Openness to trade the key to fight turmoil

If you look at a graph of the euro to dollar exchange rate versus the rand to dollar exchange rate for 2012, they look almost identical; of all the determinants of the value of the rand, the value of the euro is by far the strongest.

When dismal news comes in about the state of the euro zone economy – growth forecasts are cut, EU summit will have no result, Spain and Cyprus announce need for help, German Chancellor Angela Merkel refuses to relax on contagion, Greece teeters on the brink of exit – the value of the euro takes a knock. And so does that of the rand. But South Africa is not part of the EU. It’s banks are not facing bankruptcy, it’s government is not buckling under debt and when European countries are begging for help South Africa is the one donating R17 billion to finance it. So why is it that when the euro devalues the rand does not appreciate?

Exchange rates are entirely determined by the demand for the currency and there are two reasons why the rand would depreciate; lower inflows of foreign capital (the purchase of bonds and shares) or lower demand for local exports.

Movements in the health of the EU economy affect both of these.

It is not just the rand that shows strong links to the euro but all commodity currencies (currencies considered highly dependent on commodity exports such as those of Canada, Brazil, Chile and South Africa).

When the EU economy faces decline its demand for imports decreases as lower growth means lower demand for commodities and the depreciating euro makes the price of all imports more expensive.

For those economies that traditionally export to the EU this results in lower demand for their goods and depressing growth prospects; both of which put depreciating pressure on their currencies.

South Africa is an extreme example. Not only is it a commodity-based economy, with 45 percent of its exports made up of metals and minerals, but it relies on Europe for more than 25 percent of its export demand. In the last month, movements in the rand have had a 90 percent correlation to movements in the euro, they move almost identically.

Fluctuations in the rand value are also exaggerated due to a highly liquid market for the rand and high volumes of trade. This is unlike the Argentinian peso, for example, which should face similar outcomes as South Africa, but the iron grip of the Argentinian government over trade of foreign exchange makes it near impossible for flows of their currency to happen and therefore for the price to change.

Another effect which makes the rand-to-dollar value highly correlated to international bad news is the world’s remaining fixation with the dollar as a reserve currency and safe holding.

Even if the bad news is created by the US itself, such as rising unemployment rates or risk of debt default, the reaction in the market is not to shed their dollars but to buy more of them. Economic turmoil in the world superpowers is a strong indication of troubled global times to come and the first to lose in such times are the emerging markets. Instead of diversifying their portfolios in times of risk, investors and currency traders immediately shed their more dangerous currency holdings (such as the rand) and run for safe havens.

The success of the South African economy rests on its openness to trade and its embrace of the world’s goods and financial markets. Vulnerability and lack of control is the price it pays.

Pierre Heistein is the convener for UCT’s Applied Economics for Smart Decision-Making course.