The South Africa rand declined on Friday in line with emerging market currencies as hints from the United States Fed indicate that it would remain on a policy tightening path depleted the demand for risk that heightened after the US election results. Recently, the rand strengthened following a positive change in investor attitude concerning emerging markets (EM), and Investec, one of South Africa’s top investment management banks, expects further progress.
Investec’s call came at a time when the South African rand had an impressive run that has seen it rise against the G10 peers over the past month, with a gain of 5.4% versus the pound and a gain of 4.6% relative to the dollar.
Analysts at Investec see a 40% chance that the rand will rise towards the end of the year, but warn against a 35% risk that the currency will enter into a steeper downward trend.
The critical question now is whether the rand can maintain these gains.
South Africa’s budget, credit rating, and economic downturn
A significant reason for the rand’s recovery seen earlier this month is the defrosting of previously frozen relations between Beijing and Washington, signifying that the most unpleasant trade war scenario will perhaps be averted.
Xi Jinping and Donald Trump, both presidents, have expressed their willingness to arrive at a trade agreement. Xi Jinping has stated that his government intends to lower import tariffs and tackle intellectual property theft, while Trump said he is interested in talking to Xi at the G20 and is open to an agreement and has ordered his officials to begin drafting a treaty. While the prospects for world trade appear to be getting better, the query remains whether the domestic headwind could be a botcher or not.
Concerns about the government’s medium-term budget statement (MTBPS) have however begun to weaken the rand. In addition, concerns about the country’s creditworthiness, which is Baa3, only one level more than the minimum investment grade, contribute to the weakness. Tito Mboweni, the Finance Minister of South Africa, presented an expenditure plan at the end of October that will leave the overall budget shortfall at 4% and 4.2% in 2018 and 2019, respectively.
That contrasts with the government’s February forecasts, which claimed that the deficit would decline to 3.6% in 2018, from 4.3% last year and become stable at 3.5% by 2020. In February South Africa avoided a “junk status” rating, but analysts are wondering for how long Moody’s will leave the South African currency at “investment grade.”
Commenting on Rand’s weakness, Cristian Maggio, head of emerging market strategy at TD Securities, said “We now see higher risks of a downgrade to junk by Moody’s over the next 12-18 months, although we continue to assess this risk below 50%. The biggest imminent risk, in our opinion, is the change of outlook by Moody’s on SA’s sovereign debt from stable to negative, which would prompt markets to price in higher odds of a downgrade – this could already happen over the course of November or December.”
Losing the investment-grade ranking would be damaging for both the economy and the South African rand, as funds whose portfolios correspond to the Citi World Government Bond Index will have to discard South African bonds. In August, foreigners held roughly 40% of the government bonds, and any credit downgrade would result in a substantial increase in capital outflow and a new problem for the currency.
Annabel Bishop, an analyst for Investec bank, said: “The Rand’s retracement since September has had a few false starts, most recently SA’s MTBPS which saw the yield on the R186 reach 9.45%, with Moody’s deeming this mini-Budget ‘credit negative.”
As the country’s creditworthiness is dangerously above the minimum investment grade level by a minimum, there is undoubtedly a risk that a growing budget deficit will put the country’s bonds in junk status. However, Investec argues that this will not happen. The primary expectation of Investec with a probability of 40% is that SA will maintain its “investment grade” rating.
Analysts expect the economy to expand by 2.0% and 3.0% in 2019 and 2023, respectively, which is significantly higher than the present annualized contraction of -0.7% in the second quarter of 2018 and the first-quarter contraction of -2.6%. South Africa is currently in a technical recession.
However, the possible compulsory confiscation of land for redistribution purposes is a significant risk faced by the financial markets. Overseas investors are afraid that the government could suddenly confiscate their assets, and if the plans were executed without any amendments, it would lead to a massive decrease in foreign investment and strain the rand.
ETM economist Halen Bothma had the following to say about the rand’s weakness: “The rand along with its emerging market peers struggled today and gave up gains for the week as momentum in favor of the dollar after the Fed meeting. Fresh tail wind supported the dollar after the hawkish Fed affirmed that it would be continuing with policy stabilization.”
South African mining production has contracted, manufacturing remains weak, primarily due to refinery closure and other disruptions, net trade has fallen steeply in the first quarter, and the agriculture sector is performing weaker than expected, partly due to drought.
The country’s poor economic performance makes it increasingly difficult for the government to balance national books because the economy continues to underperform after slipping back into recession in 2Q18. This means that the rand could lose further after the US political situation settles.
Technically, the rand is moving along a descending channel as shown in the image below. The greenback is now moving towards the upper range of the channel after testing the lower range, which acts as support. As a result, we can expect the US dollar to gain further ground against the rand.
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