Everything you need to know about currency devaluation

The South African rand (ZAR) is currently trading for around R18.9 to the US Dollar, stronger than in May this year when it peaked at R19.7, but still weaker than the R16 in August last year, and a lot weaker than the R14.7 in the same month of the previous year. And much, much weaker than the R7-something to one US Dollar twenty years ago. You get the point.

The further you zoom out on the ZAR/USD graph, it’s clear that the strength of the rand has consistently weakened over time. That squiggly worm on the graph has been relentlessly inching upwards over the years as investors require more and more rands to buy one US Dollar.

This often happens with currencies of developing nations against a global reserve currency like the USD. But why? 

6 factors that impact the rand’s value 

Like all tradable assets, the value of the rand is underpinned by supply and demand and is impacted by various factors that play out locally and abroad. 

1. Interest rates 

The level of interest rates set by the South African Reserve Bank (SARB) has a significant impact on the rand’s value. Higher interest rates tend to attract foreign investment, as investors can earn more interest on their investment. This increase in demand for the rand can boost its value.

2. Economic performance 

The overall health of South Africa’s economy plays a role in determining the rand’s value. Factors such as gross domestic product (GDP) growth, employment levels, and trade balances can affect investor confidence and influence the currency’s value.

3. Political stability 

Political stability and the country’s perceived risk affect foreign investors’ confidence. Political uncertainty, corruption, or social unrest can lead to a lack of confidence in the rand and result in a drop in value.

4. Inflation 

High inflation erodes the purchasing power of a currency over time. Inflation plays out in many ways, but the most obvious symptom is an increase in the cost of living that usually coincides with a decline in the buying power of money. For example, inflation can lead to an increase in the price of bread while at the same time eroding the value of the money in your pocket. 

High inflation can dent investor confidence in a country and put downward pressure on its currency. The various ways that central banks try to contain inflation can also have an impact on the value of a currency, one being to heighten interest rates to curb spending and lending, but also to attract investors. 

5. Trade balance 

South Africa’s trade balance, which is the difference between its exports and imports, can impact the demand for the rand. A trade surplus – more exports than imports – can increase demand for the rand, as there’s an increase in demand for its goods, and so too its currency, while a trade deficit can put pressure on the currency.

6. Global economic conditions 

Global economic trends and geopolitical events can affect investor sentiment and the demand for emerging market currencies like the rand, often when high interest rates in these emerging countries offer promising returns on investment. 

A focus on interest rates

Interest rates are often cited as one of the key drivers of price movements in financial markets, particularly in the last few years as central banks around the world employ interest rate rises more frequently as they struggle to contain inflation. 

The US Central Bank, the Federal Reserve, has led the charge in raising interest rates to suppress inflation and other governments have followed. But a bank like the South African Reserve Bank (SARB) may have more to consider than just taming inflation in that lower interest rates can actually dampen investor appetite for the rand. 

When the SARB decides to raise interest rates, it’s sort of like giving the rand a shot of adrenaline because higher interest rates make South African bonds and other debt investments more attractive to foreign investors as they can get more from their investment. How does this work? ​​Imagine you have two places to invest your money. The one offers a higher interest rate than the other. Naturally, you’d want to go with the one that gives you more return on your investment, right? Foreign investors feel the same way.

An example 

Let’s take Bob, for example. Bob notices that the South African Reserve Bank has recently raised interest rates in line with other central banks around the world in its fight against inflation. 

Now, considering that the current interest rate in South Africa is higher than in many other countries, Bob realises that South African government bonds offer a competitive and promising yield compared to fixed income investments in other countries. 

He decides to allocate a portion of his investment funds to invest in South African government bonds, taking advantage of the higher interest. As Bob and other investors buy rand to make the investment, the increased demand for the currency contributes to its appreciation relative to other currencies.

In this scenario, the higher interest rates in South Africa are an incentive for Bob to invest in the South African bonds and take advantage of potentially higher returns on his investment. 

In raising rates, the SARB is both trying to tame inflation while also trying to encourage investors from abroad.

What happens when rates go down?

With lower interest rates, foreign investors might not find the rand as enticing. This waning foreign demand can put downward pressure on the price of the rand and it can end up losing some of its shine against other major currencies. It’s not as simple, though.

The impact of interest rates on a currency’s value is just one piece of the puzzle. Exchange rates are influenced by a complex interplay of various factors. While higher interest rates can positively influence the rand’s value in the short term, the long-term currency movements are subject to a combination of economic, political, and market factors both in South Africa and globally.  

Hedging against currency devaluation

Investors hedge against currency depreciation using various strategies, but one is to invest in a more stable currency like the US Dollar, which has proven to be more stable than currencies from most developing nations.  

Everyday investors can get exposure to US Dollars directly or indirectly. By opening a foreign currency account with their bank, they can invest directly by buying Dollars with rands, or, they can invest in local funds that have exposure to the US market. These investments are known as feeder funds. 

Stablecoins could be another way for investors to access the US Dollar. Stablecoins are cryptocurrencies that are pegged to the price of the US Dollar. USDC, for example, is a stablecoin that claims to be backed 100% by US Dollar and other cash reserves, while USDT (Tether) is backed by a broader range of assets. 

In both cases, because they are pegged to the price of the US Dollar, the devaluation of the rand won’t figure in when you eventually decide to sell your USDT. On the contrary, if the rand continues to depreciate, and USDT keeps its Dollar peg, you can, hypothetically, get more rands out than you initially invested. 

To be clear, stablecoins are not the same as investing in actual USD or funds that invest in US markets. Rather, USDC and USDT (Tether) are cryptocurrencies, traded on crypto exchanges, which aim to keep their prices pegged that of the US Dollar. 

*This information should not be construed as a solicitation to trade. All opinions, news, research, analysis, prices or other information is provided as general market commentary for information purposes only and is not investment advice or recommendation. Luno always advises you to obtain your own independent financial advice before investing or trading in cryptocurrency.