Keynote address by Daniel Mminele,
Deputy Governor of the South African Reserve Bank,
at the Bloomberg FX'18 Johannesburg: South Africa Economy in Focus event
Johannesburg
28 November 2018
economies'
Recent developments in emerging foreign exchange markets
Good afternoon, ladies and gentlemen.
This year has certainly been another challenging one for the foreign exchange (FX)
market.
The emerging market (EM) currency complex has just emerged from one of the
steepest corrections since the taper tantrum of 2013. Some of the worst-hit currencies
have recovered from their year-to-date lows, including the Argentine peso, the
Brazilian real, the Turkish lira, and the South African rand. But the broader EM basket,
as measured by the JP Morgan Emerging Market Currency Index, remains close to its
lowest levels on record.
As we enter the final weeks of this year, it seems apt to reflect, and to share some
perspectives on recent developments in EM FX markets, including developments in
the local foreign exchange market. I will also touch briefly on some of the initiatives
that have been undertaken to improve governance in the domestic FX market. But
before I share my pearls of wisdom with you, let me remind you what one Winston
Churchhill said in the House of Commons, on 29 September 1949:
"There is no sphere of human thought in which it is easier to show superficial
cleverness and the appearance of superior wisdom than in discussing
questions of currency and exchange."
Or the famous words of former Fed Chairman, Alan Greenspan, who in 2004 observed
"Nonetheless, despite extensive efforts on the part of analysts, to my
that
knowledge, no model projecting directional movements in exchange rates is
significantly superior to tossing a coin. I am aware that of the thousands who
contests".
try, some are quite successful. So are winners of coin-tossing
Recent developments in EM FX
So far this year, the JP Morgan EM Currency Index has declined by more than 10%,
and losses among the major EM currencies have ranged between a tenth of a per cent
(Hong Kong dollar) and 49% (Argentine peso). This is the first year since 2015 that
EM currencies as a group have depreciated by this much on a cumulative basis.
A number of factors contributed to the recent sell-off. The most important one was
probably the tightening in global financial conditions. Much has already been said
about global policy tightening so I will not add to the debate here. But to paraphrase
Warren Buffett, the tightening of global financial conditions was synonymous with a
tide that receded and revealed who was swimming naked. Without pointing fingers, if
you consider who has weak policy and institutional frameworks, and who has not done
their homework in the area of structural reform implementation, and enhancing
resilience, it will become clear who was found to be swimming naked.
The EM FX weakness in 2018 can also be attributed to the strengthening of the dollar
on improved macroeconomic performance in the United States (US), more signs that
the synchronised recovery in the global economy was fragmenting, geopolitical
events, including sanctions on Iran and Russia, which also contributed to higher oil
prices.
Another factor that contributed to the sell-off was the growing trade tensions between
the US and its major trading partners, and the subsequent imposition of tariffs, which
threaten global economic and financial integration. Besides the possible negative
impact on global trade and economic growth, this situation also has negative
consequences for business and financial market sentiment. This, in turn, could further
undermine investment and international trade, ultimately lowering global productivity
levels by disrupting global supply chains and slowing the development of new
technology.
world's
The fact that growth in China, the second-largest economy, is already slowing
down on the back of structural reforms makes the possible consequences of the trade
war particularly concerning for EMs. Signs of an adverse impact on the global
economy through a further weakening in demand from China for commodities such as
metals and other raw materials could weigh further on commodity prices and therefore
on export-oriented countries.
Policymakers need to tackle all these developments through a multilateral, rules-
based and coordinated approach. History has shown time and again that there are no
winners in trade wars.
The depreciation of EM currencies, which had started in April, worsened during the
third quarter of the year. And as it worsened, much of the market commentary claimed
that this was a highly correlated sell-off, despite the long-standing realisation that EMs,
as an asset class, are not homogeneous.
In times like these, it becomes harder for some investors to ignore the risk of contagion
in EMs. In fact, at the height of the sell-off, an opinion piece was published on the
Bloomberg platform titled 'We may be facing a textbook emerging market crisis'.1 The
article expressed the view that, given the fundamental problems in EMs in general,
EMs as an asset class were likely to come under pressure. Weakening currencies, it
was feared, would drive foreign investors away, hurting all assets.2 Much to our relief,
these fears did not materialise.
Despite this, our conversations with global and local investors reiterated the view that
differentiation, informed by a top-down assessment of the overall economic
environment in EMs, had increased over the years. This appears to suggest that
investors were increasingly reassessing their investments in EMs on a selective basis.
We have also found evidence to suggest that the distribution of performance this year
across the EM FX complex was one of the most differentiated sell-offs since the global
financial crisis.3 However, as idiosyncratic and geopolitical risks became more
prevalent, market players also started to consider the 'tail risk' of a more generalised
risk asset sell-off.
Notably, EMs with higher external debt and current account deficits, coupled with high
sensitivity to monetary policy normalisation in the US, witnessed severe market losses.
By contrast, EMs in Asia showed more resilience to the recent market turmoil, which
is being attributed to their relatively sound economic fundamentals as well as solid
external balances.
In this volatile environment, policy actions by monetary authorities varied, depending
on their mandates, their level of independence, and how their economies were
affected by the recent economic and financial developments. The central bank of
Argentina increased the benchmark policy rate to 60% and sold significant amounts
of FX reserves to stabilise the peso. In addition, the Argentinian government unveiled
austerity measures and secured a bailout facility with the International Monetary Fund.
The central bank of Turkey, in turn, increased its policy rate to 24% and implemented
other measures to stabilise the exchange rate of the lira.
Recent developments in the rand exchange rate
Similar to other EM currencies, the rand depreciated against the US dollar for most of
the year. According to Bloomberg, the local currency depreciated by 28% from late
February to early September, 'peaking' at R15.70 to the dollar on 4 September.
Despite the fact that there were no events unique to South Africa that could have
triggered weakness of such magnitude, the local unit ranked among the worst-
performing EM currencies during that period. Many reasons have been put forward for
why this was the case, such as the fact that the rand is a high-beta currency and is
used as a proxy hedge for other EM currencies. But attention also needs to be drawn
to the starting point of the depreciation, as the rand had appreciated significantly
towards the end of last year, and in early 2018, on the back of improved perceptions
around domestic political risks. This resulted in portfolio inflows which contributed to
the relative strength of the rand.
According to data from the Johannesburg Stock Exchange, non-residents purchased
R48.4 billion worth of bonds and equities during the first quarter of this year. However,
in the second quarter, non-residents sold R85 billion worth of bonds and equites as
expectations for global financial conditions tightening increased and risky assets came
under pressure. The vast majority of this selling was in government bonds. The selling
of South African financial assets continued in the third quarter, with R62.5 billion worth
of bonds and equities being sold. But more recently we have seen some slowdown of
outflows and some resumption of inflows. This contributed to the rand recovering some
of its losses, to the current level of R13.9 against the US currency, although this still
represents an 11.6% depreciation since the beginning of the year.
The rand also weakened on a trade-weighted basis, and its real effective exchange
rate declined below its long-term average. According to the SARB's equilibrium
exchange rate model, the real effective exchange rate of the rand moved from being
overvalued at the beginning of the year to currently finding itself at an undervalued
level. The forecast presented to the MPC at its meeting last week showed the implied
starting point for the rand against the US Dollar at R14.50. According to the Quarterly
Projection Model, this undervaluation is expected to persist through 2019, as the local
currency is expected to only gradually revert to its equilibrium level.
2018 has also seen a significant pick up in volatility with the 3-month option implied
volatility for the rand rising from 11.8 per cent in April to peak at a level of 23.6 per
cent on 5 September before receding to the current level of around 16.7 per cent. This
has gone along with reduced turnover in the South African FX markets, which saw the
total average daily turnover in the rand market reducing from an average of US$12.5
billion in 2017 to an average of US$9.9 billion in the first 10 months of 2018, caused
mainly by lesser activity by non-residents and thus partly reflecting risk-aversion
towards emerging markets.
What the future holds remains uncertain. The continued tightening in global financial
conditions, a change in investor sentiment towards EMs, escalating trade conflicts and
geo-political developments, together with some idiosyncratic risks, remain the key
risks to the local currency. As such, it is likely that the rand, along with other EM
currencies, will remain volatile.
As a consequence of the recent volatility, exchange rate forecasts remain widely
dispersed. Between this quarter and the third quarter of 2019, the exchange rate of
-
the rand is expected to average R14.50 to the US dollar this is according to
Bloomberg median forecasts.4 However, the difference between the most optimistic
and the most pessimistic survey participants on the exchange rate forecast for the first
-
quarter of 2019 is almost R3.00 I have little doubt that one of the participants
somewhere within that range will be correct! Such a wide dispersion around the
median forecast over such a short forecast horizon is representative of the uncertainty
that has become an inherent part of our lives. And this uncertainty adds significant
complexity to the conduct of monetary policy, the most recent outcome of our
monetary policy meeting and the finely balanced decision being a good case in point.
As regards the exchange rate and monetary policy, allow me to reiterate that forward-
looking and medium-term oriented monetary policy within a flexible inflation targeting
framework, requires us to look through volatility and to focus on macroeconomic
fundamentals, as we stated in our most recent Monetary Policy Review. In this vein,
we will continue to allow the exchange rate to absorb the initial shocks, and focus our
policy actions on addressing second-round price effects, much as at times it can
become difficult to distinguish first and second round effects in the wake of extended
or multiple supply side shocks. However, it is important that policy decisions should
not be informed by short-run market developments in either direction.
Before I conclude, let me briefly touch on some initiatives to strengthen governance
issues in the domestic FX market.
The South African Foreign Exchange Committee
During the past year, we have made further progress in promoting high ethical and
professional standards in support of fairness, integrity and thus the reputation of our
foreign exchange market.
Following the establishment of the Global Foreign Exchange Committee (GFXC) in
2017, of which South Africa is a member, the SARB facilitated the establishment of a
stand-alone local foreign exchange committee, the South African Foreign Exchange
Committee (SAFXC). This forum consists of a wide range of key professionals
involved in the domestic wholesale FX market (including Authorised dealers, the
interdealer broker community, the Association of Savings and Investment South
Africa, the Banking Association, and others). Its purpose is aligned to that of the GFXC,
which is to promote a robust, fair, liquid, open and appropriately transparent FX
market, in which a set of diverse participants is able to transact confidently and
effectively at competitive prices that reflect available information, and in a manner that
conforms to acceptable standards of behaviour.5 The key activity in giving effect to this
is providing guidance to the local FX market by endorsing and upholding the FX Global
Code (Global Code), and encouraging adherence to it.
The SAFXC has launched various outreach programmes aimed at creating public
awareness and promoting the Code to the broader FX market community. Members
of the SAFXC have been reaching out to their respective constituencies in the FX
market (and hopefully to all of you here present), encouraging them to endorse the
Global Code and commit to it by publishing a Statement of Commitment. To date, all
the SAFXC members have endorsed the Global Code and have published their
respective Statements of Commitment. By way of leading by example, since 01
September 2018 in its foreign exchange operations, the SARB only deals with
counterparties, both local and offshore, that have endorsed the Global Code through
the issuance of Statements of Commitment.
The outreach programmes by the SAFXC should be viewed as a collaborative initiative
by the public and the private sectors aimed at strengthening the integrity and
effectiveness of the domestic wholesale FX market, and should be supported by all of
us. If your institution is an active participant in the FX market but has not endorsed the
Global Code yet, I would like to encourage you to review your FX market operation
practices and align them with the principles of the Global Code so that you too are
able to publish a Statement of Commitment.
In conclusion, the road ahead for EMs remains fraught with risks despite the recent
stabilisation in market sentiment. The prospects of further US monetary policy
normalisation, financial market volatility and less certain global trade environment
coupled with weak economic fundamentals suggest that the EM currencies will remain
volatile. This will require vigilance and prudent decisions by policy makers.
Thank you.