Mark Shuttleworth has struck the Reserve Bank a heavy R350m or so blow. Most significantly and laudably he is to put R100m of his damages into a fund to help South Africans pursue their constitutional rights. In this way he may well help to protect SA property against seizure by the government without proper compensation. Whether exchange control itself would survive a constitutional court action remains as moot as ever.
The Shuttleworth Appeal succeeded on the basis that the 10% levy collected by the Reserve Bank did not pass the constitutional test of “A Money Bill – as defined by sections 75 and 77 of the Constitution of South Africa” and not because the court decided that exchange control was either illegal or unhelpful. Nor, it appears, was the court asked to so decide.
The argument made by Shuttleworth that the purpose of exchange control is to benefit SA banks, provides a very narrow and inadequate case against exchange control. It is true that exchange control is administered diligently by the SA banks and could not work without them. However it is not at all so obvious that the banks (that is their shareholders) in practice charge more than it costs them to provide the service demanded of them by the law. The considerable cost in management time and computer systems devoted to the task is mostly bundled into the fees all the customers of the banks are charged.
While trading in foreign exchange may be a profit centre for SA banks, managing exchange control is something the banks would surely happily give up if they were allowed to do so. It should be noted that these days exchange control and controls against money laundering (also a cost to be borne by the fees charged clients of banks) are inevitably combined.
More convincingly, Shuttleworth’s team said that:
“The case has a strong personal element for him, because it is exchange controls that make it impossible for him to pursue the work he is most interested in from within South Africa and that forced him to emigrate years ago.”
According to Shuttleworth:
“I pursue this case in the hope that the next generation of South Africans who want to build small but global operations will be able to do so without leaving the country. In our modern, connected world, and our modern connected country, that is the right outcome for all South Africans.”
The intended purpose of exchange control is to restrict the flow of SA wealth abroad so that it increases the availability of capital to SA borrowers , thus reducing the cost of capital in SA to the intended advantage of South African borrowers or raisers of equity capital. Lower returns to wealth or savings however will be to the disadvantage of lenders or suppliers of equity capital (mostly supplied by pension and retirement funds) that are therefore denied the opportunity to seek or realize the highest expected risk adjusted returns.
These apparent benefits (in the form of lower than otherwise interest rates) are most obvious when the exchange controls, especially when first imposed, appear to protect the exchange rate against devaluation. Indeed, the SA exchange controls imposed in the early 1960s were seen as an alternative to a threatened devaluation which would have brought more inflation and higher interest rates in its wake. Higher interest rates may also be used as a defence (usually ineffectually) against devaluation.
The practical question (as opposed to the principle issue about the freedom to allocate your wealth as you may wish) is whether exchange controls actually serve to reduce the costs of funding over the longer term. Answering this question with confidence becomes especially difficult when the evidence is complicated by flexible exchange rates and differences in rates of inflation across countries that make it difficult to measure and compare real interest rates- with or without exchange control.
There can be little doubt that imposing exchange controls on foreign residents in SA, or even any threat of such, would greatly discourage foreign investors. It would add to their risks of doing business in SA for which they would demand higher returns as compensation. SA cannot fund even the modest share of gross capital formation in GDP (about 19% of GDP) from domestic savings that run at about 14% of GDP. Thus SA is highly dependent on inflows of foreign capital to sustain even lacklustre growth. Any exchange control imposed on foreign investors would very clearly mean more expensive capital for SA business and government. It might frighten such capital away almost completely.
The current inflows of foreign capital mostly take the form of foreign purchases of SA government bonds, including purchases of newly issued securities that fund the fiscal deficit, and of purchases of shares in JSE listed companies. These are sold by SA fund managers who manage the great bulk of SA wealth via contributions to pension and retirement plans. For almost every foreign buyer of a share in a JSE listed company there is a local seller. These local sellers are doing so to buy foreign assets that help diversify the risks and to improve the risk adjusted returns on the portfolios they manage. These exchanges of local for foreign shares and bonds have been made possible by the partial relief of exchange controls and can be expected to enhance the risk adjusted returns provided for SA savers and their retirement planning.
The complete relief of exchange control could be expected to add further to these benefits for savers. Surely serving the interests of savers is an important practical consideration for a society where individuals do not in general provide adequately for their old age and who are very likely to become a burden on the hard pressed tax payer?
Would however such greater freedom that came with the abolition of exchange controls, actually add to the costs of capital for SA capital raisers and borrowers? The abandonment of exchange control would not only lead to a lower cost of banking in SA and ease the costs of running a global business from SA, as Shuttleworth has suggested, but it may well lead to a reduction in the risk premium demanded on any investment in SA. If so, it would reduce the cost of capital.
The freer a capital market, the more liquid and less volatile it becomes and the more capital it would tend to attract. A free capital market, unencumbered by exchange controls and its expensive administration would also discourage the so-called transfer pricing that the tax authorities in SA are much agitated about. These actions are designed to reduce taxes but also serve as exchange control avoidance. The more severe the exchange controls the more exchange control evasion of this kind and the corruption associated with it.
SA has ample experience of the unintended influence of exchange controls as well as the wealth creating opportunities, with few social benefits, it can provide financially nimble and lawless types gaming the system. As we also know only too well, exchange controls encourage the export of dividend or allowance receiving children sent abroad. It also encourages the emigration of skilled high income and high tax paying individuals who would be frustrated by their inability to diversify their wealth from the risks associated with working and living in SA.
The absence of exchange controls would mean an increased supply of professional and other skills and so less expensive skills. It might also result in increased flows of funds to SA based rather than foreign based wealth managers fully able to invest abroad.
Exchange control is an affront to economic freedom. It has unintended consequences that are impossible to measure with any accuracy. The intended consequence of a lower cost of capital may well prove illusory. Reforming exchange control in SA has been a step in the right direction – though it remains an expensive administrative burden that the clients of banks have to cover in the fees they pay. Wisdom would lead us to fully abolish exchange control.