The Rand Effect- Foreign Exchange
What is Exchange Rate?
In a closed economy, there is no export or import of goods and services. And as a result, there is no need for an exchange rate in respect of the local currency used for purchase and sale within that economy – it is insulated from every other economy. However, when we get an open economy, there is now an exchange (import and export) of goods and services between that economy and the one it is trading with.
There therefore needs to be an agreed rate at which a country’s goods or services are priced, in the currency of the country being traded with, compared with its price in the home currency. And thus you have an exchange rate – a rate at which one currency is exchanged for another, based on the cost of goods and services in each of these economies.
So, as an example, if we have a widget that costs R700 to produce here, and costs $100 to produce in the US, the exchange rate based on these costs is R700 / $100 = R7.00 per 1 US Dollar.
Generally, since March, the average trend has been moving north.
The South African Rand exchange rate for May, 2012 averaged 8.15 ZAR to USD. That’s 31.8 basis points higher than the April, 2012 rate of 7.83, and 130 basis points higher than the May, 2011 rate of 6.86.
The rise in the ZAR/USD exchange rate from April to May provides evidence that the short term trend in ZAR/USD is up. In other words, a strengthening of the US Dollar against the South African Rand in the short term. If the trend continues in the currency market, we should see an average daily rate in June, 2012 close to8.47. The average South African Rand conversion rate over the last 12 months was 7.65. The average rate over the last 10 years was 7.46. The minimal change in the South African Rands to dollars exchange rate over the last 12 months compared to average conversion rates over the last 10 years serve as an indicator that the long term trend in ZAR/USD is relatively flat.
The highest currency rate for ZAR/USD over the last 12 months was 8.19. The lowest was 6.79. The market high was attained in December, 2011. The market low was achieved in June, 2011.
The Villager`s historical research covers South African Rand data back to January, 1971. The average exchange value during that period of history was 3.81 ZAR/USD. The highest rate was 11.68. The lowest was 0.67. The market high was attained in December, of 2001. The market low was achieved in July of 1974. Recent rates experienced in May of 2012 are high relative to the historical 3.81 average.
Exchange rates have a significant impact on economic growth through manufacturing, employment, inflation, the balance of payments, and the well-being of individuals, but, as with most economic variables, there are time lags involved in establishing economic equilibrium. Once this economic equilibrium is established, a weaker exchange rate can lead to increased demand for domestic goods and thereby boost local production and job creation. Initially, economic agents will be unwilling to take advantage of a weaker currency to manufacture for export as they might rationally expect a sudden Rand strengthening. But once they are confident that the weaker Rand will remain stable, export manufacturing, and hence employment, would rise; improving the balance of payments.
Furthermore, commodities in transit are priced at the old exchange rate and will only contribute towards growth at the next round of imports by foreigners. There’s also adjustment lags associated with export/import volumes.
For a Rand weakening to have a full impact on growth, structural issues such as infrastructure, product regulation, too-high minimum wages, and information/ telecommunications technology will have to be resolved.
Haddad et al (2010) explain that a long-term undervalued currency could aggravate inflation and destabilise liquidity growth if prices/wages are not moderated; constrain monetary policy, and demotivate financial sector development. Policy makers must therefore be aware that such a strategy’s costs may outweigh its benefits over the medium- to long-term.
To be successful, this policy must be accompanied by strong institutions and sound macroeconomic conditions. Hausmann (2008) indicates that to offset volatile exchange rate and work towards an equilibrium exchange rate, where full employment and external balance exists, government should maintain its macroeconomic strategy of fiscal caution and inflation targeting, but also include a fiscal policy aimed at increasing savings, target the structural deficit instead of the actual deficit, and BoN must increase its responsiveness to deviations of the real exchange rate in addition to inflation targeting.
A weaker domestic currency encourages export growth by lowering relative prices and raises the profitability of the manufacturing sector, thereby expanding the domestic value added by tradable goods (Haddad et al, 2010).
Increased exports or fewer imports of substitutable goods, caused by a depreciation of the domestic currency, will be short lived if the prices of domestically produced substitutes rise to such an extent that importing these goods would again become favourable to consumers. Namibia`s end-to-end supply-chain has to be improved for a currency weakening strategy to be sustainable, since an export growth strategy associated with a weaker Rand will be impaired by a costly logistics system and would increase the probability that foreign importers of Namibian goods will turn elsewhere (Hausmann, 2008).
Manufacturing and Job Creation
A more competitive exchange rate will motivate entrepreneurs to make larger investments in the export oriented manufacturing sector; improving aggregate skills as more people become employed.
Inflation and interest rates
A weaker Rand would raise inflation and interest rates, as well as the cost of imported capital, intermediate, and final goods (Edwards et al, 2007). Higher interest rates constrain economic growth by making borrowing expensive, which will not be good for businesses already struggling to finance debt.
Poverty, inequality, and the well-being of individuals
A weaker Rand will improve export capacity and job creation, reduce poverty and inequality, and improve the well being of individuals ONLY if we invest in export oriented companies. An expanded non-resource Namibian tradables sector will enhance macroeconomic stability, growth, and social equity.
Lower wages will accelerate this process as firms will be more willing to hire low-skilled labour. The question policy makers should ask themselves is whether to enable some workers to work for more, or more workers to work for less. However, the paradox is to sold unemployment.
Advantages of a weaker Rand
Faster economic growth: Through increased exports, manufacturing/productivity, job creation, income distribution, poverty alleviation, and the balance of payments – all contributing to higher GDP. Export expansion: A weaker Rand lowers its value in comparison to other currencies, causing Namibian goods to become cheaper for foreign buyers.
Less competitive pressure on domestic firms to keep prices low: Competition amongst firms forces them to keep their prices low in order to retain their respective market shares. A weaker Rand leads to lower prices of Namibians goods in foreign markets, giving domestic firms more room to breathe with respect to their prices. More foreign tourists can afford to visit Namibia: A weaker Rand will increase foreigners’ purchasing power of money in Namibia, enabling them to afford more and thereby drawing them to the country.
Domestic capital markets become more attractive to foreign investors: Higher domestic interest rates are attractive for foreign investors since they will receive higher returns from their Namibian investments.
Disadvantages of a weaker Rand
Consumers face higher import prices: A lower Rand value causes foreign goods to become more expensive in comparison to Namibia goods, making import prices less attractive for domestic importers.
Higher foreign product prices increases cost-of-living: Higher foreign prices fuels inflation and therefore increases day-to-day costs incurred by consumers. This is typically the scenario we have in Namibia.
More difficult for domestic firms to expand in foreign markets: A foreign country might also impose protective barriers to limit the flow of Namibian goods into that country.
Tighter monetary policy: Bank of Namibia (BoN) will curb rising inflation caused by a weaker Rand by raising the repo rate, which is good for savers but not for lenders.