The Institute of International Finance released a report on South Africa this week entitled “Rand Strength: Can Anything Be Done?” The key take-away is “options to contain further rand appreciation, or weaken the currency as certain groups within South Africa are advocating, are fairly limited and not guaranteed to succeed”. Overall I think the report identifies most of the key issues in the Rand debate. This report combined with earlier discussions by the IMF provide a very useful ‘outsiders’ view on the Rand.
The following is a summary of the key points in the report. These points have been extracted directly from the report:
Ø The strength of the rand is mirrored in many emerging markets that have found favor with international investors seeking yield during the global economic downturn. The rand has also been supported by the surge in the price of gold to new record highs.
Ø In South Africa, even after the recent 50 basis point cut in the repo rate to 6.0%, the short-term interest rate differential is large at 575 basis points, as is the spread (about 530 basis points) between yields on 10-year government bonds and U.S. Treasuries.
Ø In the first eight months, net purchases of bonds rose to a record $9.2 billion, which was sharply higher than $2.3 billion in the whole of last year.
Ø Although the strong rand may be creating difficulties for export-based manufacturing companies, it is having positive benefits on the economy in other ways. Lower import costs are helping reduce inflationary pressures. The IIF expects inflation to remain well contained through 2011 which should help ratchet down inflation expectations and reduce wage pressure going forward. This suggests an extended period of relatively low interest rates.
Options to weaken the Rand:
Ø The first option would be for the Reserve Bank to become more active in the foreign exchange market than current policy dictates by selling the rand more aggressively and building reserves at a faster pace. However, if not sterilized, such a course of action would increase the money supply, potentially jeopardizing the fight against inflation further out.
Ø The second option of sterilized intervention comes at a cost, as the authorities would have to mop up liquidity by selling bonds that yield over 7% to hold foreign assets that would yield substantially less.
Ø A third option, which is less costly initially but carries a high level of risk, would be to use the forward book. This course of action was used over a decade ago in an attempt to stave off depreciation, but ultimately failed and it took many years to rebalance the books and normalize the situation. After that debacle, the authorities would be highly unlikely to go down that road again.
Ø Option four; slashing interest rates to weaken the currency would be a major about-turn by the authorities who have built credibility by using monetary policy to target inflation rather than a predetermined level of the exchange rate. Abandoning its inflation targeting framework at this stage (which the IIF believes is highly improbable) would likely result in significant market loss of confidence and could precipitate a sharp depreciation of the currency and heightened volatility, an outcome that would be counterproductive and damaging to the nascent economic recovery.
Ø Option five, removing residual capital controls on residents, would probably have little impact in the current sluggish global environment
Given the choices before it the government may well conclude that the current strength of the rand, although not ideal, is largely determined by external conditions, and altering its own policy stance may not yield the desired results. As a result, the IIF expects no fundamental change in policy although more intervention may be used to counter currency volatility in the period ahead.
Kevin Lings (Economist Stanlib)
Economist
