Rand strength, reserves and capital controls

The increase in the Reserve Bank’s gross gold and foreign exchange reserves exceeded our [Standard Bank] estimate, increasing to USD43.2bn from USD42.2bn in June. The surprise was largely a result of a higher-than-expected increase in foreign deposits received from the government, to the tune of USD480m. The USD956m increase in gross gold and foreign exchange reserves is ascribed to:

• a hefty USD1.127bn increase in foreign exchange reserves, of which USD480m (USD661m in June) is ascribed to an increase in government’s foreign deposits. Valuation effects accounted for some USD614m of this rise (the euro and the pound appreciated by 7% and 4%, respectively, against the dollar in July). We estimate that, while SARB purchases of foreign exchange may have amounted to around USD33m.
• an USD83m increase in SDR holdings,
• which was partly offset by a USD254m decline in gold reserves, owing to the softer gold price in the month.

On balance, the net reserves position (international liquidity position) rose to USD38.7bn from USD38.2bn
The Bank continued with very gradual accumulation of reserves in July, but government again subsidised the increase in reserves in May. This synergy is likely to endure for some time, as government’s ability to step in with its foreign exchange reserves’ contribution may be ascribed to increased confidence over revenue collection this year. In addition, the fact that the rand strengthened significantly in July (4.2% against the dollar), provided nourishment for accumulation. Clearly, government’s expectations of GDP growth at 2.3% are falling short of the likely outcome closer to 3%. The cost of sterilization and the huge interest rate disadvantage of investing in reserves will continue to translate in minimal reserves accumulation by the Bank. However, the joint responsibility of minimising rand volatility suggests that this relationship may only strengthen in due course. Certainly, the debate regarding policy endeavours to limit rand appreciation is yet to grow. In our opinion, measures to limit rand volatility should enjoy attention over and above policies aimed at limiting rand strength, as the former is more harmful to growth, inflation expectations and the Reserve Bank’s reserves accumulation strategy. Below we provide some thoughts on the issue of capital controls.

Research reviewing the impact of capital controls in limiting exchange rate appreciation resulting from capital inflows is ambiguous. Concerns that currency strength limits foreign competitiveness of the tradable sector are warranted. However, reviewing past international experiences, several policy measures are often combined in an approach to fight currency strength – it is thus difficult to isolate the effectiveness of capital controls.

According to the International Monetary Fund (IMF), the use of capital controls is justified if an economy is operating near potential, if the level of reserves is adequate, if the exchange rate is not undervalued, and if the capital inflows are likely to be transitory. Importantly, the IMF states that capital controls, as a measure to manage appreciation-induced inflows, should be part of a toolkit and should be combined with prudential and macroeconomic policy. See the IMF’s diagram explaining macroeconomic and prudential policy considerations. A general rule of thumb suggests that capital controls should be introduced if capital inflows stem from more fundamental factors rather than a temporary flight to risky assets. The latter thus tends to result in an exchange rate overshoot, which will be corrected in due course; however, the former could consistently pressure the real exchange rate towards its equilibrium level, and may thus require some form of tax on foreign flows.

Given the IMF’s advice, introducing capital controls may seem risky as the economy is operating below potential, and may be doing so for a few years still. Moreover, further tools will have to be considered as part of a wholesome approach to stem currency appreciation. Capital controls, in conjunction with other policies, should make it very costly for investors to circumvent these controls – a foreign tax on inflows in isolation may make it easy for investors to bypass them, Brazil is a case in point. On these grounds, current macroeconomic policy leaves much to be desired in respect of promoting foreign competitiveness. Introducing capital controls may thus be more complicated than it appears, given the multitude of factors that need consideration. In essence, South Africa is a net dissaver (current account deficit), requiring foreign capital to plug this gap. As such, if capital controls were to be introduced, they will have to be temporary at best; clearly this may only provide a temporary solution to a “problem” that will occur time and again. Moreover, there may be unintended consequences attached to capital controls, for example, they may signal to foreign investors that government aims to preserve the attractiveness of local assets for local investors, thus leading to more capital inflows into the economy. Another factor worth mentioning is that several emerging markets with high yields are facing the same problem as South Africa. Capital inflows have led to many emerging markets’ currencies strengthening. If capital controls are thus becoming more widespread, they could become harmful to market efficiency i.e. efficient allocation of investment, and hamper prospects of global recovery and growth.

Rand strength provided a fitting ground for reserves accumulation in the month, driven predominantly by government. This trend should continue in coming months, while the Reserve Bank is seen largely on the sidelines for now. The rand’s current strength has opened up the wounds of debate around intervention and capital controls. However, research dictates that capital controls should not be used in isolation, or introduced when the economy is operating below potential. For capital controls to be effective, they should form part of macroeconomic and prudential policy considerations, making it a more complicated process. South Africa remains a net dissaver, rendering the implementation of such controls risky and pointless if they can be circumvented.

Source: Standard Bank Research