him?

I never called R25/$ because I am not a seer but what I will call that if you did invest abroad keep it there and in fact invest some more abroad especially now with the rand on the upswing. What goes up eventually falls. You will not be disappointed.

The long-term trend is always one of continuous weakening against major currencies.
The Rand does put up the odd fight, but then it receives a serious blow, either from within (Let’s not elaborate on this one!), or it takes it on the chin for some less developed country not honoring its debt.

There’s also a long-term inflation differential between SA and major economies, hence the theory that PPP should hold, and the teams should devalue at approximately the same rate as that inflation rate differential over time…

End of comments.

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