How important is the exchange rate?

Jul 03 2013 08:24
*Jac Laubscher


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Cape Town - The recent sharp deterioration in the rand exchange rate, the first since the heightened focus on financial stability in the wake of the global financial crisis, has given rise to the question of whether exchange rate movements should be taken into account in the pursuit of financial stability.

More specifically: Should exchange rate stability be part of central banks’ responsibility with regard to macro-prudential regulation?

The global financial crisis inevitably resulted in a radical review of the regulation and supervision of the financial system.

Part of this was the realisation that focusing only on individual financial institutions is not enough, but that the stability of the system as a whole is even more important as it is vital for the ongoing provision of financial intermediation services to the economy.

The result was a formal distinction between micro-prudential regulation, which relates to individual institutions, and macro-prudential regulation, which in turn focuses on the system as a whole.

The latter includes the continuous monitoring of macroeconomic and financial trends in order to identify risks to financial stability in good time and take preventative measures.

The objective of macro-prudential regulation is to address systemic risk in the financial system with a view to protecting the real economy against the consequences of financial instability.

This instability could arise from a sharp curtailment of credit extension, which would disrupt real economic activity (a credit crunch) and could even result in a recession and/or a sell-off of financial assets (a fire sale) that would cause asset prices to decline sharply, with similar negative consequences for the real economy. History shows that house prices in particular are key to stability in the banking system.

Special sectoral regulators are responsible for regulation on microlevel, with capital requirements as the most important policy instrument, whereas central banks have the responsibility for macro-prudential regulation.

The central bank can use policy instruments such as anti-cyclical capital requirements, liquidity requirements and maximum leverage ratios, with which banks have to comply, to promote financial stability.

However, the use of interest rates to promote financial stability would be controversial as it could clash with the central bank’s inflation mandate.

The risk is that the political independence of central banks could be jeopardised owing to their responsibility for macro-prudential regulation, which could result in the combating of inflation being regarded as less important.

For example, a central bank might allow higher inflation in an effort to make it easier for the government to manage national debt.

An important issue for emerging-market countries (like South Africa) confronted with sharp fluctuations in capital flows and therefore potential exchange rate instability, is whether it should form part of the central bank’s financial stability mandate.

If it should, it could also prejudice the central bank’s political independence, as capital flows are sensitive to economic policy in general and political instability, among other things.

Direct foreign investment in particular is strongly impacted by structural economic policies.

In order to answer the question of whether or not exchange rate movements are important for financial stability and macro-prudential regulation, one need to ask oneself what the impact thereof would be on credit extension and asset prices.

Exchange rate movements would have a material impact on the availability of credit to the real economy if banks were to be dependent on foreign financing as a source of capital.

This was very clearly illustrated by the Asian financial crisis in 1997/98 when banks in Thailand, for example, were unable to repay their foreign loans (denominated in dollars) owing to the sharp depreciation of the baht.

But could one not put exchange rate instability in the same category as volatility in financial asset prices, which would make it part of the financial stability mandate and thus macro-prudential regulation?

Purists would say the foreign exchange market is not a financial market in the same sense as the equity market or the bond market and that the exchange rate is not an asset price as foreign exchange is not deemed a conventional portfolio asset.

Others would argue that in a world of global financial markets in which a high percentage of assets is owned and traded by non-residents of a country, the foreign exchange market, and therefore the exchange rate, forms an integral part of the financial system and is thus important for financial stability.

The interaction between the foreign exchange market and financial markets is not only in one direction. Sometimes exchange rate instability is the result of volatile asset markets, which could lead to the withdrawal of foreign investors.

At other times factors such as movements in commodity prices cause exchange rate instability, which in turn affects asset prices.

In general, a free floating exchange rate determined by market forces has a stabilising effect on asset prices and portfolio capital flows owing to the role it plays in the repricing of assets.

In any event, international diversification of portfolios has a stabilising effect on the total value of households’ assets in the face of currency fluctuations.

The only policy tool at the disposal of the central bank with which to influence the exchange rate are interest rates, with exchange controls and measures such as taxes on inflows of short-term capital being the domain of the fiscal authorities.

However, using interest rate policy to influence the exchange rate would lead to the classic dilemma of one policy instrument bearing the burden of two policy objectives if inflation is added to the mix. At times the two objectives may coincide, but not inevitably.

The best any central bank, including the South African Reserve Bank, can therefore do is to keep a close watch on banks’ foreign currency denominated liabilities.

The impact of exchange rate movements on asset prices is of lesser concern, except during episodes of global instability which is in any case beyond the control of emerging market central banks.

* Jac Laubscher is the group economist of Sanlam [JSE: SLM].

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sanlam  |  jac laubscher  |  economy  |  exchange rate



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