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Description
Abstract This article indicates how different measures of the real exchange rate, i.e., the exchange rate adapted for cost inflation, price inflation and labour costs, influence the equilibrium view and misalignment of the South African rand/US dollar exchange rate. The approach followed is based on the behavioural equilibrium exchange rate approach by Clark and MacDonald (1998), where the exchange rate is influenced by a number of fundamental and transitory factors. The real equilibrium exchange is estimated by using a single equation regression and a number of key explanatory variables. To determine the long-run relationship a Vector Error Correction Mechanism is used.
Keywords equilibrium exchange rate * South Africa
Introduction
Since the fall of the Bretton Woods fixed exchange rate system, currencies worldwide have experienced increased velocity. This is also true for the South African rand (ZAR), which turned to various degrees of a floating exchange rate system after the abolishment of the Bretton Woods system. During the 1980s and 1990s, the South African rand exchange rate was determined according to a managed floating system. During much of this time (1985 to 1995), the dual exchange rate system, i.e., the commercial rand and the financial rand, was in use. In 1995 the financial rand was abolished and exchange controls on residents were gradually relaxed (van der Merwe, 2003). This left South Africa with one exchange rate, which proved to be increasingly volatile in a volatile global environment.
After a period of stability, the ZAR started to crack in February 1996 and between the end of March 1996 and April 1996, the effective exchange rate of the rand plummeted by approximately 8%. The prime rate reached 20.50% in May 1996 and in the first 6 months of 1996 the ZAR lost 15.7% to a basket of currencies. The introduction of GEAR (Growth, Employment and Redistribution Plan) saw a change in sentiment towards the ZAR and the ZAR kept its ground throughout the early days of the Asian crisis in 1997. But the first couple of months in 1998 saw the rand shedding approximately 8% of its value. The Russian crisis, coupled with the end of term of the Reserve Bank governor (often referred to as the Mboweni bump), sucked South Africa backed into the vortex with the ZAR shedding 23.2% of its value against the dollar from May to July 1998 (Steyn, 2004).
More emerging market crises (for example Brazil in 1999 and Argentina in 2001-02) led to greater world financial instability and affected the value of the ZAR and the nominal effective exchange rate of the ZAR decreased by 12 1/2% in 2000 and by another 34 1/2% in 2001. Steyn (2004) states that one lesson learned from all these crises is that it does not work to try and manage the value of the exchange rate if there is pressure on it to weaken. This led the Reserve Bank to implement a formal inflation targeting approach and a flexible exchange rate in February 2000.
It was generally expected that the ZAR would depreciate gradually against developed country currencies (such as the US dollar and the euro), but since the end of 2002 the ZAR has recovered strongly against both the US dollar and the euro with an increase in value of 26% in 2002 and 19% in the first quarter of 2003. Even though the ZAR has also depreciated under the managed floating exchange rate system during the 1990s, the recovery in 2002 was the first time in the past 30 years that such as sharp reversal in the exchange rate of the ZAR has occurred (van der Merwe, 2003). This has obviously led to various concerns regarding the level of the exchange rate and the competitiveness of South African exports. The Reserve Bank and government has been under pressure from, amongst others, labour unions and the mining houses, to intervene in the market and devalue the currency in order to stimulate export and job creation.
Yet, the policy-makers have stuck to their decision not to intervene and the ZAR has remained relative stable at its current stronger levels. Despite the doomed prophecies for the economy because of the stronger ZAR, the economy has performed reasonably well in the past two to three years. Economic growth has increased, unemployment levels are down, inflation is under control and the current account deficit is financed by positive capital inflows.
The question that remains to be answered is whether the South African rand is currently overvalued in real terms, since it obviously have an impact on the competitiveness of the country and the long-term stability of the currency? While this question may seem quite straightforward to answer at first, a closer examination reveals that it contains a number of controversies. Firstly it should be determined what is meant by the real exchange rate? And secondly, how will the equilibrium exchange rate level be determined in order to evaluate whether the currency is over or undervalued? These questions will be addressed in the next section, after which the method used will be discussed, followed by the results.
Literature Review
The Real Exchange Rate
Standard international economics textbooks define the real exchange rate as the price adjusted nominal exchange rate. The real exchange rate (E) is thus the nominal exchange rate (e) times the ratio of the foreign price level (P*) to the local price level (P*). In other words:
E = e [P*/P]
It can thus be noted that the real exchange rate denotes the ratio of prices of foreign goods to prices of domestic goods, expressed in the home currency. An increase in the real exchange rate would thus indicate that the home country becomes more competitive... |
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