Impact of SA's Rand depreciation

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27 Feb 2013

The suggestion of devaluing the Rand, potentially to R15 or even R20 to the US dollar to gain demand for South Africa’s exports, must raise the question of whether a weakening currency would really be good for SA.

If SA attempts to follow the path of massive currency depreciation it will just result in greater social unrest and political instability. A substantially depreciated currency is easy to achieve, but the reversal of the unintended (and clearly destructive) consequences of such depreciation are not easy to reverse.

Does a weak currency really increase competitiveness and is it positive for growth and job creation, given that the costs of labour in many areas of the production sector, and of electricity, are increasing at double digits?

Or is Rand depreciation just a short-term, easy solution, outweighed by the longer-term damage which includes sharply higher inflation and resultant human suffering of the poor, and the erosion of living standards?

Essentially, competitiveness is a country’s share of the world market for the sale of its goods and services.

In attempting to increase a country’s share of world markets, the temptation often arises to use price competitiveness through either a) currency devaluation or b) keeping wages too low.

But the unavoidable truth is that under marked currency devaluation the citizens of the country take a communal pay cut through dropping the cost of their goods sold in world markets, and paying substantially more for imports.

The simple explanation of ‘halving the cost of exports by halving the value of the rand’ misses this point.

Continued Rand devaluation runs the risk of entrenching SA as a country with a substantial export share but one which still remains poor (has a low GDP per capita and hence low living standards for its population) with a high unemployment rate.

By pursuing a weaker Rand, workers become trapped with ever lower wages, as their purchasing power continually diminishes (inflation rises relentlessly).

There is no real escape other than attempting to stem the tide of currency devaluation, which becomes harder to do the longer it is pursued.

As should have already been learnt in SA, Rand weakness results in higher import costs. The Rand’s weakness of the past two years demonstrates this as strike incidence has increased as workers agitate for higher wages to meet the higher cost of living.

Indeed, substantial, ongoing rand weakness makes the cost of importing goods, particularly machinery and other technology used in production, exorbitant or unaffordable.

This negatively impacts infrastructure expansion and so electricity tariffs will need to be pushed up even much more significantly than is already occurring (the cost of importing the capital equipment needed in new power stations rises as the Rand weakens).

The risk to foreign investment in SA that seeks higher interest rates is clearly not an increase in global interest rates but rather the risk that the rating agencies will downgrade SA’s bond to closer to speculative grade on ongoing strike action and the resultant reduction in GDP growth (and so widening of the budget deficit and debt ratios) and widening of the trade deficit.

Workers under substantial Rand depreciation are doomed to face producing relatively cheap products and earning low salaries as a result of substantial currency depreciations, without the ability to tap into economies of scale as the cost of mechanisation of the production process is beyond the country’s reach because of the severe weakness of the currency.

Unsurprisingly strike incidence increases.

Clearly, weakening the currency for the immediate gratification of a more competitive rand, i.e. one which temporarily increases the country’s level of exports, would actually result in a substantial lowering of living standards for those already employed.

A country’s standard of living is shaped by its output, the more it produces through the use of its resources, whether these are human, natural or capital, and the more efficient the production, the more there is to go around (including tax revenue) so long as the gains are not eroded by inflation.

High levels of quality health care, education and public services become easily affordable and per capita incomes keep rising significantly (sustainable employment growth results) in an environment of high growth and low inflation.

Furthermore, the manufacture of high quality, innovative products, which come with a high price tag and do not need currency deprecation to boost demand, allows a nation to support high wages, a strong currency and attractive returns to capital resulting in a sustainable, high standard of living.

Restructuring the economy to export low priced products will only support subsistence wages, and translates into a low level of GDP per capita, an outcome workers are already showing they will clearly not accept with the rise in strike action in the mining, agriculture, transport and other productive sectors such as the textile industry.

And substantial wage increases have caused retrenchments when companies find they cannot increase the price of their products to match the rise in labour costs.

A perceived need for Rand depreciation merely indicates a perceived lack of belief in a country’s potential competitiveness, i.e. the country has to compete on price instead of on quality to gain market share.

Clearly pursuing either a massive, or endlessly, depreciating currency is not the answer.

However, some temporary mild Rand weakness, and the emphasis really needs to be on the words ‘temporary and mild’, can help export demand only when there is significant demand globally for exports, as opposed to the current situation of the euro zone recession and weak global demand.

It should also be noted that SA’s exports from the mining sector are priced in US dollars as they are determined by global resource prices, while all agricultural exports are influenced by the international US dollar price of agricultural goods.

If the Rand is weakened substantially producers will prefer to sell agricultural products overseas (given the higher return) and workers will find food prices escalating sharply and so demand higher wages.

The resulting sharp increase in labour costs and electricity tariffs to compensate for higher wages demanded because of the higher cost of food, living expenses and capital equipment respectively will quickly erode any competitive benefit from the rand’s weakness.

Foreigners own around a third of SA’s equities and bonds and inflows are chiefly into these sources to take advantage of SA’s emerging consumer market and the deep liquid nature of the financial system, which makes purchases of SA’s investment grade bonds (which qualify for inclusion in Citi Bank’s World Global Bond index) attractive.

Indeed, Rand depreciation to R15 or R20 to the US dollar would doubtless cause a wage-price spiral.

It is also key to note that the current account is not being propped up by foreign purchases of SA’s assets.

Foreigners own around a third of SA’s equities and bonds and inflows are chiefly into these sources to take advantage of SA’s emerging consumer market and the deep liquid nature of the financial system, which makes purchases of SA’s investment grade bonds (which qualify for inclusion in Citi Bank’s World Global Bond index) attractive.

Additionally, the current account deficit is large (- 6.4 percent of GDP at the last reading) not because the trade deficit is as large (only -2.6 percent of GDP for the same period), but because the bulk of the current account deficit consists of dividend and coupon payment to foreigners holding SA’s equities and bonds.

Foreign sell-off of SA’s equities and bonds will automatically collapse the current account deficit as these foreigners will no longer receive dividend and coupon payments on SA assets and so this component of the current account deficit would collapse meaningfully.

However, sharp currency depreciation would cause the trade deficit to balloon as the cost of oil imports and capital equipment climb, and the demand for exports then drops off as the input costs of labour, electricity, transport etc rise sharply, driving up the cost of exports and driving down their competitiveness.

Additionally, SA’s transport system does not have the ability to cope with a substantial rise in demand for bulk exports, as was evinced by SA’s inability to meet the increased demand for coal during Australia’s recent floods.

Existing foreign (particularly direct) investments would be prejudiced by a sudden sharp fall in the Rand (loss of value in the investment).

Foreign direct investment (bricks and mortar investment) is urgently needed to transfer skills, create jobs and bring in savings given SA’s exceptionally low savings base.

Chasing away foreign investment, either direct, or portfolio (purchases of bonds and equities) through massive currency devaluation and so devaluation of the value of foreigners’ investments, will chase away the huge inflow of funds SA receives on its capital account that is vital in financing its infrastructure investment (given the dearth of domestic savings).

SA’s interest rates are historically low but higher than those in advanced economies.

However, as the global interest rate environment moves into an upward phase on higher economic growth, so will SA’s interest rates for the same reason (SA’s economy will experience faster economic growth as demand for SA’s goods strengthen on the pick-up in global demand).

The risk to foreign investment in SA that seeks higher interest rates is clearly not an increase in global interest rates but rather the risk that the rating agencies will downgrade SA’s bond to closer to speculative grade on ongoing strike action and the resultant reduction in GDP growth (and so widening of the budget deficit and debt ratios) and widening of the trade deficit.

The resultant unavoidable rapid rise in inflation and drop in living standards due to marked Rand devaluation would also concern the rating agencies.

A massively depreciated Rand would substantially increase the cost of SA servicing its foreign debt and increase the cost of borrowing for SA’s government, and so would increase the chance of further rating downgrades.

Even China shows that its workers are not happy with subsistence wages.

If SA attempts to follow the path of massive currency depreciation it will just result in greater social unrest and political instability. A substantially depreciated currency is easy to achieve, but the reversal of the unintended (and clearly destructive) consequences of such depreciation are not easy to reverse. - Annabel Bishop

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