The rand exchange rate is one of the world’s most volatile currencies. Given SA’s open economy and its deep capital markets, the rand is exposed to fast-changing international investor perceptions. This complicates business planning and investment, as well as rendering forecasting point estimates for the rand a largely futile exercise.
The often overlooked fact about the rand’s volatility is that the currency has over the past close to 40 years of being a floating currency always reverted to some equilibrium level, or fair value. Despite sharp deviations from such a fair value over the short term, the long-term path of the rand exchange rate is identifiable.
Typically, at such a value, the SA economy is on a sustainable track, given the level of growth, inflation and the current account of the balance of payments. While these conditions are rare to find in any economy, with econometric modelling this ‘invisible’ fair value of the currency can be estimated.
BCA developed six econometric models simulating the quarterly changes in the real R$ exchange rate. Applying accepted econometric techniques, two pooled estimates of the rand’s long-term equilibrium value (or ‘fair value’) were estimated. These two values serve as the respective upper and lower bounds of the suggested fair value, i.e. the value to which the rand is likely to revert in time, should transitory factors drive it away.
The fair value is estimated for the most recent quarter and can vary in itself due to shifts in key economic fundamentals. These changes tend to be small over time and the estimated fair value is a reliable guide for where the actual rand may be headed/ revert to over the short term. The results from the underlying study have been very satisfactory since the launch of the model in 17Q1 – see chart (left):
Any actual market value above the fair value would suggest the rand is overvalued and should over the short- to medium term tend to depreciate. Conversely, a market value below the fair value would suggest the rand is undervalued and likely to appreciate. Additional modelling techniques allow one to get a handle on the estimated time before reverting to a fair value, based on developments in the past.
The fact of the matter is, that the value the rand is likely to revert to in time, can be estimated with greater confidence than its short-term deviations driven by transitory factors. A reliable handle on the rand’s fair value is useful in making decisions around the rand.
- When the rand is overvalued (i.e. more expensive in US dollar terms compared to the prevailing fair value) with a significant margin, exporters would tend to go uncovered, importers would tend to cover forward; investors would use the opportunity to invest abroad.
- Conversely, when the rand is undervalued, importers would tend to go uncovered, while exporters would cover forward; investors may use the opportunity to reduce the weight of foreign assets in their portfolios – see diagram (above right).
- To purchase the latest issue of R$ fair value update, or subscribe, visit the Publications store (subscribers will receive a complementary copy of the monthly BCA newsletter, State of the business cycle.)
- Earlier issues of R$ fair value update are also available in the Publication store.