Exchange-rate volatility is a global issue

SA is very open to international trade. Annually, the value of imports and exports is equal to 50% of GDP. Yet all this trade across borders is subject to highly volatile exchange rates, which add considerable risks to exporters, importers and those who compete with imported goods in the local market.

Operating margins depend on exchange rates adjusted for differences in inflation between trading partners — known as real exchange rates. An undervalued currency will add to profit margins, and an overvalued one — should the exchange rate change by less than the differences in inflation with trading partners — will depress margins.

Changes in nominal exchange rates are, however, the predominant force behind changes in the real exchange rate. In SA and elsewhere, frequent shocks to the exchange rates lead and inflation rates follow.

SA’s experience with real exchange rate volatility is by no means unique. The tradeweighted real dollar exchange rate has been even more variable than the real rand exchange rate. The exchange rates of other emerging markets including Brazil, are similarly variable, as are those of the EU and UK.

Not coincidentally, the real trade-weighted rand has moved in the opposite direction to the real dollar. The real euro and real pound have also been highly variable since 1995. Real sterling was consistently overvalued and less competitive between 1996 and 2007. More recently, with Brexit in sight, sterling has become much more competitive.

Moreover, none of these real exchange rates can pass a statistical test for mean reversion to trade-neutral purchasing power equivalent exchange rates.

The Chinese and Japanese real exchange rate trends most conspicuously do not revert to purchasing power parity rates. The real yuan has had a distinct and persistent stronger trend (off a very undervalued base in the mid-1990s), while the real yen has moved persistently weaker off a presumably very overvalued base in 1995.

This global exchange rate volatility — as well as the lack of mean reversion to trade-neutral purchasing power parity exchange rates — has greatly inconvenienced global trade. It has also greatly complicated the reactions of central banks.

The best approach central banks should adopt to exchange rate shocks is to ignore them, since they are unpredictable and largely beyond their control. They have little to do with competitiveness in international trade and almost all to do with capital flows that respond to changes in expected returns.

Given that such exchange rate shocks are temporary — even perhaps rapidly reversible — their impact on inflation will be just as temporary. They therefore will not be expected to permanently add to inflation nor will they add to expected (forecast) inflation.

But to react to exchange rate shocks as if they threatened to cause permanently higher inflation is to make monetary policy hostage to unpredictable dollar exchange rates.

Unfortunately, the South African Reserve Bank from early 2014 added higher interest rates to the contractionary forces emanating from a weaker rand and a much stronger dollar. We regard this as an error of monetary policy that unhelpfully further reduced growth rates without any obvious reduction in inflation rates or expected inflation.

US monetary policy does not react to the dollar’s exchange value. Thus, when investing abroad, a bias in favour of US-based investing seems appropriate. The risks posed to monetary policy and real economic activity by a volatile dollar are best hedged by investing in the US rather than economies where macro policy is more error-prone.

Kantor is the chief economist and strategist at Investec Wealth & Investment. He writes in his personal capacity.