Download 24 Facing the Open Economy Trilemma in Post

"Facing the Open Economy Tri-lemma in post-Apartheid South Africa"
After the ending of Apartheid in 1994 and the introduction of a democratic
dispensation, the South African economy experienced a new openness to
international trade and financial flows.
The Apartheid-era economy was closed – in the sense that trade in goods
and services was constrained by sanctions and embargoes aimed at isolating
and weakening the Apartheid regime and the inflow of foreign capital was
severely restricted. The dawn of democracy in 1994, ushered in an open
economy era for South Africa in which both trade and financial flows became
relatively free.
Chart 1 shows how both South Africa’s imports and exports increased (as a %
of GDP) after 1994 until the global recession of 2008 dented the country’s
imports, due to slowing domestic growth, and exports, due to the poor
performance of South Africa’s major trading partners.
Chart 1: South Africa Exports and Imports
as (% of GDP)
35
Axis Title
30
25
South Africa Exports as
% of GDP
20
15
South Africa Imports as
% of GDP
10
5
2010
2005
2000
1995
1990
1985
1980
1975
1970
1965
1960
1955
1950
0
Chart 2 shows how the post-1994 period heralded a rapid increase in financial
inflows into South Africa. This is represented by a surplus on the financial
account for most years since 1994, as compared to the deficit on the financial
account during the mid-1980’s and the early 1990’s, a period of growing
financial isolation of Apartheid South Africa.
The increased financial inflows of post-1994 era have coincided with a period
of persistent current account deficits for South Africa. This gives an indication
that post-Apartheid, democratic South Africa has to a significant extent relied
on the inflow of savings from abroad, rather than on export revenues, to
provide the foreign currency necessary to fund the country’s economic growth
and development.
Chart 2: South African Current Account
and Financial Account (as % of GDP)
10
8
6
4
2
-
-
-
-
-
2008
2004
2000
1996
1992
1988
1984
1980
1976
1972
1968
-6
Current Account
-8
Financial Account
-10
-
1964
-4
1960
-2
1956
0
The potential benefit for South Africa of such an open economy relationship is
that:
access to foreign finance will assist in funding investment in necessary
infrastructure, as foreign finance means that the size of the savings pool
available to fund such investment is increased, resulting in a lower cost of
capital, and
increased investment in growth-enhancing infrastructure such as powerstations, and road, rail and harbour networks will increase the future growth
and export potential of the economy in the medium-run, easing the current
account deficit in future
The potential risk for South Africa of such an open economy relationship is
that:
if financial inflows result in a consumption boom, particularly increased
importation of consumer goods, and are not accompanied by an effective
growth-enhancing infrastructural expansion then the possibility of an intertemporal reduction in the current account deficit is reduced,
if the country experiences negative wealth effects, associated with increased
foreign ownership of capital, this will in the medium-run lead to reduced
domestic consumption and will constrain output, and
as ‘hot money’ financial inflows are notoriously reversible and sentimentdriven, this means that the country’s growth trajectory is subject to reversals
based on foreign perceptions of the risks associated with domestic policy
interventions and on the risks associated with being categorised along with
other emerging markets and related contagion effects
Like all economies, South Africa faces the Open Economy Tri-lemma in that it
can only simultaneously choose two out of three of the following policy
options:
to have an open capital market, in which foreign finance can flow freely into
and out of the economy;
to have monetary policy autonomy, where interest rates are set by the Central
Bank based on the conditions and goals of the domestic economy rather than
-
based on the interest rate decisions of another country’s monetary authorities,
and
to peg or manage the country’s exchange rate, that is to set the exchange
rate at a competitive level to promote a country’s exports and avoid exchange
rate volatility.
In the post-1994, democratic era, South Africa has generally opted to solve
the Open Economy Tri-lemma by choosing an open capital market, to attract
foreign capital (although restrictions have been maintained on domestic
capital), and monetary policy autonomy, setting its interest rates based on its
domestic conditions, guided specifically by an inflation targeting framework.
As such, South Africa has eschewed the possibility of fixing its exchange rate
and has allowed its currency to float freely. The free-floating South African
Rand has experienced periods of extreme exchange-rate volatility, including
both sharp currency depreciations as well as prolonged periods of relative
currency strength, which have complicated a number of the county’s
industrialisation and export-promotion policies.
Nonetheless, there was an episode, during the Asian crisis in 1998, when
South African policy makers trade to beat the Open Economy Tri-lemma and
aimed to achieve all three objectives, that is, an open capital market,
monetary policy autonomy and intervention in the currency markets aimed at
avoiding a sharp deprecation of the South African Rand. The problems that
arose as a result of this unsustainable policy stance provided strong evidence
of the validity of the Open Economy Tri-lemma.
Faced with a rapidly depreciating South African Rand, associated with the
negative contagion effects rolling-over emerging markets due to the 1998
Asian crisis, the South African authorities attempted not only to keep the
capital account open and conduct autonomous monetary policy, but also to
intervene in the currency markets to avoid a currency depreciation. The
authorities did this apparently due to their concern over the perceived
negative political implications for South Africa’s relatively new democratic
government of a sharply weakening Rand and due to the inflationary effects
that the currency deprecation would have.
In attempting to beat the Open Economy Tri-lemma the South African
authorities borrowed and spent about US$25-billion buying Rands in an
attempt to avoid the depreciation of the Rand. To the same end, the
authorities also raised interest rates by 7%. Given the magnitude of capital
outflows associated with the contagion, the efforts of the authorities were
ineffective. The Rand eventually depreciated to a new level, about 20%
weaker than before the crisis, but the cost to the country’s holdings of foreign
currency reserves was substantial. It took over five years, until early 2004, for
the country’s reserve position to recover from the positions taken during the
1998 currency intervention.
As stated in March 2004, by Tito Mboweni, then Governor of the South
African Reserve Bank: “Since October 1998, the Bank has not used the
forward book to finance intervention to support the exchange rate of the rand.
This policy change was partly necessitated by the costs of pursuing such a
policy and partly by the ineffectiveness of such intervention strategies on their
own. Moreover, the Government introduced a formal inflation targeting
monetary policy framework in February 2000.”
After the 1998 episode the South African authorities ceased trying to beat the
Open Economy Tri-lemma. Instead, an inflation targeting framework was
adopted under which two of the Tri-lemma’s objectives could be pursued, that
is, the allowance of free capital flows and the maintenance of monetary policy
autonomy, but attempts to influence the value of the currency were disavowed
and the currency was allowed to float freely.
More recently, since the mid-2000’s this position has been tempered
somewhat in that pressure has arisen on the authorities to respond to the
appreciation of the Rand, which has had negative implications for South
African growth, exports and employment.
The authorities have responded by putting downward pressure on the Rand
by gradually building up South Africa’s holdings of foreign exchange reserves.
However, due to the costs associated with the 1998 attempt to beat the Open
Economy Tri-lemma, it is unlikely that the South African authorities would
again intervene in the currency markets to try and avoid a currency
depreciation in the manner that they did during the Asian crisis.
From a series of lectures titled ‘Macroeconomics – Theory and Policy’
delivered by Kenneth Creamer at the University of Witwatersrand,
Johannesburg.
Lecture
notes
are
available
at:
http://www.kennethcreamer.co.za/page.php?p_id=15