Why is the rand falling now?

With the CPIX inflation rate now flying high above its official target range, we can’t avoid noticing that the rand is a weak currency. The latest CPIX inflation rate, as of December 2007, is 8.5%. That is 2.5 percentage points above the Reserve Bank’s target range of 6%. Current expectations in the markets are that inflation will go higher and the rand will depreciate further. Why is this happening?

The past few years have been easy ones for the rand: CPIX inflation was within its target range (until the beginning of 2007) and the weak US dollar has made all but the weakest currencies look good. This period of rand-dollar stability gave reason to believe that the Reserve Bank had matters in hand, and would take appropriate action to maintain this stability. The fact that the Bank was injecting huge amounts of money into the economy didn’t seem to matter as long as the usual benchmark comparisons looked okay.

Dollar weakness meant commodity price strength. The rapidly rising gold price gave the Reserve Bank an incentive to monetize gold over the past two and a half years in order to prevent the rand from appreciating “too much” compared to the dollar. The trouble is that rather than merely leaning against dollar weakness, the Bank has joined the US Federal Reserve in a race to the bottom.

This is not (yet) a reason for panic. The SA Reserve bank is certainly inflating the money supply – thereby ensuring high inflation – but it does not appear to have lost control of its policy programme. As long as the money-supply growth rate slows down and levels off during 2008, we need not assume that policy is reverting to that of the inflationary past.

The key will be a slowing of monetary growth rates. Given the high CPIX inflation rate, this must happen. If it does not, then all bets are off. The rand will be sunk.

Whatever problems the US economy might be facing, they won’t last forever. Similarly, US inflation rates won’t be allowed to remain as high as they are now. When those changes come to pass, the de facto weakness of the rand will become apparent to all. Unless the SA Reserve Bank regains its discipline and meets its own standards by that time, then all market signals will say, “Dump the rand.”

The rand has recently depreciated to its lowest level in 16 months. Various explanations have been offered: the “Zuma effect,” the US sub-prime crisis leading to “global risk aversion,” and certainly the recent electricity crisis. None of these is causing the high inflation in South Africa – so none of these can be blamed for the downward trend in the value of the rand, by any measure.

Certainly, political uncertainty can cause everyone, including currency traders, to become more cautious. As the underlying truth about new political leadership is revealed, the markets will respond accordingly: either slightly up, or slightly down. Similarly, the failure of Eskom to maintain its generating capacity has discoverable reasons. As the public evaluates these reasons and Eskom’s response, judgments will also be made about the quality of South Africa’s political leadership and investment climate.

“Risk aversion” is merely an avoidance of the unknown, or of that which has been less reliable in the past. South Africa has learned a lot about living with its past. One lesson that policy makers, and market commentators, must keep in mind is that the rand has several decades of poor policy and poor performance to outlive. During the two years following mid-2002, monetary policy was conducted relatively well, and rightly gave the markets confidence. Since mid-2004, however, monetary policy has been loosening under the cover of dollar weakness. If this slackening of Reserve Bank discipline continues, investors will soon forget the two years of good performance and begin to remember the previous two decades of high inflation and rand weakness. Who could blame them?

Author: Dr. Richard J Grant is Professor of Finance & Economics at Lipscomb University in Nashville, Tennessee, and is Publications Editor at the Free Market Foundation. This article may be republished without prior consent but with acknowledgement to the author. The views expressed in the article are the author’s and are not necessarily shared by the members of the Foundation.

FMF Feature Article/ 12 February 2008