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News Article : The SARB and the carry trade
Category: Economy & Global : Local Economy
Author:Jac Laubscher
Email:[email protected]
Posted:11 Aug 2015

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Trying to support the exchange rate of the rand by hiking interest rates is an exercise in futility

The recent Monetary Policy Statement of the South African Reserve Bank (SARB) after it had hiked the repo rate by 25 basis points to 6% made it quite clear that the Monetary Policy Committee (MPC) regards possible exchange rate depreciation as the most important threat to future inflation.

That immediately leads to the question of the MPC’s understanding of the monetary policy transmission mechanism, in particular how the repo rate increase can help to stabilise the exchange rate of the rand.

The external value of the rand is buffeted by many factors, internal as well as external.

Some of these factors are susceptible to changes in interest rates, but not all of them.

This was clearly demonstrated by the fall in the exchange rate of the rand (along with those of a number of other emerging-market countries) in response to declining global commodity prices the day after the SARB had announced its decision to raise the repo rate.

The fundamental force behind the exchange rate is the deficit on the current account of the balance of payments and its financing by capital inflows, or more precisely the changes in the deficit and financing conditions.

In theory both sides of the equation is dependent on the level of and changes in interest rates.

Higher interest rates could, for example, dampen demand in the economy, including demand for imported goods (and reduce the inflation pass-through from rand weakness).

Dampening domestic demand could also encourage local businesses to look more ardently for export opportunities.

Both forces could result in a decline in the deficit on the current account, except that the SARB already recognises that domestic demand is weak, and that the demand for and prices of the bulk of South Africa’s exports are determined by global conditions that take no notice of local interest rates.

On the financing side, viz. the capital account of the balance of payments, different types of capital inflows will respond differently (positively as well as negatively) to changes in interest rates.

Foreign direct investment depends on a host of fundamental factors to which an increase of 25 basis points in the repo rate will make no direct difference, although it may well be encouraged by the authorities’ apparent commitment to maintain macroeconomic stability.

Portfolio investment may show a mixed reaction, with investors in domestic bonds being pleased with the SARB’s obvious determination to pursue its inflation target (although they could of course have invested in inflation-linked bonds), while equity investors may be disheartened by the negative effect of higher interest rates on domestic demand and therefore company profits, as well as equity valuations.

But then South African companies already derive a large (and growing) part of their profits from offshore, and valuations tend to depend on global trends.

Which leaves one with the conclusion that the SARB could be aiming at short-term capital flows, in particular the carry trade, to hold up the value of the rand.

As the carry trade encompasses the borrowing of funds in low-interest-rate countries for investment in high-interest-rate countries, it follows that the interest rate differential is an important influence on the rand exchange rate.

A narrowing of this differential, as can be expected once the US Federal Reserve starts on its own tightening cycle, possibly in September, may therefore cause a negative tilt in carry-trade flows, to the detriment of the rand.

The SARB may therefore well have decided to pre-empt the Fed’s likely decision in order to keep the interest rate differential steady.

(Although one may with some justification ask whether it would be advisable for the SARB to humour the carry trade, given that it is generally regarded as hot-money flows that should be discouraged rather than encouraged.)

But all this just sounds too easy.

According to the uncovered interest rate parity theory this strategy should not work, with exchange rate changes eliminating any gains arising from interest rate differentials.

However, in the real world carry trades do form a profitable strategy, especially after active trading in emerging-market currencies became viable in the late 90’s (see the graph below), with high-interest-rate currencies tending to appreciate while low-interest-rate currencies tend to depreciate.

The question then becomes whether high-interest-rate currencies inherently has higher risk (measured by exchange rate volatility) and whether carry-trade profits merely compensate investors for this increased risk.

Empirical tests show that “there is a significantly negative co-movement of high-interest-rate currencies (carry-trade-investment currencies) with global foreign-exchange volatility innovations, whereas low-interest-rate currencies (carry-trade-funding currencies) provide a hedge against unexpected volatility changes”. (Menkhoff, Sarno, Schmeling and Schrimpf, 2011)

This is just a formal way of saying that the biggest risk to carry trades originates from global risk appetite - a shock to risk appetite will normally be followed by increased exchange rate volatility, causing carry trades to crash.

So what should we conclude from this? That the fortunes of the rand depend on developments in global markets over which the SARB has no control?

In other words, that trying to support the exchange rate of the rand by hiking interest rates is an exercise in futility?

That the best the SARB can do is to try and limit the exchange rate pass through?

Jac Laubscher, Economic Advisor: Sanlam Limited

References
Menkhoff, L.; Sarno, L.; Schmeling, M. and Schrimpf, A.: The Risk in Carry Trades. VoxEU, 23 March 2011.
Menkhoff, L.; Sarno, L.; Schmeling, M. and Schrimpf, A: Carry Trades and Global Foreign Exchange Volatility. Journal of Finance, April 2012.
Dobrynskaya, V.: Downside Market Risk of Carry Trades. Review of Finance, August 2014.

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