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The Volatility of Capital Flows in South Africa: Some Empirical Observations By Michael Nowak African Department International Monetary Fund Prepared for BER Conference, Johannesburg, June 1, 2001
The Volatility of Capital Flows in South Africa: Some Empirical Observations By Michael Nowak African Department International Monetary Fund Prepared for BER Conference, Johannesburg, June 1, 2001 The views expressed in this paper are those of the author and do not necessarily represent those of the International Monetary Fund. Research assistance was provided by Ms. Pamela Mjandana and Mr. Nehrunaman Pillay. - 2 - The Volatility of Capital Flows in South Africa: Some Empirical Observations I. SUMMARY AND CONCLUSIONS In the past several years, South Africa has taken a number of steps, such as budget-deficit reduction and adoption of a more flexible exchange rate regime, that have helped reduce its vulnerability to adverse external shocks. In addition, the SARB has made considerable strides in reducing the net open forward position (NOFP), which has represented a major source of external vulnerability, has been lowered significantly. The NOFP, however, remains relatively large. As such, it continues to represent a source of concern to investors that is reflected in South Africa’s sovereign risk spreads. The SARB has, therefore, expressed its commitment to achieving further reductions. This note examines alternative options available to the SARB for reducing the NOFP. On the basis of some preliminary statistical findings, it argues that: ?? Regular pre-announced foreign exchange purchases may help bring about up-front cuts in borrowing spreads, but could place undue pressure on the rand, the external current account, and the real economy. ?? Care should be taken in targeting capital inflows, such as FDI, that may be perceived as stable; while such flows may indeed be less volatile than other capital flows, they still tend to show little persistence over time. However, in the case of certain large one-off inflows of FDI, such as privatization proceeds, there may be a strong basis to suppose that the inflows will not be reversed. It makes sense, therefore, to purchase some or most of these inflows. ?? The evidence tentatively suggests that incoming FDI may be partially offset by long-term capital outflows, possibly reflecting cover operations by investors. However, when the picture is extended to include all other capital flows, there is no significant offset. ?? Additional external borrowing may be appropriate in modest amounts. II. EXTERNAL VULNERABILITY AND BORROWING SPREADS Over the course of the past several years, macroeconomic policies in South Africa have helped reduce the vulnerability of the economy to adverse external shocks and contagion from other emerging markets. The public finances have been brought firmly under control, an inflation-targeting regime is now in place, and the exchange rate has been allowed to float with a significant gain in external competitiveness. The banking system is strong and healthy. In addition, South Africa’s medium- and long-term external debt remains low in comparison with other emerging market economies (Table 1). And the SARB’s net open forward position - 3 - (NOFP), which is a measure of its short-term foreign currency exposure, has been reduced by nearly two-thirds since the currency crisis of 1998. Nevertheless, the NOFP and other indicators of international reserve adequacy remain a source of concern for investors that is reflected in South Africa’s sovereign risk spreads (Figure 1). The relationship between the NOFP and borrowing spreads has been quantified by Jonsson (2001),1 who found that a reduction of US$1 billion in the NOFP was typically associated with a decline in spreads of nearly 15 basis points.2 This means that the cut in the NOFP from its recent peak of US$23 billion (18 percent of GDP) in September 1998 to US$9 billion (7 percent of GDP) at end-April 2001 would have helped lower spreads by over 200 basis points. Moreover, if the NOFP were to be reduced to zero, spreads could fall a further 135 basis points. Narrower spreads should translate into lower long-term interest rates. III. REDUCING THE NOFP: THE OPTIONS The benefits of lowering the SARB’s short-term foreign currency exposure are not seriously contested. What is perhaps more debatable is the best means by which the SARB should acquire the foreign exchange needed to reduce the NOFP. At least three options are available: ?? To make regular purchases of dollars in the foreign exchange market according to a predetermined schedule. ?? To acquire dollars in the foreign exchange market from capital inflows that are considered relatively stable and persistent (so-called “cool” money). ?? To use the proceeds from additional medium-or long-term external borrowing. Option 1: Regular purchases The SARB could buy dollars in the spot market on a regular periodic basis in predetermined amounts until the NOFP had been reduced to an acceptable level. This would have the benefit of establishing a clear timetable for NOFP cuts and help allay concerns that the process of NOFP reduction might be open-ended. Moreover, if the profile of purchases were 1 Jonsson (2001), “The Risk Premium in South African Long-Term Interest Rates,” IMF, mimeo.” 2 This study identified other important determinants of South Africa’s risk spreads. These included external borrowing (spreads are raised), reductions in the budget deficit (spreads are lowered), contagion from other emerging markets, as captured by the Emerging Bond Market Index (spreads are raised, but impact is small). - 4 - to be announced ahead of time, and if the exercise carried with it sufficient credibility, the favorable impact on spreads and interest rates would likely take place up-front. Despite its appeal, there are downside risks with such an approach. By stepping into the market to purchase foreign exchange, irrespective of prevailing market conditions, the SARB would be adding to pressure on the rand at times of weak investor sentiment. On such occasions, the SARB may need to attract capital into the country by offering improved rates of return. This could be done either by forcing a step exchange rate depreciation (and thereby generating the expectation of a strengthening of the rand) or by raising interest rates. Under either of these options, it would probably be both difficult and undesirable for the SARB to maintain the higher rates of return for any sustained period of time. To do so could introduce excessive exchange rate and/or interest rate volatility and, in the process, undermine the SARB’s inflation-targeting strategy or hurt growth performance. Eventually, the return on capital would need to decline, and the capital inflows would be reversed. The external current account would, therefore, need to provide the necessary foreign exchange flows through a large real currency depreciation, and this could place considerable strain on the real economy. In short, to expect the current account to improve by the equivalent of up to 7 percent of GDP, even over a few years, is neither realistic nor advisable. Moreover, macroeconomic policy would be “held hostage” to the objective of reducing the NOFP. Not surprisingly, the SARB has chosen not to pursue this option. Option 2: Identifying “cool” capital inflows Rather than stepping into the market on a regular basis, one option might be for the SARB to wait until South Africa enjoyed capital inflows and to make an assessment as to whether these inflows were likely to stay. This approach would enable the NOFP to be lowered without subjecting the rand to undue downward pressure or having to raise interest rates keeping macroeconomic policy predictable. The question that arises is what information would be useful to the SARB to help it make a decision about when, how much, and what type of capital inflow to buy. Specifically, how can the central bank make use of prior knowledge relating to the volatility and persistence of capital flows? And how would the interaction between different types of capital flows affect the decision to buy foreign exchange? In principle, foreign direct investment (FDI) is commonly perceived as less volatile and less likely to be reversed than so-called “hot money,” such as short-term capital. It has been argued that, by their nature, FDI flows are driven by long-term sentiment and are more likely to be “stable” than short-term flows. Moreover, to the extent that FDI entails physical investment in plant and equipment, it is “illiquid” and, therefore, relatively difficult to reverse. - 5 - However, the international evidence on whether FDI flows tend to be “cool” is mixed. On the one hand, in a study of industrial and developing economies (which did not include South Africa), Claessens, et al. (1995) concluded, that for most of the countries reviewed, FDI was as volatile as other types of flows and that it was generally neither persistent nor predictable.3 On the other, an IMF study argued that, during the recent Asia and Mexico currency crises, FDI was relatively more stable, and less likely to be reversed, than other types of flows.4 Let us focus on these points. Volatility The table below presents standard deviations (as a measure of volatility) for different components of South Africa’s capital account for the period since 1994 when capital controls on nonresidents were liberalized.5 The standard deviations are lowest for FDI and long-term capital (which consists primarily of bank loans), suggesting that these flows are indeed less volatile than other capital transactions. Surprisingly, perhaps, equity flows are markedly more volatile than FDI even though the distinction between the two is somewhat arbitrary. 6 South Africa: Means and Standard Deviations for Capital Flows, 1994 Q1–2000 Q3 Mean Standard Deviation FDI Equity Debt Long-term Short-term -70.49 467.51 443.83 -111.40 107.27 499.23 789.42 1,037.78 356.06 897.90 Persistence When considering buying inflows of capital, the central bank may wish to know the likelihood of that type of inflow being repeated over a given period of time. To test for persistence, we examined the autocorrelation properties of the major components of South Africa’s capital account (Figure 3). The tests indicate that none of the components, including 3 Claessens, Dooley, and Warner (1995), “Portfolio Capital Flows: Hot or Cold?” World Bank Economic Review, Vol. 9 (January). 4 IMF, 1998, “International Capital Markets: Developments, Prospects, and Key Policy Issues,” Washington, D.C. 5 The data are quarterly and available from the IMF’s Balance of Payments Yearbook. 6 FDI covers an investment that involves an “effective voice in management,” usually considered to be 10 percent or more of voting power in local enterprises. - 6 - FDI, exhibit any persistence. Each type is essentially “white noise.” In other words, capital that comes into South Africa in one quarter is just as likely to be followed in the next quarter by an outflow as it is by another inflow. This is not a reason to avoid targeting capital inflows (evidence of negative autocorrelation, however, probably would be). Rather, it suggests that, as a general rule, the SARB would need to exercise considerable caution when buying inflows to reduce the NOFP. Nonetheless, in certain cases involving large one-off inflows of FDI, the SARB may have sufficient prior information to make an assessment as to whether the inflow is unlikely to be reversed. This would probably be the case, for example, with privatization proceeds or inflows associated with the restructuring of De Beers’ shareholdings. Interaction with other flows Even if the SARB knew that a particular inflow was not going to be reversed, it would be important to know whether or not this inflow was likely to give rise to a corresponding outflow elsewhere in the capital account, or even the current account. In the case of FDI, this could happen if foreign investors wished to avoid taking an open position in South Africa; they might decide to take cover by borrowing locally and buying foreign assets or repaying foreign loans.7 This is a testable proposition that appears to be partially correct. The table below reports the correlation coefficients between the various components of South Africa’s capital account. It suggests that long-term capital, which consists primarily of bank loans, is the only form of capital that is negatively correlated to FDI in any significant degree (the partial correlation coefficient is about 40 percent). By itself, this should provide the SARB with some pause for thought before buying FDI inflows. South Africa: Correlation Matrix for Capital Flows, 1994 Q1–2000 Q3 FDI Equity Debt Long-Term Short-Term All excluding FDI FDI Equity Debt Long-term Short-term All excl. FDI 1.000 -0.147 0.347 -0.398** -0.054 0.061 1.000 -0.037 0.159 -0.280 0.503** 1.000 -0.356 -0.527* 0.465** 1.000 -0.103 -0.262 1.000 0.106 1.000 * Significant at 5 percent level. ** Significant at 10 percent level. 7 Alternatively or the recipient of the inflow may decide to reinvest the funds overseas, exchange control regulations permitting. - 7 - However, the findings also indicate that all other components of the capital account, when taken together, do not offset FDI. This point should not be overstated since there is no obvious explanation as to why FDI and debt security (i.e., fixed income assets) flows, but not other types of capital, are positively correlated. Further research using more sophisticated statistical techniques could shed further light on these relationships. It is also possible that FDI inflows are offset by purchases of imports. This may be the case, for example, when FDI takes the form of physical investment. The data do indeed indicate that FDI and the current account are negatively correlated; the correlation coefficient is, however, relatively small (just over 10 percent).8 Option 3: External borrowing Empirical work conducted in the IMF indicates that medium-and long-term external borrowing by the public sector tends to raise spreads, but that the impact diminishes significantly as the maturity of the debt increases.9 The benefit of external borrowing to reduce the NOFP stems primarily from an improvement in the maturity structure of South Africa’s total foreign currency exposure. It does not lead to any overall reduction in exposure and should, therefore, be undertaken in modest amounts. Borrowing in the longer maturity ranges would have the most beneficial net impact on spreads. 8 The partial correlation coefficient is essentially the same for both quarterly data (1994: Q1–2001: Q3) and for annual data (1985–2000). 9 Jonsson (2001), op. cit. . when buying inflows to reduce the NOFP. Nonetheless, in certain cases involving large one-off inflows of FDI, the SARB may have sufficient prior information. - 2 - The Volatility of Capital Flows in South Africa: Some Empirical Observations I. SUMMARY AND CONCLUSIONS In the past several years, South Africa