A world of exchange rate volatility – tough on trade and central banks

November 13th, 2017 by Brian Kantor

SA is very open to international trade. The aggregate value of imports and exports in any year is equal to 50% of GDP. Yet all this great volume of trade across borders is subject to highly volatile exchange rates. This volatility adds considerable risks to exporters, importers and those who compete with imports and exports in the local market.

What matters for the operating margins of businesses is exchange rates adjusted for differences in inflation between trading partners. These are known as real exchange rates. An undervalued exchange rate will add to profit margins, while an overvalued one – should the exchange rate change by less than the differences in inflation – will depress margins.

When the offset is complete, or when what is gained or lost on the exchange rate is equal to the difference in inflation rates, purchasing power parity (PPP) exchange rates are said to hold. In such a case, the prices of common goods or services delivered in any market place will be about the same when expressed in any common currency. Real exchange rates above 100 indicate overvalued exchange rates while real exchange rates below 100 indicate the opposite: an undervalued or generally competitive exchange rate.

It is however changes in nominal exchange rates that are the predominant force behind changes in the real exchange rate. In SA and elsewhere, frequent shocks to the exchange rates lead the process and inflation rates follow.

However the SA experience with real exchange rate volatility is by no means unique. The trade-weighted real US dollar exchange rate has been even more variable than the real rand exchange rate. And those of Europe and the UK are similarly variable.

In figure 1 below we show the performance of the US dollar rate of exchange against its developed market peers (DXY). We also show the real dollar exchange rate against its major trading partners. The pattern has been a highly unstable and destabilising one for the global economy, which relies on the US dollar as a reserve currency and unit of account.



We compare below in figure 2 a variety of trade weighted real exchange rates for the period 1995- 2017. As may be seen, all these real exchange rates are highly variable. Not co-incidentally, the real trade-weighted rand moved in very much the opposite direction to the real US dollar. The real euro and real sterling have also been highly variable since 1995. A consistently overvalued, less competitive real sterling between 1996 and 2007 can be identified. More recently, with Brexit in sight, sterling has become much more competitive.


Moreover none of the real exchange rates considered above can pass a statistical test for mean reversion. The Chinese and Japanese real exchange rates trends shown below conspicuously do not revert to the theoretical PPP 100. The real yuan has had a distinct and persistently stronger trend (off what was a very undervalued base in the mid-90s) while the real yen moves persistently weaker off what was presumably a very overvalued base in 1995.


How should monetary policy react to exchange rate shocks?

This global nominal and real exchange rate volatility – as well as the lack of mean reversion to trade neutral purchasing power parity exchange rates – has greatly inconvenienced global trade. It has also greatly complicated the reactions of central banks.

We would argue the best approach central banks should adopt to exchange rate shocks is to ignore them. This is because such shocks are unpredictable and largely beyond their control. They have little to do with competitiveness in international trade and almost all to do with capital flows responding to changes in expected returns across different economies. If such exchange rate shocks are temporary – even perhaps rapidly reversible – the impact they have on inflation will be as temporary. They therefore will not be expected to permanently add to inflation and therefore will not add to expected (forecast) inflation.

It should be recognised that dollar strength and other currency weakness in response to persistent capital flows can persist for an extended period of time. Persistent US dollar strength – against its developed economy peer currencies and against most emerging market currencies – explains much of the nominal and real rand weakness and also emerging market currency weakness observed between 2014 and mid-2016. Ditto the higher inflation rates that followed.

But to react to exchange rate shocks as if they threatened permanently higher inflation is to make monetary policy hostage to the unpredictable US dollar exchange rate. Monetary policy in the emerging market world would do better to moderate rather than exaggerate the shocks to spending intentions and confidence that may emanate from the market in foreign exchange.

Unfortunately the SA Reserve Bank, from early 2014, added higher interest rates to the contractionary forces emanating from a weaker exchange rate. We regard this as an error of monetary policy that unhelpfully further reduced growth rates without any obvious reduction in inflation rates or inflation expected.

The implications of exchange rate volatility for investment portfolios

Monetary policy in the US understandably does not react to the exchange value of the dollar. Thus when investing abroad (investments that always carry extra risks given exchange rate volatility) a bias in favour of US-based investing seems appropriate. Or, in other words, the risks posed by a volatile real and nominal US dollar to monetary policy and real economic activity everywhere else are best hedged by investing in the US rather than in more macro policy error prone economies. 9 November 2017