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With the indications that the global economy has bottomed and will soon exit the recession becoming more compelling, attention has shifted to the response of the South African economy to the improvement in the global environment. Evidence is mounting that South Africa is lagging the global recovery, especially where emerging-market countries are concerned, and the recent strength in the rand exchange rate is one of the reasons being advanced for this unwelcome development.

Let’s first set the record straight on the recent behaviour of the rand.

• Compared with exchange rates prevailing on 1 September 2008, just before the global financial crisis really turned ugly and evolved into a full-blown economic crisis, the rand at current exchange rates has appreciated by 1,7%,  and 9,4% in nominal terms versus the US dollar and the British pound respectively, while remaining virtually unchanged against the euro. Against the dollar and the euro the change is therefore hardly worth noting, while the much larger appreciation against the British pound has clearly been the result of the general weakness in the pound due to the dire straits in which the British economy finds itself.
• Using 1 March 2009 as the starting point for our comparison, the rand has appreciated by 24%, 10% and 11% against the dollar, the euro, and the pound respectively. This highlights the general weakness in the dollar in the past few months as a major driver of perceived rand strength. (The dollar index, reflecting movements versus the US’s major trading partners, depreciated by 14% during this period.) One could perhaps argue that we should pay more attention to the Chinese renminbi in view of China having become South Africa’s no. 1 trading partner recently, but given the close link between the renminbi and the US dollar the rand’s movements against the renminbi closely follow those against the dollar.

• The reason for using the beginning of March as a point of reference is that reports of the resilience of the Chinese economy started surfacing at that time and the prospect of an early turnaround in that economy resulted in a strong recovery in commodity prices. It therefore does not come as a surprise that the rand has performed very much in line with other commodity currencies such as those of New Zealand, Australia and Brazil since March, with the appreciation of these currencies against the dollar falling into the narrow range of 26% to 31% (see the accompanying graph).

• The past few months have also seen a marked improvement in investor risk appetite and a concomitant recovery in portfolio investment flows to emerging markets. In the nine months since February, South Africa has received a cumulative inflow of R70 billion in portfolio capital compared with R30 billion in the 2007 calendar year. It is striking that the movements in the rand exchange rate are almost perfectly correlated with those in the emerging-market bond spread (96%) and emerging-market equity prices (98%).
• The improvement in risk appetite has reportedly gone hand in hand with the return of the carry trade, viz. the practice of borrowing in low interest rate countries and investing the proceeds in high interest rate countries. According to recent reports, the near-zero interest rates in the USA have led to the dollar being used as the funding currency in the carry trade in addition to the yen and the Swiss franc. Although evidence of the contribution of the carry trade in determining the value of the rand is unconvincing (for example, since the start of the year the rand has appreciated against the dollar in spite of a narrowing interest rate differential), it could have played a supportive role.
• Finally, the appreciation of the rand since March has been fundamentally supported by an improved current account deficit, which more than halved from 7% of GDP in the first quarter of the year to 3,2% in the second quarter.

Where does this leave us?

Firstly, it should be clear from the above that the recent change in the rand exchange rate can be logically explained and there is nothing sinister about it.

Secondly, the movements in the rand exchange rate are not a one-sided affair, and they depend heavily on the woes of other countries.

Thirdly, the rand is being buffeted by a range of extremely strong forces over which South African policy-makers have no control. Once again, the primary problem is not the value of the rand as such, but its volatility which is playing havoc with informed business decisions.

It is a well-reported fact that the exchange rate is causing policy-makers a major headache. There is a strong school of thought that an undervalued rand should be actively pursued to promote economic growth and development. However, nobody has yet come up with a feasible strategy for achieving this goal.

The recent rumour (quickly denied) that government was contemplating “freezing” the rand, which presumably means that SA would abandon its floating exchange rate regime in favour of some sort of pegged regime lacks credibility. For SA to maintain the exchange rate at a fixed, permanently undervalued level could be an extremely costly exercise. More fundamentally, moving to a fixed exchange rate regime will deprive the economy of a handy shock absorber. Or, even worse, it will require macroeconomic policy to be conducted in support of the exchange rate, thereby negating the purpose of the exercise.

The challenge is rather to reduce the volatility of the rand, which has been in an upward trend since the liberalisation of the foreign exchange market started in 1995. The further liberalisation of exchange controls announced in the 2009 MTBPS is primarily an attempt to achieve this goal by encouraging greater two-way trade in the forex market. However, it is questionable whether it will be enough.

The liberalisation of the foreign exchange market as part of South Africa’s reintegration into the international economy in the second half of the nineteen-nineties has resulted in a trading profile that is closer to that of a developed country than an emerging market country. The average daily volume of trading has increased to $13.2 billion, making the rand the 15th most traded currency globally with its share increasing four-fold since 1995.

To put it into further perspective, the net turnover in the rand after eliminating double counting exceeds that in the Indian rupee by 35%, the Chinese renminbi by 98%, and the Brazilian real by 158%, in spite of these economies being substantially larger. If the US$ is excluded, 1,6% of  global currency trading involves the rand.  Seventy percent of trading involves non-residents, fifty percent takes place in off-shore money centres such as New York and London, and 80% of trading is in the form of derivatives.

The vast liquidity and the internationalisation of the trading in the rand have substantially increased the cost of intervention in the currency market. Should SA therefore decide to peg the exchange rate of the rand and intervene in the market on a daily basis by buying or selling dollars to maintain the exchange rate at its pegged value it will have to commit vast resources to this purpose – the net foreign exchange reserves, for example, is the equivalent of only three days trading.

An important cause of increased volatility is probably to be found in the excessive liquidity of the rand with a large part of the trading in the rand being of a speculative nature by, e.g., the trading desks of international banks. The question is how to turn back the clock on the liberalisation of trading in the rand without causing a confidence crisis.
On the other hand, the same trend of increasing volatility applies to other commodity currencies such as the Australian dollar, which points to increased volatility in commodity prices as an underlying driver of currency volatility. The latter is probably the result of the increase in investor/speculative interest in commodities, inter alia through exchange traded funds (ETF’s).

There is no way in which the South African authorities can control the volatility of commodity prices. The solution is rather to be found in the creation of a commodity stabilisation fund (sovereign wealth fund) that will form a buffer between commodity markets and the foreign exchange market, but this can also be an expensive option depending on the returns earned by such a fund. (Commodity stabilisation funds are generally aimed at protecting the fiscus against sharp declines in commodity prices and therefore in the tax raised from commodity producers.)

Norway is a good example of the successful implementation of such a strategy, with the Norwegian crown not displaying the same rising trend in volatility in spite of being closely tied to the oil market (see the graph below). However, it is an open question whether a country with such huge development needs as South Africa can afford to permanently hold a large amount of capital off-shore.

An alternative to a commodity stabilisation fund is macro-hedging of commodity price risk using derivative instruments, one of the advantages of which is a reduced need to hold foreign exchange reserves. The effectiveness of this strategy can be greatly enhanced by using it in conjunction with a precautionary build-up in foreign exchange reserves.

Another option is the introduction of a so-called Tobin tax to increase the cost of trading in the rand, thus discouraging short-term, speculative capital flows. Tobin originally suggested a 1% tax rate, but it was subsequently reduced to between 0.1% and 0.25%. The 2% tax on portfolio investment inflows announced last week by the Brazilian government is an example of this approach. However, it is questionable whether SA can afford at all to discourage capital inflows due to the persistent deficit on the current account.

In summary, it would not be a good idea to peg the value of the rand against some foreign currency or basket of currencies. However, it would be worthwhile to explore further ways to reduce the volatility of the rand.

References

• Triennual Central Bank Survey. Foreign exchange and derivatives market activity. Bank for International Settlements. April 2004 and December 2007.
• Eduardo Borensztein, Olivier Jeanne and Damiano Sandri: “Macro-Hedging for Commodity Exporters”. IMF Working Paper WP/09/229. October 2009.
• Yinqiu Lu and Salih Neftci: “Financial Instruments to Hedge Commodity Price Risk for Developing Countries.” IMF Working Paper WP/08/6. January 2008.
• Medium Term Budget Policy Statement 2009. National Treasury. 27 October 2009.