Issue: Oct 2010/Jan 2011
Back to Basics 1
Carry on the rand
Why is the currency so strong? Is it too strong? Investec group economist Annabel Bishop discusses the inflation and interest-rate risks in trying to contain ‘hot money’ whose inward flow can quickly reverse.
SA has seen its currency return to 2008 levels, along with most emerging markets (see Figure 1). Indeed, many countries are purposely intervening in the foreign-exchange markets to bring their currencies back to more competitive levels.
Central banks in Japan, South Korea and Taiwan have been particularly active, and even the SA Reserve Bank has admitted to spending R1bn in the past year to neutralise the impact of its activities in the foreign-exchange market. Typically, the monetary authorities sold rands (supplied by National Treasury) and purchased hard currency in order to build SA’s level of foreign-exchange reserves. The level is still extremely low by international standards.
More recently, as the rand has relentlessly attempted to strengthen through R7,00/US$1 to R6,90/$1, the Reserve Bank has started to use less costly methods to build foreign exchange reserves. This has the effect of limiting rand strength.
Over the past couple of years, carry-trade activity has been credited with driving both rand strength and the general strength of emerging-market currencies. Interest rates in many advanced economies are negative in real terms (i.e. the actual interest rate minus inflation, or the 6,0% repo rate minus the 3,7% cpi inflation rate in the case of SA, as shown in Figure 2).
This situation has prevailed since the sharp drop in interest rates which materialised as 2008’s credit crisis morphed into a global recession. Indeed, SA’s exchange rate has strengthened from R11,68/$1 at end-September 2008 to around R6,90/$1 at present. But what exactly is the carry trade, and how does it cause such substantial currency strength?
Carry-trade activity occurs when money is borrowed at low or negative real interest rates in one country, for example the US, and then invested in another country which is offering a high return, such as SA (see Figure 3). The money, if obtained in the US for example, will be in US dollars. These will be sold to purchase rands which are invested to earn SA’s comparatively high rate of interest. As long as the difference between SA and the US interest rates is positive, and relatively high in either real or nominal terms, the carry trade is attractive.
This ongoing strength of the rand has caused SA’s export sector to be negatively impacted. Rand strength both raises the cost of goods produced in SA and reduces the profitability of commodities, typically priced in hard currency, that SA exports.
For this reason a ‘Tobin tax’ on foreign portfolio-investment inflows is being mooted for SA. It’s an attempt to limit the rand’s volatility and strength. Various means of achieving a stable and competitive currency are under discussion.
Last year Brazil’s currency (the real) appreciated rapidly because of the carry trade. It led Brazil to introduce a 2% Tobin (dissuasive) tax intended to reduce foreign-currency inflows and hence the continued appreciation of its currency.
While significant currency strength not only makes a country’s goods a lot more expensive, and so reduces that country’s share of the world export market, it also places the country at risk of a sudden reversal in investment flows. By its nature, carry-trade flows are short-term investments that are otherwise known as ‘hot money’. If interest rates were to start falling rapidly in the destination country, or its exchange rate depreciates, the carry trade would likely reverse and monies flow out rapidly. This would exacerbate currency depreciation.
In SA so far this year, foreign net purchases of bonds (R67,8bn) have been driven largely by the carry trade. This amount is more than triple that of foreigners’ net purchases of equities (R19,7bn).
The risk is that these carry-trade flows could reverse rapidly, causing the rand to weaken dramatically; a move back to R10,50/$1 would not be unlikely over a few months. This risk is another reason why the authorities are looking at some form of dissuasion that will make carry-trade flows to SA less attractive.
Dramatic rand weakness, say of the R10,50/$1 magnitude, would cause inflation to move above the 6% upper limit of the inflation target. This would eventually result in higher interest rates.
A simpler method, to counteract relentless rand strength, would be for the SA authorities in November to cut interest rates by one percentage point. This would reduce SA’s attractiveness to the carry trade. But a 50bp cut is probably the most that can be hoped, although even this minor easing is unlikely to transpire.
The most likely approach is the path of a small tightening in exchange controls by the institution of a Tobin or dissuasive tax. However, the institution of such an additional cost on foreign purchase of SA equities and bonds would have a negative impact on foreign investor sentiment; a risk government may not wish to run, on deeper analysis, as it could negatively affect foreign purchases of domestic bonds.
In an environment of high debt levels and budget deficits globally, SA’s low debt levels and sustainable fiscal deficit trajectory over the medium-term means that it can increase borrowings substantially to fund infrastructure. A Tobin tax on portfolio inflows would limit foreign investor appetite for SA debt and raise funding costs at a time when finances are tight and SA needs massive spend on infrastructure and social services.
If then the tax is limited purely to equities, the negative impact could be significant for the market valuations of SA companies – so limiting future demand for SA stocks and hurting local companies’ ability to raise capital. The hurdle rate for investing in SA would become much higher.