From Business Day
October 9 2007
By Hilary Joffe
DOES SA have enough foreign exchange reserves? It is an odd question to ask just as new Reserve Bank figures show that gross gold and foreign exchange reserves have for the first time exceeded $30bn.
Four years ago, before the Bank began accumulating reserves by buying dollars in the market at appropriate moments, gross reserves were stuck below $10bn. On a net basis, the swing is much sharper: five years ago the Bank's international liquidity position, now a positive $28,4bn, was still slightly negative -- and in the late 1990s, after the Bank gambled large quantities of hard currency trying to defend the rand from speculative attack, it was $23bn in the red.
The turnaround in reserves is a result of good judgment and good luck. The bank has been able to pursue its policy of accumulating hard currency reserves because there has been plenty of hard currency coming in by way of foreign investment, mainly in SA's equity and bond markets. And SA has felt the benefits, even though these aren't always as straightforward as the textbook suggests. The international rating agencies have upgraded SA's sovereign rating partly in response to the improvement in the reserve position and that helps to lower the cost of borrowing on international markets.
Accumulating reserves should also help to reduce exchange rate volatility, and though the rand may have been all over the place lately, it's a lot less volatile than during the 2001 currency crisis. In theory, too, buying dollars could also help weaken the rand, though in practice it can go either way -- stronger reserves can improve, and probably have improved, SA's standing in the eyes of investors, so strengthening the rand. But it might have been even stronger lately without the bank's intervention.
The Bank always emphasises it only "creams off" dollars when there is an excess in the market, and doesn't try to influence the exchange rate. In practice, it's known to do a bit more than that, though critics have argued for an even more aggressive approach to reserve accumulation as one way to weaken the rand and support SA's export industries.
Exchange rate reasons apart, does SA still need a lot more reserves? Economists can't specify an optimal level, and absolute numbers aren't much use. At $30bn, SA looks respectable by the standards of advanced industrial countries but pathetic compared with many emerging markets. But on the external vulnerability indicator of rating agency Moody's, which measures the extent to which a country's short-term debt and long-term debt falling due are covered by official reserves, SA improved spectacularly, from 224% in 1999 to 62% at the end of last year, and at this level it's no longer out of line with its peer group.
The International Monetary Fund (IMF) uses a measure that also takes into account the current account deficit, as well as short-term foreign debt, and on that basis, SA's reserves still look fairly weak, at 74%, compared with an emerging market average of 112%. The IMF's recent staff report on SA recommended "that some further accumulation would be beneficial".
Assuming foreign capital inflows continue to make that possible, there's still the question of how to pay for it. When the central bank creates rands to buy dollars, it has to take the rands out of the market -- "sterilise" them -- so they don't fuel inflation. And converting high-yielding rands into lower-yielding dollars has a cost in terms of lost revenue. The treasury bears that cost, since it is too large for the Bank and it is, ultimately, taxpayers who benefit.
There are a couple of tools, such as the issuing of debentures, that can be used to sterilise the cash and allocate the costs, but as the quantum of reserves grows larger, it becomes more complex (and expensive). Overruns in tax revenue and the fiscal surplus have come to the rescue in the past year or two.
The main tool now being used is that the government puts its excess cash on deposit at the Bank, where it earns hard currency-related, not rand-related, interest rates. That takes the cash out of circulation and ensures the cost is for the account of the treasury, not the Bank. At end-March the Bank was holding R45,7bn in government "sterilisation deposits", a figure that's likely to have risen since. Indeed, if it is important for SA to keep accumulating reserves, that may well imply that the government will have to continue running a fiscal surplus to support the strategy.