1. 1 The currency premium and local-currency denominated debt costs in South Africa Martin Grandes (DELTA and OECD Development Centre, Paris) Marcel Peter (HEI, Geneva and IMF, Washington D.C.) Nicolas Pinaud (OECD Development Centre, Paris)

2. 2 This presentation will Make the case for investigating the determinants of the currency premium in South Africa Sketch an analytical framework thereby measuring the currency premium and pinning down its determinants Bring to the fore our main econometric results with respect to the determinants of the currency premium Draw policy recommendations based on our findings

3. 3 Affordable long-term local-currency debt : - Allows agents to avoid currency mismatches with disruptive balance sheet effects; - Allows these agents to find hedging strategies for firms confronted with exchange rate risk; - Fosters domestic financial market development, especially with respect to providing alternative sources of long-term project finance; - Potential positive externalities for neighbouring countries Issuing ZAR-denominated bonds: an opportunity for South Africa

4. 4... a component of local currency denominated debt cost Why the currency premium? The Cost of LC Debt for an Emerging Market Borrower is This presentation This afternoon

5. 5 The currency premium in South Africa... is the major element of the total risk premium required by investors to hold ZAR-denominated bonds

6. 6 The currency premium in South Africa... must be a concern for the monetary authorities: - While South Africa enjoys the specificity of being a no « original sin » country (Hausmann & alii, 1999)... -... the latter may not last forever: heightened volatility of the currency premium over the last few years

7. 7 Rising instability of the currency premium over the last years in South Africa Rolling standard deviation of the currency premium first differences

8. 8 The currency premium in South Africa... must be a concern for the monetary authorities: - While South Africa enjoys the specificity of being a no « original sin » country (Hausmann & alii, 1999)... -... the latter may not last forever: heightened volatility of the currency premium over the last few years Should the rand remain or become even more volatile, investors might require unaffordable currency premia and shy away from holding ZAR-denominated assets

9. 9 Bottom-line: the lower and more stable the currency premium, the larger the scope for a country (companies and government) to issue local currency-denominated paper at reasonable cost with long maturities and fixed rates... A case for investigating the determinants of the currency premium

10. 10 How to measure the currency premium? The currency premium and its determinants. Subjective probability of depreciation Expected magnitude of depreciation Forward premiumExpected rate of change in the exchange-rate Exchange risk premium CP = forward exchange rate - spot exchange rate

11. 11 The determinants of the currency premium and their expected sign VariablesProxy forExpected Sign REER misalignmentMagnitude and ProbabilityNegative NOFPMagnitude and ProbabilityAmbiguous Inflation GapMagnitude and ProbabilityPositive Gold PriceProbabilityAmbiguous Exchange Control RegulationsProbabilityAmbiguous Risk Aversion IndicatorsExchange risk premiumAmbiguous Rating RSA (Moodys)Exchange risk premiumNegative

12. 12 Model specification & estimation: Explanatory variables: - High-frequency financial data (daily) - Monthly data & dummies Dependent variable: daily data - One-month currency premium: CP1M - One-year currency premium: CP1Y Time span: 1997 – 2002 (no earlier available data; capital controls gradually lifted since 1996) Econometrics: volatility modelling (EGARCH)

13. 13 Regression Output The long-term determinants of the currency premium: expected signs and actual results VariablesCP1M ActualCP1Y ActualExpected Sign REER misalignment Positive/Negative NOFPNegative Ambiguous Inflation GapPositive/ Gold Price/PositiveAmbiguous Exchange Control Regulations Positive (02 – 2001) Positive (02-2001 / 01-2002) Ambiguous Risk Aversion/PositiveAmbiguous Rating RSA/Negative

14. 14 Main Findings & Policy Recommendations South African currency risk far from idiosyncratic - Liquid financial and currency markets, the pitfalls of success (James Cross) - Necessity to keep on improving ratings and liquidity ratios The downsizing of the NOFP: a major breakthrough Capital controls liberalization must be handled carefully and in a timely fashion Strong commitment to inflation targeting: key to stabilizing the currency premium