Greta Steyn, Finweek journalist

The big surprise at the start of this year has been the quick strengthening of the rand, which gained more than R1 in value from its worst levels in 2011 to its best levels in 2012. This strengthening occurred even as the Reserve Bank warned that uncertainty over the rand was the biggest upside risk to the inflation rate this year. Still, a question mark hangs over the rand’s future this year.

It goes without saying that the most important factor this year for the exchange rate – and for the global economy – is the outcome of the eurozone sovereign debt crisis. This crisis last year, together with disappointment about growth in the US, led to fears of a double dip recession in the global economy. In that environment, risk aversion flourished and the rand and other risky assets weakened.

Fragile environment

As 2012 starts, there appears on the face of it to be little reason to be optimistic about the eurozone crisis. Greece has missed deadline after deadline on a new deal to receive bailout funds for debt falling due in March. Analysts, such as Citibank, have raised the probability that Greece will exit the eurozone this year. At the time of writing, uncertainty still prevailed about whether a Greek deal will be secured. Nevertheless, the rand started the year off strongly. What lay behind the rand’s new year rally, and can it continue?

Rand Merchant Bank (RMB) provides some answers in its latest monthly note to clients. RMB notes that the immediate risk of the global economy falling into a recession seems to have reduced. “There is also a growing probability that global economic activity may surprise on the high side of our expectations,” the bank says.

The combination of a decreasing probability of the global economy falling into recession and declining global inflation and monetary policy easing have provided significant support to risk assets, RMB says. “While we are surprised about the extent of the rally in risky assets, it is nevertheless in line with our directional view for the year. We caution, however, that the environment remains extremely fragile and risk aversion may spike easily,” RMB says.

Confident on gains

One of the major reasons why the world economy is less likely to fall into a renewed recession is action taken the the European Central Bank (ECB) in the second half of last year to rescue European banks. The ECB, through its long-term refinancing operation (LTRO), has injected billions of euros into the European banking system and has alleviated the funding constraints in the European interbank market.

RMB is confident that the strong gains that have been seen this year for the rand will continue, despite the year so far seeing a lack of foreign capital inflows. RMB forecasts for the rand to be at R7.20/$ and R9.22/euro by year-end, with a possibility of those levels being reached earlier. However, again RMB cautions: “While the improvement in the global environment has been very positive for the rand, we should be aware that risks remain extremely large.”

RMB makes a prediction on the rand, because that is what banks are supposed to do. It’s the economists’ curse that they have to take a view. But, as long as there’s a possibility that the eurozone will break up – leading to a vicious return to risk aversion – it’s perhaps wise to caution repeatedly on taking a view, as RMB does.

Greece falls from grace

Citibank provides an interesting perspective on the fall-out of a possible Greek exit from the eurozone. The bank raises the probability of this happening to 50%. Crucially, Citibank argues that the implications of a Greek exit from the eurozone for the world economy would be negative, but moderate. The reasons why a Greek exit no longer spells doom and gloom include the fact that foreign banks have reduced their exposures to Greece considerably, so a global banking crisis is unlikely.

Citibank also argues that the willingness of European policymakers to ensure that contagion from a Greek crisis is contained has improved strongly. Previously, it was argued that a Greek exit would lead to markets believing that an Italian, Spanish and Portuguese exit would be unavoidable, leading to a complete breakup of the eurozone. Now Citibank argues that the political will exists to protect countries other than Greece that comply with bailout conditions.

If Greece should exit the eurozone, this will at first lead to risk aversion and a weaker rand. But as the situation stabilises, the rand may regain its footing and may strengthen again. But that’s a lot of maybes. At this point, we simply don’t know.