Intro4u2u

Since the end of December 2007, the rand has depreciated heavily against the currencies of its major trading partners, but this could provide a short-term boost to the country’s competitiveness.

Global Insight Perspective  
Significance A depreciating rand could boost the country’s competitiveness over the short term, but may impact negatively on inflation and interest rates.
Implications Over the short term, economic growth will benefit, but rising inflation will impede this growth over the longer term. 
Outlook Global Insight expects the rand to depreciate by around 7.3% in 2008, thus slowing the downward trend in interest rates expected from the second half of the year onwards.

From the end of December 2007 to 15 February 2008, the rand weakened by 12% and 11.5% against the U.S. dollar and the euro respectively, compared to 3% and 2.6% over the same period last year. The rand also fell by nearly 16% against the yen and 10% against the pound sterling in the same period. Previously, the real effective exchange rate of the rand has been notoriously volatile, but showed a measure of stability over the past two years, while weakening steadily at a rate of 2.5% and 3.5% in 2006 and 2007 respectively. This weakening was mainly driven by exposure to a growing current-account deficit in South Africa. However, in 2008 the slowing global, especially U.S., economy - helped along by financial uncertainty and increasing risk aversion among foreign investors, and coupled with electricity supply problems in South Africa - added to the depreciating bias of the currency.

The Effect of 15% Depreciation against U.S. Dollar

Under the assumption that the current depreciating trend of the rand will continue, an alternative simulation has been done using the Global Insight South African macro-econometric model, in which the rand is expected to depreciate by 15% against the U.S. dollar from the first to the last quarter of 2008. A depreciating rand stimulates exports and inhibits the demand for imports (with a lag). Despite some short-term effects - export prices adjust slower to exchange-rate depreciation than import prices - the current account of the balance of payments improves over the longer term (around 1.2 percentage points by 2009). Real output growth rises on average by 0.4% in 2008 and 1.0 % in 2009 when compared to the baseline.

However, the depreciation increases the cost of imported goods, which with lags translates into higher producer and consumer price inflation. CPIX inflation (excluding mortgages) shows an increase of 1.4% in 2008 and 0.9% in 2009 compared to the baseline. As prices rise, inflation expectations rise, pushing up nominal wages and unit labour costs, which in turn further fuels domestic inflationary processes. This also reduces foreign competitiveness. With inflation and, more importantly, inflation expectations rising, the monetary authorities will usually react with higher real interest rates. These then lower domestic demand and economy-wide levels of capacity utilisation fall. The extent and timing of the increase in real interest rates will ultimately affect the extent of the downward adjustment of domestic demand and output. However, the simulation shows that GDP growth could again be lower by up to two percentage points in 2010 compared to the baseline.

Outlook and Implications

The extent and duration of rand depreciation depends heavily on the international financial situation. However, we forecast that the global scenario will stabilise as supportive actions by the U.S. monetary authorities take affect and lead to a dollar weakness. Improving global market conditions will bolster investor confidence and support emerging market currencies once again and South Africa’s current account is expected to be sufficiently funded by foreign inflows. With limited electricity outages later in the year, following the successful implementation of energy action plans in South Africa and supported by buoyant commodity prices, the rand is now expected to average the year around 7.57 rand:US$1 (from the previously expected 7.1 rand:US$1), giving a depreciation of around 7.3% from 2007. The effect on prices will thus be less than indicated in the alternative scenario. Domestic inflation will also be tempered by lower domestic food prices as good summer rains indicate a bumper crop this year. Nevertheless, a weaker currency could slow the downward trend in interest rates expected from the middle of 2008 onwards.