The South African rand was one of the worst-performing currencies in the expanded majors during March as the dollar reigned supreme in the global flight to safety. The rand depreciated nearly 16% against the dollar and 15.8% against the euro in March, ultimately touching an all-time low on the 6th April against both respective currencies (USDZAR 19.354, EURZAR 20.9298).
The initial moves were a product of carry trades unwinding, flowing back into funding currencies such as the euro, however, the rand’s depreciation extended even as the euro depreciated at the back-end of the month. This was due to a substantial deterioration in risk appetite coupled with domestic lockdown measures being implemented, leading to substantial portfolio outflows. South Africa’s economy was already in a precarious position before the epidemic with a downgrade in the sovereign credit rating looming from Moody’s. The economy was characterised by ballooning fiscal deficits, slowing growth and structural fragilities stemming from state-owned entities such as Eskom. The implementation of social distancing measures in South Africa exacerbated the economic slowdown, however.
Graph: South Africa’s portfolio data shows investors fled from EM assets as quickly in Q1 2020 as they did in the whole of 2008
Since touching record lows in the early part of April, the rand has recovered lost ground to return to its March closing price. The higher-yielding nature of South African debt, especially during a time of suppressed yields on developed market debt due to a swathe of monetary easing, has supported the rand this week amid an easing risk climate.
On Tuesday’s bond auction, foreign investors were net buyers of SAGBs after selling a net R10.6bn ($571m) only the week prior. We expect this theme to continue in the coming weeks conditional on the risk-climate supporting the re-emergence of carry trades.
Conditions are ripe for flows back into riskier emerging market assets – monetary easing in developed markets including unlimited quantitative easing measures couples with heightened issuance of debt instruments in emerging markets. At least part of the R500bn pledged fiscal measures is expected to be financed by bond issuance. South African 10-year government debt is currently the second-highest yielding in the EM space, behind Turkey. With this in mind, inflows into SAGB’s on renewed risk appetite is likely to spur a substantive ZAR rally.
Graph: Foreign ownership of South African debt hits record lows following the collapse of risk sentiment in March, but signs emerge of increased foreign investment in SAGB’s
The current exit strategy in South Africa is a five stage plan, with the economy expected to go into stage 4 from April 30th.
Stage 4 includes some activity, subject to extreme precautions after President Ramaphosa announced that the economy couldn’t be in a state of lockdown indefinitely. The gradual exiting of the economy from containment policies bodes well for the currency, conditional on it not resulting in the re-emergence of a second wave. Another outbreak in South Africa will be detrimental, especially if this is an isolated occurrence. The economy has already taken a substantive hit from lockdown measures, resulting in a more entrenched recession. With rapidly diminishing monetary and fiscal space to stimulate the economy, South Africa must get the exit strategy correct. A second outbreak resulting in a nationwide lockdown would completely cripple the domestic economy, likely leading to the heightened prospects of sovereign default and fresh all-time lows in the currency.
This is the main tail risk to our outlook going forward, which on the whole is generally bullish on the rand given its higher-yielding nature and our base case of a global exit from lockdown measures resulting in an increase in risk appetite and global growth conditions.
Graph: An ad hoc selection of forecasts supplied to Bloomberg
Author: Simon Harvey, FX Market Analyst