In October last year, I wrote a post on the Balance of Payments. Specifically: “Demystifying the Balance of Payments Part 1“. At the end of said post, I promised a part 2 that would deal with the exchange rate.

*shifts awkwardly in seat*

So about that. It seems that I got distracted*.
*Actually, almost entirely on purpose. I remember trying to write this post the next day and getting bored. So instead, I wrote something scathing about Ted Cruz. Who is still incredibly annoying. I checked.

But I’m less distracted today, for a few reasons:

  1. I’ve been asked for my opinion on the movements in the South African Rand; and
  2. This article from Moneyweb: “Foreign Capital flows back into SA“.

If you do a google search for “main factors influencing the exchange rate”, you get a lot of articles talking about inflation, interest rates, and so on. But for me, those are more like sub-factors; because exchange rates are about demand and supply for a particular currency, and that market is driven by two types of people:

  • Traders; and
  • Investors (and/or speculators, depending on how negatively you feel about them, and how quick they are to leave).

There’re the real “factors” behind an exchange rate. So let’s take South Africa as the example, and the Rand.

Demand for the Rand is driven by:

  • Exporters (who are going to sell our goods abroad – and we sell financial services, gold, platinum and coal);
  • Tourists;
  • Foreign investors that like South African returns; and
  • South Africans that are spending their offshore inheritance on a house in Sandhurst.

On the other side of the equation, the Supply is driven by:

  • Importers (who are bringing us the fun stuff from overseas – like fuel, and clothing, and food);
  • South Africans going on holiday;
  • Local investors that feel the need to take their money offshore; and
  • Foreign investors that have earned their return, and are now leaving with it, thanks.

Back to the Sub-Factors

Exporters and importers, being the traders, are influenced by the following:

  • Demand for their products; and
  • Global competitiveness.

It’s a little bit chicken-and-egg: competitiveness influences demand, which influences the exchange rate, with impacts competitiveness, which affects demand, and then so on until we’re fully globalised and trading in a future derivation of bitcoin.

But most traders, because their real trade is the product and not the exchange rate, will engage in forward contracts to cover a particular trade from exchange rate risk. So they trade on future rates, rather than the spot rate, even though future rates are based on the spot rate. So I guess what I’m saying is: importers and exporters tend to take the spot rate as given, rather than make the rate directly.

Tourists also just take the rate, paying almost no attention to the so-called “factors” other than perhaps deciding against a visit to London when the Rand is having a particularly bad time of it.

Investors and/or speculators, on the other hand, engage in the spot trade and the forward trade. And their decisions are influenced by:

  • Interest Rates (and expectations of future interest rate changes)
  • Inflation Rates (and expectations of future inflation)
  • Political Stability (or lack thereof)
  • Relative Strength of other currencies
  • Relative Return offered in other currencies
  • Global capital flows (read: Risk On…Risk Off)
  • And so on.

Which is why the South African Rand, along with the Brazilian Real and the Turkish Lira (amongst others), tumbled at the end of last year.

The Emerging Market Unwinding

It had very little to do with strikes, and political instability, and internal South African affairs. It was all about the carry-trade and quantitative easing in the first world:

  • The Federal Reserve had flooded the US market with liquidity;
  • Instead of finding American investments to absorb all the money, investors looked elsewhere, and took their money to the emerging markets to earn some real returns.
  • In fact, they did more than take their own money. They also borrowed money (ie. the carry trade).
  • Then the Fed announced that it was slowing QE.
  • So investors said “Right then – off home we go to repay our money before interest rates rise.”
  • And like herd animals, everyone went.
  • Money spun out of the emerging markets like whirling dervishes on speed, and despite lots of interest-rate raising by various central bankers, the emerging market currencies crumbled.

But now that craze is over. Investor money is starting to return. The elections are over, and the Rand has recovered to R10.39 to the US dollar. The real question: will it recover back to its R9 to $1?

That seems…unlikely.

Some reasoning:

  1. The real traders (and by that, I mean the importers and exporters) have been adjusting their prices to take into account the weakening rand. Not fully (the South African consumer can’t really absorb the full cost adjustment upfront), but enough that there have already been shifts in competitiveness relative to the rest of the world. So in some ways, the exchange rate shift has become more intrinsic – even if it didn’t start out that way.
  2. Foreign money may be returning – but is it returning in the same spirit of grab-the-chance-before-the-cheap-money-stops? The Fed is drying up its Save America subsidy. The money that’s returning to SA has more options, it feels more lucid, and it can bargain harder for a more favourable rate.
  3. And as for our export side… There are all of those strikes. So perhaps when we start production again, there’ll be some renewed vigour in rand. But enough vigour to have the same effect as the panicked hoards of investors riding a tide of cheap Federal Reserve money? Um – doubtful.

But hey. It’s just an opinion. And it’s an opinion that can be completely invalidated by a single world event – like a Lehman. So if you’re planning some meaningful exchange trades…

Happy coin-tossing.