Exports need to be raised to protect the rand

In 2010 Brazil’s finance minister accused the developed countries of waging "war" against developing countries. Expansionary monetary policies to help the developed nations recover from the financial crisis were, he alleged, causing large flows of capital from rich countries into developing nations.

These inflows drove down interest rates in developing countries, reducing borrowing costs for their investors and governments — but also caused their exchange rates to strengthen, undermining their competitiveness, causing exports to fall and imports to rise. The rich countries were, he argued, trying to grow their economies at the expense of poorer nations.

Today things look different. The exchange rates of developing nations are weakening. Many commentators are asking whether emerging economies might be on the brink of a severe crisis, where large capital outflows could trigger dramatic currency collapse.

Such concerns are prompted by expectations of tighter monetary policy in the US. Higher interest rates in developed economies reduce the attractiveness of developing markets for global investors. It is feared that if just a portion of the trillions of dollars invested in emerging market bonds and equities were to shift hurriedly, the impact on the developing world would be dramatic and widespread.

The most recent emerging market crisis was in Asia in 1997. It started in Thailand, but swiftly spread across Asia. When Russia defaulted on its debt in 1998 the crisis spread worldwide to all emerging markets, including South Africa, where the rand exchange rate fell 25%.

There are many examples of similar crises in the past. Most occurred when interest rates were rising in developed economies, which is why the prospect today of higher interest rates in the US is a matter of concern. Emerging market crises generally start in just one country, but spread like wildfire through its neighbours and even to developing economies. Emerging markets are vulnerable to this because international investors often view them through a single lens. Even though there may be country-specific circumstances when the crisis starts, investors quickly see all exposure to emerging markets as being equally risky. They withdraw even from stable economies whose circumstances differ from the country where the crisis began.

Such "contagion" is amplified because of the way much of the inflows into emerging market bond and equity markets is structured. It tends to take place through dedicated investment funds based in New York and London. These funds invest shareholders’ capital across emerging economies based on an index that weighs countries by the size of their markets.

If these investors experience large losses because of events in one country they may take fright and withdraw from the fund. To finance these withdrawals, funds must sell their holdings in all emerging markets, thus driving down asset prices and exchange rates everywhere. A problem in one developing country quickly becomes a problem for the whole sector.

What is the likelihood of this happening again in the near future? While there are grounds for concern, there are also strong factors mitigating against a general emerging market collapse. Firstly, it is not at all clear that the US economic recovery will be strong or sustained. Tightening of US monetary policy is likely to be cautious and gradual to prevent it from stalling. This will create the space for global capital flows to adjust.

Second, previous crises were worsened by overvalued and usually fixed exchange rates which became too costly to protect. This is not true today. The central banks in countries such as Brazil and South Africa have not backed overvalued exchange rates. In fact, they tried to prevent their exchange rates strengthening under the influence of the earlier large capital inflows. And currencies in many emerging economies have already weakened substantially, suggesting that part of the required adjustment has already occurred.

Nonetheless, it would be foolish to work on the assumption that "this time things will be different". Developing countries most at risk are those, such as South Africa, with large current account deficits. A net loss of foreign capital is not necessary for these currencies to come under pressure. It only requires a drop in future inflows such that we can no longer fund the foreign currency purchases needed to balance our national accounts.

The best way to insulate ourselves from this is to increase exports so as to reduce our dependence on foreign capital inflows. This is not happening because of production disruptions in major export sectors. There have been many calls in recent times for co-ordinated action among producers, unions and the government to get our mining production back on track.

This is now even more urgent because changing global realities threaten the foreign capital inflows on which we have become so dependent. There is little to protect the rand should global capital flows turn sharply against us.

By Gavin Keeton

Keeton is with the economics department at Rhodes University.

Article Source: Business Day