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Blog : 23 November 2016 (South Africa's real effective exchange rate)
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In today's blog we take a look at South Africas real effective exchange rate against the US dollar and use it to determine the level of over or under valuation of the Rand against the US dollar.
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Rand undervalued
The line graph above shows the nominal and real exchange rate indexed to December 2012=100.
From the line graphs above it is clear that there is strong divergence from the nominal exchange rate and the real exchange rate, due to variations in the inflation rates experienced by both countries. What the graphic is showing is that South Africa's real exchange rate against the dollar is actually a lot lower than the nominal rate. Real Effective Exchange Rate (REER) as just calculated provides an indication of the over/undervaluation of a country's currency. Similar to metrics such as the Big Mac Index which is used in order to determine currency over/undervaluation based on the dollar expressed price of a Big Mac across the world. If the dollar price of a Big Mac in a specific country is less than the dollar price of a Big Mac in the USA, it shows that that country's currency is undervalued. If the price is more than the price in the USA, it shows that that country's currency is overvalued.
From the line graphs above it is clear that there is strong divergence from the nominal exchange rate and the real exchange rate, due to variations in the inflation rates experienced by both countries. What the graphic is showing is that South Africa's real exchange rate against the dollar is actually a lot lower than the nominal rate. Real Effective Exchange Rate (REER) as just calculated provides an indication of the over/undervaluation of a country's currency. Similar to metrics such as the Big Mac Index which is used in order to determine currency over/undervaluation based on the dollar expressed price of a Big Mac across the world. If the dollar price of a Big Mac in a specific country is less than the dollar price of a Big Mac in the USA, it shows that that country's currency is undervalued. If the price is more than the price in the USA, it shows that that country's currency is overvalued.
The Big Mac index is released every 6 months. The graphic below compares the estimated over/under valuation of the South African Rand compared to the US dollar calculated using both the Big Mac Index and the REER as calculated via the REER index shown in the figure above.
The bar chart above shows that both methods come to the same conclusion, though levels are vastly different, and that is that the Rand is undevalued when compared to the US dollar. According to the adjusted Big Mac index the Rand is undervalued by 29.4% as at July 2016, while South Africa's nominal effective exchange rate is showing that the Rand is undervalued by roughly 16%. There is a 88% correlation between the two methods used to estimate the over/undervaluation of the Rand against the dollar.
The impact of "Nenegate" on the exchange rate (and the ensuing Big Mac Index for January 2016) is pretty clear, as the estimate following the "Nenegate" shock is back to levels prior to the "Nenegate" debacle. Sadly looking at the graphic above it does not look like there is a any light at the end of the tunnel for South Africa's currency, as the estimated undervalution is getting bigger with time, instead of improving.
And as we said in the past, the currency is very good estimator of current market sentiment towards a country and it's economy and policies. And based on these currency valuation methods it shows sentiment towards South Africa has soured and continues to do so, even though from a valuation point of view, it looks like the currency is heavily undervalued.
With continued political turmoil and infighting and state capture carrying on unabadted, slow/no economic growth and presistently high levels of unemployment, South African's should not expect their currency to close the valuation gap to the dollar any time soon.
And as we said in the past, the currency is very good estimator of current market sentiment towards a country and it's economy and policies. And based on these currency valuation methods it shows sentiment towards South Africa has soured and continues to do so, even though from a valuation point of view, it looks like the currency is heavily undervalued.
With continued political turmoil and infighting and state capture carrying on unabadted, slow/no economic growth and presistently high levels of unemployment, South African's should not expect their currency to close the valuation gap to the dollar any time soon.
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