The fate of the rand

Some people believe that the rand is strong. Sorry folks, it's not. And it won't be strong any time soon. “Wait!” you may say. “Hasn't the rand been rising compared to the dollar?” Yes it has, but what has the dollar been doing? The dollar itself has been falling against other currencies and, notably, against gold. How useful is the rand-dollar exchange rate as a benchmark when that is happening?

When the dollar was strong, the rand looked weaker than it was. Now that the dollar is weaker, the rand looks stronger than it really is. The dollar is just one commodity and, although it is used as a currency all over the world, it is still subject to the control of one organisation, the U.S. Federal Reserve Board. Whether acting alone or in concert with other central banks, the "Fed" can significantly weaken or strengthen the dollar within a short time period It can do this using the powers and techniques that are available to all central banks including the South African Reserve Bank.

So if the rand has been rising against a falling standard, how do we know whether the rand is weak or strong? We don't need to look very far. How about checking the consumer price index, the CPI? Or, why not take a look at what the Reserve Bank uses to measure its own performance, the CPIX (which is the CPI excluding the interest on mortgage bonds)? Since August 2002, both of these measures have been registering double-digit annual increases. As of January 2003 the rate of price inflation as measured by the CPI was running at 13.7%, while the rate as measured by the CPIX was 11.8%. Anyone who frequents the shops will have noticed that prices have been rising: a rand buys noticeably less than it did only a little while ago. Another way of saying the same thing: the rand is losing its value; the rand is weak.

Two years ago, the CPIX inflation rate was running at around 7%. It would have been fair to refer to the rand as being weak even then, but the inflation trend was clearly downward. There was good reason for optimism: the Reserve Bank exuded an air of determination to bring inflation down, and looked certain to be able to hold it below the 6% upper bound of its target range. But then, as we all know, the opposite happened.

To the average person, the first thing that happened was a precipitous fall in the dollar-value of the rand. This fall happened to coincide with a currency crisis in Argentina and a sudden deepening of the ongoing social and economic malaise in Zimbabwe. Although only faintly related, and certainly not the cause, these events provided a very convenient distraction for those who were not disposed to seek out real root causes. And then, of course, those ubiquitous financial scavengers known as "speculators" arrived to help bring the whole mess to what passes for a conclusion in the great circle of life. The speculators are, it seems, always there, whether profitably or not, to provide the service of giving the politicians someone to blame – just as the terminally parched wanderer blames the circling vultures for having lured him into the desert.

It wasn’t the Argentineans, the Zimbabweans, or the hordes of speculators that forced the Reserve Bank to pass billions of unneeded rand into the economy. There may have been some political pressure but, for whatever reason, the Bank drastically increased the quantity of money during the last half of 2001. M0, which is the sum of notes and coins in circulation plus the reserves held by banks at the Reserve Bank, increased at an annualised rate of 30% from July through November that year. Such an increase went way beyond that which might have been justified by an increased demand for cash or reserves. It is quite understandable that the rand’s fundamentals would be weakened by this flash flood of money. And so they were.

In the panic to escape a risky situation the damage is often compounded. As people traded their rand for more predictable assets, it became clear that the rand-dollar exchange rate had "overshot" the level warranted by the new fundamentals. This is not, however, to suggest that the traders were irrational: had the Bank continued its steep inflation of the money supply, the rand would have continued its plunge. By February 2002 the level of M0 had peaked and then appeared to level off for the next few months as if to atone for the previous burst. From March through July the Bank seemed to have acquired a new steadiness, which, if continued for the rest of the year, would have brought the rate of price inflation back into single digits by early 2003. Instead, the M0 growth rate remained flat just long enough to resume its long-term inflationary trend.

This recent reversion to trend is, and should be, disturbing. Unless the Reserve Bank can regain control of its operations and hold the growth rate of M0 to low levels, it will never be able to achieve its inflation target. The task at hand is neither difficult nor complicated; and it remains reasonable to expect the Bank to succeed in regaining monetary control so as to build and maintain public confidence. The deviation from plan during the past two years was unnecessary: it was a policy error. It caused a delay in meeting the inflation targets by at least two years, maybe three.

If the Bank persists in its recent de facto policy of excessive monetary inflation, one reason may be that it has become overconfident due to the apparent strength of the rand. Policy errors generally derive from theoretical errors, and the belief that a currency depreciation "just happens" and then causes inflation is a very serious theoretical error. During the past six years the Reserve Bank built up the value of its foreign assets and reduced its Net Open Foreign Position, thereby strengthening its position to support temporarily the external value of the rand. The value of foreign assets held on its balance sheet is now being reduced; and to the extent that this is helping to support the rand exchange rate, the rand’s external strength is illusory. Such techniques have been used in the past to buy time and to slow the monetary-inflation transmission mechanism, but they are ultimately unsustainable.

If you want to know the fate of the rand, then watch what comes out of the Reserve Bank. If the quantity of M0 continues to grow at a high rate then the result will be a continuing high rate of price inflation. That is the monetary story of 2003.

Author: Dr Richard J Grant previously taught economics at Wits University and is a former chief economist at the Chamber of Mines. He is the author of the FMF book Real Money, monograph Gold, the euro, the dollar and the rand and recent Occasional Paper The real reason for the fall of the rand. This article may be republished without prior consent but with acknowledgement to the author. These are the author's views and they may not be shared by all the Foundation's members.

FMF Article of the Week/11 March 2003 - Policy Bulletin / 22 September 2009
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