Our current low interest-rate environment, comes with a number of opportunities and risks. Find out how they impact business and international banking as Reggie Mlangeni, Head of Client Solutions Group at Absa Corporate and Investment Banking, explains the art and science of managing your foreign exchange (FX) risk.
In mid-2020, South Africa’s prime lending rate was 7% per annum – a record low compared to previous highs of 17% p.a. in 2000-04, 15.5% in 2005-09 and the 10.5% peak reached since 2010.
But the current low lending rate affects more than just your monthly repayments. In fact, it has a number of impacts on businesses who understand the opportunities and risks.
Risk 1: Institutional Investors
‘The most prominent risk caused by low interest rates is on institutional investors,’ says Mlangeni. ‘Those are your pension funds and insurance companies who receive monthly premiums for life cover, medical aid, etc. Their investment philosophy is to diversify their risks, so they will put some cash in equities, some in real estate, and some in money markets.’ Of those, money markets are the most stable, offering low risk but also typically low returns. ‘In the current market, the low interest rates mean they’re getting even less return than they ordinarily would, so they’re incentivised to take on a bit more risk, just to meet their obligation,’ Mlangeni explains.
Risk 2: Consumers
In a low interest-rate environment, consumers (who have more disposable income and less incentive to save) should be spending more and saving less. ‘That’s the theory, but it doesn’t actually manifest,’ says Mlangeni. ‘The biggest reason is consumer sentiment. If your outlook is negative – as captured by lower interest rates – you’re not as inclined to spend. You might have more cash in your pocket, but you’ll put it away, even though you know it’s not going to give you much of a return.’
Risk 3: The Volatile Rand
The Rand is an infamously volatile currency. Consider how things have looked like in the past few years: in January 2016 it was trading at about R16.75 to the US Dollar; in January 2018 it had dipped to about R11.75; and then, just three months later in the uncertainty of 2020, it was up to about R19,35 to the Dollar! ‘Trying to predict the movement of the Rand is a fool’s errand,’ says Mlangeni – and the current low interest-rate environment only makes predictions more complex.
The risk to your Rands
In conditions like these, one would expect the Rand to come under pressure. In mid-2020, the opposite has happened. Mlangeni believes that this is due to two factors:
1. Rands coming home.
‘South African institutional investors are given a relative cap – known as a macroprudential limit – within which they’re allowed to invest a certain percentage of their assets under management offshore,’ he says. ‘As the Rand weakens, those foreign assets occupy a proportionately greater percentage of the investors’ asset base. This may exceed the macroprudential limit, thereby necessitating that they repatriate these Rands back. That inflow of Rands then bolsters the Rand, which is why you never see the currency blowing out for an extended period.’
2. Thoughts on the Dollar.
The second factor is, again, sentiment-driven. ‘Sometimes the strength in the Rand isn’t because of a pro-Rand sentiment, but more because of negative sentiment towards the Dollar,’ Mlangeni explains. ‘That’s tricky, because sentiment changes like the wind. Consumers and corporates could then be lulled into a sense of the Rand being strong, and be caught on the wrong side of another sharp spike in Rand appreciation.’
How to manage your risk
Mlangeni recommends a risk management strategy that yields the most stable financial performance. He suggests breaking your currency exposure down into three components: ‘You’ll want a portion – let’s call it one-third – of your currency to be fixed,’ Mlangeni says. ‘If you’re an importer or exporter, you want to know, for at least one-third of your exposure, what exchange rate you’re going to be using. So fix it for a year or 18 months.
‘Then you’ll want another portion – the next one-third – of your exposure to be variable, where you blow with the winds of the market. Finally, you’ll want the last one-third to be defined. Here you need a strategy that gives you known bands between maximum exposure and minimum participation.’
The first two steps are easy: for the first portion you buy a foreign exchange forward, which commits you to a known exchange rate at a known date and time; and for the second you buy at whatever the prevailing rate is in the spot market. ‘The third is a bit trickier,’ Mlangeni warns, ‘but it’s like buying an insurance policy on the exchange rate or interest rate. These solutions exist. You may be required to pay a premium upfront, as you would with any insurance policy, but you can account for that premium as a cost of hedging.’
Get tailored advice
‘What I’ve described above is the science,’ says Mlangeni. ‘The art is knowing when to flick between components: when to move from fixed, when to move from purely variable, when to go into some kind of insurance, as well as how much, and at what level.’ To find the right strategy, Absa’s Client Solutions Group, will help you put frameworks in place that establish which market conditions are best for which approach.
‘No single solution will work for everyone,’ say Mlangeni, ‘so consult and debate with your bankers. Challenge them to come up with solutions. At Absa we’re very open to having those conversations.’