The rand is likely to continue strengthening, leading to some difficult decisions for the South African Reserve Bank’s (SARB) Monetary Policy Committee (MPC), a senior economist said on Friday.
”The strong rand scenario that sees the rand strengthening to R5,58 (to the US dollar) by year-end is beginning to look like a distinct possibility,” said Absa economist John Loos in a statement.
Loos said South Africa’s monetary policy was geared to achieve a three percent to six percent CPIX (year-on-year consumer inflation less mortgage costs) inflation target.
”For as long as the rand continues to strengthen, exceeding the upper-target limit is not a strong possibility,” he said.
The rand’s strength has seen low interest rates by South African standards and strong growth in domestic expenditure.
But Loos warned that ”for as long as the rand is apparently benefiting from negative global factors, it may not necessarily respond negatively to a widening current account deficit”.
The current account deficit more-or-less reflects the difference between gross domestic expenditure and gross national income.
Although the MPC was concentrating on curbing inflation, in future it might have to turn its attention to the current account imbalance. This ”may deteriorate significantly should the rand go even stronger”, Loos said.
He said the United States had ignored its growing current account deficit in the late 1990s ”at a time when the dollar seemed invincible and US inflation was not a major problem”.
The country had let real interest rates decline and the population lived well beyond its means.
But now, however, the ”capital flows are no longer strong enough to finance this deficit, the dollar has weakened significantly, and looks set to weaken substantially more”.
Most of the United States’ debt is dollar-based, so the cost of debt-repayment does not increase when the dollar weakens.
South Africa, however, has a significant portion of its debt in foreign currency. Thus a weakening of the rand would increase the cost of debt repayment.
Loos said given this situation, the MPC would be expected to address the current account deficit so ”that when, at some future point in time, domestic ‘fundamentals’ once again become the focus of the market the chances of the rand plummeting into the depths (and causing an inflationary shock) are reduced”.
But this is not easy. Loos suggests three scenarios. First the MPC could increase interest rates to bring domestic expenditure into line with national income.
But this could actually ”provide additional support for the rand, driving it even stronger”, Loos cautioned.
”This would exert further pressure on the current account deficit, necessitating even further interest rate hikes and could at worst lead to a vicious cycle in which interest rates would have to keep on rising, ending in a possible scenario of deflation.”
The MPC would have to hope that in raising rates the rand would not react.
In the second scenario, the bank could cut rates to fuel demand. It would then have to hope for a sharp currency weakening. If the rand did not weaken sufficiently, ”domestic demand can spiral out of control, and the fact of the matter is that last year’s series of aggressive rate cuts showed little sign of driving the rand weaker”.
Thirdly, the bank could leave interest rates unchanged until 2005. Loos said this would probably lead to a further widening in the current account deficit and ”a three percent of GDP (gross domestic product) level could be on the cards by late next year should the rand remain at around current levels”.
Thus Loos concluded: ”The implications of the rand strength for monetary policy are thus not yet clear, except that it makes life extremely difficult for the MPC.”
Loos said that as the SARB tends to be conservative, ”its bias lies somewhere between hiking and leaving rates unchanged throughout the next year and a half”. ‒ Sapa