Rand value exactly right
Nothing wrong with the currency’s weighted exchange rate
A COUNTRY’S REAL exchange rate is simply calculated by choosing one base year – in South Africa’s case it’s 2000 – and making that equal to 100. All the other important currencies are allocated a weight in terms of our trade with that currency in the preceding years. The 2000 weighting of SA’s real effective exchange rate (REER), as calculated by the SA Reserve Bank, is as follows:
SA’s REER, as calculated by the Bank, was 102,17 at end-November last year. Wichard Cilliers, of Treasury One, a boutique treasury specialist in Pretoria, says the rate was about 100 last week – precisely the same as the base of 100 in 2000 that’s used by the SA Reserve Bank.
The graph shows that the REER fell to nearly 70 after the sharp drop in the value of the rand at end-2001, when it fell to around US$1/R12. At that time, the rand was a dramatically undervalued currency and the ordinary exchange rate then had to recover.
However, the graph shows clearly that the recovery was too excessive. For example, by May 2006 – when the rand was trading at less than US$1/R6 on the ordinary spot market – the REER shot up to more than 118. That meant the rand was definitely overvalued.
President Thabo Mbeki pointed out in his State of the Nation address that the significant fluctuations in the value of the rand are/were bad for the development of SA’s industries. Mbeki is quite right to be concerned. The fluctuation from a base of 100 in 2000 to 70 and then back to 118 before now settling calmly on 100 – all within six years – may be rather difficult for exporters who need an exchange rate projection of five to 10 years to determine the viability of a project.
In terms of mutual trade, the euro is twice as important as the US dollar (see table). In fact, SA’s news services should therefore give the euro/rand exchange rate first and we should base our predictions on that.
After the Bank’s initial value calculation of 100 for 2000, it’s adjusted monthly for the difference in our inflation and that of other countries (in terms of the weightings set out in the table).
The Bank decided to use the producer price index (PPI) for that. Our producer prices rose by 8,4% in 2001. Assuming the weighted inflation of our trading partners increased by only 2,4% in 2001 in terms of the weights above, then the REER theory states that, on a weighted basis, the rand should have devalued by 6% (8,4% -2,4%) in 2001.
If it works out exactly like this every year, the REER will remain at exactly 100 and the purchasing power parity – because that’s what the REER is – of our currency will always remain the same. Below 100 the purchasing power is too low and above 100 it’s too high.
That’s easy. It’s just a pity that heavyweights such as the management at SA Airways, didn’t have time to look at the graph in 2002/2003 to find out a little bit about the REER. Then they wouldn’t have taken out that ridiculous forward cover, which cost SA’s taxpayers more than R10bn.
But where to now with our exchange rate? Investopedia points out the following six important forces that can determine the direction of a country’s exchange rate: • Differentials in inflation. If a country’s inflation rate is higher than that of its trading partners, its currency should devalue by the difference annually. In the case of SA, our current PPI presumably still requires the rand to fall by about 5%/year. • Differential in interest rates. A higher interest rate than that of your trading partners, as we currently have, can stimulate the inflow of overseas money and lead to the rand strengthening. • Current account deficits. SA currently has a huge deficit of about 6% of its gross domestic product. Our imports are far more than our exports, and this means that the demand for foreign exchange is greater than the supply. That causes the rand exchange rate to fall. Public debt and the fiscal deficit. We don’t have a fiscal deficit. In fact, there will be a surplus for the year to March 2007. Government is therefore not printing money. That’s good, and that could strengthen the rand. Terms of trade. This relationship measures the trend between the prices of a country’s imports and exports. Currently, the terms of trade are in SA’s favour, as the prices of manufactured goods that we import are rising slower than (in particular) our gold and platinum exports. Another plus for a stronger rand. Political stability and economic performance. SA probably has somewhat less of that than its trading partners and it should cause a weaker rand. That list tells us that there are exactly an equal number of factors in our economy that can cause the rand to strengthen or weaken. At the same time, the REER is exactly correct on 100 at the moment. All in all, that tells us that for the next year or so we’ll probably see little fluctuation in our exchange rate.
However, if the REER again sharply diverges from its 100 value, importers and exporters should be on the alert and not miss the opportunity to hedge themselves.
And don’t put the blame on Government after the event either. It’s the fault of a free market – which we all like to pamper so much – that there are sometimes large changes.