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South African Rand Will Weaken Before February Budget and See Double-digit Loss in 2018 say BofA

High interest rates and falling inflation mean that “real yields” have risen in recent months, supporting the Rand, but this could change in 2018. 

South Africa’s Rand has held onto much of its recent gains during January but uncertainty around the next budget statement and lingering risks to the nation’s local currency credit rating could see the currency weaken as February comes around.

Meanwhile, the passing of the ANC party leadership contest, and resultant victory for the reformist Cyril Ramaphosa, means South African economic fundamentals are returning as the dominant driver of the currency.

“The market turned euphoric following the Ramaphosa election as ANC leader, and the downgrade has now been priced out of ZAR. The run-up to the February budget may thus lead to currency weakness,” says Claudio Irigoyen, an FX strategist and economist at Bank of America Merrill Lynch.

Standard & Poor’s cut South Africa’s local currency credit rating to junk in November while Moody’s placed it under review for downgrade, pending the outcome of December’s ANC vote and February’s budget statement.

The fact that Moody’s held off on a downgrade in November and Ramaphosa was victorious in the ANC vote has emboldened the market to bet that a second downgrade will be avoided. It might.

Above: USD/ZAR rate shown at daily intervals.

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However, if a downgrade isn’t avoided, South Africa will face exclusion from the Citi World Government Bond Index and its debts will no longer be eligible for inclusion in investment grade bond funds. That would trigger a large wave of forced-selling that would pressure the Rand.

South Africa’s Treasury must unveil a credible plan for bringing down the budget deficit, which is estimated to have risen above 4% of GDP for 2017, if Moody’s are to award the country another stay of execution. This means February’s budget statement is a critical event for the Rand.

“In the February budget, the Treasury needs to take permanent measures to close the R50bn gap (see Medium-term budget shows no aspirations) and the potential gap that can be created by implementation of free education. Moreover, it needs to address building contingent liabilities. Failing to deliver the measures would trigger the second downgrade on local currency debt and increase rand volatility,” Irigoyen notes.

The combination of current high interest rates (6.75%) and falling inflation (4.6%) mean that “real yields”, or returns for investors in South African government debt, have risen over the course of recent months.

“The rand has been the top performer since EM FX turned bid in November, and the currency is now at extreme levels. USD/ZAR trades at lows since early 2016, lower than in the most euphoric phases of the past 2y rally,” says Irigoyen.

Real interest rates and yields were already high to begin with, even by emerging market standards, which may have helped to drive the Rand to 18 month highs against the Dollar in the wake of Ramaphosa’s December ANC victory.

“This suggests scope for monetary easing down to 6.25%. The SARB erred on the side of caution ahead of ratings decisions and the ANC conference in 4Q17. We believe event risks around the February budget and the Moody's rating decision thereafter would continue to constrain SARB to move on January 18,” Irigoyen adds.

If Bank of America are right in their forecasts then South Africa’s real interest rate tailwind could diminish as 2018 progresses, with inflation rising a touch from its current levels while the South African Reserve Bank is seen cutting the cash rate by 50 basis points to 6.25%.

This might undermine some of the support enjoyed by the Rand over recent weeks. Indeed, Irigoyen’s foreign exchange forecasts suggest the Rand will lose ground to the greenback and other international rivals over the course of the year.

Above: Pound-to-Rand rate shown at daily intervals.

“We now expect the rand to only reach 14.0 by year-end 2018 (previously 15.0),” says Irigoyen, setting a forecast that implies a 12.5% loss for the South African currency in 2018.

Bank of America forecast that the Pound-to-Dollar rate will rise to 1.40 by the end of 2018. Cross-currency triangulation means that BAML are forecasting, by implication, a Pound-to-Rand rate of 19.60 at year end.

Readers can learn more about what other analysts think will happen to the Rand in 2018 from our Compilation of Major Bank Forecasts, Currency Views for 2018. Not everybody expects losses for the South African currency this year.

“The positive scenario is that Zuma will resign in the next few months, and Cyril Ramaphosa will succeed him without massive turbulence or the ruling African National Congress party breaking self-destructing factions,” says Peter Rosenstreich, an analyst at Swissquote Bank.

South Africa’s parliament said Sunday that it is reviewing the rules relating to a sitting president’s removal from office, with a view to making them more easy to implement. The statement came in the wake of a constitutional court ruling ordering lawmakers to overhaul rules and make them clearer.

President Jacob Zuma has been dogged by corruption allegations in recent years and is seen as a barrier to improved governance within South African politics and state owned enterprises. Reform is a another necessity if the country is to avoid a ratings downgrade.

“Is South Africa’s President Jacob Zuma about to be ousted? Markets think so, judging from the rapid appreciation of the ZAR, which is pricing in improved stability and decreased corruption. A smooth transition will press USDZAR down further,” says Swissquote’s Rosenstreich. “We remain bullish on the Rand.”

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