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South Africa
Tuesday, September 2, 2014 - 09:00
Tell us something we don’t know

The recently launched Adjusted Big Mac Index* shows that the South African Rand is currently one of the most undervalued currencies in the world. The Adjusted Index shows the rand is undervalued by 23.6% against the dollar. This is an improved assessment given that the original Big Mac Index did not account for the average burger price being cheaper in emerging countries than in developed ones because of lower labour costs.

While this is significantly better than the rand’s current 53% undervaluation reflected in the original Big Mac Index, it still places the currency as the fifth most undervalued currency against the dollar and the euro after Hong Kong, India, Japan and Malaysia.
According to Mohammed Nalla, Head of Strategic Research at Nedbank Capital, while there are certain key technical flaws, which constrain the usefulness of both the original and adjusted Big Mac Indexes as an accurate gauge of relative over or under valuation of currencies, he agrees that the rand is undervalued although the quantum is debatable.
“In South Africa, the litany of factors contributing to our undervaluation includes labour unrest, a large output gap in our economy, massive structural deficiencies in our education and healthcare sectors, labour market rigidity, the threat of land reform and many others.
“As a result, the currency has deteriorated and continues to remain weaker than its long run average. A persistently weaker currency unfortunately erodes the real purchasing power of the South African consumer in global terms and, as we remain a large net importer, this is, in my view, a negative for the economy as a whole. This is due to South Africa not being positioned as a net exporter and as such, calls for a weaker rand (historically) to spur growth have always been flawed.”
Nalla adds that much negativity is currently being priced into the rand. “Any further deterioration in domestic macroeconomic fundamentals or the social and labour unrest will likely continue to taint the outlook for the local unit. That being said, provided that no further slippage occurs, it is likely to remain rather range-bound and take direction from global developments. As the rand remains a largely liquid emerging market currency, global sentiment toward emerging markets is also a large determining factor.”
He says that the best outcome for business is not a ‘strong’ or a ‘weak’ rand but rather a stable exchange rate. “Volatility erodes confidence and constrains business activity and investment in the medium to longer term. Also, with history as a guide, the rand strengthens slowly but tends to weaken quickly and violently. As such, the risks are always disproportionately skewed towards the Rand with further weakness regardless of an absolute level.
“In light of this, a proactive strategy to hedging Rand risks is critical. Businesses need to do their sums and work out at what levels they can profitably operate. Then, around these levels, they should look to a variety of hedging strategies to optimise their outcome.”
Nalla advises that sophisticated businesses would do well to look at the asymmetric hedging opportunities which derivatives or currency options provide. “The best way to do this will be in discussion with experts in this field who can assist in putting a diversified hedging strategy in place that suits their unique requirements.”

Note to the editor:

*The Big Mac index was invented by The Economist in 1986 as a light-hearted guide to whether currencies are at their “correct” level. It is based on the theory of purchasing-power parity (PPP), and the notion that in the long run exchange rates should move towards the rate that would equalise the prices of an identical basket of goods and services (in this case, a burger) in any two countries.
The adjusted index addresses the criticism that you would expect average burger prices to be cheaper in poorer countries than in rich ones because labour costs are lower. PPP signals where exchange rates should be heading in the long run, as a country like China gets richer, but it says little about today's equilibrium rate. The relationship between prices and GDP per person may be a better guide to the current fair value of a currency. The adjusted index uses the “line of best fit” between Big Mac prices and GDP per person for 48 countries (plus the euro area). The difference between the price predicted by the red line for each country, given its income per person, and its actual price gives a supersized measure of currency under- and over-valuation.
Big Macs are produced locally and the price depends on factors such as the cost of local labour and other inputs. In order for purchasing power parity to hold, the good needs to be freely tradeable across borders. For example, if burgers are much cheaper in SA than Botswana, it should be possible to ship the burger over to the consumer in the other country to ‘force’ equilibrium prices.
In addition, domestic taxation differences, fixed currency pegs (in some countries like China) as well as upstream subsidies of certain agricultural sectors in many countries further complicates a ‘clean’ view of what the true burger price would be in a free market.
As such, measuring a single, albeit largely homogenous, product cannot infer the complexities of relative under or over valuation of a currency, which is largely an amalgamation of numerous macroeconomic considerations ranging from perceptions of risk to liquidity, credit worthiness, and so on.

Copyright © Insurance Times and Investments® Vol:27.9 1st September, 2014
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