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As the US Federal Reserve is about to engage in a new round of quantitative easing to revive a flagging US economy, the South African Reserve Bank is faced with a major policy challenge. How should the SARB best respond to a new flood of US dollars that now threaten to cause the Rand to appreciate further from its already presently heady levels? In mulling its policy options, the SARB would do well to consider that the Fed’s prospective quantitative easing also offers the SARB the rare opportunity of rescuing the Rand from its present dubious status of being among the world’s most volatile currencies. The SARB should seize this opportunity to better equip it to cope with the stormier days that all too likely lie ahead for the global economy.
Over the past two decades, the SARB’s policy of non-intervention has contributed to the acute volatility of the Rand as markets have come to regard the Rand as a one-way bet at a time of global financial market turbulence. This volatility has seen the Rand weaken on a number occasions from less than 7 Rand to the US dollar to more than 11 Rand to the US dollar. This volatility has hardly been conducive to satisfactory domestic macroeconomic performance. Since at times of undue currency strength it has hampered the country’s export sector, while at times of acute weakness it has contributed to domestic financial market instability and it has complicated the attainment of the SARB’s inflation targets.
Most emerging market economies do not share South Africa’s almost pathological reluctance to engage in serious foreign exchange market intervention to prevent their currencies from getting too strong. On the contrary, they routinely engage in sterilized foreign exchange market intervention in size to ensure that their country’s international competitive edge is not undermined by any undue strengthening in their currencies. China is the most egregious example of a country that massively intervenes in its currency market to keep its currency undervalued as is reflected by the build-up in its international reserves to a staggering US$2.6 trillion. However, the practice of aggressive exchange rate intervention is commonplace throughout non-Japan Asia, Argentina, Brazil, Russia, and Turkey.
Over the past decade, to the Americans’ consternation, China has amply demonstrated that a country can keep its currency grossly undervalued if it is prepared to engage in truly massive foreign exchange intervention. By most measures, China’s currency has been successfully maintained at between 20-30 percent below its fair value over the past ten years despite the largest of external current account surpluses and despite periodic bouts of hot money inflows. And China has managed to hold its currency down without having to pay the price of higher domestic inflation.
An argument frequently advanced against foreign exchange intervention is its potential large cost to the Treasury. This cost arises since relatively high interest rates have to be paid on the bonds that the SARB would sell to sterilize the inflationary impact of any such intervention. Since the SARB currently has to pay over 6 percent on any sterilization bonds it issues yet it would receive only 1 percent on the US dollar reserves that it accumulates, the interest rate costs on foreign exchange intervention could be large especially if such intervention was carried out on a massive scale.
While one would not wish to minimize the potential interest rate cost of foreign exchange intervention, one needs to balance such costs with the potentially large capital gains that would be associated with such intervention. In the present South African context of an exchange rate that is likely overvalued by at least 15 percent, the potential capital gains from intervention would over time more than likely swamp any interest rate costs. The SARB would realize these gains by buying US dollars at less than 7 Rand to the dollar at present and selling them at over 10 Rand to the dollar at a time of renewed global financial market turmoil. Aside from being potentially highly profitable, by creating a two way market such intervention would help to reduce the excessive volatility that has traditionally characterized the Rand at a time of global financial market turmoil.
In the absence of markedly stepped up foreign exchange intervention, the SARB will soon be forced to resort either to interest rate cuts or to the imposition of capital controls in an effort to minimize further upward pressure on the exchange rate. However, international experience would raise questions as to how successful such measures would be over the longer haul and how distortive such measures might be for the economy. And such measures would certainly not have the benefit that building up international reserves through foreign exchange intervention would have in terms of preparing the country for the rainy days in global financial markets that almost certainly lie ahead.
Desmond Lachman is a resident fellow at AEI.
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