Some thoughts on South Africa's exchange rate

The weaker rand exchange rate raises alarms in the monetary policy sphere. The rand depreciated by 23% against the US$ from January 2012 to December 2013. This has implications for people wanting to take a holiday in the US or purchase anything that has a $ tag assigned to it. Apart from the worrying tourist, the central bank has to keep an eye on the exchange rate as it could lead to higher inflation. A final issue related to the rand is the trade deficit narrowed – and why it has not narrowed.

In essence three economic questions arise: (i) Is the rand permanently weaker (i.e. what has happened to the equilibrium exchange rate), (ii) what is the effect of the weaker rand on inflation (i.e. what is the exchange rate pass-through) and finally (iii) how do imports and exports respond to the rand.

I will summarise the results here in case you don’t have time to read the entire section.

·    The rand’s equilibrium value to the US$ is R8.50. The rand is thus undervalued and should start appreciating (given that SA or the rest of the world don’t undergo some massive structural change).

·    Rand appreciations are shorter lived than depreciations. Depreciations are usually more persistent over time.

·    The exchange rate pass-through to inflation is time varying; i.e. it changes over time and across different policy decisions. The current exchange rate pass-through is low, however, depends on low and stable inflation.

·    The trade deficit did not narrow since the rand depreciation. Both export and import volumes increased. Imports simply increased more than exports. Some researchers argue that this is due to a J-curve effect. I, however, argue that the response of certain imports is inelastic to the exchange rate. This means that if SA imported exchange rate inelastic imports, then any rand depreciation would have a very small effect on decreasing imports.

11.    Some (important) preliminary statistics of the exchange rate

Figure 1: The rand is not alone – Other developing countries’ exchange rates have also depreciated

Source: Bloomberg

South Africa’s rand is not the only developing country exchange rate that depreciated; The Indian rupee along with the Brazilian real depreciated by similar margins. The Chinese yuan remained at similar levels only because of its massive reserves – the Chinese actively intervene to maintain a stable currency. 

The top row of Figure 2 illustrates the distribution of depreciations vs. appreciations. Notice that large depreciations occur quite frequently. This is supported by the fact that depreciations are more persistent. Appreciations are small the majority of time. There are, however, periods of massive appreciations. These occur at low frequencies as appreciations are abrupt. Row two of Figure 2 shows that the r/$ exchange rate is much weaker than it historical averages (comparing the average of 1990 until 2013 vs. the average since inflation targeting). We also see that the rand is weaker than an HP-filtered exchange rate (a measure of the long-run exchange rate).

Figure 2: Appreciations are abrupt while depreciations are persistent

Source: South African reserve bank and own calculations

It can be argued that the rand fluctuates around its steady state (equilibrium) if one can identify the factors that determine it. The figure above illustrates that the rand does not deviate too much from such a steady state (assuming that this steady state is represented by the smoothed line).

This paper shows that interest rate differentials, productivity differentials, openness and the government’s budget balance determine the equilibrium value of the rand. Thus any deviation from the rand away from equilibrium will tend towards equilibrium later. The author finds that it takes just under a year for the rand to move back to equilibrium.

  

The paper above shows that:

·        * If SA interest rates increase by 100 basis points relative to US interest rates then the exchange rate will appreciate by 0.8 percentage points.

·        * If SA GDP growth increases by 1 percentage point relative to its trading partners then the exchange rate will appreciate by 1.3 percentage points.

·         *A 1 per cent increase in the government deficit will appreciate the currency by 1.5 percentage points.

Figure 3: The equilibrium exchange rate in 2011Q4 was R8.15 to the US$

Source: de Jager

22.      On exchange rate pass-through to consumer prices

How will the SARB react to the weaker exchange rate? This depends on what they believe will be the impact on inflation. If the exchange rate depreciation translates into higher consumer price inflation then the probability of an interest rate hike increases. So not only are consumers concerned about higher prices due to the exchange rate, but also higher interest rates from the SARB to curb inflation.

Econometric analysis that measures the exchange rate pass-through to inflation over time shows that it has decreased since implementing inflation targeting (see Figure 4). The highest pass-through occurred in 2002 and 2003 at a time when inflation was very high and volatile and the exchange rate very weak. Currently the pass-through is close to zero. This means that the weaker exchange rate hardly translated into higher consumer prices. In Figure 4 the exchange rate pass-through is highest over four quarters. Exchange rate shocks almost dissipate completely over three years.

  

Figure 4: Pass-through has been lower since inflation targeting

Is it reasonable to assume that low pass-through will persist? If this can be assumed then we need worry very little about the possibility on an increase in interest rates due to exchange rate pass-through. But to make this assertion we need to know what causes high vs. low pass-through.

We use the pass-through coefficients in Figure 4 as a dependent variable and analyse likely factors that influence it. The most important determinants of exchange rate pass-through is the extent of mark-ups and inflation (see Table 1). A 1 per cent increase in mark-ups reduces exchange rate pass-through by 2.71 per cent on average. This seems counterintuitive at first but makes sense given that monopolies are able to absorb price shocks. Perfectly competitive firms that operate at the margin have no choice but to pass-on higher prices when a shock occurs. High and volatile inflation increases exchange rate pass-through by large margins. This highlights the importance of a credible monetary policy: If firms expect inflation to be contained by the monetary authority it knows very well that high inflation will be reduced by an increase in interest rates. These firms trust the SARB to do its job and they are thus not that much concerned about the exchange rate shock and could absorb it. This story is however dependent that depreciations do not occur for much longer periods than one would normally anticipate.

Table 1: Low pass-through depends on low and stable inflation

Variable	Mean	Standard deviation
Market concentration (PCM)	-2.71	0.43
Neer	-0.01	0.04
Neer-squared	0.00	0.01
Inflation	1.00	0.77
Inflation-squared	0.02	0.04
Output gap	-1.23	0.99
Government debt (gov)	0.06	0.14
Variance inflation	5.39	1.53
Variance Neer	-0.74	0.23

33.      Some imports do not respond that strongly to an exchange rate depreciation

Imports have grown by 24.8%, 2.71 and 14.3% during the first three quarters of 2013 while exports grew by 11.3%, 5.1% and 13.5% over the same period. The consequence is that the trade deficit worsened and payments to SACU countries increased.

So by how much do imports respond to exchange rate depreciations? To control for income effects we used G7 growth as a proxy and to control for long-run vs. short-run effects we estimate these elasticities in a dynamic panel setup (we use Pesaran’s (1999) PMG methodology). Aggregate imports decrease by 0.8 per cent given a 1 per cent exchange rate depreciation. But we are only interested in import components. We see that building equipment, petrol, metals and transport equipment have a less than one per cent decline when the exchange rate depreciates. Coincidentally minerals, vehicle equipment, machinery and appliances contributed the largest shares of import in 2013. This analysis helps explain why imports have not decreased in line with the exchange rate depreciation.

Figure 5: Recently SA has imported more inelastic goods

44.      So what do we make of all this?

The concerns about the devalued rand are probably overstated in the media. Exchange rate pass-through to inflation is still low (partly thanks to credible monetary policy and firms absorbing the exchange rate shocks); the rand has deviated from its equilibrium – it is expected to return to its equilibrium (i.e. close to R8 against the dollar). As a negative, the exchange rate has not reduced the current account deficit. Imports have increased in response to the rand depreciation despite muted household consumption growth. While it is difficult to say whether this is a permanent trend (it could reflect fixed contracts that were signed over a specified period), the likely future appreciation will deter import growth – probably causing the current account deficit to persist.

55.      Appendix: The probability of an appreciation is not too low

In one of the previous sections we were interested in whether the exchange rate will depreciate indefinitely. We mentioned that an indefinite depreciation is not realistic if the structural fundamentals of our economy are maintained. These structural fundamentals, as mentioned above, are informed by the interest rate differential, GDP growth and the government’s budget balance. We estimate the probability of an oncoming appreciation by using a probit model. Our dependent variable is a binary variable that equals 1 in case of a rand depreciation and zero when the rand appreciates. Unfortunately some of the data is only in quarterly frequency with the latest update in 2013Q3. We can use this as a gauge on how useful the model is in picking up the likelihood of an appreciation. Figure 6 shows that the probability of an appreciation from 2013Q3 was less than 20%; the rand has not appreciated since then. On the right hand side of Figure 6 we examine how probable a depreciation is on a scale of interest rate differentials (assuming that all the other variables are evaluated at its mean except for growth). 

Figure 6: The probability of an appreciation vs. depreciation?

In pursuit of the real

It seems like I have forgotten what is real. All I see are infomercials, adds, cars, computers, mobile phones and other types of electronic gadgets. In addition to tangible things, I also see how we race through time being occupied by making money, visiting friends or experiencing thrills that let the heart pulsate. Before we know it we have become part of a rat race, engulfed by desires, pleasures and "easy way outs". And this makes me wonder if I am really myself or am I just simulating what is required for an artificial world system to work?

To make the point clearer; when I was young I made an effort to keep myself busy with activities outside home walls, I was forced to spend many hours by myself and as a consequence had a lot to think about. I was also very concerned about the well-being of others and would make genuine attempts to improve the lives of others. My mind was not yet programmed, or rather deceived by things that have absolutely no substance. I find myself now doing the opposite. I care for myself more than others and am consumed by noise that adds little life substance.

To fill the void and to keep ourselves occupied (we have other people and machinery that simplify our lives thus making more time available) we turn to entertainment. Our main goal is being happy right? This is the greatest illusion ever! We revel in drunkenness, desires of the flesh, money and status while there are real struggles across the world. We call ourselves human, but what we are is something very far from it. Most likely these words will just fall on deaf ears since we already believe the lies around us.

It becomes close to impossible to distinguish the real from the fake. Even if we realise that we are living a lie we find it very hard to escape too. It is a struggle for our lives and our souls. This I believe is the biggest challenge that humanity has ever had to face. In true adversary we realise what it is to live. In struggling we appreciate life for what it really is - this is but a glimpse in time, so important, yet so fragile. This is all we have. If we don't struggle, if we don't experience pain we become disillusioned and mindless. I would much rather know myself in pain and struggle than lose myself in endless pleasures.

Sometime fighting to become oneself again becomes disheartening. Especially when you see yourself succumb frequently to the very thing that you wish to escape. Often we want to be part of the thing that we wish to escape. But knowing this truth and trying to deceive yourself will only lead to despair.

Despair, purposeless and deceit; these words describe our reality when we purchase from the world. From experience, the only true escape from these lies is faith in God. This is simultaneously an easy way out but also the hardest to accomplish. It requires a total dilution of the ego - pride. Fortunately it is God, not us that does all the work. I personally struggle to distinguish between reality and that which poses to be real. I know that only God is real. I do not have to visibly see Him (the world deals in appearances), my heart knows Him and my soul thirsts for Him. Even if I have everything that the world has to offer and not have God, I would be but a speck of dust, a simulation that follows worldly rules. Yet, I experience the pain of betraying myself to a world that is not real and all I can hope for is God's endless mercy. I can only hope to escape all of this if He is completely in charge. I have experienced too frequently how my strength fails me. There is no hope, but there is only God.

Morality, judgment and love

We hold ourselves to certain moral standards. The obvious one is do to unto others as you want others to do to you. Yet I observe how "moral" people are swift in passing judgment based on ambiguous evidence. From experience I have learned that those who claim to be proponents of morality are indeed very far from being moral. In fact they are just as immoral as I am when I judge them. The difference is that I do not claim to be a moralist and I also do not attack morality but rather pursue it. In a world filled with injustices and heinous crimes one might almost be justified to ignore strangers who look "different" to what society dictates. But what in the end drives the decision process to ignore or befriend a stranger. And, based on logical inference, and if we dare call ourselves moralists, shouldn't we first examine the person before making inference about his existence by mere hints of clothing, race, sex etc.? And where does this lead us in terms of helping the needy (not necessarily the poor)?

If the answer evades you we may look at the actions of the great moralist in history. While there are many to choose from, I choose Jesus as an example. He regularly met with society's outcasts. He protected the life of a prostitute, made friends with tax collectors, had meals and drank with society's rejected and healed the sick. On the other hand he judged Israel's religious leaders of following man-made rules at the cost of loving one's neighbour, he exposed their insincere motives and showed that pride lay behind the veil of "righteousness". A few things happened during this process - the poor and needy were elevated while the proud were humbled. This brought some form equality, or equilibrium to the society.

What is then implied when we claim to be disciples of our moral leaders but do not follow them? It can only mean two things: Either we are hypocrites, or we are sincere followers but somehow are not able to live according to their moral code. If we hold this moral code in high esteem then surely all our available energy should be spent on trying to live morally. But since most of us do not spend all our energy on this it would mean that most of us are hypocrites. This matter is more serious. Instead of realising our corrupt nature we are completely oblivious to it or in denial. I guess this is why we become so disdained with many Christians who give us plenty of examples of false judgment. And most often you will hear an excuse and justification for their actions rather than a simple acknowledgment of being in the wrong and trying to set the record straight. Not only are a majority of these excuses illogical but it also reveals something sinister about our ideas of morality, good and evil and life.

I find myself bemused at trying to figure out how to change people's attitudes towards racial differences, class divisions and image perception. The only answer is love. Yes, the same love that you have heard from many people, read about in books and even experienced. But the honest truth is that our society is crumbling due to a lack of love. More dissent and hatred is replacing values that are essential to being human. Many books have been written about Love thy neighbour as you love yourself. Our wise God knows what is best for us. Even if you don't believe in a God, seeing the world from our neighbour's eyes might just soften our hardened and unlearned hearts about humanity.

But love has a cost too. It requires sacrifice. And the sacrifice is the ego. It is pride inhibits the ability to love those around you. It is not about survival of the fittest. There is also no joy in spending hours hating others, ignoring the plights of the needy and impressing on others that you are important. Let go. Work hard. In the end the investment is worth it. If you really want to discover who you are and what your purpose is then you need elevate the needy and humble yourself.

The world is a mysterious place where interesting events unfold and people from various backgrounds change continuously. We are part of something and we need to learn that to be part of that something means to love. We cannot function as individuals, but a collective species we may make great strides in doing what is best for each other. May God forgive us our many trespasses and may he guide our bodies, minds and hearts to seek and follow His will first.