RMB FINANCIAL MARKETS RESEARCH ZAR OUTLOOK 21 October 2008

CURRENCIES MORE NEUTRAL BUT RISKS REMAIN

CORE VIEWS

The return of relative stability to the global financial markets provides scope for the ZAR to recover some lost ground in the short term. Risks remain high though because of the continued problems with financing the current account deficit and, on a medium-term basis, it appears that the ZAR will have to remain at undervalued levels for some time. We revise our USD/ZAR forecast to 9.50 for end-08 and 10.50 for end-09. Risks to this core view remain to the upside. After being solidly bearish since late 2007, we turn more neutral but still see the risks as biased for weakness.

• • •

SENTIMENT IS KEY IN THE SHORT TERM The ZAR has been tracking global themes very closely. Effectively, this implies very strong correlations to global equity markets and to other currencies — a positive relationship with risky currencies and negative with safe havens — notably the JPY. The ZAR remains very susceptible to these factors, offering scope for a short-term pullback as we are possibly past the worst in terms of the sell-off in global markets.

UNDERVALUED AND LIKELY TO REMAIN SO The ZAR is now clearly undervalued. EUR/ZAR and JPY/ZAR hit record highs in October and GBP/ZAR was not far off. On a trade-weighted basis, the ZAR is now at the level seen at the worst of the 2001 blow-out. On a purchasing power basis the ZAR is now 33% undervalued, but on a real effective basis the undervaluation is 20%. This undervaluation is unlikely to reverse any time soon. Certainly the current account deficit remains very problematic and essentially our view is that the ZAR has to remain weak for the tradable sector to adjust to bring the economy back towards equilibrium. Moreover, don’t look at the 2001 blowout for direction. That blow-out was followed by a rapid and long-lasting ZAR recovery on the back of a string of positives — booming commodity prices, a surge of money to emerging markets, accelerating global and local growth — none of which are likely to be repeated, at least for the foreseeable future.

USD/ZAR year-end forecast 9.50, end-09 10.50 EUR/ZAR year-end forecast 12.83, end-09 13.65 Risks remain for greater ZAR losses

Figure 1: Revised ZAR forecasts

15.0

12.0 EUR/ZAR 9.0

6.0 USD/ZAR 3.0

0.0 2000

2002

For disclaimer please refer to last page

2006

2008

2010

Source: Reuters, RMB FM Research

Figure 2: ZAR at weakest levels on a trade-weighted basis

110

95

80

65

50 2000

2002

Source: I-Net Bridge

John Cairns [email protected] +27 (0)11 282 8656

2004

2004

2006

2008

RMB FINANCIAL MARKETS RESEARCH ZAR OUTLOOK 21 October 2008

FUNDING PROBLEMS REMAIN The underlying problem for the ZAR remains financing the current account deficit. Our current forecast is for a 7.8% deficit in 2008 but this will be affected by the fall in commodity prices, the response of exports and imports to the ZAR weakness and, just possibly, by a slowdown in dividend payments. Our revised figure is, however, highly unlikely to show a much improved picture, essentially implying that the deficit will remain a concern. And funding the deficit is becoming increasingly problematic. Not surprisingly, October saw foreigners dump local portfolio assets, with net sales of R20bn month-to-date making this the second-worst month ever, only behind January. With some stability returning to global markets, we can look for this to improve. But the country hasn’t received the much-needed portfolio capital in more than a year and a return to the inflows seen between 2004 and 2007 seems unlikely. There is at least good news in that the Vodafone purchase of Vodacom is highly likely to go ahead, generating R20bn of inflows. Although this would be meaningful, to put it into perspective the current account deficit is still R180bn per year! And with the global credit crisis, further FDI deals seem unlikely. Large mining sector mergers are likely to be constrained by the fall in commodity prices and any deal requiring financing will be tough. We have been warning about financing the current account for some time. It does seem though that it has been slow to make an impact. Late last year it took three months of negative inflows before the ZAR finally reacted and only after sharp movements in the Dow triggered the move. Similarly, it took five months of no inflows before the ZAR finally blew in October again when global markets took a tumble. At least, so far then, the weakness in the current account has been a necessary condition for ZAR weakness, but it still needs some form of trigger.

TO TURN MORE POSITIVE For us to turn outright positive on the ZAR, one of three conditions needs to be fulfilled. 1. A local interest rate hike. This would be positive in three ways: • It would signal that the ZAR has reached a level where the SARB is unhappy; • It raises the cost of carry of shorting the local unit; and • Perhaps most importantly, it would imply that the adjustment in the current account would fall on the local economy directly rather than just on the ZAR. Our view though is that the MPC looks highly unlikely to raise rates. Indeed, with the weakness in the economy, we have actually brought our first expected cut forward to February.

Figure 3: Current account deficit remains problematic

Rbn 40 -10 -60 -110 -160 -210 2000

2002

2004

2006

2008

Source: I-Net Bridge, RMB FM Research

Figure 4: Local portfolio flows remain negative

Rbn 45

Total portfolio inflows Current account deficit

30 15 0 -15 -30 2000

2002

2004

2006

2008

Source: I-Net Bridge, RMB FM Research

Figure 5: We still look for rates to fall %

Prime rate

Repo rate

20

CPIX inflation

CPIX forecast

16 12 8 4 0 2004

2006

2008

Source: SARB, RMB FM Research For disclaimer please refer to last page

RAND MERCHANT BANK | page 2

RMB FINANCIAL MARKETS RESEARCH ZAR OUTLOOK 21 October 2008

2. Return of strong capital inflows to emerging markets. This, to say the least, is highly unlikely right now given the risk environment and continued deleveraging in financial markets. By mid next year, however, conditions could well change and it is possible that cash could go in search of economic growth, which will still be fairly decent in South Africa and pretty dismal in the developed world. 3. The current account adjusts to more reasonable levels. Various academic estimates are that the sustainable current account deficit is around 3% or 4% of GDP. This is still a long way off even with the ZAR weakness and the slowdown in the domestic economy. The point then is that even though the ZAR is already undervalued, conditions are not yet in place to forecast a sustained recovery. Indeed, risks around the core view are still negative.

THE EASTERN EUROPEAN CONNECTION The last few weeks have seen the global financial crisis spread from the developed world to emerging markets. EM currencies in general have lost ground against the USD. Of particular relevance to the ZAR is that concerns have started to be raised about countries running large current account deficits, notably South Africa and those in Eastern Europe. Indeed, some countries have already experienced funding problems to the extent that they have had to turn to the IMF or ECB for assistance. Admittedly, South Africa’s balance of payments funding problem is slightly different. Eastern Europe has relied on cross-border bank lending to subsidiaries, which has naturally dried up in the credit crisis. This has generated both BOP and banking sector problems — South Africa has none of the latter. Nevertheless, to the extent that South Africa gets lumped in the same basket, currency weakness on the fringes of Europe may well spill over into the ZAR.

Figure 6: Capital flows to emerging markets, 3-month m/ave

US$bn

14 Emerging Markets

30

South Africa (RHS)

US$bn 3

20

2

10

1

0

0

-10 -20 2000

-1 -2 2002

2004

2006

2008

Source: Bloomberg, I-Net, RMB FM Research

Figure 7: ZAR and current account deficit currencies versus USD

170

ZAR

CA Deficit Countries

150

130

110

90

70 Jan-06

Jul-06

Jan-07

Jul-07

Jan-08

Jul-08

SUDDEN STOP The really bearish case scenario for the ZAR — as we have been warning for a long time — can be termed a sudden stop. This is generally defined as a 5% or more of GDP reduction in capital inflows from one year to the next. Generally, this would necessitate a sudden contraction in the current account deficit. For instance, in the local case the current account could be forced in a year or less to contract from 8% of GDP to 3% or less. This can be achieved through a combination of currency and economic weakness. Note that the extent of ZAR weakness thus far is still far from being enough to generate this adjustment. Unless the country can continue to attract capital inflows in some way or another then the ZAR will come under pressure. It’s not hard to foresee a potentially very serious scenario.

Source: Reuters, RMB FM Research

Figure 8: ZAR and TRY versus USD

165

ZAR

TRY

150 135 120 105 90

VOLATILITY AND BOUTS OF WEAKNESS Volatility is a given in this environment. And the ZAR will remain more susceptible to bouts of weakness rather than sharp rallies. Expect trade to resemble slow ZAR gains, followed by sharp ZAR weakness. For disclaimer please refer to last page

75 Jan-06

Jul-06

Jan-07

Jul-07

Jan-08

Jul-08

Source: Reuters, RMB FM Research

RAND MERCHANT BANK | page 3

RMB FINANCIAL MARKETS RESEARCH ZAR OUTLOOK 21 October 2008

Table 1: RMB Currency forecasts 4Q08

1Q09

2Q09

3Q09

2008

2009

2010

2011

2012

USD/ZAR

9.50

9.75

10.00

10.25

9.50

10.50

10.72

11.12

11.69

EUR/ZAR

12.83

13.07

13.30

13.48

12.83

13.65

13.93

14.23

14.37

GBP/ZAR

16.63

17.18

17.75

18.32

16.63

18.90

19.83

20.57

21.62

JPY/ZAR

0.090

0.092

0.094

0.096

0.090

0.097

0.102

0.106

0.111

AUD/ZAR

6.84

7.02

7.20

7.28

6.84

7.35

8.04

8.23

8.47

NZD/ZAR

6.18

6.34

6.50

6.66

6.18

6.83

6.75

6.89

7.13

CHF/ZAR

8.27

8.43

8.58

8.70

8.27

8.81

8.99

9.18

9.27

NOK/ZAR

1.51

1.51

1.52

1.56

1.51

1.61

1.69

1.78

1.80

SEK/ZAR

1.32

1.35

1.39

1.41

1.32

1.44

1.50

1.53

1.55

CAD/ZAR

7.92

8.13

8.33

8.54

7.92

8.75

8.93

9.27

9.74

CNY/ZAR

1.40

1.46

1.52

1.58

1.40

1.65

1.68

1.88

2.12

INR/ZAR

0.190

0.189

0.189

0.199

0.190

0.210

0.214

0.265

0.278

BRL/ZAR

4.75

4.88

5.00

5.13

4.75

5.25

5.36

5.56

5.84

BWP/ZAR

1.22

1.22

1.22

1.22

1.22

1.23

1.23

1.24

1.25

55.25

54.02

52.86

51.85

55.25

50.90

49.46

48.06

46.69

NEER

Source: RMB FM Research

For disclaimer please refer to last page

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RMB FINANCIAL MARKETS RESEARCH ZAR OUTLOOK 21 October 2008

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RMB FINANCIAL MARKETS RESEARCH ZAR OUTLOOK 21 October 2008

RMB FINANCIAL MARKETS RESEARCH AFRICAN RESEARCH Celeste Fauconnier: Politics Gunther Kuschke: Economics +27 11 282-8469

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