Impact Partner Content: Absa / by Justin Schmidt
The manufacturing sector saw capacity utilization fall to 79.3% in February, a 7-year low, indicating that there was rising pressure on the sector even before COVID-19 enforced lockdown restrictions. This underutilization was driven by a lack of demand, as well as the high levels of load shedding.
Furthermore, the April print of the Absa Purchasing Managers Index (PMI), an indicator of the confidence level of manufacturers, saw a reduction in confidence. The business activity component of PMI came in at a historic low of 5.1. This is a clear indicator of the devastating impact of the initial lockdown. Disruptions to supply chains have been another key feature of the global pandemic. Despite all the current pressure facing the manufacturing sector, these supply chain disruptions and the need to kick start our economy have brought the importance of manufacturing and localisation thereof into sharp focus.
Effective 1 May manufacturers (outside of those defined as essential) began work with the partial lifting of lockdown and as we move into less stringent levels, we will see more activity. Manufacturing is an important creator of jobs and if South Africans support initiatives like Proudly South African, for example, we will see greater levels of goods produced locally. Another important aspect of localisation will mean that we import fewer goods but also hopefully export more goods.
Things to consider when hedging your bets…
In addition to all these factors, the volatility of the Rand is another critical component affecting manufacturing. A positive side effect of the COVID-19 shock for exporters (a negative for those importing raw material) is a weaker Rand. However, South Africa has one of the most volatile exchange rates in the world, which adds a level of complexity in determining the value of future revenues or input costs (when denominated in a foreign currency). Understanding the exposure to foreign exchange rates and how to manage this is important for manufacturers, especially in an environment where every cent counts towards an already strained bottom line.
The Rand has weakened substantially against the US dollar this year, hitting a peak of R19.35 per USD at the start of April, before rallying to R17.38 per USD on 26 May. This drop has come on the back of heightened global risk aversion associated with the COVID-19 pandemic. There have also been substantial outflows from the South African bond and equity markets, with bond outflows due in part to South Africa’s sovereign credit rating downgrades from both Moody’s and Fitch and SA’s exclusion from the World Government Bond Index.
If the South African economy is able to restart as lockdown measures ease, there are a few scenarios that could lead to the strengthening of the Rand in the latter half of the year:
Capital inflows: Where local asset managers are above their offshore investment allowances as a result of the weakening of the Rand and a sharper sell-off of domestic markets compared to international markets, there is a need to repatriate some of their offshore investments.
Valuations: From a purchasing power parity perspective, the trade-weighted Rand looks undervalued. In other words, for a basket of goods in Rand terms to equal the cost of the same basket of goods in other currencies the Rand needs to appreciate.
Current account balance: If improvements in South Africa’s terms-of-trade (price of its exports versus that of its imports), reduced dividend and interest payments abroad, and import compression due to the weak economy continue, the current account deficit is likely to narrow significantly this year. The slump in the oil price as well as strong precious metal prices underpin sharply better terms of trade over the last year, while aggressive net sales of South African bonds and equities in recent quarters ought to lower coupon and dividend commitments to offshore investors.
Carry trade: If the South African Reserve Bank does not continue to cut rates to the extent that is priced into the market, and global volatility levels continue to reduce this could enhance the Rand’s carry trade appeal. In other words, in the search for returns South African bond yields may be more attractive to foreign investors and lead to an inflow of funds into South Africa.
However, there are also risk scenarios, such as global risk aversion, that could see the Rand depreciate. Global investors may feel a fresh wave of risk aversion due to the heightened USA / China trade war tensions or Covid-19 related fears which will see a weaker Rand.
Hedging Rand exposure might give manufacturers more control in this highly uncertain environment
Due to the open nature of our economy and mature financial markets, the Rand is a highly volatile currency and a variable that is outside of the control of manufacturers who import raw materials or export final goods. Understanding your sensitivities to exchange rates and the hedging thereof can give you more control, allowing for one less variable in your business that you must be uncertain over. In this unpredictable environment planning around cash flows is key and paying a premium to hedge this variable and better understanding of your inflows and outflows as they relate to foreign exchange exposures may be a prudent practice. Successful management of foreign currency revenues or input costs can optimize a manufacturers effort to limit margin pressure.
