Overvalued Rand Comes Home to Roost

The rand’s collapse over the past few weeks was an accident waiting to happen. As such, it should not have taken South Africa’s policy makers by surprise. For, far from being primarily the result of the vagaries of the financial markets, the rand’s recent collapse was more a reflection of past policy mistakes that allowed the rand to become highly overvalued and that allowed the external current account deficit of the balance of payments to balloon.

Resident Fellow Desmond Lachman

Among the more depressing aspects of these developments is that they underline how little the Reserve Bank learnt from the rand’s exchange rate crisis at the end of 2001. One would have thought that the harrowing experience of that crisis, which saw the rand in virtual freefall, would have made the Reserve Bank more wary about ever again allowing the rand to become overvalued and about leaving the value of the currency to be purely market-determined.

One would also have thought that the Reserve Bank would have seized the first opportunity with which it was presented, as did the east Asian countries following the 1998 Asian currency crisis, to build up a veritable arsenal of international reserves. One might have expected the Reserve Bank to do so in order to ensure that it was never again in the position where it lacked the necessary foreign currency reserves to smooth currency fluctuations and to prevent the currency from becoming a one-way bet.

Rather than lean heavily against the wind during the period of highly favourable international conditions for emerging markets of the past three years, the Reserve Bank largely stood by as the rand steadily appreciated from its low of more than R12 to the US dollar in early 2002 to below R6 to the dollar this year. It did so despite the fact that such a move resulted in a currency level that was substantially overvalued by any reasonable yardstick.

The degree to which the rand had become overvalued by early this year is suggested by the recent dramatic widening in the external current account deficit. Despite highly favourable international commodity prices and robust global economic growth, by the first quarter of this year the current account deficit had widened to 6.5% of gross domestic product. This was the widest the deficit had been for the past 24 years.

In a world of ample global liquidity, the recent ballooning of the current account deficit would not be of much consequence. But in a world where global liquidity is being drained in the US, Europe and Japan, the ballooning deficit was bound to draw attention. It would seem to be no mere coincidence that the recent pressure on the rand has coincided with similar pressure on the currencies of Hungary, New Zealand and Turkey, which all suffer from gaping current account deficits and over- valued currencies.

At the time it raised interest rates last month, the Reserve Bank suggested that high oil prices and a weakening currency could raise inflation to 6.2% by mid-2007. If that were to occur, inflation would rise to a level above the upper bound of the Reserve Bank’s 3%-6% target range. Since the latest interest rate hike, the currency has weakened by a further 10% to its present level of R7, 40 to the dollar, which threatens to push inflation up towards 7%.

Lacking an arsenal of international reserves, the Reserve Bank is not in a position to follow the interventionist style exchange rate policies that the east Asian countries adopt when their currencies come under pressure. Instead, it is reduced to having to hike interest rates both to stabilise the currency and to prevent past movements in the currency from undermining its inflation target.

The problem with a pure interest rate defence of the currency is that it might involve having to raise interest rates to uncomfortably high levels. As Turkey has demonstrated over the past few weeks, even sharp interest rate hikes are not always sufficient to stabilise the currency. This is a great pity since it runs the very real risk of putting an end to the economic recovery with all of the social dislocation that a recession involves.

Currently, the main focus of the Reserve Bank is rightly on coping with today’s difficult international financial market conditions. It must be hoped, however, that this time around, when the dust settles, the Reserve Bank will draw the right lessons from the present exchange rate crisis and adopt an exchange rate policy more akin to those of the successful east Asian economies.

Desmond Lachman is a resident fellow at AEI.