Factors Determining Real Exchange Rate Change in South Africa

Abstract

1) RECENT EVENTS IN SOUTH AFRICA provide an opportunity to test theories that purport to identify the determinants of real exchange rate movements -in particular, the real as opposed to the monetary determinants. This paper suggests that real fac-tors overshadow monetary influences. Two features play an important role in the foreign sector of the South Afri-can economy. (1) Oscillations in the terms of trade, arising chiefly from fluctuations in the gold price and (2) recurrent political shocks that cause outflows of foreign capital. These fea-tures are interrelated, the sequence of events usually running as follows. A decline in the gold price and hence in the country's terms of trade occurs and is initially regarded as transitory. There may be an incentive for foreign capital to flow in at this stage. If the lower gold price persists, the market gradually re-assesses the decline in the terms of trade as permanent; and capi-tal, seeking higher risk-adjusted rates of return, begins to flow out of the country. In either event expectations that were formed before the decline in the gold price are disappointed. The two gold 'busts' of 1975/76 and 1983/84 were followed by racial un-rest that in each case precipitated a political crisis and a flight of foreign capital. In this paper these events are drawn on to highlight aspects of the theory of real exchange rates. Thus the progression moves somewhat unconventionally from the specific to the general. Section 1 attempts to identify the key determinants of real exchange rate movements in South Africa. The ac-cent here is on econometric tests with-out any explicit theoretical frame-work. The determinants are primarily the flight of foreign capital and, to a lesser extent, changes in the terms of trade. Monetary shocks seem to have had little effect. Section 2 presents an informal analysis of capital flight as a determinant of the real exchange rate, the impact of changes in the terms of trade also receiving attention. The thread running through this section is that the rate of absorption determines 1988 SAJE v56(2) p125 the real exchange rate. Section 3 investigates the link between productivity and the real exchange rate and presents an adapted version of a model by Officer (1974) which yields conclusions different from those advanced by him. The implications of the amended model are examined in Section 4. Like all models, the one presented in this paper is a simplification of reality. In particular, the production function implies constant returns to scale which renders its conclusions incompatible with the more plausible informal analysis of Section 2. The model directs attention to the productivity of immobile factors as a determinant of the long-run equilibrium real ex-change rate and highlights the link between purchasing power parity (which constitutes one of the definitions of the real exchange rate) and factor price equalization, which is an important theorem in the literature of international trade theory.

Real Exchange Rates and their Measurement

“…A further definition of the real exchange rate viz. the relative price of im-portables to non-tradables (e M ) attempts to come to terms with the problem of aggregating exportables and importables into the composite `tradables' by measuring the competitive position of importables relative to non-tradables (Dornbusch, 1980 andKahn andMontiel, 1987). It is defined as, where P* m is the foreign price of importables.…”

“…It is defined as, where P* m is the foreign price of importables. The fourth definition of the real exchange rate is the relative price of exportables to non-tradables (e x ) and considers the competitive position of exportables in relation to non-tradables (Dornbusch, 1980 andKahn andMontiel, 1987). It is defined as, This definition of the real exchange rate can be interpreted as the relative price of the domestic basket of goods and services in terms of what Harberger refers to as a 'dollar's worth' of 'goods somewhere on the high seas.'…”

“…SAJE v59(1) p5 political crises(Gerson and Kahn, 1988). These shocks have impinged considerably on the various concepts of the real exchange…”