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South African Reserve Bank

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Working Paper – WP/15/02: Speculative Flows, Exchange Rate Volatility and Monetary Policy: the South African Experience
Publish Date:
Shakill Hassan
Working Papers

Long-term real exchange rate volatility raises the risks associated with investment in the tradable sector, and it is detrimental to long-term growth. Short-term volatility can however be hedged; reduces the currency’s attractiveness as a carry trade target; induces necessary caution against the build-up of liabilities denominated in foreign currency;  helps maintain the scope for independent monetary policy; and, through rapid up and down movements, it can help reduce prolonged misalignment and long-run volatility.

Capital flow variability affects exchange rate volatility; restrictions (e.g., as adopted in Brazil) on the level of inflows do not necessarily reduce the variability of inflows. Measures of external vulnerability have a strong association with emerging market currencies’ sensitivity to global flows. South Africa’s external financing requirement leaves its currency vulnerable, and points to unused scope for foreign exchange reserve accumulation. (Existing restrictions on outflows by residents could also vary depending on the size and direction of non-resident inflows.) Macro fundamentals matter for long-run rand behaviour. Upper variance bounds implied by fundamentals are not systematically breached at low frequencies.

Speculative carry inflows can be destabilizing, and may reduce the effectiveness and scope for independent monetary policy – depending on the responsiveness of domestic credit growth to capital inflows. In South Africa, this responsiveness has been comparatively low (under QE-driven liquidity). Yields at the short end of the South African term structure of interest rates are significantly responsive to the domestic factors which affect the (domestic) monetary policy stance. Changes in long-term yields are however highly responsive to changes in global yields, but not more so than long yields in advanced economies.

Low and stable inflation serves a counter-speculative role. It permits low nominal interest rates (and interest differentials), which reduces the rand’s appeal as a speculative target, without the repression of negative real interest rates.  Low interest differentials are associated (cross-section) with low exchange rate volatility.

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