Banking group Absa new sector development in retail and business banking head Justin Schmidt argues that successful management of foreign currency revenues or input costs in an environment characterised by rand volatility can optimise a manufacturer’s effort to limit margin pressure.

The manufacturing sector saw capacity utilisation fall to 79.3% in February – a seven-year low – indicating that there was rising pressure on the sector even before the imposition of Covid-19-related lockdown restrictions. This underutilisation was driven by a lack of demand and load-shedding.

Further, 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 the PMI came in at a historic low of 5.1. This is a clear indication 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 pressures facing the manufacturing sector, these supply chain disruptions and the need to kick-start the economy have brought the importance of manufacturing and localisation thereof into sharp focus.

From May 1, manufacturers (excluding those defined as essential) resumed operations, following the partial lifting of lockdown restrictions, and, as we move to 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, we will see greater quantities of goods produced locally. Another important aspect of localisation is that we import fewer goods and, 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 (but a negative one 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 exposure is important for manufacturers.

The rand has weakened substantially against the US dollar this year, hitting a peak of R19.35:$1 at the start of April, before rallying to R17.38:$1 on May 26. This decline 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 by both Moody’s and Fitch and South Africa’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 with 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 to 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 (the price of its exports versus the price of imports), reduced dividend and interest payments abroad, and import compression as a result of the weak economy continue, the current account deficit is likely to narrow significantly this year. The slump in the oil price and 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, which could see the rand depreciate. Global investors may feel a fresh wave of risk aversion, owing to the heightened US-China trade war tensions or Covid-19-related fears, which will result in the rand weakening.

Owing to the open nature of South Africa’s economy and mature financial markets, the rand is a highly volatile currency and a variable that is beyond the control of manufacturers that 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 can be uncertain of. 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 optimise a manufacturer’s effort to limit margin pressure.