The exchange rate and its implications

National TreasuryApril 2010

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Recent movements

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70

90

110

130

150

170

Australia

New Zealand

South Africa

Brazil

Ind

ex

20

08

=1

00

, d

om

es

tic

cu

rre

nc

y p

er

US

do

lla

r

Long run nominal and real effective exchange rates

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Long term trends in nominal exchange rates

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0

50

100

150

200

250

ind

ex (

1999

=10

0)

R/$

R/Pound

R/Euro

Trend against other emerging market currencies…

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0

50

100

150

200

250

inde

x(19

99=1

00)

R/Brazillian Real

R/Renminbi

R/Rupee

Rand has sustained depreciation over the long term against both EM and developed currencies.

Spikes occur during severe international financial contagion.

Total nominal declines

Renminbi -34%

Dollar -20%

Euro -35%

Exchange rate movements and manufacturing production

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Periods of severe international financial crisis correspond with slower growth in mnf production.

SR exchange rate movements not correlated with major increases or decreases in production.

LR, X and production rises as REER depreciates.

Defining the exchange rate

RER = NER Pf Pd

50 = 100 2 4

55 = 110 2 4

40 = 100 2 5

100 = 100 4 4

Real exchange rate = nominal exchange rate (foreign prices/domestic prices)

RER = NER (Pf/Pd)

So… a depreciation shown as a rise in the NER (R/$ or R7 to R8)

Question is what happens to the RER?

A rise in Pf also raises the RER.A rise in Pd lowers (appreciates) the RER.

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What happens when the exchange rate depreciates?

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Deflation…Prices rise

Consumption fallsNTs fallTs rise

Wages respond to loss of income

Interest rates rise again

Reversal of relative prices?

If Pd > Pf, then RER appreciates

If ULCs > import prices, then X fall

Relative rates of return in Ts and NTs

Income from X > Income from NTs and higher

debt costs

Evidence for SA

1) Does export & import competing production permanently increase?

2) Speeds of adjustment of prices and production?

3) What happens to aggregate economic growth? Higher level? Faster rate?

4) Does saving and investment rise?

Depreciation events followed by rise in exports, but no ST impact on total production… 1% = 0.1% export gain.

Domestic price adjustments fully reflect % depreciation within 1 year.

Growth pick ups initially for about one calendar year, then it is lower for the next 2-3 years

Investment accelerates initially in response to the higher export growth but moderates as growth slows down.

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Macroeconomics of real depreciation

• Idea is to lower total consumption…

– And increase saving & investment.

– Lowers trade deficit and CAD (as imports fall)

– Higher I = more sustainable growth in traded goods production

– Higher I = more productivity growth

– Higher I also means less demand on non-traded goods & lower overall inflation

– Higher I generates RER depreciation.

• How to lower consumption?

– Increase saving by firms, households and/or government… resulting in lower debt levels, higher fiscal surpluses.

– Someone has to consume less to achieve higher S.

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Why inflation matters…

RER = NER (Pf/Pd)

Foreign prices…Increase relative to Pd is home country depreciationDecrease relative to Pd is home country appreciation

Domestic prices…Increase relative to Pf is home country appreciationDecrease relative to Pf is home country depreciation

Argument for depreciation and higher inflation…

1.Relative prices argument… some prices go up (imported goods) and some will go up less rapidly (domestic goods).2.Inflation supports depreciation argument… higher inflation increases growth and generates more depreciation.

But neither argument works…

1.See the equation… rise in Pd = appreciation2.And, rise in Pf generates import parity pricing & wage demands3.Higher inflation means need another larger depreciation to re-lower domestic price level relative to foreign.4.Higher interest rates have larger negative effect on the economy than depreciation has positive on tradeables.

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The role of productivity

Productivity growth means more is created with less inputs at a constant price and constant profit…

But can hold profit constantAnd we can lower prices.

RER = NER (Pf/Pd)

Higher productivity growth enables lower price inflation and results in real depreciation

Why is China’s real exchange rate so low?

1.Consumption low relative to income growth = high IS

2.Surplus labour that is mobile = low labour costs & high productivity

3.Inflation target prevents erosion of Pf/Pd

4.NER recently pegged to the US dollar

Why is China’s real exchange rate so low?

1.Consumption low relative to income growth = high IS

2.Surplus labour that is mobile = low labour costs & high productivity

3.Inflation target prevents erosion of Pf/Pd

4.NER recently pegged to the US dollar

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The managed float

• IT suggests floating… enables greater flexibility for the CB to sustain economic growth, with less volatility

of growth.

• Floating allows the exchange rate to adjust to external shocks…

– Food and oil price shock… pegged or fixed rate = more volatile interest rate and more volatile GDP.

– Global financial crisis… 70% of the economy less volatile, while 30% more volatile as exchange rate

‘cushions’ non-tradeables.

• Escape/explanation clause provides CB flexibility to address external and/or supply shocks to inflation,

again without major changes to interest rates.

• Forward book ‘closed’ to reverse net negative fx position and build reserves in 2001…

– Net deficit of –US$25 billion reversed to +US$39 billion in 2009.

– Purchase of reserves leaned against appreciating R/$.

Rand volatility

Interest rate volatility

GDP Employment

1980s 0.042 0.63 1.5 1.2

1990s 0.021 0.43 1.4 -1.6

2000s 0.042 0.34 3.2 6.7

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Risks of depreciation

• Once-off gains to competitiveness not followed up by sustained investment and productivity gains

• Higher export prices exacerbates dutch disease effects and no export diversification

• Higher inflation in wake of depreciation follows Latin and Southern European approaches…

– runaway inflation necessitates further depreciations & greater use of fiscal expansion to increase GDP growth.

• To create a real depreciation of 10, the nominal exchange rate needs to depreciate by 10 per cent, then by higher rates after that.

• Inflation explodes from this continuous depreciation, almost doubles from the baseline.

• While exports benefit, consumption and investment decline.

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Achieving real depreciation

Macroeconomic policy

• Increase S and I

• More counter-cyclical fiscal policy

• More active fx accumulation

• More consistent achievement of lower inflation

• More active communication on the exchange rate

Microeconomic policy

• Incentivise productivity growth with IP

• Lower costs & raise productivity of inputs (labour, transport, other networks) to raise efficiency and capacity utilisation

• Strengthen competition with CP and by reducing licensing & other barriers to entry to network and other sectors

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