South Africa
USDZAR Fair Value - A Fresh Look
July 13, 2009

By Michael Kafe, CFA, Andrea Masia | Johannesburg & Ronald Leven | New York

Summary

Capital flows no doubt exert some influence on currencies in the short run. However, the sustainability of such rallies and/or sell-offs is ultimately determined by developments in the home country's macroeconomic fundamentals, relative to its trading partners. To investigate the sustainability of the recent rally in USDZAR - which has no doubt been driven by a barrage of rather chunky capital inflows including Anglo-American plc's sale of 11.3% of AngloGold Ashanti for US$1.3 billion, Vodafone's purchase of a further 15% of Vodacom from Telkom for R22.5 billion (some US$2.4 billion), roughly R33 billion worth of portfolio inflows, expectations around a possible 49% purchase of MTN by Bharti-Airtel, as well as talks of an Xstrata-Anglo-American deal - we estimate a variant of the Monetary Approach to exchange rate determination. 

This framework relies on relative price and output ratios, real interest rate differentials as well as capital flows; it suggests that, at current levels of 8.15, USDZAR is some 12% over-valued relative to its 3Q09 fair value estimate of 9.20. Interestingly, however, the model points to a near-term path of USDZAR appreciation as fair value migrates towards 8.60 in 1Q10, suggesting that one may need to look beyond movements in macroeconomic fundamentals to trigger a correction to fair value in the near term. Macro fundamentals are nonetheless expected to engineer currency weakness from 2Q10 onwards, with a 4Q10 target of some 9.30.

USDZAR Fair Value Model

The Sticky Price Monetary Approach (SPMA) to exchange rate determination - like the long-run Flexible Price Approach (FLMA) - is based on the theories of price determination and Purchasing Power Parity (PPP). Both models propound that movements in bilateral exchange rates are determined by interest rate differentials, relative money supplies and output ratios; however, the SPMA is generally regarded as the more realistic framework, in that it accommodates short-run deviations from PPP by accepting that financial market variables (interest rates, exchange rates, money supply, etc.) may adjust instantaneously to external shocks, but that product markets (real goods, commodities, etc.) are ‘sticky' in the short run. In this way, deviations from PPP take time to revert to equilibrium. It further postulates that this relative asymmetry between commodity and asset price changes means that financial markets may need to over-adjust to external disturbances in order to compensate for the sluggishness of prices in the goods market . The usefulness of this framework lies in its ability to isolate and quantify the impact of fundamental macroeconomic drivers of exchange rates.

A Variant of the Monetary Approach

To calculate fair value for USDZAR, we estimate a variant of the monetary framework via OLS regression for 1Q95-2Q09. With the exclusion of real interest rates, all variables are specified in log-index format, so that the reported coefficients can be interpreted as elasticities. The real interest rate is specified in percentages, and so its coefficient is interpreted as a semi-elasticity. The dependent variable is specified as Rands/US$. We have tested for cointegration of the time series, and have adjusted for excess correlation/variance in the residuals where necessary.  It is worth noting that evidence of serial correlation may be confirmation of the slow adjustment process propounded by SPMA theorists.

On an a priori basis, we expect the sign of the growth and interest rate variables to be negative, but expect relative prices and money supply to be positive.

Estimation Results and Discussion

In equations 1 and 2, we introduce the price level and output parameters in step-wise format. Both are statistically significant at 99%, with the expected signs (i.e., a widening price ratio results in currency depreciation, while a widening output ratio results in currency appreciation).

We then introduce real interest rate differentials (a good proxy for the attractiveness of local markets to yield-hungry capital) in equation 3. The real interest rate differential holds the correct sign, and is statistically significant. However, the joint significance of the coefficients, as captured by the F-statistic, is slightly compromised. Nevertheless, this is a welcome improvement on earlier research (see South Africa Chartbook: Revised USDZAR Outlook, May 13, 2009).

While there is no doubt that high interest rates have often attracted ‘carry' flows into South Africa, we have shown in previous research that such episodes are usually short and discrete (see South Africa Chartbook: Macro Cracks Widening, October 30, 2008). In our view, it is actually growth-seeking and commodity price-oriented portfolio equity flows that have been the greater source of capital flows into South Africa.  We therefore believe that our estimation results could be improved upon by differentiating between pure ‘carry' flows and equity-based flows.

To do this, we introduce an additional capital flow variable - the Morgan Stanley Composite Index for Emerging Markets (MSCI EM), which also serves as a proxy for general emerging market risk-love. Upon the introduction of the MSCI EM in equation 4, we notice a significant improvement in the goodness of fit, the joint significance of the independent variables, and residual normality. The Akaike criterion suggests that the trade-off between parsimony and the gain in explanatory power resulting from the addition of this variable is favorable too.

We then close the theoretical loop of the Monetary Approach by introducing relative money supplies (equation 5). Although this variable reflects the correct sign, it is not statistically different from zero. It also detracts from explanatory power, and reduces the parameters' joint significance.

To investigate the usefulness of the money supply variable, we estimated various permutations of the earlier regressions, such that relative money supplies remained, but at the expense of other variables. We found that money supply did have a statistically significant impact on USDZAR in certain specifications. However, these regressions were unable to match the explanatory power of equation 4. We therefore dropped the money supply variable from our framework.

In our final specification, we incorporate a dummy variable to control for the 2001/02 currency crisis (equation 6). Thankfully, the introduction of this dummy does not artificially boost the fit of the regression.

Model Forecasts 

Using Morgan Stanley's baseline macro assumptions for South Africa and the US as inputs, we provide quarterly model estimates of USDZAR in the full report. The forecasts suggest a 3Q09 fair value estimate of 9.20, which then appreciates to 8.60 over 1Q10. Through the remainder of 2010, however, fair value depreciates toward a year-end average of 9.30.

The predicted appreciation through 1Q10 - driven by an anticipated improvement in emerging market risk-love, and widening of real interest rate differentials - raises the risk that the presently overvalued currency may remain overvalued in the near term. In fact, in-sample tests show that on 36 out of the 58 occasions during 1Q95-2Q09 that fair value forecasts pointed towards an appreciation (depreciation), the currency appreciated (depreciated) for at least one quarter. This suggests that one may need to look beyond movements in macroeconomic fundamentals to trigger a near-term correction to fair value. Eventually, macro fundamentals are expected to engineer currency weakness from 2Q10 onwards, with a 4Q10 target of 9.30.

However, the combination of narrowing T-bill spreads and relatively sticky inflation in South Africa should drive the rand weaker over the remainder of 2010 - a period where South Africa may also suffer from post-World Cup fatigue.

Forecast Risks

The baseline forecast is only as good as the underlying assumptions. Clearly, upside risks to our USDZAR forecast may emerge from an earlier-than-anticipated correction in US T-bill rates (as markets become overly concerned about the possible inflationary effects of quantitative easing a lot earlier than expected by our US colleagues). Additionally, a more gradual decline in South African inflation or a reversal of its downward trend (e.g., on the back of rising oil, electricity tariffs and other administered prices) would pose upside risks to USDZAR as the carry trade becomes less appealing.

On the flip-side, an early recovery in South African output and/or an early recovery in emerging markets more generally could see USDZAR trade at much lower levels than we currently anticipate. Also, a step-up in inward foreign direct investment ahead of the 2010 FIFA World Cup could lead to sustained ZAR appreciation. 

Finally, our global currency team expects the USD to remain a structurally weak currency in 2009/10, depreciating from current levels of EUR1.40 to EUR1.45 at end-2009, and 1.60 at end-2010. Clearly, a fundamentally weak USD may also cap ZAR depreciation and/or exaggerate ZAR strength.

Trade Idea

In summary, our analysis suggests that, at current levels of 8.15, USDZAR is currently trading at a discount of around 12% to fair value. However, our fair value estimates point towards a path of ZAR appreciation through 1Q10, offering tailwinds to an already overvalued currency.  From 1Q10 onwards, the combination of narrowing T-bill spreads and relatively sticky inflation in South Africa are expected to engineer currency weakness, with a 4Q10 target of some 9.30.

To play this theme, investors may consider going short volatility via a long 6M 1x2 USDZAR dollar call spread. The position benefits from an orderly weakening of the ZAR over the next six months. Setting the two strikes at 8.10 and 8.60, respectively, we estimate that the position will initially be close to premium- and delta-neutral.

This structure has maximum upside of 6.12% if USDZAR is at the top-side strike of 8.60 at expiry. Strength in the US dollar beyond this level will reduce profits and eventually generate a loss. In theory the risk of loss is unlimited, but the US dollar would have to strengthen above ZAR9.30 (14% above the current spot level) before the structure would start registering losses.

For a technical discussion of the Monetary Approach and data sources, please see the detailed appendix in South Africa: USDZAR Fair Value: A Fresh Look, July 9, 2009.

Important Disclosure Information at the end of this Forum

United Kingdom
Emerging from Recession into a Multitude of Medium-Term Challenges
July 13, 2009

By Melanie Baker | London

Summary

The effects of massive UK stimulus are apparent.  We are now seeing some greenish shoots in some of the forward-looking data.  The end of the UK recession will likely come earlier than many had expected, in our view.  However, there are several major challenges for the medium-term outlook and GDP growth looks set to remain more volatile than in the previous decade for several years to come.

This recession has been deeper than we had anticipated and that backward-looking picture became even worse with the recent downward revision to 1Q GDP.  This has led us to revise down our forecast for annual 2009 GDP growth from -2.8% to -3.5%.  Compared to what we would have anticipated six months ago, manufacturing, construction, investment and household consumption growth have all been much weaker.

However, the UK economy looks likely to stop contracting in 2Q or 3Q, and our central forecast is for 2H09 to see some semblance of recovery (with a first rate rise from the BoE in 1Q10 already).  Combined with our central forecast for only a ~6% further fall in house prices in 2009, this could turn what has been something of a vicious cycle into something more virtuous (a better tone to economic and house price data leads to lower impairment assumptions on bank balance sheets and stronger lending growth).  However, at this stage we remain cautious and continue to expect a sub-par recovery in 2010.

Significant Uncertainty Around the Base Case

The level of uncertainty surrounding our own central projection is larger than usual.  In particular, we are in relatively uncharted territory in terms of the depth and synchronicity of this global recession and in terms of the global policy response.  This recession has been much deeper than we had anticipated, and the medium-term challenges the UK faces will make the recovery vulnerable to setbacks, in our view.  In our bull scenario, some of the vicious cycles turn virtuous.  The hit to wealth experienced by households triggers an increase in the labour supply.  Beyond 2010, this boosts domestic demand without triggering higher inflation.  In the bear case, a sharp increase in the household savings rate causes much slower consumer spending growth throughout the profile. 

With green(ish) shoots apparent in the data, our central forecast is that 2Q GDP growth is flattish (slightly positive), and we expect reasonable (although certainly not stellar) sequential GDP growth in 3Q and 4Q09 too.  We think that forecasts suggesting that the UK will not grow until 4Q or the beginning of 2010 are too pessimistic.

Some Clear ‘Greenish Shoots'

We are now seeing some green(ish) shoots, especially in some of the more forward-looking data.  These include improvements in consumer and business confidence, sharply improving PMI surveys and genuine signs of life in the beleaguered UK housing market.

UK Well Placed to Emerge Early from the Recession

After a sharp contraction in 1Q GDP, we expect (slightly) positive GDP growth as early as 2Q09 (although recent weak May industrial production data increase the risks we see of a small contraction instead).  Four things improve the relative prospects of the UK for an early escape from recession:

1)         Big past depreciation in sterling: Trade-weighted sterling has regained some ground, but would still imply a depreciation of some 20% or so from July 2007 levels.  The trade deficit seems to have stabilised and is tentatively starting to improve after a decade of deterioration.  The contribution to real GDP growth from net exports has been neutral or positive for five consecutive quarters.

2)         Household interest payments: High levels of household indebtedness, although a medium-term challenge for the UK, combined with large numbers of people on variable-rate mortgages, means that the cuts in interest rates we have seen have provided significant support to households in aggregate.

3)         Inventory cycle: We have seen negative GDP growth contributions from inventories in five out of the last six quarters.  For a positive contribution, inventories just need to be cut by less - they do not necessarily need to rise.  We tentatively expect the inventory component to become a neutral-to-positive contributor to GDP growth over the rest of 2009.  One interpretation of the synchronous, sharp recession is that this partly reflects ‘just-in-time' techniques for production management (see Elga Bartsch's Inside the Inventory Cycle, February 23, 2009).  That may imply that the transmission of a recovery and the resulting restocking could be quick too.

4)         Planned reversal of the VAT rate cut: On January 1, 2010 the standard rate of VAT is scheduled to return to 17.5% from 15%.  This could have the temporary effect of bringing forward consumer spending to the latter part of this year, helping to support consumer spending somewhat.  This is, of course, an effect likely to dampen growth in early 2010. 

Medium-Term Challenges

Despite the recession, the UK still has a long way to go in terms of a long-awaited ‘rebalancing' and in the deleveraging of the household (and banking) sector.  As in several other major economies, a legacy of massive global policy stimulus raises risks of higher inflationary outcomes, the need for post-recession fiscal tightening and the prospect of some very tricky decisions on monetary (and fiscal) policy.

•           Rebalancing: When people talk about rebalancing the UK economy, they generally mean rebalancing in the sense of a movement away from running current account deficits associated with a relatively low household savings rate.  They mean rebalancing towards an economy where the financial sector and the consumer play somewhat less of a role towards an economy where manufacturing, business investment and the export sector play somewhat more of a role.  The very substantial depreciation in sterling seen over the past couple of years should be a great aid to this rebalancing.  Banking sector regulation may also help to contain the size of the UK financial sector.  Households are likely to increase their savings rate over the next few years, with underlying incentives to save relatively strong. 

Any significant rebalancing implies a major upheaval for the UK economy and one you can argue is currently underway.  Over the coming years, the BoE will presumably not want to stand in the way of such rebalancing, subject to meeting its mandate.

•           Deleveraging: UK households remain heavily indebted, and the UK banking system remains a long way from full health.  UK households will probably want to reduce that debt burden over time, and banks will presumably want to reduce their funding gaps (loans versus deposits). See Housing Downturn Abating, but Keep Expectations Low, June 22, 2009 by Melanie Baker and Steven Hayne

Underlying household incentives to save and, equivalently, pay down debt should be strong:

1) Households are highly indebted and therefore more sensitive to a given change in interest rates.  This matters somewhat less when interest rates are stable, credit conditions loose and employment plentiful.  The credit turmoil should have shaken households' faith that these things will hold in the future.  2) House prices are unlikely to increase enough to imply big positive wealth effects.  3) Lending availability seems likely to remain relatively tight.  4) Levels of negative equity will likely remain substantial in 2009/10.

For the banks, the step-down in lending is likely to be sustained, in our view, as there is a structural mismatch between customer loans and customer deposits that should be reduced over time.  The Bank of England's Financial Stability Report has been highlighting this mismatch for some time and indicates an £800 billion customer funding gap for major UK lenders.  Further, funding constraints remain and the banks are continuing to use government-guaranteed issues.

•           Policy unwind: The policy rate is at its lowest level since the BoE was founded in 1694, and on the Treasury's own forecasts, we are set to hit a level of public sector net debt to GDP almost double the previous ‘limit' set by the government's old ‘sustainable investment rule'.  We are in uncharted territory in terms of the depth and synchronicity of the global recession, particularly when combined with the enormous global policy response.  All this leaves policymakers to make very difficult decisions against a very uncertain backdrop.  Clearly, monetary and fiscal policy will need to be tightened in the years ahead (assuming some semblance of a recovery), but getting the timing and magnitude right will be tricky and the probability of a significant policy error must be higher than it has been for many years.

Volatile Growth and Vulnerability 

What is the confluence of all these medium-term challenges likely to amount to?  While a plunge back into deep recession isn't a central case, these medium-term challenges (as well as already planned events such as the 2012 London Olympics) are likely to continue to make for a much more volatile pattern of growth in the coming years than in the pre-credit crisis decade.  (At least) two further factors can be added to the mix here:

1) Changed household and company expectations: The Bank of England might have been under no illusions about its ability to maintain the Great Stability indefinitely (e.g., Governor King's first speech as governor in October 2003), but households and companies may well have shifted their expectations towards assuming that such a state could be maintained.  In which case, recent events will have sorely tested expectations.  If this is accompanied by a loss of faith in policymakers (and credit) to smooth the cycle, economic agents may themselves react in more pro-cyclical ways as they witness fluctuations in the economy.  For example, companies and households may be faster to cut spending/investment to increase precautionary capital in response to early signs of a slowing economy rather than prepare to borrow a little more or simply sit tight.

2) More pro-cyclical inventories: Our Chief European Economist, Elga Bartsch, believes that rather than act as a business cycle buffer, inventory changes may have become more pro-cyclical.  See Elga's Inside the Inventory Cycle, February 23, 2009.

We continue to think that this will be a relatively sub-par recovery; it could also be a pretty volatile one.

Important Disclosure Information at the end of this Forum

Disclosure Statement

The information and opinions in Morgan Stanley Research were prepared by Morgan Stanley & Co. Incorporated, and/or Morgan Stanley C.T.V.M. S.A. and their affiliates (collectively, "Morgan Stanley").

Global Research Conflict Management Policy

Morgan Stanley Research observes our conflict management policy, available at www.morganstanley.com/institutional/research/conflictpolicies.

Important Disclosure for Morgan Stanley Smith Barney LLC Customers The subject matter in this Morgan Stanley report may also be covered in a similar report from Citigroup Global Markets Inc. Ask your Financial Advisor or use Research Center to view any reports in addition to this report.

Important Disclosures

Morgan Stanley Research does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages them to seek a financial adviser's advice. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. Morgan Stanley Research is not an offer to buy or sell any security or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.

With the exception of information regarding Morgan Stanley, research prepared by Morgan Stanley Research personnel is based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we do not represent that it is accurate or complete. We have no obligation to tell you when opinions or information in Morgan Stanley Research change apart from when we intend to discontinue research coverage of a company. Facts and views in Morgan Stanley Research have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.

To our readers in Taiwan: Morgan Stanley Research is distributed by Morgan Stanley Taiwan Limited; it may not be distributed to or quoted or used by the public media without the express written consent of Morgan Stanley. To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.

Morgan Stanley Research is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of and takes responsibility for its contents in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin);in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, supervised by the Spanish Securities Markets Commission(CNMV), which states that it is written and distributed in accordance with rules of conduct for financial research under Spanish regulations; in the US by Morgan Stanley & Co. Incorporated, which accepts responsibility for its contents. Morgan Stanley & Co. International plc, authorized and regulated by Financial Services Authority, disseminates in the UK research it has prepared, and approves solely for purposes of section 21 of the Financial Services and Markets Act 2000, research prepared by any affiliates. Private UK investors should obtain the advice of their Morgan Stanley & Co. International plc representative about the investments concerned. RMB Morgan Stanley (Proprietary) Limited is a member of the JSE Limited and regulated by the Financial Services Board in South Africa. RMB Morgan Stanley (Proprietary) Limited is a joint venture owned equally by Morgan Stanley International Holdings Inc. and RMB Investment Advisory (Proprietary) Limited, which is wholly owned by FirstRand Limited.

Trademarks and service marks in Morgan Stanley Research are their owners' property. Third-party data providers make no warranties or representations of the accuracy, completeness, or timeliness of their data and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. Morgan Stanley Research or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities/instruments is available on request.

The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (DIFC Branch), regulated by the Dubai Financial Services Authority (the DFSA), and is directed at wholesale customers only, as defined by the DFSA. This research will only be made available to a wholesale customer who we are satisfied meets the regulatory criteria to be a client.

The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (QFC Branch), regulated by the Qatar Financial Centre Regulatory Authority (the QFCRA), and is directed at business customers and market counterparties only and is not intended for Retail Customers as defined by the QFCRA.

As required by the Capital Markets Board of Turkey, investment information, comments and recommendations stated here, are not within the scope of investment advisory activity. Investment advisory service is provided in accordance with a contract of engagement on investment advisory concluded between brokerage houses, portfolio management companies, non-deposit banks and clients. Comments and recommendations stated here rely on the individual opinions of the ones providing these comments and recommendations. These opinions may not fit to your financial status, risk and return preferences. For this reason, to make an investment decision by relying solely to this information stated here may not bring about outcomes that fit your expectations.