NOMURA emerging markets expert Peter Attard Montalto takes a look at what drives the embattled rand:
Risk events for the second quarter are only beginning to develop, so we still see medium-run upside risks to dollar-rand from here.
Our original Q2 forecast for the dollar-rand was 9.50 which we pencilled in at the end of last year, citing the many risk factors that looked likely to develop this quarter.
In the end we hit pretty weak levels pretty quickly (up to 9.37) by March, thanks to a combination of strikes affecting coal supply and electricity supply concerns as Eskom's safety margin collapsed.
Of the recent move to breach those highs and now trade over 9.50, part has been dollar strength thanks to the moves in real yields there. The euro-rand had lagged lower until a sharp move higher on Tuesday.
However, a large part has also been South Africa idiosyncrasies especially around the mining sector, the role of unions and restructuring at Anglo Platinum [JSE:AMS]
We had originally positioned ourselves from mid-April for a further unwind of the Q1 real money long dollar-rand hedging with a low-cost put-spread – a trade idea that worked initially but we were too slow to take profit and it will now likely expire out of the money.
However, events have now materialised that we think should arrest the potential for that unwind to continue.
The thing is, we have barely scratched the surface of the Q2 risk events we originally identified here. The municipal workers' wage round still has to kick off as well as the violence that may follow as we move into mid-June.
Similarly, the other wage rounds in the economy, such as transport and cars, are only just starting (with already an illegal strike at one car manufacturer).
On top of that, as South Africa enters a winter that is expected to be colder than average, Eskom's limits are likely to be tested once again, along with its plan to actually accelerate maintenance through winter.
We also don't think that the market has fully come to terms yet with how the 'David McWilliams austerity is dead' theme could affect South Africa’s fiscal and the increased pressures on issuance from parastatals and Eskom in particular, after its lower tariff award.
We also have to wait another month for the Q1 current account number, which we expect to be very poor. Focus on a possible ratings downgrade should also increase as we move forwards and Moody’s has already commented on this recently.
On the more bullish side, while growth may print weaker in Q1 data out next week, we think it may come in a notch above the market on the year-on-year print.
What is new or at least more developed than we thought, however, is the inter-union tension between the National Union of Mineworkers (NUM) and the Association of Mineworkers and Construction Union (Amcu) - and the National Union of Metalworkers of SA in the background too.
Cosatu and the ANC (and government) are clearly rattled by Amcu's sharp rise and now its majority voice in many parts of Rustenburg.
The real issue for us is that, despite Amcu's attempts to get recognition as the majority union now at Lonmin [JSE:LON]
, we should remember that at Marikana and since it has been a catalyst more than a causal factor for unrest and strike action (i e the rise of unaffiliated and undirected worker groupings taking action has arguably outstripped the rise of Amcu).
In addition, we do not believe the ANC/government will allow Amcu to achieve dominance via whatever means at their disposal. This theme has much further to run in our view (and further to deteriorate too).
The poor results of tier II unsecured credit lender African Bank on Monday have for some signalled the bursting of an unsecured credit bubble, though we would distance ourselves from that view but recognise it may be a negative influence on the market.
We think provisioning levels and the natural saturation of the targeted income deciles for unsecured credit actually mean the unsecured credit market is finding a natural stabilisation point and growth is naturally slowing – the outcome will probably be lower earnings for the likes of African Bank, but not a systemic or macroprudential event, in our view.
Overall, there still are many of the same risks to play out from here. Of course such risks are to some extent priced in, and markets do get tired (as in Q1) with many headlines from different mines or areas of the economy on strike action.
Part of that is the cost of holding hedges and short positions, particularly for real money.
Nevertheless, an interesting difference in the market compared with Q1 is the lack of a strong amount of real money hedging. These things are difficult to fully track, but we think such long dollar-rand positions are now at a much lower level than at their peak at end-March.
We think this means that there is an additional leg of rand weakness to come, particularly as the euro-rand breaks old highs.
Of course, once again cost factors and the fact the underlying current account position is improving - albeit from very bad levels in Q1 - and also because of a still solid if drip-by-drip underlying inflow position for foreigners buying bonds week by week, we think we are still nowhere near a 'parabolic' event.
However, the moves in global yields and increasing discussions of a US Federal Reserve exit from quantative easing means markets will continue, combined with SA's own idiosyncrasies, to analyse the risks from the dual-deficit theme.
Hence we reinforce our view that the risks to our Q3 forecast for dollar-rand of 9.25 and year-end forecast of 9.00 is to the upside. Indeed, as in the last month continued dollar strength will be an important component of rand cross weakness.
The currency is now entering fair value for the first time since the start of 2009. We have long held the view that (extracting from the rand in real terms) long unfair value for the currency is in the dollar-rand much more around 9.75 than the South African Reserve Bank's (Sarb's) own view of short-run fair value of 8.50-8.75.
We look through the short-term bubble up in the current account - which is partly caused by infrastructure imports - to look instead at the medium-run funding difficulties that a structural current account deficit of around 4.5-5.0% of gross domestic product (GDP), with sustainable funding of probably only around 3% of GDP, as the clear gap to be filled by a currency at current levels.
Of course, this is not to say that the competitiveness gap is now filled. It is only one small piece of the puzzle - of which the far more significant is domestic potential growth boosting structural reforms along the lines we talk about.
We think the Sarb is right about one thing though – the rand normally overshoots fair value; however, we would say that is as much true of our own fair value estimate as theirs.
*Peter Attard Montalto
is a director and emerging markets economist at Nomura. Views expressed are his own.
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