Vol.1 No.15, 21 October 2001
There are Better Ways of Protecting the Rand, Mr. Manuel
In several earlier contributions to SANE-Views the advisability of returning to separate commercial and financial Rands - as was the situation well into the 1990s - was raised. In this contribution the case for this is spelt out in more detail by Prof Johan van Zyl. Prof van Zyl is a member of the SANE board and teaches economics at Pretoria and Vista Universities.
Prof. Johan van Zyl
A short while ago a well-known Sunday paper carried the headline: who is killing the Rand? Surely a much more appropriate question is: why are we allowing the rand to be killed?
Hence it is heartening to see that the Minister is trying to protect our currency. But he is on the wrong track. In many ways a return to a dual exchange rate system i.e. a market-determined financial rand alongside a commercial rand, such as South Africa had not so long ago, would be a much more effective way to go.
In discussing such an option inter alia with some senior research economists at the Reserve Bank their basic contention was that such a move would constitute "a step backwards". It is necessary to examine this kind of received wisdom critically.
The basic argument put forward here is that such a view no longer applies in the modern-day international financial world. In fact, this piece of conventional wisdom has become little more than misguided faith in a foreign exchange dispensation which today no longer exists.
According to Business Day the Minister indicated that the government was concerned about speculative financial flows "unsupported by underlying transactions" (presumably of goods and services) because these could be damaging to the economy. Reserve Bank governor Tito Mboweni apparently shares this concern with his reference to requiring financial institutions to justify trades as "genuine economic trades".
The objective is then to find a mechanism to prevent "unacceptable behaviour" by financial institutions or speculators. But is this at all realistic in today's new financial world?
It is widely acknowledged that up to about the middle 'seventies some 80% of foreign exchange transactions was directly related to financing international trade i.e. to the underlying flow of real goods and services. However, since then this ratio has been more than turned on its head with footloose speculative capital flows currently dominating almost entirely viz. up to well over 90% of all transactions. Such capital movements are based mostly on the perceptions and the financial power of speculative investor groups world wide and but little on real trade flows.
The hard fact is that the structure and operation of the foreign exchange market has changed fundamentally. Small wonder that international financial markets are often referred to as "the global casino"!
A basic point follows: the determination of exchange rates on so-called "free exchange markets" can no longer be regarded as a so-called "first best" solution as orthodox economics often suggested. In fact, it is now more of a third or even a fourth-best solution. Yet the blind faith continues !
It should be noted that in a dual exchange rate system there is no direct quantitative control over all transactions. Instead the market is split in two with the exchange rate in each still determined by "market forces". However, the administrative difficulties of effectively separating the financial from the "real" market are substantial. This is why it is essentially a "second-best" solution. Yet it would still be more effective in protecting the "real" value of the (commercial) rand than the present free-for-all system so hugely dominated by the world's footloose speculators. Indeed Minister Manuel's effort to curb the activities of such operators is quite unrealistic and thus doomed to failure.
Even so, many South Africans persist with the curious idea that subjecting our entire economy to the volatile eccentricities of the world's financial markets is - rather like hurricanes - a regrettable but inevitable fact of nature. This would include today's so-called "Afro-discount" which results from the firmly ingrained negative perceptions about African countries that prevail among most foreign investment analysts and speculative traders.
Thus, short-term instabilities apart, another issue is raised: has the rand become (seriously) undervalued and if so by how much ? Perhaps surprisingly, getting clear answers to this vital question is proving quite difficult.
A number of unpublished econometric models investigated do indicate that the rand is currently undervalued. But the authors usually point out correctly that the results obtained depend crucially on the specification of the particular economic model used i.e. wider applicability cannot be guaranteed. While this is scientifically admirable it does not help a finance minister anxious to find out what the overall picture really looks like.
This is one reason why the rather rough and ready exchange rate indicator published by The Economist viz. the Big Mac Index has proved to be so useful in practical affairs. It is based on the well-known idea of purchasing power parity and has already achieved some notable successes since its introduction in 1986.
This index too indicates that during recent years the Rand has become progressively undervalued. According to this "popular" yardstick, by early 2001 the rand was undervalued by some 50% against the U.S. dollar. Hence at that time the rand should have been trading at around R3.60 to the dollar instead of over R7. Since the tragic events of September 11 the rand has seen further drastic depreciation.
It is actually quite astonishing that this continuous and serious depreciation of South Africa's currency has been so blithely accepted by government and by responsible economic commentators. It surely does imply a huge and uncritical faith in the continued ability of "free foreign exchange markets" to determine the "correct" exchange rate of the Rand - despite the fundamental structural changes in these markets indicated earlier.
The negative impact of the progressive undervaluation of the rand on South Africans has been severe. The key implication is that all our goods and services have been selling for unnecessarily low prices overseas while those imported have cost South Africans much more than necessary. Hence local citizens have been progressively impoverished on a considerable scale.
Furthermore, currency values do not affect only traded goods and services. The undervalued rand also means that South African assets in industry, commerce and agriculture have been available to foreign investors at well below their true worth. In consequence, the returns on inward private investment - so anxiously sought by government - are for South Africans relatively minimal.
The entire South African economy struggles under the above burdens. This sad situation can only be rectified by a new dispensation to secure a more stable as well as a more realistic "real" exchange rate for the (commercial) rand. In the new financial world of the 21st century a dual exchange rate system seems to be the best option - even if only relatively so - to achieve such a vital policy goal.
Prof. Johan van Zyl,
School of Public Management and Administration,
University of Pretoria,
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