The enduring myth of the collapsing rand

[alfiano]

@weeze Apologies, I'm not sure I understand your question, could you please rephrase, and/or clarify what currency you're earning in and what currency your debt is denominated in?

 

[weeze]

@alfiano If I follow, cross border investment allows purchasing parity to be maintained between two countries even though rates of return and inflation differ. How does the purchasing power of local currency compare when the inflation rates internally differ? If there is a balancing mechanism what would it be?

 

[alfiano]

@weeze How is purchasing power parity maintained?

Through substitution and law of demand. If goods in ZA become relatively cheaper (and relatively expensive in US), US will rather import what they were buying locally or from other countries from ZA. ZA will rather buy locally or from other countries what they were importing from US.
This increases demand for ZAR and decreases it for USD. This has the effect of moving the exchange rate until the goods are the same price.

In practice there are transaction costs and tariffs, so this doesn’t hold 100%, but roughly speaking it should.

 

[deus_ex_machina]

@weeze A depreciating currency is a cause for concern for any nation. It threatens the stability of the economy, affects the standard of living, and can lead to an array of unfavourable consequences. As economies around the world grapple with various challenges, the depreciating value of their currencies warrants worry.

One of the primary concerns related to a depreciating currency is its adverse effect on international trade. When a country's currency loses value, it makes its exports cheaper for other nations, potentially boosting exports in the short term. However, in the long run, it can harm export-oriented industries by reducing their competitiveness. As the currency depreciates further, the cost of importing goods rises, leading to inflation and increased prices for consumers. This can lead to a decline in domestic consumption and adversely affect the overall economic growth.

Inflation is another worrisome consequence of a depreciating currency. As the value of the domestic currency falls, the cost of imported goods and raw materials increases. This inflationary pressure affects the costs of production and ultimately gets passed onto consumers. A depreciating currency fuels inflationary pressures, which can erode purchasing power, reduce real wages, and squeeze household budgets. This degrades the standard of living for ordinary citizens who find it increasingly challenging to afford basic necessities. Inflation also devalues savings, impacting the financial stability of individuals and families.

Foreign investments also bear the brunt of a depreciating currency. A falling currency discourages foreign investors from injecting capital into the country. In an effort to mitigate the risk, investors demand higher returns or interest rates on their investments. This can lead to high borrowing costs for domestic businesses, reducing their profitability and hindering investment in key sectors. Furthermore, a depreciating currency reduces the overall attractiveness of a country's assets, deterring foreign direct investment (FDI) and hindering economic growth.

Additionally, a depreciating currency can create a vicious cycle. As the currency loses value, people tend to convert their savings into more stable currencies, further fueling the depreciation. This capital flight hampers domestic investment and deprives the economy of much-needed liquidity. It also weakens the country's ability to manage its fiscal and monetary policies effectively. Central banks may face difficulties in controlling interest rates and stabilizing the economy due to the volatility caused by a depreciating currency.

TL;DR: The danger of a depreciating currency is multi-faceted as it affects trade, inflation, and foreign investments. The short-term benefits of cheaper exports are overshadowed by the long-term challenges created by an uncompetitive export industry. Inflation wreaks havoc on the purchasing power of individuals, exacerbating the inequalities in society. Foreign investments become scarce, and borrowing costs increase, stifling economic growth. A depreciating currency creates a detrimental cycle that erodes the stability and potential for development in any nation. Therefore, policymakers must be wary and adopt measures to mitigate such risks, ensuring a stable and prosperous economy for their citizens.

 

[alfiano]

@deus_ex_machina With respect, did you ask ChatGPT to write this for you?

You’ve missed the whole point of the post. A depreciating currency is not the same as a weakening currency. Not all depreciation is weakening. Not all weakening of particular currency pairs is related to our economy (eg. dollar strengthening).

Yes, currency weakening is not good. That is plainly obvious. The whole point is that our currency has weakened much less than commonly thought.

 

[seekeroftruth365]

@alfiano Hi, I disagree with a lot of points in your post. Let's tackle them all piece by piece shall we?

Interest rate parity is an economic theory that suggests that the difference in interest rates between two countries should equal the relative change in their exchange rate. According to interest rate parity, if the interest rates in one country are higher than in another, the currency of the country with higher interest rates should depreciate relative to the currency of the country with lower interest rates.

However, it's important to note that real-world currency movements are influenced by a multitude of factors, including economic indicators, geopolitical events, market speculation, and central bank policies. Interest rate parity is just one of the many factors that can affect exchange rates, and it might not always hold true in the short term due to the complexity of global financial markets.

source:

https://www.academia.edu/download/33565472/IJAIEM-2014-03-05-013.pdf

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=878972

In the example you gave about interest rate parity you didn't take the inflation rate into account. You shouldn't be looking at the rate of return, but the real rate of return after taking inflation into account, so you could've been earning 10% when holding the rand, but it could be possible that high inflation would outstrip that, relative to the inflation rate in the US which could have been higher and would not outstrip the returns achieved when holding the USD in these "risk free investments".

In the example you gave about interest rate parity, you didn't consider the inflation rate. You shouldn't be looking at the rate of return, but the real rate of return after taking inflation into account, so you could've been earning 10% when holding the rand, but it could be possible that high inflation would outstrip that, relative to the inflation rate in the US which could have been higher and would not outstrip the returns achieved when holding the USD in these "risk free investments".

In addition, you should look at things such as the increase in energy prices, prices of goods, rent prices, and so on. The increases in these prices would have been different between the US and South Africa and historically it has been different. Meaning that relative to Americans we would afford fewer goods than the previous years.

Your Purchasing Power Parity point doesn't warrant that much of a deep dive, you assumed that salaries keep up with local inflation year on year, which is not the case. South African real salaries have actually been declining for 5 years. Again your point in this regard was an oversimplification of what occurs in reality, first, you assumed that wages do not lag behind inflation, then you gave the example of the iPhone, without considering possible changes in tariffs and so on.

Source: https://www.news24.com/fin24/econom...5-years-trend-set-to-continue-report-20230517

There is your last point "But this doesn't affect us so much as we only import 6.7% of our imports from the US. So those imports will cost twice as much, but the rest of our imports cost the same"

What do you mean, this "doesn't affect us so much"? We are completely dependent on the import of Petroleum and let me remind you crude oil is denominated in the USD, meaning that depreciation to this extent is very very very bad, I don't need to explain why oil is much more expensive to this extreme extent is bad for the country. Also, although we only have 6.7% of our imports from the US we export to the US at a volume that is much less meaning that we have a balance of payment deficit with them, which is never good.

Also, 6.7% of our EXPORTS are made to the US 9.6% of our IMPORTS are from the US as of August 2023. I linked the source below, it seems you read it incorrectly and thus quoted the incorrect percentage.

Source: https://oec.world/en/profile/country/zaf#:~:text=Imports%20The%20top%20imports%20of,(%245.2B)%2C%20and%20Saudi

https://www.sars.gov.za/customs-and-excise/trade-statistics/

 

[alfiano]

@seekeroftruth365 That I’m giving simplified examples is self-evident and not disputed. It doesn’t invalidate the concepts and big picture analysis. You even mention a critique that says IRP doesn’t hold in the short term. Is 20Y the short term?

You are correct that I should have been using real interest rates, thanks for that point, I have revised and updated. I probably picked the imports figure from an outdated source, thanks.

As for looking into different types of inflation eg. energy, rent, etc, this would not be helpful. This is big picture analysis, we're not performing a cost-of-living comparison exercise. CPI is the best (or at least close to the best) indicator available.

As for oil being dollar-denominated, that is minimally relevant unless it’s being imported from US. The dollar strengthening doesn’t necessarily cause oil to become more expensive in ZAR. Historically a strong dollar has meant cheaper oil (in USD).

As for wages lagging inflation, yes that (sadly) has been the case at least recently, but again it's just an example, we don't have 100% inflation either. Adding in tariffs is not needed to make the point.

 

[seekeroftruth365]

@alfiano Thanks for helping me study for my exam on Friday. This was a fun exercise.

 

[silbo]

@alfiano Doesn't this also mean that any savings loses massive value? Even if my salary goes up my savings doesnt

 

[alfiano]

@silbo No, your short term savings should be in interest-bearing accounts, which right now are yielding about 4% more than inflation. The expected currency slide is in line with our excess inflation.

Your long term savings should be in globally diversified equities (and/or some bonds) which in the long run should return at least 4% more than the interest-bearing accounts.

Both gaining in value. Unless you’re keeping your money in a current account, when of course you are losing money to inflation at 4% per annum. The expected exchange rate movement just (mostly) accounts for the US’s lower inflation.

• Example: So this year R19 buys one apple in the US ($1, exchange rate of R19) or here. Next year R19.76 buys one apple here (4% inflation) or in the US ($1.02, 2% inflation, exchange rate of R19.37).
  If you put R19 in the bank today, you should have R20.52 at 8% interest next year. Your savings have increased in value as they’re worth > 1 apple.
  In the long term, if you invested in equities, you might expect your savings after one year to be R21.28 (but equities are volatile over one year).

 

[silbo]

@alfiano Thanks. Yeah I have 600k sitting in a savings account generating 7.75% per annum which is more than inflation but my long term plan is to get to like 3 or 4M and live off that interest (my retirement) but yeah I get the option In mutual funds > savings interest in the long run. At about 2m I will buy a house cash and the save up again and start investing most likely

 

[tod64]

@alfiano Value. It is perceived. A valid point is that we are not generating enough economic activity to pay reasonable salaries because the high unemployment and competition for jobs. Employers do not need to pay more because we desperately need work. R10 000 is the salary for a manager in a rural area I stay. It has been for 3 years. And the employer still thinks its too much. As the government gazette on minimum wage show in area B min wage for a manager is 7196.90. And with new entrants to the labor force being educated, people work for that money, because bob and john are competeing for a slot on the job ladder and theres not enough jobs to go around. So yes, maybe the rand retains value, but theres no growth to sustain the economic power of the rand and to strenghten it and in the long run, you are still earing 7196.90 but you bread was 8 rand last year but now its 20 and you are feeling poorer every year.

 

[deus_ex_machina]

@alfiano There you go South Africa, hang in, it's not the end of the world. /s

 

[markdg]

@alfiano Thanks

 

[eoim]

@alfiano Thanks for the great post! I have a couple questions:

1. Something isn’t clicking for me re interest rate parity: if the SA central bank hiked rates my intuition says the ZAR should strengthen because investors now get a better risk-free return… but compared to the US, a now higher rate differential surely means that over time the ZAR should depreciate more every year??
2. Why are some currencies so tightly linked? For example the ZAR, AUD, and NOK? I can’t see why they all move in the same direction relative to the USD. Can this just be explained by your point on USD strength/weakness?

 

[alfiano]

@eoim Sure! Number 1 is something I personally mulled over too.

I think (open to correction, I haven’t delved into the mechanics of it), it’s because at the end of the day, the US investor who puts their USD into South Africa, wants it back eventually as ZAR are not useful to them. So at 10%pa interest, they buy R1000, but they sell R1100. The net effect is selling R100ZAR which weakens the exchange rate, this continues until parity is reached for the interest differential. In reality, the arbitrage opportunity disappears in seconds not a year because the US investor can enter into forward exchange contracts to sell ZAR. As the price of forward exchange contract changes (future rand exchange rate weakening), the arbitrage opportunity disappears.

On 2, I didn’t know that specifically, but yes I can explain.
If the USD strengthens, all else equal that means all other currencies should weaken against it.

Similar story for the rand, if we weaken, all else equal every currency should strengthen against us.

Currencies where the rate stays much the same over time presumably have very similar real interest rates.

Let’s follow that original example and say the three currencies we’re looking at are AUD, GBP and TWD (Taiwan). Assuming 0% inflation in all countries.

The dollar doubles in value, which is why $100 buys double the amount of Taiwanese, British and Australian goods (and Norway & SA for that matter).
There is no inflation, the microchips/cheese/lithium still cost the same in local currencies. Therefore in each of these countries, the exchange rate doubles. Eg USD/TWD goes from 30 to 60. USD/GBP goes from 0.8 to 1.6 and USD/AUD goes from 1.5 to 3.

Before the strengthening, GBP/TWD was 40. In other words, 40 TWD buys you 1.25 USD buys you 1 GBP. Now after strengthening, 40 TWD buys you 0.66 USD which still buys you 1 GBP.
Ie. despite the strengthened dollar, GBP/TWD is still 40.

The same is true for NOK/ZAR/AUD. The dollar strengthening or weakening only impacts their USD currency pair. Not the relative exchange rates between them eg AUD/ZAR.

Bit complicated, does this make any sense?

 

[eoim]

@alfiano Great, thanks for the response

 

[kevin_67]

@eoim Regarding your point 1

It depends a little on which central bank goes first. In this most recent cycle, the FED started the interest rate hiking cycle, which pulled investment into the dollar, the SARB was a follower trying to keep up, also the general consensus was that the FED would keep hiking. Inherently the ECB also lagged and we saw the Euro lose value too.

Coming up it is likely that the Fed will drop rates and that the trend will be dropping for a while so I expect the rand to strengthen slightly all things being equal. It also kind of explains the SARB keeping rates high despite inflation trending lower, well it is at least one factor in their consideration.

 

[alfiano]

@hktm16 We import about a quarter of our food, so it would have some impact, but you’re right it is more to do with other factors - though I don’t think the amount taxation of fuel has changed.
Here’s an article on food inflation drivers.

It does note a weakening rand, which is probably true year on year, I didn’t do my analysis over one year since it’s fairly meaningless, but I suspect the rand did actually weaken YoY not just depreciate.

 

[kam4031]

@alfiano Nice theorycrafting. My take away is that depreciation is the default state of the rand against the dollar and has been for decades. To what extent, I guess, is debatable.

This state of depreciation may be somewhat mitigated if you park your cash in high interest rate accounts i.e slow death.

Did I misunderstand anything?