25 March 2004

1. Capital flows, exchange control regulations and exchange rate policy: the South African experience 25 March 2004

2. 1 Introduction • The relationship between capital flows, exchange control regulations and exchange rate arrangements has long occupied policymakers • This paper reviews the SA experience

3. Figure 1 The South African financial account

4. 1 Introduction • The relationship between capital flows, exchange control regulations and exchange rate arrangements has long occupied policymakers • This paper reviews the SA experience • Presentation proceeds chronologically: • Evolution of controls prior to 1983 • The 1985 debt crisis and the re-imposition of controls on non-residents • The liberalisation of controls in the post-1994 period • Some issues for the future

5. 2 Evolution of controls prior to 1983 • The British influence • The relationship between controls and parallel foreign exchange markets

6. 2 Evolution of controls prior to 1983 • We never thought at the time that we were instituting a dual exchange rate system. We thought we were simply applying exchange control, blocking funds of non-residents ... there were some suggestions that we should, in fact, institute a formal dual exchange rate system. But we decided against this, partly because the extended exchange control was considered to be a temporary crisis measure (emphasis in the original).De Kock (1979)

7. 2 Evolution of controls prior to 1983 • The British influence • The relationship between controls and parallel foreign exchange markets • Evolution of the parallel exchange rate system: • the Blocked Rand • the Securities Rand • the Financial Rand

8. The Financial Rand system 1979-83: • Located in Johannesburg and London • Operated via 2 linked channels: • the ‘cash’ market • the stock exchanges • Some implications of the system • Implications for the BOP

9. Implications for the BOP: • A non-resident seller of South African assets had to be matched by a non-resident buyer, with the exchange rate adjusting to clear the market. • Therefore, non-resident disinvestment had no impact on the country’s balance of payments. • However, there could be no net investment via the financial rand either. • To quote Stals (1980) “investments in South Africa by non-residents with financial rand do not benefit the balance of payments. The mechanism only enables non-residents as a group to shift existing investments in South Africa from one application to another”

10. The Financial Rand system 1979-83: • Located in Johannesburg and London • Operated via 2 linked channels: • the ‘cash’ market • the stock exchanges • Some implications of the system • Implications for the BOP • Inherent uncertainty regarding duration • Abolished February 1983

11. Figure 2b The financial rand: 1979-83 and 1985-95

12. 2 Evolution of controls prior to 1983 • “… with the wisdom of hindsight it is clear that in 1982/3 the monetary authorities were too optimistic about the financial strength of the rand and certainly insufficiently sensitive to the international market perceptions of the basic weaknesses of the rand, the high liquidity of the country’s foreign debt, the downside prospects for the country’s foreign terms of trade, the doubts concerning its internal monetary stability as measured by the increase in the domestic money supply, the low level of real interest rates, and the low level of fiscal discipline.” Lombard (1994)

13. 3 The 1985 Debt crisis and the re-imposition of controls on non-residents • The 1985 debt crisis: the backdrop • Between the end of 1980 and the end of 1984, South Africa’s total foreign debt increased from R12,6 billion to R48,2 billion (US $16,7 billion to $25,5 billion) • of this, short-term debt increased from 49,1 per cent to 68,0 per cent • largest share of this was private sector debt. • Deteriorating economic fundamentals and a political catalyst

14. 3 The 1985 Debt crisis and the re-imposition of controls on non-residents (cont.) • The deterioration of economic fundamentals • Gold price declined from over US$500 per fine ounce in February 1983 to US$299 per fine ounce in February 1985 • Exchange rate depreciated by 53 per cent against the USD between September 1983 and January 1985 (44 per cent vs NEER) • Weak world commodity markets, 3 years of drought, excessive money creation in 1983-84

15. 3 The 1985 Debt crisis and the re-imposition of controls on non-residents (cont.) • The political catalyst • Declaration of State of Emergency 20 July 1985, and subsequent capital outflows • Rumours banks wouldn’t renew loans • Rubicon speech 15 August 1995 • Large-scale outflows until 27 August when government suspended trading on the JSE and foreign exchanges • 1 September 1985: emergency package announced including moratorium on debt repayments and re-imposition of the financial rand

16. Was the financial rand system ‘effective’? • It depends • Very little empirical work done • Can perhaps say something about insulation provided to interest rates and exchange rates but this has to be weighed against the costs of the system

17. Source: Kahn (2001: 238)

18. Tests for volatility shifts in nominal exchange rates: • Compared various exchange rates for first unified (1983-85), financial rand (1985-95) and re-unified periods (March 1995 – October 1998) • Conditional variance proxies for exchange rate volatility in each of the three time periods obtained from ARCH-type models • The conditional variance proxies for exchange rate volatility were then compared for the various periods

21. Some further evidence • The Engle-Kozicki common feature test • No evidence was found of a common volatility (ARCH) process in the dual foreign exchange rates using the ‘common features’ methodology • Tests for volatility spillovers • Hamao et al (1990) approach used • estimated volatility shock for finrand included as explanatory variable in the conditional variance equation for comrand, and reverse • results revealed volatility spillovers from the commercial rand exchange rate to the financial rand, but not in reverse direction

22. 4 The post-1994 liberalisation • The debate on exchange control liberalisation • The ‘big bang’ approach • controls provide a disincentive to foreign investment • immediate abolition as a signalling device • The gradualist approach • sequencing of financial liberalisation (McKinnon 1973 and 1979, Edwards 1984) • risks involved in ‘big bang’ approach • Abolition of financial rand March 1995 • Further relaxation of controls

23. 4 The post-1994 liberalisation (cont.) • Resident institutional investors • asset swap mechanism introduced July 1995 • involved proposals to swap part of existing portfolios for the foreign assets of foreign investors (incorporating measures to “lock-in” the reciprocal foreign investment) • some problems, but “… even so they achieved their basic objective of greater diversification without capital flight” Vittas (2003) • 2003: as an interim step towards prudential regulation, institutional investors allowed to invest on approval up to the foreign asset limits • Resident companies and private individuals

24. The foreign exchange and tax amnesty • Dangers associated with amnesties • Motivation: repatriation of capital vs regularisation of affairs • Emigrants ‘blocked’ funds to be released

25. Some issues for the future • Volatile capital flows are a fact of life • Revival of debate on controls with each crisis • Softening of attitudes towards controls? • earlier positions may have overstated benefits and not emphasised enough the dangers of liberalisation • current state of the debate

26. Some issues for the future • Implications for SA • Gradual approach seems to be consistent with the direction debate has taken • obvious that further liberalisation should seek to maximise benefits and minimise costs • How is perhaps less straightforward? • Shift away from managing flows directly and toward limiting the vulnerability of the economy via prudential regulation is important, but it would seem there are still important policy decisions to take

27. Figure 2a The financial rand: 1979-83 and 1985-95