`` 25 March 2004 Capital flows, exchange control regulations and exchange rate policy: the South African experience

``

25 March 200425 March 2004

Capital flows, exchange control regulations and exchange

rate policy: the South African experience

1 Introduction1 Introduction

The relationship between capital flows, exchange control regulations and exchange rate arrangements has long occupied policymakers

This paper reviews the SA experience

Figure 1 The South African financial account Figure 1 The South African financial account

1 Introduction1 Introduction

The relationship between capital flows, exchange control regulations and exchange rate arrangements has long occupied policymakers

This paper reviews the SA experience Presentation proceeds chronologically:

• Evolution of controls prior to 1983• The 1985 debt crisis and the re-

imposition of controls on non-residents• The liberalisation of controls in the post-

1994 period Some issues for the future

2 Evolution of controls prior to 19832 Evolution of controls prior to 1983 The British influence The relationship between controls and

parallel foreign exchange markets

2 Evolution of controls prior to 19832 Evolution of controls prior to 1983 We never thought at the time that we

were instituting a dual exchange rate system. We thought we were simply applying exchange control, blocking funds of non-residents ... there were some suggestions that we should, in fact, institute a formal dual exchange rate system. But we decided against this, partly because the extended exchange control was considered to be a temporary crisis measure (emphasis in the original). De Kock (1979)

2 Evolution of controls prior to 19832 Evolution of controls prior to 1983 The British influence The relationship between controls and

parallel foreign exchange markets Evolution of the parallel exchange rate

system: • the Blocked Rand• the Securities Rand• the Financial Rand

The Financial Rand system 1979-83:The Financial Rand system 1979-83: Located in Johannesburg and London Operated via 2 linked channels:

• the ‘cash’ market• the stock exchanges

Some implications of the system • Implications for the BOP

Implications for the BOP:Implications for the BOP: A non-resident seller of South African assets

had to be matched by a non-resident buyer, with the exchange rate adjusting to clear the market.

Therefore, non-resident disinvestment had no impact on the country’s balance of payments.

However, there could be no net investment via the financial rand either.

To quote Stals (1980) “investments in South Africa by non-residents with financial rand do not benefit the balance of payments. The mechanism only enables non-residents as a group to shift existing investments in South Africa from one application to another”

The Financial Rand system 1979-83:The Financial Rand system 1979-83: Located in Johannesburg and London Operated via 2 linked channels:

• the ‘cash’ market• the stock exchanges

Some implications of the system • Implications for the BOP• Inherent uncertainty regarding duration

Abolished February 1983

Figure 2b The financial rand: 1979-83 and 1985-95 Figure 2b The financial rand: 1979-83 and 1985-95

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60

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Financial rand discount

2 Evolution of controls prior to 19832 Evolution of controls prior to 1983 “… with the wisdom of hindsight it is clear that

in 1982/3 the monetary authorities were too optimistic about the financial strength of the rand and certainly insufficiently sensitive to the international market perceptions of the basic weaknesses of the rand, the high liquidity of the country’s foreign debt, the downside prospects for the country’s foreign terms of trade, the doubts concerning its internal monetary stability as measured by the increase in the domestic money supply, the low level of real interest rates, and the low level of fiscal discipline.” Lombard (1994)

3 The 1985 Debt crisis and the re-imposition of controls on non-residents

3 The 1985 Debt crisis and the re-imposition of controls on non-residents

The 1985 debt crisis: the backdrop• Between the end of 1980 and the end of

1984, South Africa’s total foreign debt increased from R12,6 billion to R48,2 billion (US $16,7 billion to $25,5 billion)

• of this, short-term debt increased from 49,1 per cent to 68,0 per cent

• largest share of this was private sector debt.

Deteriorating economic fundamentals and a political catalyst

3 The 1985 Debt crisis and the re-imposition of controls on non-residents (cont.)


The deterioration of economic fundamentals• Gold price declined from over US$500

per fine ounce in February 1983 to US$299 per fine ounce in February 1985

• Exchange rate depreciated by 53 per cent against the USD between September 1983 and January 1985 (44 per cent vs NEER)

• Weak world commodity markets, 3 years of drought, excessive money creation in 1983-84



The political catalyst• Declaration of State of Emergency 20

July 1985, and subsequent capital outflows

• Rumours banks wouldn’t renew loans• Rubicon speech 15 August 1995• Large-scale outflows until 27 August

when government suspended trading on the JSE and foreign exchanges

• 1 September 1985: emergency package announced including moratorium on debt repayments and re-imposition of the financial rand

Was the financial rand system ‘effective’?

Was the financial rand system ‘effective’?

It depends Very little empirical work done Can perhaps say something about

insulation provided to interest rates and exchange rates but this has to be weighed against the costs of the system

Source: Kahn (2001: 238)

Tests for volatility shifts in nominal exchange rates:

Tests for volatility shifts in nominal exchange rates:

Compared various exchange rates for first unified (1983-85), financial rand (1985-95) and re-unified periods (March 1995 – October 1998)

Conditional variance proxies for exchange rate volatility in each of the three time periods obtained from ARCH-type models

The conditional variance proxies for exchange rate volatility were then compared for the various periods

Sample period

1st unified

Finrand

Sign of change

Mean

ratio test

Variance ratio test

Rand/US$

mean

2,287

0,723

-

3,163**

-

standard deviation

3,322

2,805

-

-

1,403**

Rand/British ?

mean

1,778

0,786

-

2,262**

-

standard deviation

2,757

1,656

-

-

2,772**

Rand/German mark

mean

1,810

0,602

-

3,007**

-

standard deviation

2,971

1,311

-

-

5,136**

Rand/Japanese ¥

mean

2,453

0,734

-

3,342**

-

standard deviation

3,069

1,342

-

-

5,230**

NEER

mean

2,352

0,605

-

3,888**

-

standard deviation

4,923

2,866

-

-

2,951**

Sample period

Finrand 2nd unified

Sign of change

Mean ratio

test

Variance ratio test

Rand/US$

mean 0,723 0,531 - 1,362** -

standard deviation 2,805 1,320 - - 4,516**

Rand/British ,

mean 0,786 0,800 + 1,018 -


Rand/German mark

mean 0,602 0,823 + 1,367** -


Rand/Japanese ¥

mean 0,734 1,092 + 1,488** -


NEER

mean 0,605 0,696 + 1,150** -


Some further evidenceSome further evidence

The Engle-Kozicki common feature test • No evidence was found of a common volatility

(ARCH) process in the dual foreign exchange rates using the ‘common features’ methodology

Tests for volatility spillovers • Hamao et al (1990) approach used• estimated volatility shock for finrand included as

explanatory variable in the conditional variance equation for comrand, and reverse

• results revealed volatility spillovers from the commercial rand exchange rate to the financial rand, but not in reverse direction

4 The post-1994 liberalisation4 The post-1994 liberalisation

The debate on exchange control liberalisation

The ‘big bang’ approach• controls provide a disincentive to foreign

investment• immediate abolition as a signalling device

The gradualist approach• sequencing of financial liberalisation (McKinnon

1973 and 1979, Edwards 1984)• risks involved in ‘big bang’ approach

Abolition of financial rand March 1995 Further relaxation of controls

4 The post-1994 liberalisation (cont.)4 The post-1994 liberalisation (cont.) Resident institutional investors

• asset swap mechanism introduced July 1995• involved proposals to swap part of existing

portfolios for the foreign assets of foreign investors (incorporating measures to “lock-in” the reciprocal foreign investment)

• some problems, but “… even so they achieved their basic objective of greater diversification without capital flight” Vittas (2003)

• 2003: as an interim step towards prudential regulation, institutional investors allowed to invest on approval up to the foreign asset limits

Resident companies and private individuals

The foreign exchange and tax amnestyThe foreign exchange and tax amnesty Dangers associated with amnesties Motivation: repatriation of capital vs

regularisation of affairs Emigrants ‘blocked’ funds to be released

Some issues for the futureSome issues for the future Volatile capital flows are a fact of life Revival of debate on controls with each

crisis Softening of attitudes towards controls?

• earlier positions may have overstated benefits and not emphasised enough the dangers of liberalisation

• current state of the debate

Some issues for the futureSome issues for the future

Implications for SA • Gradual approach seems to be consistent

with the direction debate has taken• obvious that further liberalisation should

seek to maximise benefits and minimise costs

• How is perhaps less straightforward?• Shift away from managing flows directly

and toward limiting the vulnerability of the economy via prudential regulation is important, but it would seem there are still important policy decisions to take

Figure 2a The financial rand: 1979-83 and 1985-95 Figure 2a The financial rand: 1979-83 and 1985-95

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Financial rand/US$ Commercial rand/US$

Documents

`` 25 March 2004 Capital flows, exchange control regulations and exchange rate policy: the South African experience