The South African Rand is one of the most traded emerging market currencies. The SA financial markets are exceptionally well regulated, very well integrated with global financial markets and, importantly, very liquid. That is certainly a blessing in good times but in bad times, it can be a curse.

Significant changes on the political front (as we have seen recently), as well as other developments (like the budget) can have a big effect on the rand’s exchange rate for exactly this reason — the nature (liquidity) of our financial markets. As with all financial markets, the exchange rate of the rand also tends to overreact. Then what is the correct value of the rand?

Many economic forces affect the exchange rate of a currency. Factors like, the balance on the current account, capital flows in and out of a country, interest rates, and the like. For this reason, sophisticated models attempt to incorporate a myriad of economic data to forecast the exchange rate of a currency. Yet very few of these models are accurate.

Most exchange rate theories are based on purchasing power. This theory states that the exchange rate of currencies will converge to the buying power of currencies or purchasing power parity (PPP). The reason why the exchange rate of currencies will, according to this theory, reflect buying power is because once the price of goods is more expensive in one country than in another, imports and exports will eventually “force” prices to be the same (i.e. exchange rate PPP).

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