Reducing Exchange Rate Volatility and Supporting Competitiveness

In this paper we analyze the relationships between exchange rates, inflation and competitiveness. We show that over the 1994-2006 sample period real exchange rate depreciations did not improve the trade balance and therefore had no positive effect on growth. One reason is that SA exports are priced to market (PTM instead of PCP). We also show that if the monetary authorities would be interested in targeting competitiveness via the real exchange rate, a good way to do this is by narrowing the present inflation targeting band from the present 3-6 percent, to say 1-3 percent. The reason is that the easiest way to become uncompetitive is to let your domestic price level rise faster than those of your trading partners. Higher inflation does not lower the real exchange rate it appreciates it.

Background

There is a strong belief by certain sections of the South African economy that a weaker exchange rate will boost exports thereby employment and growth. Key among these are COSATU and the Department of Trade and Industry (DTI). Most importantly, the volatility of the rand exchange rate has been cited in government's macroeconomic programme, ASGI-SA, as one of the major constraints inhibiting economic growth in South Africa. Government and in particular the Presidency keen on finding ways to mitigate the effect of these constraints on growth, and therefore set out a team of researchers to conduct a proper and thorough  investigation. Leading economists from Harvard University were sourced for inputs on the various economic constraints. A number of suggestions came out of these papers and one that deserves mention in the context of this  paper is one by Dani Rodrik (2006) who argues that the South African Reserve Bank (SARB) should switch to a modified inflation targeting framework which allows considerations of competitiveness (or the real exchange rate) to affect its decision-making.

Economic Theory and Preliminary Results

Our paper argues that economic growth is not necessarily spurred by a weaker exchange rate, which makes exports competitive, but rather that the main determinant of exports is foreign activity. One reason is that SA exports are priced to market (PTM instead of PCP). Put another way, the exchange rate is just the price of goods and services produced in South Africa and that alone is not a chief determinant of the quantity demanded by foreigners - the principal determinant is income (economic activity) i.e. the buying power of foreigners. We also contend that a weaker real exchange rate tends to increase the CPI inflation as a result of higher domestic currency prices of imported final goods and/or higher wage inflation.

Theoretically, when analyzing the effect of the exchange rate on exports hence economic growth it is important to start with the national income identity: y = c + i + g +(x - m) . The latter, in particular the last term of the identity means that growth rate, y, is not only affected by exports, x, but also imports, m - the difference between the two (net exports). We use the Marshall-Lerner condition to assert our case, which states that for economic growth to occur the long-term price elasticity of demand for exports should be greater than one plus the long-term price elasticity of demand for imports (i.e. ).
Our preliminary estimation reveals that this condition is not satisfied; hence we conclude that in the review period, 1994-2006, real depreciations did not improve the trade balance and therefore had no positive effect on growth. In fact in the standard version of the ML condition we have 0.359 > 1 + 0.336(?). Cleary the condition is violated.

This paper forms the first part of a two-part project. It was commissioned by the Presidency, managed by TIPS and prepared by Prof. Eric Schaling , South African Reserve Bank Chair, University of Pretoria and CentER for Economic Research, Tilburg University. Bongani Motsa from TIPS provided research assistance.

The main objective of the study was to analyse growth and competitiveness issues relevant for the South African economy. The project also looked at other policy instruments (additional to and consistent with inflation targeting and the present floating nominal exchange rate regime) that can be used to reduce exchange rate volatility and in that way support the competitiveness of the South African non-commodities tradable sector.

For instance, in February 2007, President Mbeki suggested measures other than interest rates that could be employed to manage credit. Although the president did not elaborate on the latter, this would include, amongst other things, credit rationing and/or higher bank reserve requirements. The role of additional instruments is to provide trade-offs: decrease inflation without sacrificing growth via higher interest rates.

The second part of the project examines potential growth and its constraints by attempting to sketch an integrated post-GEAR growth and poverty alleviation strategy that is likely to move South Africa from the present low growth state to a high growth state.

Advisers and Project Management team for this project include Dr. Alan Hirsch (The Presidency), Stephen Hanival (TIPS) and Ashraf Kariem (The Presidency).