The implications of an ailing rand

The rand has been hit by a plethora of negative shocks, which have driven it to its cheapest level since the onset of the COVID-19 pandemic. These include higher global risk-free interest rates, a fall in the terms of trade, grey-listing by the Financial Action Task Force (FATF), concerns around the US debt ceiling and electricity load-shedding.

Uncertainty as to the likely duration of these shocks implies elevated near-term forecast risk. Even, so, expect real GDP to contract outright in 2023, if electricity load-shedding remains at its current elevated level through the remainder of the year.

At the same time, it is likely inflation forecasts will be revised higher. Given base effects we still expect inflation to slow in 2023. However, in the absence of a firmer rand, disinflation is likely to be less pronounced than previously expected, leaving headline CPI around the upper end of the Reserve Bank’s target range at year-end.

In turn, this is expected to prompt the Reserve Bank to continue with its interest rate hiking cycle. We now expect a 50bp hike in the repo rate the next Monetary Policy Committee (MPC) meeting on 25 May 2023. Whether or not this is the last interest rate hike in the cycle will largely depend on the behaviour of the rand.

Looking forward it is reasonable to expect the currency to fare better over the medium term as the US interest rate hiking cycle turns down, new electricity capacity is installed (albeit delayed) and the negative terms of trade impact fades. This remains our base case.

However, it is important to recognize that the fundamental problem for the rand is a balance of payments constraint. Net capital inflows into South Africa have been insufficient to fund the current account deficit. This implies macroeconomic policy must be tightened.

South Africa’s pressing socio-economic problems precludes aggressive fiscal policy tightening. Indeed, given a recessionary environment, government revenue collection is likely to be weaker than expected, resulting in larger than expected budget deficits, while entrenching the upward trajectory in the government’s gross loan debt ratio.

Hence, the onus is on the Reserve Bank to do the heavy lifting, which implies upside risk to interest rates. That said, the Reserve Bank can only do so much. Net capital inflows into South Africa have been on a declining trend since 2015. This highlights the importance of economic reforms to lift our potential growth rate and returns on foreign direct investment.

It also speaks to the risk posed by emerging geopolitical alignments. Already, strategic global foreign direct investment flows are being realigned towards the US and Europe and away from, for example, China. Against this backdrop, the unfolding diplomatic spat between South Africa and the United States around the former country’s alleged support for Russia in the Ukraine- Russian war should not be dismissed lightly.

If no diplomatic solution is found, the immediate risk scenario is the potential future exclusion of South Africa from the African Growth and Opportunity Act (AGOA), which benefits around $3 billion of South Africa’s exports to the US. The loss of the duty-free status of South African exports would be a significant blow.

However, another concern is the potential risk that relations between the US and South Africa continue to deteriorate to the point where sanctions are imposed, which may include bans on trade in specific products to and from South Africa and / or financial sanctions. The latter would be especially damaging. South Africa has a sophisticated financial system, which is highly integrated with the rest of the world. Severe disruption to external financial flows would have a strong negative feedback loop into real economic activity and, by extension, our fiscal sustainability.

To be clear, we think the risk of sanctions is currently low. They are likely to be used as a last resort only if South Africa does not remain neutral going forward and diplomacy is unsuccessful in preventing ongoing deterioration in the relationship between South Africa and the US.

However, even in the absence of sanctions, the risk is continued low capital inflows, or even disinvestment from South Africa, by investors in the US, UK and parts of Europe. This would be especially damaging. Investment into South Africa from these countries dwarfs investment from the BRIC countries. Indeed, at end 2021, South Africa’s total foreign liabilities (that is the stock of foreign direct, portfolio and other investment into our country) were heavily skewed towards the US (R1.73 trillion) and the UK (R1.45 trillion), which dwarfed investment from China (R0.23 trillion).

In a sustained scarce capital inflow scenario, the risk is the rand trades perpetually weaker than its “fair value”, supported only occasionally by temporary influences such as higher commodity prices. Simultaneously, trend GDP growth would remain weak, driving fiscal policy into an increasingly unsustainable position, risking a high inflation outcome.