16 January 2002, Financial Times

Currency-driven investments are inherently risky plays.  Even foreign exchange traders are fortunate to be right half the time.  But special opportunities do occasionally arise that merit a closer look. The sudden collapse of the South African rand late last year is such an event.

While the country is off most investment managers’ radar screens, South Africa is among the most compelling emerging market stories around.  The country enjoys a relatively open market economy that’s become increasingly integrated in world trade since it lost the stigma of apartheid.  And its government is generally applauded for sound fiscal management, negotiating the diametric demands of extensive poverty and those necessary to spur domestic and foreign investment.

Between 1995 and 2000, the South African Reserve Bank reported that gross fixed capital formation increased annually by 3.8 percent.  Real GDP growth averaged 2.7 percent.  Consumer price inflation has been reigned in under 6 percent.  A sizable current account deficit, that reached $2.29 billion in 1997, fell to $469 million in 2000, while foreign-exchange reserves soared from $942 million in 1996 to over $6 billion in 2000.  And in November, Moody’s upgraded the country’s credit rating.

South African equities have enjoyed an impressive run over the past five years through 2001, with FTSE reporting annualized total returns [in rands] of 16.6 percent.  Performance of late has been even more impressive, with trailing 12-month returns of 21.7 percent and three-year annualized returns of 37.9 percent.

But foreign exchange has been the rub.  Dollar-based returns over the last five years are down an average of 3.3 percent a year.  Three-year annualized returns were 10.8 percent.  And last year’s impressive performance actually translated into an 18.1 percent loss for a US investor, highlighting the rand’s sudden collapse during the fourth quarter of 2001.

The rand was the worst performing currency in 2001 as measured against the dollar, falling from R7.60 to R12.11, a loss of 60 percent.

“Behavior of the rand defies ordinary explanation,” posits Brian Kantor, analyst at Investec Securities, one of South Africa’s major banks.  “There is no banking or liquidity crisis, no emerging market crisis, no foreign or local debt default or balance of payments crisis, no political crisis, no economic crisis, no deflating stock market bubble, nothing to provide a clue to its weak behaviour.”

John Morris, a Merrill Lynch analyst based on Johannesburg, observes that over the past 20 years, the real value of the rand has correlated with the Australian dollar as both economies rely significantly on natural resources, with substantial exposure to commodity prices.  But as of July 2001, the two currencies decoupled, with early signs of the Aussie dollar’s recovery having had no effect on the rand.

Morris doesn’t believe sharply declining platinum prices explains it.  Troubles in Zimbabwe probably does not account for more than 5 percent of the rand’s value.  And the Argentine crisis appears moot, given the strength of the Brazilian real.

Other factors may be working against the rand.  But none are new or of significant magnitude.  The government has been slow to privatize assets, which has hindered foreign investment, corporate restructuring, and performance.  A number of important South African companies have now listed on the London Stock Exchange, shifting equity demand from the rand to sterling.  Exporters, who have been enjoying windfall gains from the tumbling currency, have delayed repatriating hard currencies in hopes of realizing additional gains, thus further reducing demand for the rand.  And in October, the government’s attempt to curb speculation ended up reducing trading volumes, exposing the rand to even greater downward volatility.

Senior Merrill Lynch economist Jos Gerson thinks that an exchange rate above R9.40 cannot be justified.  For dollar-based investors, exchange rate reversion to that level would reflect nearly 20 percent appreciation.  But Gerson warns that even over the medium term, fundamentals don’t necessarily drive value.

Not surprisingly, last year’s strong equity returns were paced by resource groups that profited from products whose costs are in rands but which generate hard-currency revenues.  South African mining companies all did well in local currency terms, led by Gold Fields whose shares soared 124.6 percent.  The oil and gas concern Sasol rose 115.3 percent, while the forestry and paper company Sappi gained 121.8 percent.

Domestic banks generally faired poorly as interest rates declined, hurting margins.  And the declining rand hurt investment activity.  Nedcor declined 27.4 percent and FirstRand Holdings lost 39.1 percent.  Standard Bank, however, eeked out a 2.3 percent gain while the Absa Group pushed up 22.7 percent.

However, investors may see a reversal of sector fortunes this year if the rand is able to stabilize and reclaim a portion of its lost value, as most analysts expect it will.

Raphe Herrmannsen, an analyst at the brokerage Barnard Jacobs Mellet in Johannesburg, observes that “periods of currency collapse always result in outperformance by the resources sector, followed by underperformance once the rand stabilizes.”

Financials work just the opposite of resources, he notes, underperforming when the rand is collapsing.  This has left financials trading at a 32 percent discount to the overall market, the lowest it has been in nine years.  While Herrmannsen admits that valuation is not a good timing tool, “contrarian and value-oriented investors should be intrigued by financials.”

As for the rand’s future, Herrmannsen believes the rand will rebound, just as it has done in 1996 and 1998 after it lost 18 and 21 percent, respectively.  The rand looks deeply oversold especially in comparison to these last two selloffs, and relative to the commodity cycle, which appears now to be turning around as major global economies show signs of recovery.  But he warns that “a speculative assault on a thinly traded currency like the rand, especially one where the psychology of perpetual weakness is so deeply ingrained, builds a momentum of its own over time–regardless of the fundamentals.”