The Rand: Do we need a significant currency depreciation?

by David Irish | March 26, 2020

BCA Research Inc.’s recent Emerging Markets Strategy weekly report prescribes a weakening of the rand versus the US dollar for South Africa to sustain a healthy public debt-to-GDP ratio.
Any business that has a declining debt-to-revenue ratio could find it harder and harder to service its debt unless it can sufficiently increase revenues, achieve higher margins and/or lower its overhead expenditure. If this cannot be achieved its value will decrease.
The same applies to countries.
Two prerequisites for public debt sustainability are:
1.     for interest rates to be below nominal GDP growth or
2.     continuous robust primary fiscal surpluses, meaning government revenues exceed government expenditure net of interest payments on a consistent basis.
South Africa is currently reflecting the opposite.
The gap between government local currency bond yields and nominal GDP growth is at its widest since 2009. (BCA Chart 1).

Meanwhile, the primary fiscal deficit is 0.75% of GDP (BCA Chart 2). It is worth noting, however that although South Africa has not had a primary fiscal surplus for ten years, the deficit percentage has been declining.

Faced with very low real potential GDP growth stemming from the economy’s poor structural backdrop, the authorities ultimately have two choices to stabilize the public debt-to-GDP ratio:

1. Allow inflation to rise in order to boost nominal GDP growth above borrowing costs. This would require a lowering of interest rates and the willingness to accept a large currency depreciation; or

2. Reduce government expenditure significantly in order to generate large primary budget surpluses

With this in mind, BCA performed a simulation on public debt, assuming fiscal tightening (i.e. reducing government expenditure) but no substantial currency depreciation (BCA Table 1).

The first scenario uses the 2019 consolidated budget government assumptions and projections for nominal GDP, government revenues and expenditures, i.e., it is the government’s scenario. In this scenario, the public debt-to-GDP ratio rises only to 58% by the end of the 2021/22 fiscal year.

However, government forecasts always end up being optimistic. BCA believes this scenario is implausible due to its overestimation of nominal GDP, and hence government revenue growth. As the government tightens fiscal policy, nominal GDP growth and ultimately government revenue will disappoint substantially.

The second scenario uses government projections for fiscal spending in the coming years, but BCA’s own estimates for nominal GDP and government revenue growth. Notably, excluding interest payments and fiscal support for ailing state-owned enterprises like Eskom, nominal growth of government expenditures in the current year is at 7.5%, and estimated to be 6.8% the next two fiscal years. That is why nominal GDP and government revenue growth is projected to be very weak.

The basis for this assumption is as follows:

Without considerable currency depreciation, as the authorities undertake substantial fiscal tightening in the next three years, nominal GDP and consequently government revenue growth will plunge. According to BCA’s projections (BCA Table 1) as government revenue growth underwhelms, the primary deficit will widen and the public debt-to-GDP ratio will rise, reaching 70% of GDP by the end of the 2021/22 fiscal year.

Overall, without considerably lower interest rates and material currency depreciation, the government’s financial position will enter a debt deflation spiral. This means fiscal tightening will hurt nominal growth which will damage fiscal revenues. As a result, the fiscal deficit will widen – not narrow – and the debt-to-GDP ratio will rise.

Therefore, the only feasible option for South Africa to stabilize public debt is to reduce interest rates dramatically and depreciate the currency. This will lead to higher inflation and nominal growth, thereby boosting government revenues and capping the public debt burden.

At 10%, the share of foreign currency debt as part of South Africa’s public debt is low. Hence, currency depreciation will do less damage to public debt dynamics than keeping interest rates at high levels.

Overall, the rand is a structurally weak currency, and is bound to depreciate due to deteriorating public debt dynamics. BCA Chart 3 plots the real effective exchange rate of the rand based on CPI and PPI. It is evident that its valuation is not yet depressed.

Meanwhile, cyclical headwinds also warrant currency depreciation as indicted by the correlation between the trade deficit and the ZAR/USD exchange rate with the trade deficit being a leading indicator (BCA Chart 4).

But how relevant is this to the average business faced with foreign currency risk? Recent studies have generally concurred that the dominating factors driving rand volatility in the short term in descending order of importance are:

1. Global economic factors when there is a marked gap between the actual and the expected values of key macroeconomic indicators released by the relevant institutions, primarily related to the US, the EU and China.

2. Volatility in commodity prices linked to the South African economy

3. Global perceptions of financial market risk as affected by the effectiveness of structural reforms applied since the 2008 crisis, the unwinding of quantitative easing, the level of global indebtedness, and technological changes within the banking system, etc.

4. Local political uncertainty, one factor being the policy the authorities choose to follow in relation to the public debt-to-GDP ratio.

Clearly, local economic and political factors are relatively minor drivers of rand volatility despite obviously affecting the internal strength and sustainability of the South African economy.

Faced with wild swings and reactions to global factors beyond our control how does a business exposed to foreign exchange risk navigate these choppy waters.

The key, as with all financial market related strategies is the consistent application of a well thought out plan tailored to the core objectives of the business.

At Wauko we believe in developing a clear and documented foreign exchange policy that has been tailored to each of our clients’ specific circumstances and rigorously tested against historical data. Our policies protect our clients against adverse foreign exchange rate movements while still providing the opportunity to benefit when foreign exchange rates move in their favour.

David Irish CA (SA) – Wau-Creator at Wauko (Pty) Ltd

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