BUDDY WELLS: The real reason the rand is depreciating
What SA should aim for is a win-win situation where we export less in value than we import (a trade deficit) while earning more forex than we spend
The Competition Commission’s case against a range of banks for collusion on the currency markets has put a spotlight on the rand-dollar exchange rate. While bank collusion might have had small effects on the rand exchange rate in both directions, the reasons for the long term trend of the rand weakening are to be found elsewhere.
In this article I will show that the real reason for sustained rand depreciation over the last decades has been SA Reserve Bank and Treasury failure to direct sufficient SA savings and low interest credit towards productive local investment.
The rand weakens when more rands are sold to buy forex then forex is sold to buy rand. Forex is needed to make payments for goods and services and investment outside SA, while rands are needed to make payments for goods, services and investment within SA. To understand why the rand is weakening, we have to examine what is driving the sustained purchasing of forex with rands.
Payments in return for imported and exported goods, services and for investment (interest, dividends and profit) are recorded on SA's current account. Investment flows are recorded on the financial account. The current account and financial accounts explain why the rand is weakening over time.
SA’s current account is usually in deficit, meaning SA usually spends more on importing goods, services and on payments of interest, dividends and profit (primary income) to foreign investors, than the country earns from exporting goods and services and in primary income from SA investments offshore. But here’s where it gets interesting.
SA usually runs a trade and services surplus, which means we tend to export more value in goods and services than we import. But our trade and services surplus is usually dwarfed by our far larger primary income deficit. Primary income is interest dividends and profit paid in return for investment.
Foreign investors earn far more primary income from their investments in SA than SA investors earn from their investments offshore. So much so that our primary income deficit more than offsets our trade and services surplus, driving our current account into deficit even though we export more than we import.
Essentially, what this means is that SA runs a loss in real terms (more value in goods and services flow out of SA than inwards) and in financial terms (we pay more money to the rest of the world than we receive in payments). To understand this lose-lose situation (real loss and financial loss) we must look at our financial account.
Reserve Bank and Treasury policy to allow large SA companies to move their primary listings offshore, and to relax capital controls like regulation 28, has allowed for a large movement of SA assets offshore. South Africans now hold more investment offshore than foreign investors hold within SA (a positive investment position), yet we receive a great deal less in primary income (interest, dividends and profit) from our offshore investment than foreigners earn from their investments in SA.
When the rand weakens, offshore investments become more valuable in rand terms, so the market sentiment that the rand will continue its trend of weakening is a large motivator for South Africans to invest offshore. SA pension and insurance funds now have over R2,7-trillion invested offshore. This is a self-fulfilling prophecy, as the outflow of savings weakens the rand.
To counter the net outflow of payments (current account deficit) and outflow of SA investment, and to stop the rand from weakening, the Bank raises interest rates to attract foreign capital. Foreign carry-trade speculators deposit money into bank accounts in SA and buy government bonds to take advantage of high interest returns. Forex is sold and rands are bought. This gives a temporary boost to the rand’s exchange value.
But in offering nonresidents high interest returns SA is baking in a net outflow (interest plus principal) over time, so the rand gets a temporary boost but is net weakened over time. On top of that, the current policy of allowing 45% of SA pension savings to flow offshore (regulation 28), and responding to those outflows with high interest rates to attract foreign capital, will just result in even greater outflows of primary income over time and a feedback loop of an ever weaker rand and more external debt.
Another contributing factor to rand weakness is the Reserve Bank policy of borrowing from overseas at high interest to build up enormous forex reserves (now R1.2-trillion worth), which yield low interest in return. SA normally runs a current account deficit, so our reserves are borrowed and not earned. The IMF, World Bank and other “authorities” tell us it is good policy for developing nations to hold large amounts of reserves, as it reassures investors and mitigates against any sudden capital outflow. But SA has a positive net investment position. SA savings offshore are already a mitigator.
SA forex reserves are enough to cover six months of our usual imports, even if there were no exports at all. In what scenario will SA export nothing and yet keep importing at its current rate? The Bank has stated that it won’t use its reserves to try to prop up the rand if there were to be a sudden capital outflow, and rightly so. So SA’s forex reserves are just for show, yet building and holding them weakens the rand substantially. Each 1% interest cost on holding R1.2-trillion of borrowed reserves amounts to an outflow of R12bn per year in primary income.
So what can be done?
First, we can reduce unnecessary interest transfers to the foreign sector. Instead of trying to attract foreign capital by offering high interest on deposits and bonds (which leads to a weaker rand and more debt over time), the Bank and Treasury could rather tighten regulation 28 to repatriate some of the SA savings invested offshore. The inflow of such savings would allow for a stronger rand at lower interest rates. Even the mere threat of doing so might turn around market sentiment that the rand will continue weakening, and incentivise more onshore investment.
A stronger rand at lower interest rates, facilitated by more South Africans’ pension savings invested in SA, would incentivise greater productive investment by South Africans (less interest costs for producers, more local demand for product, and less reward for non-productive saving) leading to productive growth and employment.
Second, we should acknowledge that not all foreign investment is good for rand value. While foreign investment into exportables can lead to net forex gain for SA from exports, successful foreign investment into goods and services sold within SA can only lead to a net outflow in profit and dividends. We should be looking to increase SA ownership of these businesses.
While SA offshore investment yields so much less in primary income than local investment, SA’s primary income deficit (the driver of rand weakness) can be reduced by increasing productive local investment by South Africans. SA savings (existing rands held by South Africans) and credit (loans issued by SA banks to SA investors at as low an interest rate as possible) must be directed at productive investment within the country. This will ensure a greater local supply of goods and services (less imports and more exports), and ensure that more share of primary income from local production accrues to SA investors and less accrues to non-residents.
SA’s trade and services surplus, coupled with a primary income deficit, suggests that a more balanced economy would mean a larger share of productive gains go to SA workers, and less to company shareholders. There is space to increase spending on imports (gaining in real terms), and reduce primary income outflow (losing less in financial terms).
Ultimately, what SA should aim for is a win-win situation where we export less in value than we import (a trade deficit) while earning more forex than we spend. This is possible if we achieve a primary income surplus that is greater than our trade deficit.
Our current policy has placed us in a lose-lose position for decades. We lose in real and financial terms ... net paying the foreign sector (a current account deficit) to net import our goods and services (a trade and services surplus). That is why the rand has been weakening.
• Wells is a public finance policy activist and economics blogger.
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