South Africa needs interest rates of 12% or lower if the country is to avoid an economic slump, argues David Gleason
Why hasn’t the Reserve Bank dropped interest rates faster and to a greater extent than its miserable efforts so far?
And why, during the period in which the rand has enjoyed an entirely unjustified strength against the United States dollar, has the Reserve Bank not taken the opportunity to buy back against its huge forward book exposure?
The forward book is the sum of the Reserve Bank’s future contracts to buy foreign currencies. The worst-case scenario is that the Reserve Bank has to pay more for foreign currency than it had planned, incurring a loss which ultimately has to be borne by taxpayers. The reverse is that the Reserve Bank can avoid losses by day-to-day trading at current market exchange rates.
These are questions being asked in local and international financial circles. In fact, the current strength of the rand is a major surprise for many investors. When the rand suddenly takes on the entirely false appearance of a hard currency it attracts attention, and it cannot be long before someone decides to give it another smack.
At least part of the reason for the rand’s dramatic appreciation lies in the US hedge funds. These have been traumatised by the crisis which overtook Long Term Capital Management, the hedge fund managed by two Nobel economics laureates and said to have held positions worldwide of $200-billion.
After Long Term’s search for help was turned down by asset managers Warren Buffet and George Soros, the US Federal Reserve called together the country’s most important investment banks to cobble together a rescue package.
However, the crisis triggered a triple whammy for US hedge funds. First the level of leverage available to them was reduced sharply – they could obtain less credit. That meant they were obliged to shut down some positions to extricate themselves from potentially risky but profitable deals.
As hedge funds unwound their contracts, markets moved against them so they began sustaining steadily larger losses and had to sell profitable investments to cover the toll. Finally they were faced with redemptions from investors who had decided to cut their losses.
The rand didn’t escape this international financial manoeuvring. South Africa’s currency gained strength in response to the dollar’s depreciation as hedge funds sold the greenbacks they had acquired earlier in the year. The rand also appreciated due to lack of action by the Reserve Bank which was on the opposing side to many of the original hedge fund positions.
The extent of disinformation fed into the market may have contributed to the rand’s appreciation. It is patently incorrect, for example, for Reserve Bank Deputy Governor James Cross to claim, as he did in an interview with Business Day last week, that the bank would not “go back to keeping the rand artificially weak”.
Given the extent of the Reserve Bank’s forward book – now at an astonishing $23- billion – it is patently clear that the Reserve Bank has tried to keep the rand artificially strong.
Indeed, an aspect of the information being fed to the international community is that the Reserve Bank’s forward book is representative merely of the country’s imports and exports and therefore of associated leads and lags. If this is the perception, it’s profoundly inaccurate, even ludicrous.
The fact is that this country cannot for much longer escape the imperative that the value of its currency simply must reflect its economic situation. The expectation among some international observers is that South Africa is headed for a severe recession. This is based on the view that next year’s election will be economically disruptive, that unemployment will continue to impose a severe drain on productive abilities and that the government’s growth targets are demonstrably unravelling.
In those circumstances, it is inevitable that the currency will have to absorb the punishment. If history had been anything to go by, it would have been expected that the Reserve Bank would have bought rands, adding stability and liquidity to the market. What has actually happened is that the Reserve Bank did nothing to reduce its forward book, so limiting its ability to act in the future.
With a forward book equivalent to a year’s exports, South Africa is reaching the house limits, to use a casino phrase. Those on the other side of the Reserve Bank’s forward book – largely the local banks – have neither the balance sheets nor the stomachs to carry the exposure which they pass on to international banks. As a result, South Africa’s trading facilities will begin to contract. The only solution will be for the Reserve Bank to address its forward book exposure.
As it is, any sudden pressure on the rand will mean the bank will find it very difficult to defend the currency, if indeed it wants to. In fact, the bank may be forced to add fuel to the fire by buying back its forward book at the wrong time.
No one is able to provide a good answer to the question of why the bank didn’t buy back some of its liabilities when the going was good. It is probably too late now since there is already some evidence that the hedge funds are beginning to rediscover their appetite for risk. The logic is that the funds will short the rand once again, a development against which the bank will have no capacity to respond.
It is certainly valid to compare South Africa’s circumstance with that of Thailand. When Thailand’s hidden forward book problem of $27-billion was discovered, it was reckoned to be the biggest ever revealed. But what’s forgotten is that Thailand also held $33-billion in reserves. By contrast, South Africa is $20-billion in the red, a big borrowing problem for a country which supposedly has little foreign debt exposure.
The perennial argument against cutting interest rates is the perceived paramount need to control inflationary pressures. But US Federal Reserve Bank chair Alan Greenspan is acutely aware of worrying signs of global deflation and has responded by cutting US interest rates.
Presumably he is trying to keep up US consumer demand for emerging countries’ goods, even at the risk of slightly higher inflation. By contrast, South Africa ranks with the few countries which embrace an assault against inflation at the expense even of their own jobless.
If last May the rand was vulnerable to hedge fund speculation when interest rates were at 16% and growth was still evident, how much more vulnerable is the currency under an interest rate regime which is cutting off any hope of economic growth?
It is certainly worth noting that in May this year, Reserve Bank Governor Chris Stals was publicly telling local audiences that an interest rate scenario of 15% was then too high.
What is inescapable is that South Africa needs interest rates at 12% or lower if the economy is to be restimulated.