The Rand, inflation targeting and the ‘PIGIS’

Chris Gilmour, an analyst at Absa Asset Management Private Clients writes that the rand appears to have been remarkably strong in the past year or so, prompting some observers to call for intervention to weaken the currency.

The argument for such intervention mainly revolves around a perceived need for South African exports to remain competitive from a global economic perspective. But an equally compelling argument can also be raised for continued strength; in the middle of a boom in infrastructural spending, a strong rand helps to keep the current account deficit within reasonable limits.

There is no single definitive solution to these arguments but it is instructive to examine whether or not the rand is, indeed, over or undervalued. Once that has been determined, the ensuing arguments previously outlined can be given more authority.

The first question that must be rigorously debated is whether in fact the rand really has been strong. Relative to the US dollar, it has undoubtedly been strong in the past year or so and the rand has been even stronger against the weak pound.

But between 2000 and the end of 2009, the rand was especially weak against the euro, only showing some strength in very recent times. It is important to realise that the best measure of a currency’s relative strength or weakness is its trade-weighted value. This measure, in South Africa’s case, takes into account the fact that this country trades with a wide variety of other countries and also incorporates growing trading partners like China, for example.

On a trade-weighted basis, relative to South Africa’s Purchasing Power Parity line, the rand at current levels appears to be fairly valued. In other words, it appears to be neither over nor undervalued. Thus, at around R7,50 to the US dollar, R12 to the pound and R10,50 to the euro, the rand appears relatively fairly valued.

So what of the calls for a weaker rand? What would this do for the SA economy? A markedly weaker rand would theoretically help a number of South African exporters, though the current depressed global economy is not an especially welcoming marketplace for our exports. It is debatable, therefore, what the extent of any impetus to export volumes would be from a weak rand.

The longer term implications are more serious. A persistently weak rand would be inflationary, especially considering our dependence on so many imported finished goods. It would also make our industries less efficient in the longer term, as they would become used to relying on currency weakness rather than enhanced productivity to retain competitive advantage in an increasingly competitive global economy.

Many of the proponents of a weaker rand also call for a relaxation in inflation targeting. The great irony is that they often don’t realise that such a relaxation would probably lead to a fall in the value of the rand, via higher inflation.

But there is a fatal flaw in the argument for a loosening of monetary policy by way of higher and/or wider inflation targets. The current inflation target of 3% to 6% is not especially onerous in world terms. In fact, only Brazil and Turkey have more accommodating bands. Chile, the Czech Republic, Korea, Mexico and Hungary all operate in a band between 2% and 4%, while Poland’s target is between 1,5% and 3,5%. Most of these countries are classified as emerging economies and yet they have stricter inflation targeting than South Africa.

Thankfully, Finance Minister Pravin Gordhan resisted calls to loosen monetary policy by widening the inflation targeting bands in his February 2010 Budget. He also resisted calls to peg the rand or to introduce measures to artificially weaken the currency. Such a steadfast response can only be applauded.

The PIGIS

Many readers of this newsletter will be familiar with the acronym “BRIC”, which is used to refer to the group of leading developing nations – Brazil, Russia, India and China. A less familiar, though increasing used acronym is PIGIS, which refers to a group of economically distressed members of the Eurozone, namely Portugal, Ireland, Greece, Italy and Spain.

The PIGIS countries all have rising unemployment and debt to GDP as well as significantly large budget deficits. A prerequisite for membership of the Eurozone is the maintenance of a budget deficit of 3% or below. Greece is currently running a budget deficit of around 13%, Spain just over 10% and Italy has nudged past 5%.

Concerns are growing among international investors that these deficits will become unsustainable and that something will have to give. That “something”, according to these investors and speculators, includes sovereign debt defaults by some or all of the PIGIS countries as well as a possible exiting of the Eurozone by some of them.

These concerns have conspired to catalyse a risk aversion process among investors and speculators worldwide. Most of the concern currently revolves around Greece, even though it is one of the smaller economies in southern Europe. To put this in perspective, with a GDP of around $300bn, Greece’s economy is only about one quarter of the size of Spain’s and about one-sixth of the size of Italy’s.

But if Greece were to default on its sovereign debt repayments, it would have a direct effect on other European banking institutions, which is why Greece has been the centre of attention. Spain has its own highly developed and extremely well-run banking system which has managed to escape most of the impact of the global financial crisis and thus there are few concerns about Spain’s financial stability. Italy also managed to escape the worst ravages of the financial crisis.

It is important, therefore, to try to understand how Greece will extricate itself from what has become an exceptionally messy situation. The Greek government is only too aware of the consequences of what it must do to bring down its gaping budget deficit. Greece needs to borrow another $53bn this year in order to cover its deficit and refinance debts that are likely to reach almost $300bn. It will require perseverance by the Greek government in the face of what is rapidly evolving into a campaign of orchestrated civil disobedience by government employees, many of whom will bear the brunt of savage budget cuts. These employees have already flexed their not inconsiderable muscle in recent weeks by closing down airports and hospitals for example and demonstrating that they are not willing to accept significant wage cuts.

In early February, it was announced that German and French banks were exploring the possibility of throwing a lifeline to Greece in the form of a bailout package. This would be an elegant short-term solution to the problem, as the European Central Bank is not permitted to bail out errant constituent EU countries. But as elegant as it is, it would only be a temporary solution. It would stave off the spectre of a systemic “run” on PIGIS and other countries’ banking institutions. In other words, it would significantly reduce the prospect of systemic banking risk. But the task of reducing the large budget deficit would remain.

This of course raises another, more difficult issue; the sociopolitical consequences of imposing severe austerity measures on Greece and the other PIGIS countries.

Although not perfect, the EU has evolved into a relatively harmonious grouping that, in economic terms, is larger than the US. It is imperative that the EU not only remains intact as far as membership is  concerned but that it also has the possibility of growing by letting new members in. But if an existing member were to default or were allowed to exit, this would do untold damage to the Union.

Severe budget cuts and tax increases provide a fertile breeding ground for political dissent and even social unrest. And when one reflects on how large these budget cuts are going to have to be, the potential political danger becomes quite apparent.

One should not forget that, with the exception of Ireland and Italy, the PIGIS countries have all endured harsh political regimes in recent times. Greece was ruled by a military junta from 1967 to 1974, Spain was a fascist dictatorship under General Francisco Franco until 1975 and Portugal, while ostensibly a democracy under Messrs Salazar and Caetano in the 1960s and 1970s, was a fairly authoritarian place in those days. And while Italy has not had a dictatorship since the days of Benito Mussolini, it has had scores of different governments in the past sixty-five years since the end of World War Two.

 It is fair to say that Italy’s governmental landscape is volatile. So it doesn’t take a terribly stretched imagination to perceive at least a remote possibility of a profound changing of the political guard in one or more of these countries if the socio-political fabric were to deteriorate markedly.

On balance, it seems likely that a Greek bailout will soothe financial nerves in the short term, bringing an element of stability back to currency and equity markets. But it may not be too long before the dirty work - the long, grinding, painful process of reducing bloated budget deficits - has to be done.

This has the potential to refocus attention onto the PIGIS and rekindle old fears.