Big Mac Index: Is the rand still undervalued?

You can also listen to this podcast on iono.fm here.

JIMMY MOYAHA: We have been seeing the South African rand performing at some of its best levels against the US dollar in four years, at one stage dipping to below R15.70. We’re currently around the R15.97 level, just around that R16 level, and we’re struggling to see if we can maintain momentum below R16.

We’ve briefly dipped above that level this week, but even with all of the strength over the last year, it still, according to the Big Mac Index, suggests that the rand continues to be an undervalued currency.

Read:
Why does the rand exchange rate matter?
Rand is undervalued even after year-long rally, survey shows

We’re going to take a look at this and see what to make of it with the chief economist at PSG Financial Services, Johann Els. He joins me on the line now to see if we can make sense of the numbers.

Johann, lovely having you on the show as always, thanks for the time. Perhaps give us an understanding of why the Big Mac Index continues to be the barometer of how currencies are measured.

JOHANN ELS: Good evening. It’s a simplification of the typical purchasing power parity [PPP] model, which measures currencies according to inflation differentials between countries, so basically price levels.

The Big Mac Index is a product that’s widely available across the world to measure what the pricing differential is between the US and a specific country, in this case, of course, South Africa.

Read: Lower inflation target set to reshape rand’s long-term path

Simplification because it’s only one product versus the true model, which is the typical inflation basket of what people buy. But it’s roughly similar to my PPP model in terms of showing that the rand is much cheaper than what it’s supposed to be.

JIMMY MOYAHA: Johann, we’ll come back to your model. Let’s perhaps dive into the differentials, especially now that you bring up the inflation differential.

Read/listen:
Are SA assets on the brink of a rerating?
SA ‘on the right path to investment-grade rerating’ – Redefine’s Ntobeko Nyawo

We know that from a South African perspective, we basically had the equivalent of what a rerating would be on the inflation side of things when we agreed that we’re adjusting our inflation targeting down for the first time in the democratic history of South Africa.

We’re moving from a benchmark of 4.5% as a midpoint to trying to anchor inflation at 3%. What does that kind of policy shift do for the underlying differentials, and how the market then perceives the strength of a currency like the rand?

JOHANN ELS: Absolutely, great question. If we take it back even further, at the time when Gill Marcus was governor of the central bank in South Africa, she and her MPC [Monetary Policy Committee] basically targeted the top end of that 3% to 6% target range, 6%.

That meant a significant differential between South African inflation at 6% versus the US at 2%. That’s a 4% differential.

Listen/read:
South Africa books ‘big wins’ on lower inflation, Kganyago says
Treasury, the Sarb and inflation targeting
Kganyago sees inflation around 3% in 2026

Then under Lesetja Kganyago [current South African Reserve Bank governor] and his MPC targeting 4.5%, that already narrowed the band even further.

When you have your inflation significantly higher than that of your main trading partners, or the pricing of your currency – in this case against the US dollar – it means our currency in South Africa needs to depreciate by that difference every year, year after year, to maintain our relative competitiveness in terms of the stuff that we export to the US, for instance.

Our inflation is so much higher, so to maintain relative competitiveness, you depreciate the currency by that differential.

So your point exactly, now that we’re targeting 3%, and now that inflation is getting closer and closer to 3%, and down the line, on a more sustainable basis, the difference between us and the US is only 1%. US inflation is around 2% over time, and our inflation around 3% over time.

So our currency only needs to depreciate by around 1% per year on average to maintain that relative competitiveness.

Read: Sarb errs on the side of caution, holds rates steady

The currency over time can be more stable than what we’ve become used to over several years. As we’ve moved from a 6% target to a 4.5% target and now to a 3% target, we’re moving towards a more stable currency in the medium term as well.

JIMMY MOYAHA: Johann, according to the Big Mac Index, the implied exchange rate for the rand-dollar should be around R8.97.

I want to get a sense of what that real value of the rand means, especially when we start to look at things like the risk premium that gets priced into the currency, and whether or not that R9 figure is unrealistic or something that is an achievable number.

It suggests effectively that the rand is more than 40% undervalued at its current levels, even after a strong 2025.

JOHANN ELS: Yeah, that’s the danger – the risk of using just one product. I don’t believe the rand is that much undervalued. But if you take a basket, or the typical inflation differentials, the rand is still undervalued.

That Big Mac valuation means the rand is much cheaper than it’s supposed to be, so the rand should actually be much stronger.

Now, we know that currencies are inherently volatile.

The rand can strengthen substantially, just as it can weaken substantially, according to prevailing conditions around the world – whether that’s the US dollar, precious metal prices, the stuff that we export, or the oil price, for instance, which is our main import.

Read:
Gold, platinum and our mighty rand
Rand rebound paves way for rally as metals stabilise
Stronger rand delivers cheapest petrol in 4 years
Everybody suddenly loves the rand

There are a number of factors at play, including local factors such as growth. Are we managing to get the budget deficit under control? Does growth allow us to stabilise and reduce the debt-to-GDP ratio? Have we got investment-grade ratings, or are we at least moving on an improving path in terms of credit ratings?

So there’s a whole bunch of factors, and lots of those have started to come together. If we then get back to my PPP model, it also suggests that the rand is undervalued.

My model, which is based on inflation differentials – baskets of products, not just one product like the Big Mac – suggests that the rand could be closer to R12.

That’s weaker than the R9 implied by the Big Mac, but still substantially stronger than where it is at present. It still suggests the rand is undervalued.

JIMMY MOYAHA: Johann, let’s look at that model in a bit more detail. How did you put it together, and what does it suggest about what potentially needs to be looked at if we are to see R12 as an achievable target?

Is it a function of internal factors that we are able to deal with in South Africa, or is it mainly reliant on external factors, as things like the risk premium often are? How did you come up with the model and where do we sit on what it means for the South African rand?

JOHANN ELS: There are a number of factors at play here.

Firstly, the model is where the Big Mac is just the Big Mac, versus the Big Mac in South Africa versus the US. I use producer price inflation [PPI] – the stuff that we manufacture – versus US PPI inflation. On that basis, if our inflation rises faster than that of the US, the rand needs to depreciate over time.

Plotting on a graph the actual rand-dollar exchange rate versus this theoretical measure shows us that the rand is much weaker than what the model or the fundamental valuation suggests at the moment.

That’s very similar to December 2001, when the rand weakened substantially, much weaker than fundamentals suggested.

As you might recall, many people expected the rand to just keep weakening, but from early 2002 onwards, the rand strengthened substantially, and it took 15 years for the rand to again get weaker to the value we saw in December 2001.

The rand can strengthen substantially over a long period of time. Back then, we had strong economic growth.

That’s one of the factors that investors look at; strong economic growth made it much easier to get the budget under control. During those years, we got our debt-to-GDP ratio to below 25% of GDP.

All of those bundled together are the reasons why the rand strengthened.

If we now look at the current situation, the reasons why the rand has strengthened so much: a weak US dollar, US policies that allowed that weaker dollar, US policies that meant there’s a risk environment, the rise in precious metal prices – our biggest exports – and fairly low oil prices, which is our biggest import, so those relative prices, the terms of trade in our favour.

We also have somewhat better growth. We got out of grey listing. We received a ratings upgrade. It’s easier to fix the budget.

Read:
South Africa is off the dirty-money grey list
South Africa’s ratings upgraded by S&P Global

We’re heading into a period of slightly better economic growth, not nearly as strong as back in 2004, 2005, 2006 and 2007, but the anticipation of better growth will fix the fiscal situation, reduce the debt-to-GDP ratio, and lead to more ratings upgrades, alongside a weaker dollar that could be in a weaker cycle for a number of years.

So there are a number of factors behind the strength in the rand, and those factors are likely to continue for longer.

I absolutely expect the rand to continue to strengthen. I don’t think it will get back to my model’s valuation of R12, but the rand has in the past often returned to its fundamental valuation.

I think those factors are in play and I think the rand can strengthen more. It will drift again, as it has in previous cycles, and then be more stable.

One last point that I want to make, during the Covid-19 lockdown in April 2020, the rand weakened to R19.90/dollar.

Read: Rand strengthens below R16/$ for first time since 2022

The easy forecast then was that, because it was much weaker than fundamentals suggested, the rand would strengthen substantially. It’s very difficult to forecast currency, so it’s very difficult to say to what level the rand will go and when.

In the event, it went from R19.90 in April 2020 to R13.50 by June 2021. That’s a substantial strengthening.

The rand is similarly undervalued at the moment, and there are a whole bunch of factors that we mentioned that are at play that suggest the rand can strengthen further in the short term.

Then, as we discussed with inflation differentials, the rand can potentially be more stable over the medium term as well.

JIMMY MOYAHA: Much potential still exists within the South African rand. Perhaps not all the way to R9 against the US dollar, and not even to R12 against the US dollar, but certainly much stronger than the current R16 against the US dollar.

Read: What’s moving the rand: A comeback against the greenback

If we can continue to see some positive momentum in the rand, as well as some weakness continuing in the US dollar. We’ll leave the conversation on that note.

Thanks so much to the chief economist at PSG Financial Services, Johann Els, for joining us to reflect on the performance of the rand at the moment, whether it’s considered undervalued against to the Big Mac Index, and what the realistic value of the rand should be.

Follow Moneyweb’s in-depth finance and business news on WhatsApp here.