The exchange rate and its implications National Treasury April /15/20151

Recent movements 9/15/20152

Long run nominal and real effective exchange rates 9/15/20153

Long term trends in nominal exchange rates 9/15/20154

Trend against other emerging market currencies… 9/15/20155 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 9/15/20156 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=NERPfPd 50= = =10025 = 44 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. 9/15/20157

What happens during and after nominal depreciation? RER = NER (Pf/Pd) 1.SARB announces that NER = R8/$ from R7/$... 1)Import bill increases by R1/$ and volumes fall 2)Fx currency payments (on debt) rises 3)Trade balance and current account deficit initially worsens 4)Prices of traded goods start to rise (import parity pricing) 5)Trade balance starts to improve as exports rise 6)Nominal wage demands rise 7)Pd rise generally 8)Monetary response to increase in CPI 9)Growth in GDP changes Critical questions…  Does export & import competing production permanently rise?  Speeds of adjustment of prices and production?  What happens to aggregate economic growth? Higher level? Faster rate?  Does saving and investment rise? 9/15/20158

What happens when the exchange rate depreciates? Shock Nominal exchange rate ↑↓ 9/15/20159 Third round effect Real wages ↑ Domestic prices ↑ Interest rates, payments, debt stock ↑ Deflation… Prices rise Consumption falls NTs fall Ts rise Wages respond to loss of income Interest rates rise again Net effects Real exchange rate ExportsCAD GDP InvestmentEmployment Consumption Immediate effect Real exchange rate ↑ Import prices ↑ Debt stock in rand ↑ Second round effect Exports ↑ Imports ↓ Domestic prices ↑ Interest rates ↑ 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. 9/15/201510

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. 9/15/201511

Why inflation matters… RER = NER (Pf/Pd) Foreign prices… Increase relative to Pd is home country depreciation Decrease relative to Pd is home country appreciation Domestic prices… Increase relative to Pf is home country appreciation Decrease 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 = appreciation 2.And, rise in Pf generates import parity pricing & wage demands 3.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. 9/15/201512

The role of productivity Productivity growth means more is created with less inputs at a constant price and constant profit… But can hold profit constant And 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 9/15/201513

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$39 billion in – Purchase of reserves leaned against appreciating R/$. Rand volatility Interest rate volatility GDPEmployment 1980s s s /15/201514

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. 9/15/201515

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 9/15/201516