Tony Twine
A well-known local economist recently reminded an audience of economists and media writers that participants in currency markets are myopic and have no memory whatsoever.
It was less a sideswipe at traders than a reminder that in the heat of trading room battles, the luxury of a cool, calm and holistically collected economic view, neatly compartmentalised into short-, medium- and long-term buckets, is not always available.
The problem with economic analysis is that it concentrates on pinpointing ultimate outcomes, without giving much thought to whether outcomes follow stimuli instantaneously, after breakfast the next day, or after a number of years. The orderliness of the feedback systems in economic models exist to find logical connections between events that might otherwise present themselves as a chaotic mess.
To instil some order, economists use the philosophical tool of ceteris paribus, the assumption that all other things are equal. Traders often take this to an extreme, working on the assumption that the exchange value of a currency in a moment to come is based on its exchange value a moment earlier, plus or minus any instantaneous response to a piece of news that hits the trading desks.
Economists are bewildered by movements of asset values, including currency exchange rates, which run away from apparent equilibrium. Traders, by contrast, are happy to swim with any discernible tide. If you can sense the direction of the tide just before it changes, you can make more money.
Sometimes, the expected response to a stimulus is diametrically opposite when considered by economists and asset traders. A recent example was the cutting of interest rates around the world, which traders initially interpreted as a positive sign for equities and the currencies in which the equities where denominated.
The view was based on prospects of lower borrowing costs, enhancing both the profits of the companies that the equities represent, and lower costs of borrowing to fund equity purchases. Economists shrank back in horror, knowing that falling interest rates were a coinciding and leading indicator of lower corporate turnovers.
There is virtually no economic evidence to indicate that the rand should have taken off in the direction that it has, particularly since the events of September 11 in the United States. Many of the economic fundamental indicators that are used to assess the comparative health of economies make South Africa look good compared to the US. These include existing and anticipated gross domestic product growth rates, the current account balance, money supply growth and household debt to income ratios. The rand is not declining because of poor relative economic fundamentals.
It is being driven weaker by financial market operators, who are taking advantage of a vulnerability brought about by a combination of South Africa’s emerging-market status, the relatively high liquidity and ease of trading rand-denominated assets and the rand itself, and the fairly small aggregate of gold and hard currency reserves held in South Africa. Normally, most of these factors should present as an advantage, not a weakness. Financial asset traders have found the gap, which allows them to roll down the value of the rand and make money while it falls.
The rand will bounce, because markets cannot defy economic fundamentals forever. But it will regain value only when the traders and operators cease to believe that it can be driven lower by themselves, or when a more lucrative trend develops around another liquid currency. Then is not the time to be caught short on the rand, because it could come back quite viciously.
Everybody must be looking to the government, hoping that there is something that the monetary authorities may be able to pull out of the hat to turn the tide of speculation against the rand.
An honest opinion is that their hands are pretty much tied. Intervention by selling dollars was tried back in 1998 and failed miserably. Traders simply sat with two telephones, buying dollars from the Reserve Bank on one and selling them on the other.
A hike in interest rates is unlikely to be successful remember how prime climbed from 18,25% to 25,5% in 12 weeks after the South African Reserve Bank realised it could not slug it out by selling dollars. Interest rate intervention is as suicidal now as it was in 1998.
Legislation and regulation would only apply to speculators on shore, and the action would simply move offshore if it was introduced.
South Africa has long experience of what happens under a dual currency system it proved as much of a problem as a solution, with “round tripping” making lots of people lots of money at the expense of the economy.
Hands off is probably the best policy stance right now.
Tony Twine is a senior economist at Econometrix