Presentation by the South African Reserve Bank to the Portfolio Committee on Trade and Industry

1. Presentation by the South African Reserve Bank to the Portfolio Committee on Trade and Industry 6 April 2010 Parliament, Cape Town

2. Outline • Observations on the exchange rate of the rand • Observations on the cost of capital in South Africa • Conclusion

3. The exchange rate of the rand

4. In thirty years the cost of one US dollar has on balance risen from less than R1 to more than R7 Nominal exchange rate: Rand per US dollar, monthly averages

5. Does the movement in the cost of one US dollar from less than R1 to more than R7 mean a sevenfold-plus increase in the international competitiveness of South African goods? • Unfortunately not • Inflation also comes into the competitiveness picture, along with many other factors • If prices in the US stay unchanged but prices in SA rise sevenfold, the rand price of one US dollar should go up roughly sevenfold, all other things equal • To see if competitiveness has really changed, economists calculate the real exchange rate between two currencies. It is also called the inflation-adjusted exchange rate • Real rand-dollar exchange rate: $ Price index in SA in rand X R Price index in US in dollar

6. Although more competitive than in the early 1980s, the real exchange rate of the rand against the dollar is currently close to its 30-year average Real exchange rate, US dollar per rand Stronger rand=up $ Price index in SA in rand Formula: X R Price index in US in dollar

7. Not just against the US dollar but also against a basket of currencies, the rand has depreciated considerably in the 1980s and 1990s Nominal effective exchange rate of the rand Stronger rand=up “Effective” = against a basket

8. It is helpful to study the recent movements in the exchange rate more closely Nominal effective exchange rate Stronger rand=up Lehman Brothers failure

9. For long-run analysis of competitiveness, the real effective exchange rate is a useful tool Real effective exchange rate of the rand Stronger rand=up “Real” = adjusted for inflation “Effective” = against a basket of currencies

10. Numerous forces and events have an effect on the exchange rate, of which those indicated below are but a few Real effective exchange rate of the rand Stronger rand=up Gold price boom Financial rand abolished Southeast Asian crisis Lehman failure and “flight to familiarity” Rumours regarding President’s health Financial sanctions and debt standstill Severe speculation against rand

11. Drivers of the exchange rate of the rand include export commodity prices, which are currently strong Real effective exchange rate of the rand and the gold price US$ per fine ounce Stronger rand=up

12. Drivers of the exchange rate of the rand include export commodity prices, which are currently strong Commodity prices

13. Changes in non-resident investor interest in South Africa also influence the exchange rate Annual cumulative monthly net purchases of shares and bonds by non-residents Lehman failure and “flight to familiarity” Renewed interest

14. Recent movements in the exchange value of the rand traced the movement of other commodity currencies… Exchange rates - Commodity currencies Stronger rand=up Crisis

15. …and of Brazil, Russia and India, with China being an exception Exchange rates - BRICs and South Africa Stronger rand=up Crisis

16. While a lower level of the real effective rand should boost manufacturing production, other factors seem to have been more important Real effective exchange rate and share of manufacturing in GDP Stronger rand=up Strategic industries, isolation, high protection Normalisation, re-integration, reduced protection

17. Real GDP growth in manufacturing seems more sensitive to local and international income and expenditure than to the exchange rate Real effective exchange rate and annual growth rate of real GDP of manufacturing Stronger rand=up Real growth – GDP of manufacturing

18. Capital expenditure in manufacturing is partly on imported capital goods. Capital spending is often lower when the exchange rate is weak. Real effective exchange rate and real fixed capital formation in manufacturing Stronger rand=up Confidence, income are important determinants of capital expenditure

19. The fall in manufacturing production and exports in 2008 and 2009 was driven by the global economic crisis, not by the exchange rate Global and South African industrial production

20. Maintaining a stable and competitive level of the exchange rate of the rand • Both the stability and level of the exchange rate are important for sound resource allocation and sustainable growth • Stability: The problem is not with frequent smaller fluctuations but with big “order of magnitude” changes in exchange rates • Impossible to have a constant exchange rate against multiple currencies in a world of floating/constantly adjusting exchange rates • There are instruments such as forward foreign exchange contracts available to hedge against exchange rate volatility • South Africa has made progress with reinforcing the robustness of its financial system, strengthening its international financial ties and raising its foreign exchange reserves • This contributes to reduced volatility • Real effective exchange rate volatility: standard deviation calculated on monthly data • 1994-1999: 8,8 • 2000-2004: 11,0 • 2005-Jan 2010: 8,4

21. There has been a reduction in the volatility of the real effective exchange rate Real effective exchange rate of the rand Stronger rand=up

22. Maintaining a stable and competitive level of the exchange rate of the rand • Level: Again, the problem is with major overshooting or undershooting of the exchange rate • The equilibrium level of the exchange rate is a moving target which constantly adjusts to changes in the economic environment, such as: • Changes in the terms of trade • Changes in foreign appetite for acquiring assets in SA • Recognising misalignment is difficult • The authorities can contemplate various courses of action if misalignment of the exchange rate is suspected, including: • Dissemination of factual economic data/information • Official pronouncements, guidance, warnings • Exchange control relaxation or tightening • Purchases or sales of foreign currency • Policy interest rate changes

23. Options if misalignment of exchange rate is suspected • Dissemination of factual economic data/information • This is done anyway – SA subscribes to the Special Data Dissemination Standard • Official pronouncements, guidance, warnings • Can help to inform, but can also trigger speculation as market participants push to see if authorities will put their money where their mouths are • Exchange control relaxation or tightening • Difficult to forecast uptake and lags associated with relaxation, and business repulsion associated with tightening • South Africa needs foreign saving due to a domestic saving shortfall • Policy interest rate changes • Impact uncertain: A lower policy interest rate may reduce foreign depository and bond investment, but bolster foreign share investment into the country • Purchases or sales of foreign currency • Constrained by availability (if selling forex) and cost considerations (if buying forex)

24. SARB purchases have increased the country’s gross reserves from $8 billion to almost $40 billion since early 2004. South Africa’s official foreign reserves

25. If the SARB purchases foreign currency, it has money-market effects which have to be countered • The SARB purchases US$100 from a bank and pays for it with R750 • Rand in circulation has increased by R750 • To counter this and prevent an explosion of rand liquidity, the SARB has to sterilise the rand that has been created • It does so inter alia by selling SARB debentures to banks and the public. These are certificates of indebtedness which pay interest to the holder. • Government can also help by placing more money on deposit with the SARB instead of with private-sector banks.

26. Sterilising the money-market effect of foreign currency purchases has been costly, with lower interest rates on international reserves than on sterilisation instruments International reserve accumulation and related sterilisation

27. Attempts to influence the exchange rate through official purchases or sales of forex should be mindful of the size of the forex market Daily turnover in the foreign exchange market

28. The relationship running from the exchange rate to inflation is also important Exchange rate and targeted inflation Stronger rand=up

29. The cost of capital in South Africa • There are various instruments through which capital can be raised: • Loans, debentures, share capital, retained earnings, hybrid instruments etc • Focusing on loans and debentures: • It is helpful if interest rates do not fluctuate excessively • From a cash flow point of view it is also helpful if nominal interest rates are lower rather than higher • Sustainability is important: a very low interest rate environment which cannot be sustained and makes room for a high interest rate environment is extremely damaging

30. The nominal rate on long-term bond financing has been high from the mid-1970s to around 2000… Nominal bond yields

31. …but much of this was due to high inflation. Nominal bond yields and the inflation rate

32. Real (or inflation-adjusted) bond yields have not been very high in recent years, despite rising capital expenditure in South Africa Real Eskom bond yield

33. Short-term nominal lending rates were very volatile and often very high in the 1980s and 1990s Nominal prime overdraft rate

34. The real (or inflation-adjusted) prime overdraft rate has also been less volatile and well below previous highs in recent years Real prime overdraft rate

35. Real central bank interest rates depend on country circumstances Average real central bank interest rates in selected countries, 2000 - 2009

36. Conclusion • A stable and competitive exchange rate of the rand is an important component of an appropriate industrial strategy for South Africa • Building financial robustness and foreign-currency reserves when the supply of foreign currency is strong, reduces volatility and moderates undue appreciation of the rand. • That is what the SARB is currently doing, mindful of the importance of the exchange rate. • Such intervention or “leaning against the wind” is not the same as targeting a specific level of the exchange rate. The latter is not advisable, given the size of the relevant market, the cost and risk attached to such a policy, and international and domestic experience with such attempts. • Supply-side measures and programmes to build industry should simultaneously be vigorously pursued; the exchange rate is no substitute for that. • The cost of capital should not be unduly volatile or high • An environment of financial stability and low inflation reduces the uncertainty and inflation premia built into interest rates • It also counters volatility and brings down the level of nominal interest rates • Bottom line: The SARB is committed to promoting financial stability and maintaining low inflation, in conformity with its mandate. Its prime contribution is therefore to create a stable platform for sustainable growth and development.