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"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