Extreme Volatility in South Africa's Rand and Gold Miners
Since 5/11, risk aversion has become the buzzword in global financial markets, with central banks from 20 countries across the globe signaling higher interest rates and tighter liquidity ahead. Interest-rate futures traders are betting on two quarter-point hikes by the Bank of Japan, the European Central Bank, and the Federal Reserve. Joining the tightening bandwagon are the Bank of China and the Bank of India, whose economies expanded at 10.3% and 9.3% rates in the first quarter.
From a position of complacency about macroeconomic risks to the world's stock markets, traders are recognizing that the big-3 central banks are attempting engineer a slowdown in the global economy from its blistering 5% pace, to keep commodity inflation in check. Along with the continuing drag to disposable income from high energy prices, global monetary tightening might slow global growth towards 3% in the second half of 2006.
Growing fears that the Federal Reserve in particular, will over-react to growing inflationary pressures have spooked equity investors, especially in emerging markets and export oriented stock markets in Japan and South Korea, which depend on demand for their exports from American consumers. And US home prices are leveling off, and could start to tumble, which might turn the housing sector into a significant drag on growth, employment and spending.
Housing has been the pillar of strength in the US economy for the past four years, with about 2 million of the 5 million jobs created since 2002 related to the housing boom. Equity extraction from homes added trillions of dollars to consumers' spending and allowed the US personal savings rate to fall into negative territory. Falling US home prices could trigger the "reverse wealth" effect, and put a lid on inflation.
The US Dollar Emerges as an Unlikely Safe Haven
Hot money flows into and out of foreign countries come in big waves. Losses in one market trigger sales in other markets. And foreign investors, who hold huge stakes in emerging markets such as Brazil, India, Russia, and South Africa, will often influence local investors, when there is a whiff of panic is in the air. If the global tightening campaign is off the mark, and leads to a hard landing, traders could continue to unload risky assets abroad for safer pastures at home.
Fears about tighter global liquidity and higher interest rates ahead, has already sliced $6.26 trillion off the value of all global stock markets. Particularly hard hit were emerging stock markets in Brazil, India, Mexico, and Russia. Between May 9th and June 13th, Brazil's Bovespa fell 29.6 percent. India's Sensex tumbled 32.4% from an all-time high, Mexico dropped 24.7%, and Russia's RTS index lost 26 percent.
Morgan Stanley's Emerging Markets index, which tracks 820 companies from 26-countries, jumped a whopping 35% in 2005, compared to a 5% gain for the US benchmark S&P-500, but has since lost 25% of its value after peaking on 5/11. One might have expected gold to be somewhat immune to plunging stock markets, and act as a safe haven during the global turmoil. So far, that hasn't been the case.
Instead, gold tumbled as much as 26% from its 26-year high of $730 /oz, sliding in close synchronization with weaker global stock markets. Somehow, gold was lumped with riskier asset markets, such as emerging stock markets whose 20% plus losses far exceeded the 12% loss for the MSCI World index, which measures a basket of stocks from 23 developed countries, that account for 86% of world GDP.
Interestingly enough, the US dollar emerged as the safe-haven during the global stock market meltdown. Since 5/11, the US dollar rebounded 6.4% from a low of 109-yen to around 116-yen, while the Euro tumbled 3.8% or roughly 5 US-cents to $1.2500. The big-3 central banks, the Bank of Japan, the European Central Bank, and the Federal Reserve are telegraphing coordinated rate hikes ahead, so the US dollar would still retain its wide interest rate advantage above the Euro and yen.
US investors, both individuals and hedge funds, poured an estimated $500 billion into emerging bond and stock markets since 2004, seeking better rates of return than on low yielding US$ deposits and under-performing US stock markets. The enhance appetite for risk also stimulated strong demand for gold, as a hedge against monetary inflation by the big-3 central banks. But with the Fed signaling more rate hikes in July and August, US dollars are coming home to short-term deposits.
US Dollar Flexes its Muscle against South African Rand
So far, the US dollar's most spectacular gains have come at the expense of the South African rand, soaring by almost 20% to a two-year high of 7.50 rand on June 23rd. That is very noteworthy, because South Africa is the world's biggest producer of gold, platinum, and diamonds, and the rand's movements against the US dollar are often influenced by the direction of gold and platinum. In turn, South African miner profits hinge on the metal price and the rand /US$ exchange rate.
South Africa's has enormous gold ore reserves, estimated at 40,000 tons and representing 40% of global reserves. South Africa's main gold producing area is concentrated on the Archaean Witwatersrand Basin, which has been mined for more than 100 years and has produced more than 41,000 tons of gold, yet still remains one of the greatest sources of gold in the world.
The platinum deposits that stretch north of Johannesburg, account for 75% of the world's known reserves, and are enough to last 350-years at current production rates. With declining stockpiles of the metal in Russia, the second-biggest source of platinum after South Africa, and demand sustained by the use of the metal in catalytic converters and the growing popularity of platinum jewelry in China, platinum prices are a harder nut to crack.
Overall, South Africa's total mineral sales rose 14.1% to 142.8 billion rand ($23.54 billion) in 2005, mainly due to higher prices. Platinum was South Africa's top earner in 2005, contributing 38.5 billion rand, with coal at 35.6 billion, and gold at 24.6 billion. Platinum output rose 9.6% to 302.9 tons last year, exceeding gold production, which fell 13.4% to 295 tons. Diamond production achieved another record level last year, rising 9.3% to 15.8 million carats for $1.7 billion.
Yet mining only accounts for 6% of South Africa's GDP, compared with 16% for manufacturing and 19.5% for finance, real estate and business services. Nevertheless, gold and platinum together account for roughly 25% of South Africa's exports, so they're important for the balance of payments. South Africa is also the world's second largest supplier of palladium, producing 7.5 million ounces of palladium last year, or 40% of the world's output, and sixth largest producer of coal.
South Africa is the world's largest gold miner, and is more exposed than any other country to slumps in the gold price because its deep level mines are the highest cost producers in the world. Gold's sudden collapse below the psychological $600 /oz level on June 13th also triggered buy stop orders for the US dollar above 7.0 rand. On the flip side, that knocked the SA rand below 14.3 US-cents to a two-year low of 13.3 US-cents on June 23rd, or 20% below its high as 16.6 US-cents on 5/11.
The rand crashed again on June 22-23rd, following the shocking news that South Africa's current account deficit soared to a record high of 103.1 billion rand, or 6.4% of its GDP, up from a 71.6 billion shortfall in the fourth quarter of 2005, or 4.6% of its economic output. That puts South Africa's external position with the rest of the world on par with the US's 6.4% c/a deficit, and Australia's c/a deficit of 6% of GDP.
South African Economy at the Whim of Foreign Investors
South Africa, which accounts for 25% of the entire continent's economic output, and 40% of its manufacturing base, has been in an upward phase of the business cycle since September 1999, the longest period of expansion in its history. South Africa's economy grew by 4.9% in 2005. During the upswing from 1999 through to 2005, the annual economic growth rate averaged 3.5%. In the decade prior to 1994, economic growth averaged less than 1% a year.
Rising prices for commodities and strong global growth helped boost South Africa's exports by 12% last year. Finance Minister Trevor Manuel unveiled tax relief of 19.1 billion rand ($3.1) this year, with the bulk going to poor or middle income people and for small firms, which have the most potential to reduce the country's 25% jobless rate. The main corporate tax rate however, was left unchanged at 29 percent.
But South Africa buys more from abroad than it receives from sales of gold, coal, diamonds, platinum, palladium, etc, and relies on capital inflows from abroad to cover its trade deficit and to keep the rand stable. Africa's largest economy ran a trade deficit of 36.5 billion rand in the first quarter, when exports took a surprising turn for the worse and plunged 5%, while imports rose by 3.5%, led by a 14.5% surge in domestic spending and investment.
Last year, SA recorded its largest net capital in-flow ever, with a record 98.5 billion rand on the financial account of the balance of payments. Firm foreign demand for Johannesburg Stock Exchange (JSE) shares is one of the reasons why the rand had remained relatively strong, leading to a virtuous circle of currency stability, luring foreign capital inflows, and resulting in historically low interest rates. The JSE became the world's 18th largest exchange with $4 trillion of market valued stocks.
Until 5/11, foreigners had bought a net 54.7 billion of JSE listed shares this year. Foreign demand for the rand helped South Africa maintain its low interest rates, even in the face of a sharp spike in the oil price. But the virtuous cycle is now beginning to unwind and go into reverse. Foreigners were net sellers of 2 billion rand's worth of local JSE shares over the past two weeks.
Weaker Rand Generates Higher Inflation and Interest Rates
US dollar's latest 20% surge toward 7.5 rand is exerting significant upward pressure on consumer inflation, which the Reserve Bank of South Africa (RBSA) forecasts will top 6%, and above its 3% to 6% inflation target. South African Reserve Bank governor Tito Mboweni on June 22nd warned of danger signs in the economy which could signal "some major inflationary consequences down the road."
Mboweni said while "things generally look good, there are lots of dangers". Included in these dangers were "very strong domestic demand, very strong credit growth and worrying signs of increasing household debt as a ratio of household income. There is something wrong in the economy encouraging this conspicuous consumption. Maybe that borrowed money is too cheap," he said.
Stubbornly high crude oil prices and the recent weakness in the rand exchange rate against the US$, pose a risk to South Africa's inflation outlook, said RBSA chief Tito Mboweni on June 5th. "Domestic monetary policy has continued to emphasize price stability and has succeeded admirably in reducing inflation expectations. However, there are a number of unfavorable trends and risk factors," he said.
Noting the crude oil price is near $70 per barrel, there was "the possibility that it could rise to $80 per barrel," with the Iran nuclear question putting upward pressure on prices. "These factors include rising crude oil prices and their impact on global growth and inflation, the possibility that secondary inflationary pressures may be stimulated by the recent movements in the rand exchange rate." Mboweni said.
Iran brandished oil as a weapon on June 25th, amid mounting pressure on Tehran to halt enrichment of uranium, in exchange for a UN package of incentives. "If the country's interests are attacked, we will use all our capabilities, and oil is one of them," warned Iranian Oil Minister Kazem Vaziri-Hamaneh. "The world needs energy and understands the effect on the market of oil sanctions against Iran, and no-one will make such an unreasonable decision," the minister said, predicting sanctions against Iran could push crude up to 100 dollars a barrel.
Seen from another angle, US crude have been trending lower since hitting an all-time high of $75 per barrel on April 12th, due to unwinding of speculative long positions. However, with the US dollar's 20% surge against the rand, the cost of imported oil to South Africa has soared to 525 rand /barrel from 445 rand, exerting upward pressure on inflation and squeezing profit margins for its miners. The CPIX inflation measure is now forecast to peak at 6.2%, above the RBSA's target range.
South Africa imports 90% of its crude oil needs, the majority from the Middle East, with Saudi Arabia and Iran as its chief suppliers. Because South Africa is trying to diversify its sources of imported crude and reduce its dependence on Iranian oil imports, Nigeria is now the third largest supplier of imported oil to South Africa. Other major oil sources include Kuwait, Russia and Angola, and Equatorial Guinea.
South Africa is also the world's sixth largest coal producer of 245.3 million tons per year, and is the third largest coal exporter of 73.7 million tons, mostly to Euro and East Asia. The country has the world's seventh largest amount of recoverable coal reserves of 54.6 billion tons, or approximately 5% of the world total.
South African Economy hit by a double Whammy
It might take much higher RBSA interest rates to defend from rand from further speculative attack. With the BOJ, the Fed and the ECB expected to hike rates further in the weeks ahead, the RBSA might be compelled to leap-frog the big-3 central banks with more forceful rate hikes. Speculation is rife that the RBSA may consider holding an emergency monetary policy meeting to hike interest rates further, before its next scheduled meeting on August 2-3rd, to restore stability in the rand.
The rand is one of the most volatile currencies in the world, with average daily trade volume climbing from $3.8 billion in the first quarter of 1998 to $13.8 billion in the third quarter of 2005. The problem is that more than half of the daily trade in the rand takes place offshore and is often driven by foreign portfolio and speculative flows. Japanese investors were large buyers of SA rand bonds last year.
But the latest surge in South African bond yields, also coincided with a 20.4% devaluation of the rand to 15.6 Japanese yen, suggesting that Tokyo bond traders were unwinding the "yen carry" trade. The Bank of Japan has removed 20 trillion yen, ($170 billion) of excess funds out of the banking system, and Japanese traders sold rand denominated bonds to avoid foreign currency losses against the yen.
The BOJ is also preparing to go a step further in tightening liquidity, by lifting its overnight loan rate to 0.25% as early as July 14th. BOJ chief Toshihiko Fukui warned on June 20th, "It is our important challenge to minimize swings in the economy and sustain a stable economic environment by taking appropriate monetary policy decisions. We're entering a critical period for our monetary policy."
"Monetary policy decisions should be made early, and changes should be made in small increments. But at the same time, it should be done in a gradual manner." With the Federal Reserve expected to match the upcoming BOJ rate hikes this year to keep the US dollar stable against the yen, the South African rand is finding itself getting hammered against both major foreign currencies.
The US dollar's surge against the rand is putting upward pressure on South African oil import prices and the inflation rate, while the Japanese yen's 20% rise against the rand is exerting upward pressure on SA bond yields. South Africa's 10-year bond yield shot up 125 basis points to as high as 8.65%, from two months ago. Since the BOJ signaled the end of "quantitative easing" Japan's 10-year bond yield has moved about 30 basis points higher to 1.87 percent.
With the rand continuing to trade at relatively weak levels, and oil prices elevated above $70 a barrel, South African producer prices are seen going higher in coming months. Producer prices jumped 1% in May to stand 5.5% higher from a year earlier, but consumer prices were only 3.7% higher. However, when these relatively large increases absorbed by producers are passed on to consumers, the rosy picture for inflation, and the interest rate outlook, can quickly change very quickly.
Higher RBSA rates needed to Stabilize the Rand
The rand's instability is a big problem for the government and business, which must make strategic economic plans while the currency is gyrating wildly. For the RBSA, a baby-step interest rate adjustment is equal to 50 basis points, but the central bank has not shied away from more forceful 75 bp and 100 bp rate moves in the past, to combat currency speculators, who have whipped the rand around in a trading range as wide as 20% in a single month.
The Reserve Bank of South Africa has been itching to raise interest for the past eight months and the dollar's initial thrust towards 7.0 rand, was the opening salvo for a 50 basis point rate hike to 7.50% on June 8th. That ended a string of repo rate cuts totaling 650 basis points since 2003, driving prime lending rates to 10.5%, their lowest in more than two decades. Interest rates were on hold since April 2005.
Meanwhile, the Federal Reserve has lifted the fed funds rate sixteen times by 400 basis points to 5.00%, and is expected to lift the overnight loan rate 0.25% to 5.25% on June 29th. Before the RBSA's latest half-point rate hike, the spread between South Africa's six-month Libor rate and the comparable US dollar rate narrowed by a whopping 1000 basis points to as little as 2%.
Despite the shrinking rate gap, the US dollar remained weak and pinned down near 6 rand, in a background of soaring gold and platinum prices. The RBSA took advantage of the rand's strength, by purchasing $16 billion US dollars over the past two years, building up its foreign exchange reserves to $20.4 billion in April. The RBSA's quiet intervention and narrowing rate differentials put a floor under the dollar at 6-rand.
If the rand continues to plummet against the Japanese yen and US$, the RBSA could be in the unenviable position of hiking rate more forcefully than a half-percent, to restore the rand's interest differential against the big-3 currencies, including the Euro, Japanese yen, and US dollar. On the other hand, if precious metals, palladium, and coal prices can stabilize and resume their upward climb after steep corrections, the RBSA could limit the scope of its rate hike campaign.
Would South Africa use some of its $20.4 billion of foreign currency reserves for direct intervention to rescue the rand? In the past, finance minister Trevor Manuel said the primary focus of its exchange rate policy is to reduce the volatility of the rand and not to influence the level at which it trades. "Finance ministers and central bankers throughout the world have learnt the hard way over the past two decades that attempts to fix the prices of currencies carry huge costs for taxpayers."
South Africa covets its foreign currency reserves, and is unlikely to engage in a losing battle with powerful currency speculators. South Africa's newly acquired FX reserves, persuaded Fitch Ratings to upgrade it foreign currency debt ratings in August 2005 from BBB to BBB+, following similar upgrades by Moody's and Standard & Poor's. Standard & Poor's upgraded SA's local rand debt rating from A to A+.
Fitch predicts South Africa would be a net external creditor by the end of 2006, and the country's reserves and liquid foreign assets held by banks would more than cover its gross external debt. "The upgrade reflects an improvement in South Africa's growth performance and a further strengthening of its external balance sheet, resulting from a sizeable build-up of official reserves," Fitch said.
Sovereign credit ratings are a measure of a government's creditworthiness, with higher ratings implying less risk for investors, effectively making it cheaper for a country and its companies to borrow on local and international capital markets. But if the RBSA wants to defend the rand from speculative attack it would be forced to jack-up short term interest rates, at the risk of slowing down its economy.
As a result of historically low bond yields, Africa's largest economy expanded 5% last year, its fastest in pace in 20 years, from 4.5% in 2004. But a sustained rise in SA bond yields could threaten growth, in an economy where household debt jumped to a record 68% of disposable income in the first quarter of 2006 from 65.5% in the fourth quarter, raising concern about the consumers' ability to continue spending.
Weaker Rand is a double Edged Sword for South African Gold Miners
The RBSA's rate hike to 7.50% might hurt JSE stocks, if traders perceive the start of a rate hiking cycle that will trample on South Africa's economic growth. In a knee-jerk reaction, the Johannesburg All-share Index plunged 17% from 5/11 to a three-month low on June 13th near the 18,400-level. But unlike other emerging stock indexes, the JSE's All-share index quickly rebounded 15% a week later.
The rand's 20% devaluation is a double-edged sword. A weaker rand can spark inflation and higher interest rates, but multi-nationals listed on the JSE can also earn huge windfall profits from a stronger dollar and Euro on income earned abroad. New Zealand's top-50 stock index responded in a similar manner earlier this year, gaining 15% to record highs at the 3800-level, following the kiwi's 13% devaluation against the US dollar and 16% drop versus the Japanese yen.
However, South African Finance Minister Trevor Manuel on June 23rd, pointed out that a more competitive rand didn't automatically lead to more exports, which would ease the pressure on the current account, a country's broadest measure of trade. "You don't get rapid turns in access to export markets. It's not as though you have production piled up. You have to secure markets first," he said.
But too aggressive monetary tightening also carries a big danger, if it chokes off the forward momentum of the economy. If that happens, foreigners may become aggressive sellers of the JSE equities purchased on the notion that South Africa's GDP growth had entered a higher trajectory. If so, the rate hike cycle in South Africa might go much higher than equity traders expect, and to the detriment of banking shares such as Nedbank NEDJ.J and Abasa bank ASAJ.J.
Initially, global risk aversion knocked the JSE's gold share index 28% lower from its 5/11 levels, to the 2300-mark, exacerbated by foreigner traders pulling funds out of emerging markets, and JSE gold shares being the most liquid, were among the hardest hit. But South African miners are cushioned to a certain extent by a weaker rand, which improves export earnings when translated into local currency.
Two major factors influence the value of local gold companies, the spot price of gold and the value of the rand against the dollar. The plunging rand has worked to the local gold industry's favor by keeping the rand gold price at levels where mining companies can make money. So while the US-dollar gold price has lost 20% to $580 /oz since 5/11, the gold price in rand terms fell by only 1.5% to 4312 rand /oz.
For instance, on 5/11, the US$ price of gold closed at $720 /oz and the US$ closed at 6.08 rand, generating 720 x 6.08 rand = 4378 rand /oz. When gold fell to $575 /oz on June 23rd, and the dollar rose to 7.50 rand, the South African gold miner earned 575 x 7.50 = 4312 rand /oz, or only 1.5% less than five weeks earlier.
The rand gold price, revenue received by South African miners, remains close to a two-year high, owing to the weakening rand. Currently, South Africa's gold production is dominated by Anglo Gold, Gold Fields, and Harmony, which have all diversified into other gold producing countries, to diversify geographically and complement high-cost underground mines with less expensive open pit operations.
Harmony Gold (HMY) and Gold Fields (GFI), have the most exposure to South Africa, while bigger rival AngloGold (AU) has expanded much of its production portfolio outside of South Africa. The largest producer of South African gold, and the world's fourth largest gold miner, Gold Fields, recovered most of its meltdown losses in rand terms on the Johannesburg Stock Exchange.
But the investor in US-listed Goldfields (GFI) might feel a bit short-changed, with GFI trading roughly 24% below its 5/11 levels, although Goldfields on the JSE, GFIJ.J is trading at 15,100 rand per share, or 8% below its 5/11 highs. That's because investors in GFI have accepted foreign exchange risk, and have suffered thru the rand's devaluation against the US dollar. The best of all worlds for GFI traders outside of South Africa would be a revival of the bullish trend for gold, which in turn, could restore the bullish psychology for the rand.
RBSA inflated its Money Supply, Buoying Gold prices
However, as is typical of other emerging economies, the Reserve Bank of South Africa oversaw explosive growth of its M3 money supply, expanding by as much as 26.8% on an annualized basis in February 2006, and far above its average growth rate of 15% in 2003-04. The RBSA countered the rand's strength against the US dollar, by inflating the local money supply in a low interest rate environment.
South Africa's money supply growth rate exceeded China's 19.1% and India's 18.5% growth rate, and indicates that the JSE rally was partly monetized by the central bank over the past few years. Inflating the M3 money supply sent rand gold prices 70% higher to a high of 4584 rand /oz in May, so it will be very tough to restore confidence in the rand or lower inflation expectations in the local bond market.
The BIS issued a stark warning to emerging countries seeking to depress their currency values through loose monetary policy. "Prolonged large-scale intervention or monetary easing to hold the exchange rate down can lower real interest rates, raise credit growth and encourage debt accumulation. Resulting imbalances in inflation or growth would be more severe the longer monetary stimulus continues."
One must become a good juggler to trade foreign based, gold miner stocks, keeping an eye on several markets that fluctuate in a violent manner, such as the gold price, the local currency exchange rate, and incoming company news. And in the case of the South African economy, its inflation rate, interest rate, and growth rate usually hinge on the erratic flows of foreign capital into and out of the rand.
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