By: Ewald Wessles

Would a substantial depreciation of the rand, to a level of R15 to R20 to the dollar, as has recently been proposed, help to solve South Africa’s twin problems of poverty and unemployment? Unfortunately, there are few topics about which there is as much confusion in South Africa as there is about exchange rates. A recent example of muddled thinking in this connection is an article published on Engineering News Online, which reported the views of Investec economist Annabel Bishop.

Bishop maintains that rand depreciation would only be a short-term solution for South Africa’s economic problems, which would temporarily increase exports. She maintains that South African companies would not be able to tap into economies of scale because the cost of mechanisation would be beyond the country’s reach owing to currency weakness. Moreover, she says that the trade deficit would balloon because the cost of oil imports and capital equipment would climb and the demand for South African exports would drop off as the input costs of labour, electricity and transport would rise. None of this is true.

Much of the confusion revolves around the question of exactly what is meant by the various terms that are employed in discussing the subject. To clarify the terms, consider the rand:dollar exchange rate without taking other currencies into consideration.

First, there is the figure quoted in the daily press – this is the nominal exchange rate, which, on February 22, stood at R8.87 to the dollar. Second, when comparing movements in exchange rates over time, a real exchange rate can be defined. This takes into account differences in the inflation rates recorded in the two countries. Where the relative competitiveness of producers of tradable goods and services in the two countries is concerned, this is the figure that matters.

Assume, for example, that a company in the US could manufacture a product at a cost of $100 on the date mentioned above and a similar company in South Africa could on the same date manufacture the same product of the same quality for R887. Disregarding differences in incidental costs, such as the cost of transport, the two companies would then have been able to sell their product at the same price anywhere in the world (when denominated in the local currency of the country where the product is sold).

However, if the inflation rate in the US is 1% over the following year, while inflation in South Africa is 6%, the average South African company would end the year with a 5% cost disadvantage relative to a competing US company if the nominal exchange rate remained unaltered. The ‘real’ rand:dollar exchange rate would then, according to the definition commonly employed, have strengthened by 5% if the nominal rate had remained the same as it was at the beginning of the year.

To take into account the fact that South Africa trades with many different countries around the globe, the South African Reserve Bank (SARB) has, for the last three decades or so, calculated what it calls the “real effective exchange rate of the rand”. This figure is calculated by using a ‘basket’ of the currencies of countries with which South Africa trades. The SARB’s basket currently contains 15 currencies, each of which is corrected for the relevant inflation rates, given a weighting depending on the volume of South Africa’s trade with that country and then combined in a composite index.

The credence given to this figure by South African economists has been a significant cause of deindustrialisation and the country’s consequent problems of unemployment and poverty. South Africa’s exports are affected by the countries with which we compete in the world market – these are not the same as the countries to which we export.

For the last decade, South Africa’s labour-intensive industry has been decimated by competition from China and India, so the real rand:renminbi and rand:rupee exchange rates have been the important figures. Yet, until recently, the renminbi has had a weighting of only 3.14% in the SARB’s weightings, while the rupee did not figure at all until its recent revision to 2.01%.

It is not likely to console South Africa’s clothing manufacturers and the hundreds of thousands of their employees who have lost their jobs to know that domestic costs have remained competi- tive with those of the US, the UK and Europe (where South Africa competes in the clothing markets with China and India). These ‘customer’ countries have had a combined weighting of 67% in the SARB’s real effective exchange rate figure.

As is true for any business, the pricing of its products and services is an important part of the industrial strategy of a country. The total domestic cost of production rela- tive to that in other countries is relatively easily reduced by adjusting the real exchange rate. In contrast, reducing costs by ‘increasing productivity’ to counter inflation and/or a strengthening of the rand, which is the nostrum persistently advocated by many economists, is almost impossible.

Companies that face losses or declining profits as a result of competition from countries that nurture their own industries have a difficult task obtaining the capital that is required to finance competitive productivity improvements from South Africa’s banks or investors. Nobody has ever come up with a realistic plan to create jobs for South Africa’s millions of unemployed people within a reasonable timeframe by means of produc- tivity improvements.

The objection that a currency depreciation could only bring a temporary benefit is a red herring. It implies that the authorities would bring about a nominal depreciation and then sit back and allow relative inflation to erode the benefit by strengthening the real exchange rates relative to competing countries.

The argument that an increase in the cost of oil, imported capital equipment and other imported goods and services would affect exports negatively is another red herring. This impression is created by looking at costs in terms of rands at a time when the real value of the rand is changing. Yes, the price of oil does increase in rands when the rand is devalued but, measured in rands, the cost of oil increases by the same amount for every country in the world. Measured in US dollars, the oil price is not affected at all by the rand:dollar exchange rate.

In fact, the picture becomes much clearer if the costs and revenues of South African exporters (and companies that compete with imports) are converted to a currency in terms of which the prices of globally traded goods are not affected by the rand exchange rate. If the rand is depreciated, the cost in US dollars of oil, imported machinery or any other imported good is not affected, nor are the selling prices of exporters, which are typically determined by competition in the world market. In the short term, South Africa’s export revenues are, therefore, also not affected negatively, as Bishop asserts. She seems to assume that South African exporters naively limit themselves to a cost-plus pricing strategy.

What does happen immediately when the rand weakens is that the cost in dollars of domestic nontraded goods and services, such as salaries, wages, rent and professional fees, decreases. So the dollar profits of exporters and companies that compete domestically with imports increases and they are better able to afford to pay for oil and imported capital goods to improve productivity or to decrease their dollar prices to expand their markets, increase volumes, achieve economies of scale and create more jobs. This is the exact opposite of the situation that Bishop sketches.

Of course, a sudden large change in the rela- tive prices of internationally traded goods, compared with other domestic prices, would require careful planning to be optimally effective. While exporters can increase the use of installed capacity relatively quickly, an expansion of capacity takes longer – typically, a year or two. To establish a new greenfield venture, which requires mastering a new technology and penetrating new markets, takes longer still. Conventional wisdom puts this at about seven years. It follows that the business community would have to be persuaded that a change in the country’s exchange rate policy represents a genuine and lasting change of economic strategy before companies would be persuaded to make the capital commitments that are required for South Africa to achieve its economic potential.

Policies would also have to be put in place to limit inflationary increases in domestic costs. In this respect, most commentators seek to put the entire burden on wage increases but other domestic cost factors, such as salary increases, government spending and administered prices, are also important. Limits to the banking sector’s ability to increase the money supply to finance consumption, thereby fuelling inflation, should also be considered. China has successfully achieved this at times by raising the reserve ratio that its commercial banks are required to maintain.

• Dr Wessels is past president of the Cape Chamber of Commerce and Industry, former chairperson of the Cape Engineers and Founders Association and member of the executive committee of the Steel and Engineering Industries Federation of South Africa - wessels@iafrica.com.