This Selected Issues paper estimates an equilibrium path for South Africa’s real effective exchange rate. The paper briefly describes the dynamics of the real exchange rate and its determinants. It investigates the presence of a long-term relationship between the real exchange rate and certain explanatory variables, estimates the speed at which the real exchange rate converges toward its equilibrium level, and derives measures for the equilibrium real exchange rate. The paper also examines the real money demand, consumer prices, and the real exchange rate in South Africa.

Abstract

This Selected Issues paper estimates an equilibrium path for South Africa’s real effective exchange rate. The paper briefly describes the dynamics of the real exchange rate and its determinants. It investigates the presence of a long-term relationship between the real exchange rate and certain explanatory variables, estimates the speed at which the real exchange rate converges toward its equilibrium level, and derives measures for the equilibrium real exchange rate. The paper also examines the real money demand, consumer prices, and the real exchange rate in South Africa.

South Africa: Basic Data

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Sources: South African Reserve Bank; IMF, International Financial Statistics; and IMF staff estimates.

In U.S. dollars, annual percent change.

Annual average, INS definition.

Fiscal year beginning April 1.

Excludes sales of state assets and the profit/losses from forward market operations of the Reserve Bank.

Excludes sales of state assets but including the profit/losses from forward market operations of the Reserve Bank.

Excluding rand-denominated debt held by non-residents, end of period.

I. Estimation of the Equilibrium Real Exchange Rate For South Africa1

1. The real effective exchange rate of South Africa has depreciated by about 40 percent since 1995, almost half of which occurred during 2001. A depreciation of this magnitude begs the question as to what extent it can be considered an equilibrium phenomenon (i.e., consistent with persistent movements in economic variables that regularly affect the real exchange rate) rather than a temporary deviation from equilibrium. The depreciation also raises the question of how long it would take for any temporary deviation to dissipate.

2. This section of the selected issues paper addresses these questions by estimating an equilibrium path for South Africa’s real effective exchange rate. After reviewing the existing literature, the paper briefly describes the dynamics of the real exchange rate and its determinants. It then investigates the presence of a long-run relationship (cointegration) between the real exchange rate and certain explanatory variables, estimates the speed at which the real exchange rate converges toward its equilibrium level, and derives measures for the equilibrium real exchange rate and, correspondingly, the gap between the actual and the equilibrium level.

A. Brief Review of the Literature

3. There is a considerable body of literature on the estimation of the equilibrium real exchange rate, some of which has been surveyed in MacDonald (1995) and Rogoff (1996). Most recent papers investigate the presence of a long-run relationship between the real exchange rate and various determinants by making use of cointegration techniques that identify persistent patterns of co-movements among variables.

4. The main explanatory variables identified in the literature for developing countries include commodity price movements (or terms of trade), productivity and real interest rates differentials vis-à-vis trading-partner countries, measures of openness of the trade and exchange system, and the size of the fiscal balance.2 The rationale for most variables is based on a simple neoclassical theoretical framework that assumes the prices of tradable goods are equalized across countries and, hence, investigates how changes in the real exchange rate arise mainly from relative movements in the price of nontradables across countries. Relaxing the assumption of price equalization should provide richer insights into the transmission mechanisms (as in the presence of imperfect substitutable traded goods across countries, the real exchange rate would also be affected through the relative price of traded goods), but should lead to broadly similar conclusions (see MacDonald and Ricci (2002)). In either case, our chosen variables explain why the real exchange rate can be expected to vary over time and provide a rationale for deviations from purchasing power parity (PPP).

5. The classic example of an equilibrium deviation from PPP is the Balassa-Samuelson effect (see Balassa (1964); and Samuelson (1964)). If a country experiences an increase in the productivity of the tradable sector (relative to its trading partners), its real exchange rate would tend to appreciate; for given prices of tradables, stronger productivity would induce higher wages, higher prices of nontradables, and, hence, an increase in the consumer price index relative to trading partners.3

6. An increase in the world price of the commodities that a country exports would tend to appreciate the real exchange rate. Such an increase would induce a positive wealth effect, which would raise domestic demand and, hence, the price of nontradables (see Diaz-Alejandro (1982)). In principle, this effect should be captured more comprehensively by the terms of trade, as their numerator encompasses all exports—as opposed to only commodity based exports—and their denominator reflects the price of the country-specific imports, as opposed to a generic industrial country export deflator. In practice, few studies find a significant effect of the terms of trade (see, however, Goldfajn and Valdes (1999)), while many researchers find commodity prices to be strongly cointegrated with the real exchange rate of commodity exporters.4 One rationale for the findings is provided by the relative accuracy of the measurement of commodity prices, as opposed to the arbitrariness involved in the construction of country-specific export and import deflators. Another rationale relates to how frequently commodity price data are made available which may allow financial markets to tailor their financial decisions about the currencies of commodity exporters to the prices of these commodities.

7. The real interest rate differential could represent several factors—aggregate demand, productivity, and persistent monetary policy—all pointing to a positive relationship with the real exchange rate. First, an increase in absorption relative to savings would put upward pressure on the real interest rate in an economy with less than perfect capital mobility. At the same time, the demand for both tradable and nontradable goods would increase, inducing an increase in the price of nontradables, which, in turn, would result in an appreciation of the real exchange rate. Second, real interest rate differentials may also reflect productivity differentials: to the extent that the measure employed to proxy for the Balassa-Samuelson effect is not perfect, the real interest rate differential may help capture this empirically, also, if the productivity of capital raises with respect to trading partners, capital will flow to the home country, thereby inducing an appreciation of the real exchange rate.5 Third, a tightening of monetary policy would raise real interest rates—an outcome that would need to be associated with an expectation of currency depreciation, given the interest parity condition. Hence, the nominal exchange rate would appreciate beyond its long-run value, so as to allow the expected depreciation to occur once the monetary policy shock had disappeared (the “overshooting” effect described in Dornbusch (1976)). In the presence of price rigidities, the real exchange rate would also be appreciated relative to its long-run value (see Obstfeld and Rogoff (1996) for a formal derivation in the new open macroeconomic setup). This last effect could be persistent if the monetary shock—that is, the rise in real interest rates—is persistent: in this sense, the cointegration analysis would capture this effect as part of the “long-run” relation.6

8. An improvement in the fiscal balance will have an ambiguous effect on the real exchange rate. On the one hand, a depreciation would tend to occur because the improved fiscal balance would normally induce a less-than-proportional reduction in private saving, so that total domestic demand would decrease while overall savings would increase.7 As part of the decline in spending falls on nontradable goods, their prices would drop, bringing about a depreciation of the real exchange rate. The effect is likely to be stronger if the fiscal improvement comes from a reduction in government consumption, as opposed to an increase in taxes, to the extent that government consumption falls more intensively on nontradable goods than private spending (in which case, the depreciation would be reinforced in the presence of imperfectly substitutable traded goods).8 In principle, the fiscal effect should simply be part of the main aggregate demand effect described above; whether the interest rate fully captures both effects is an empirical question. To the extent that it does not, the fiscal balance would enter significantly in the cointegrating relationship. On the other hand, a further effect would operate on the relative price of traded goods in a model which features stock-flow consistency (such as the portfolio balance model). In such a model the current account surplus generated by the initial real depreciation would have to be annihilated in the long run by a real appreciation which ensures a sufficient trade deficit to offset the positive net foreign assets.

9. A more open trade regime is likely to be associated with a more depreciated real exchange rate. Trade restrictions increase the domestic price of tradable goods, thereby raising the overall price level and the real exchange rate (see Goldfajn and Valdes (1999)). In the present study, openness is proxied by the ratio of exports plus imports to GDP. Such a measure is widely used, even though it is an imperfect substitute reflecting also a multiplicity of other factors than trade and exchange restrictions. In the context of the present paper, these drawbacks are likely to have a limited impact. In fact, the endogeneity of the openness ratio to the real exchange rate is corrected automatically by the econometric methodology employed. The ratio would also reflect the effect of trade sanctions during the apartheid period, which is likely to induce a similar effect on the domestic price of the tradable goods and, hence, on the real exchange rate.

B. Data and Methodology

10. The real effective exchange rate and the main variables employed in the empirical analysis are plotted over the 1970-2001 period in Figure I.1.9 Some interesting patterns are worth highlighting, particularly for the recent period:

Figure I.1
Figure I.1

South Africa: The Real Effective Exchange Rate and Its Determinants, 1970–2001

Citation: IMF Staff Country Reports 2003, 018; 10.5089/9781451840995.002.A001

Sources: South African Reserve Bank; Statistics South Africa; and staff estimates.
  • the significant real depreciation of the rand since 1995, which accelerated in 2001;

  • the increase in real interest rates in the 1990s, partly associated with tight monetary policy;

  • the persistent decline in real GDP per capita with respect to trading partner countries, throughout the sample period;

  • the steady decline in real prices for South Africa main commodity exports since the beginning of the 1980s;

  • the decline in openness during the 1980s, in part owing to trade sanctions, and the opening up of the economy since the end of the apartheid; and

  • the strengthening of fiscal performance, as measured by the fiscal balance, in the post-apartheid period.

11. In order to investigate the existence of a long-run relationship (cointegration) between the real effective exchange rate and the variables discussed above, the study employs the Johansen (1995) maximum likelihood estimator, which corrects for autocorrelation and endogeneity parametrically using a vector error-correction mechanism (VECM) specification (see Appendix II for details).10

12. In addition to testing for cointegration, the methodology provides estimates of the coefficient of each variable in the long-run relationship, thus permitting the estimation of an equilibrium real exchange rate and a quantification of the gap between the prevailing real exchange rate and its equlibrium level. The methodology also derives estimates of the speed at which the real exchange rate converges to its equilibrium level.

C. Results

13. This section presents the main results from the estimation. Appendix III describes the derivation of the results and documents their robustness.

The Long-Run Relationship

14. There is evidence of cointegration between the real exchange rate and the explanatory variables. Accordingly, the long-run relationship between the real exchange rate and these variables can be identified as follows:

  • an increase in the real interest rate relative to trading-partner countries of 1 percentage point is associated with an appreciation of the real effective exchange rate of 5 percent;

  • an increase in real GDP per capita relative to trading-partner countries of 1 percent is associated with an appreciation of the real effective exchange rate of between 0.4–0.5 percent;

  • an increase in real commodity prices of 1 percent is associated with an appreciation of the real effective exchange rate of 0.6 percent;

  • an increase in openness of 1 percentage point of GDP is associated with a depreciation of the real effective exchange rate of 0.01 percent; and

  • an improvement in the fiscal balance of 1 percentage point of GDP is associated with a depreciation of the real effective exchange rate of 3 percent.

Equilibrium Real Exchange Rate

15. The long-run relationship summarized above permits the calculation of an estimate of the equilibrium real exchange rate. Ideally, this measure can be defined as the level of the real exchange rate that is consistent in the long run with the equilibrium values of the explanatory variables, and it can be obtained by evaluating the cointegrating relationship at these equilibrium levels. As evident from Figure I.1, however, these variables can exhibit a substantial degree of “noise” or fluctuations.

16. One way of neutralizing the impact of the temporary fluctuations in the explanatory variables on the evaluation of the equilibrium real exchange rate is the application of smoothing techniques to eliminate short run fluctuations. Figure I.2 shows an example of the equilibrium real exchange rate derived in this manner and compares the outcome with the actual real effective exchange rate.11

Figure I.2
Figure I.2

Actual and Equilibrium Real Effective Exchange Rate, 1970–2001.

Citation: IMF Staff Country Reports 2003, 018; 10.5089/9781451840995.002.A001

17. According to Figure I.2, the actual rate appears to have been close to its estimated equilibrium level in 1994–95, but it subsequently depreciated by almost double the equilibrium rate, that is, about 40 percent versus 20 percent, respectively. The decline of the equilibrium level over this period arose from conflicting factors. On the one hand, the decline in commodity prices, the slower productivity growth relative to trading partners, the increase in openness, and the improvement in the fiscal balance accounted for a depreciation of the equilibrium real exchange rate in the order of 15 percent, 3 percent, 11 percent, and 11 percent, respectively. On the other hand, the increase in real interest rate differential partly offset these forces by contributing to an appreciation of 18 percent.

The Gap Between the Real Exchange Rate and its Equilibrium Level

18. At any point in time, the real exchange rate is likely to differ from the equilibrium level either because a change in the explanatory variables alters the equilibrium level or because temporary factors (such as financial market pressure on the rand) move the real exchange rate away from it.

19. One of the aims of the study is to quantify this gap in the fourth quarter of 2001, when the rand rapidly lost value. When the equilibrium values of the explanatory variables are evaluated by smoothing them, as in Figure I.2, the gap is found to be in the order of 20 percent. Alternatively, one can evaluate the deviation of the real effective exchange rate from a notional equilibrium level, based on a set of economic priors for the equilibrium values of the explanatory variables. Accordingly, a gap of 22 percent would result from the following choices:

  • a real interest rate differential of about 250 basis points, that is, roughly the level of the yield spreads in 2001;

  • a relative real GDP per capita equal to the actual level in the fourth quarter of 2001 (given that the variable exhibits a clear and relatively smooth trend, its actual value can be considered as a good proxy for its equilibrium value at each point in time);

  • a level of real commodity prices equal to the average for the period 1995–2001 (such a choice appears appropriate in light of the quick rebound of commodity prices in 2002);

  • a degree of openness equal to the average for the period 1995–2001 (close to 50 percent of GDP); and

  • a fiscal deficit of about 2 percent of GDP, which corresponds roughly both to the average level since 1998 and to the authorities’ target for the current fiscal year.

20. As the large fluctuations in commodity prices (evident from Figure I.1) are found to contribute heavily to movements in the real exchange rate, it is interesting to evaluate the gap for the fourth quarter of 2001 at the levels of commodity prices prevailing in 1995 or at the end of 2001, while keeping the other variables unchanged at the values indicated above. In the former case, the gap would amount to only 13 percent, while in the latter case the gap would correspond to 28 percent. The difference, about 15 percent, indicates the extent of the real depreciation of the rand since 1995 that can be imputed to the decline in commodity prices, which was in the order of 27 percent.

Speed of Adjustment

21. When a gap between the real exchange rate and its equilibrium level arises, the real exchange rate will tend to converge to its equilibrium level. Depending on the cause of the gap, the adjustment requires that the real exchange rate either moves progressively toward a new equilibrium level, or returns from its temporary deviation to the original equilibrium value. The estimates derived in this study suggest that, on average, about 6 percent of the gap is eliminated every quarter, implying that in the absence of further shocks about half of the gap would be closed within two-and-one-half to three years.

D. Conclusions

22. Drawing on existing literature, this study estimates a long-run equilibrium real exchange rate path for South Africa. The main explanatory variables were found to be commodity price movements, productivity and real interest rates differentials vis-à-vis trading-partner countries, measures of openness, and the size of the fiscal balance. The analysis suggests that in 1995 the real exchange rate was close to its equilibrium level and that about half of its subsequent depreciation can be accounted for by movements in the explanatory variables. In the fourth quarter of 2001, the average value of the rand (R10.1 per U.S. dollar) appeared to be about 20 percent more depreciated than the level consistent with the equilibrium of the real exchange rate (with that level estimated at R8.4 per U.S. dollar). Different ways of distinguishing between permanent and temporary movements in the explanatory variables provide similar results, with the extent of the estimated gap ranging from 15 percent to 25 percent.12 These calculations may, however, overestimate the equilibrium exchange rate to the extent that they do not account for structural factors, such as high unemployment and the HIV/AIDS pandemic; taking these into account could generate a smaller gap than that estimated.

23. If the real exchange rate deviates from its equilibrium level owing to temporary factors, it can be expected to revert to equilibrium fairly quickly. The study suggests that, in absence of further shocks, about half of the gap could be eliminated within two-and-one-half to three years.

References

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  • Cashin, Paul, Luis Cespedes, and Ratna Sahay, 2002, “Developing Country Real Exchange Rates: How Many Are Commodity Countries?”, IMF Working Paper (forthcoming).

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  • Chen, Yu-Chin, and Kenneth Rogoff, 2002, “Commodity Currencies and Empirical Exchange Rate Puzzles,IMF Working Paper, 02/27 (Washington: International Monetary Fund).

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  • De Gregorio, José, Alberto Giovannini, and Holger Wolf, 1994, “International Evidence on Tradables and Nontradables Inflation,European Economic Review, Vol. 38 (June), pp. 122544.

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  • Diaz-Alejandro Carlos, 1982, “Exchange Rate and Terms of Trade in the Argentine Republic, 1913–1976”, in Trade, Stability, Technology, and Equity in Latin America, ed. by Moises Syrquin Simon Teitel (New York, New York, Academic Press).

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  • Dornbusch Rudiger, 1976, “Expectations and Exchange Rate Dynamics,Journal of Political Economy, Vol. 84 (December) pp. 11676.

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  • Johansen, Soren, 1988, “Statistical Analysis of Cointegration Vectors,Journal of Economic Dynamics and Control, Vol. 12 (June-September), pp. 23154.

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  • Johansen, Soren, 1995, Likelihood-based Inference in Cointegrated Vector Autoregressive Models, Oxford University Press.

  • Johansen, Soren, and Katarina Juselius, 1990, “Maximum Likelihood Estimation and Inference on Cointegration, with Application to the Demand for Money,Oxford Bulletin of Economics and Statistics, Vol. 52 (May), pp. 169210.

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Appendix I: Variables: Definitions and Source

The dataset consists of quarterly data from 1970 to 2001 for South Africa and the four major trading partners.13

  • LREERS: Real effective exchange rate. In logarithmic terms, (source: SARB).

  • RIRR: Real interest rate relative to trading partners. Nominal interest rate on 10 year bond, minus inflation in past four quarters. Foreign variable calculated as the weighted average of four major trading partners, based on the SARB weights for the real effective exchange rate: Germany (proxy for EU, 47 percent), United States (20 percent), United Kingdom (20 percent), Japan (13 percent). Source: SARB and IFS.

  • LRGDPPCR: Real GDP per capita relative to trading partners. In logarithmic terms. Normalized for each country to 1 in 2000. Foreign variable calculated as above. Source: SARB, IFS, and WB.

  • LPR2COMM5 and other indicators: Real commodity prices. In logarithmic terms. Six different indicators of commodity prices were constructed, based on three choices of aggregating the main commodities exported by South Africa and two ways of deflating them. The former encompasses weighted averages of the five, three, or single most exported commodity(ies)—excluding diamonds, for which a price series is not available. The latter relates to the price deflator for developed countries exports or to the US CPI level. The combination generates respectively: LPR2COMM5, LPR2COMM3, LPR2GOLD, LPRCOMM5, LPRCOMM3, and LPRGOLD. Source: Cashin, Cespedes, and Sahay (2002), Data Stream, and IFS.

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  • OPENY: Openness. Ratio of exports and imports to GDP. Source: SARB, IFS.

  • FBYA: Fiscal balance. Ratio of the annualized fiscal balance to GDP. Source: SARB, IFS.

  • NFAY: Net foreign assets. Ratio of the end of period net foreign assets to GDP. Source: IFS.

  • IY: Investment. Ratio of gross domestic fixed investment to GDP. Source: SARB, IFS.

  • GY: Government consumption. Ratio of government consumption to GDP. Source: SARB, IFS.

Appendix II: The Econometric Methodology

The Johansen methodology can be described as follows. Define a vector:

xt=[lreers,rirr,lrgdppcr,lpr2comm5,openy,fbya],

and assume the vector has a VAR representation of the form:

xt=η+i=1pΠixti+εt,

where η is a (nx1) vector of deterministic variables, ε is a (nx1) vector of white noise disturbances, with mean zero and covariance matrix Ξ, and Πi is a (nxn) matrix of coefficients. The above expression may be reparameterised into the so-called vector error correction mechanism (VECM) as:

Δxt=η+i=1p1ΦiΔxii+Πxi1+εt

where ∆ denotes the first difference operator, Φi is a (nxn) coefficient matrix (equal to j=i+1pΠj), Π is a (nxn) matrix (equal to i=1pΠiI whose rank determines the number of cointegrating vectors. The presence of cointegration is indicated by the rank of Π:

  • If Π is of either full rank, n, or zero rank, Π=0, no cointegration exists amongst the elements in long-run relationship (in these instances it would be appropriate to estimate the model in, respectively, levels or first differences).

  • If, Π is of reduced rank, r (where r<n), then there exist (nxr) matrices α and β such that Π=αβ’, where p is the matrix whose columns are the linearly independent cointegrating vectors, and the a matrix is interpreted as the adjustment matrix, indicating the speed with which the system responds to last period’s deviations from the cointegrating relationships.

The existence of cointegration amongst the variables contained in xt can be determined by two tests proposed by Johansen.

  • The trace test statistic (TR) for the hypothesis that there are at most r distinct cointegrating vectors is as follows:

    TR=Ti=r+1Nln(1λ^i),

    where λ^T+1,,λ^N are the N–r smallest squared canonical correlations between xt–k and Δxt series (where all of the variables entering xt are assumed to be I(1)), corrected for the effect of the lagged differences of the xt process (for details of how to extract the λs, see Johansen (1988); and Johansen and Juselius (1990)).

  • The likelihood ratio (LR) statistic, for testing at most r cointegrating vectors against r+1 is defined as:

    LR=Tln(1λ^r+1)

Johansen (1995) shows that the TR and LR statistics have non-standard distributions under the null hypothesis. He does, however, provide approximate critical values for the statistics generated using Monte Carlo methods, and these are the critical values used in this paper.

Appendix III: Econometric Results and Their Robustness

The VECM is first estimated with the following variables: the real effective exchange rate, real interest rate relative to trading partners, real GDP per capita relative to trading partners, real commodity prices (choosing the more general one, based on 5 commodities and deflated by the industrial countries export deflator), openness, fiscal balance, and net foreign assets.14 The specification also includes four lags for the changes in each variable and centered seasonal dummies: such a structure is quite common when employing quarterly data (as discussed below, the lag structure is supported by appropriate tests). Both cointegration tests indicate the presence of one cointegrating vector at the 1 percent significance level (see Table I.1, column l).15 The coefficients of the cointegrating vector are plausible, significant, and of the correct sign. All the variables are found to be nonstationary (I(1)) when using the Johansen test (see Table I.2, panel A), which (unlike standard stationarity tests) takes into account the cointegration space. Implicitly, this test indicates that the presence of cointegration is not driven by stationarity of any single variable. Hence the cointegration analysis is both appropriate (as variables are nonstationary) and meaningful (as not driven by stationarity of one variable). However, the exclusion test suggests that the net foreign asset variable can be excluded from the long-run relationship (Table 1.2, panel B).

Table I.1.

Selected Results of the VECM

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Note: t-statistics in square brackets.
Table I.2.

Johansen Test for Stationarity and Exclusion Test C

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The VECM is, therefore, estimated using the the same specification, but without the net foreign asset variable (Table I.1, second column) and indicates evidence of only one cointegrating vector at the 1 percent significance level, with coefficients very similar to the ones derived above. For this new specification, the tests presented in Table I.3 indicate that one cannot reject the hypothesis that the residuals have a normal distribution (panel A), and all four lags in our VECM specification are necessary (the test in Panel B rejects the hypotheses that each of the four lag is jointly insignificant across equations). The lag structure appears to be correct: if a fifth lag is introduced, the test accepts the hypothesis that the additional lag is jointly insignificant across equations (Table I.4). On the basis of these results, Column 2 of Table I.1 is elected as main specification.

Table I.3.

VEC test

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Numbers in [] are p-values.
Table I.4.

Main specifications with 5 lags. VEC Lag Exclusion Wald Test

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Numbers in [] are p-values.

In order to assess the robustness of the results, several exercises have been performed:

  • The main specification is also run with different measures for commodity prices (Table I.2, columns 3–7) and the results are broadly similar. However, if the terms of trade are introduced instead of commodity prices, the measure appears insignificant and alters the overall specification.

  • The results are not particularly sensitive to the elimination of either the fiscal balance variable or the measure of openness. However, the results are compromised if both variables above, or any of the three other variables, are dropped.

  • Labor productivity in the manufacturing sector (as a ratio of trading partners productivity) does not perform as well as relative real GDP percapita as a proxy for the Balassa-Samuelson effect. This could be due to the large fluctuations in employment in South Africa, which alter the link between labor productivity and total factor productivity.

  • Replacing fiscal balance with government consumption alters the results because of the high degree of collinearity between the latter and relative real GDP per capita (-0.9).

  • Other variables, such as the ratio of net capital inflows to GDP, or the ratio of gross domestic fixed investment to GDP, are not found to play an additional role.

1

Prepared by Luca Ricci. The section draws substantially on work done in collaboration with Ronald MacDonald of Strathclyde University.

2

Other variables include the extent of net foreign assets, the investment-to-GDP ratio, the net capital inflows-to-GDP ratio.

3

For recent empirical evidence on the Balassa-Samuelson effect, see MacDonald and Ricci (2001 and 2002).

5

However, the repayment of the net foreign liabilities accumulated would eventually require a depreciation of the real exchange rate to achieve current account surpluses.

6

This does not contradict the fact that in the steady state of the economy (the long run, as commonly conceived), the Dornbusch model would not predict an effect of monetary policy on the real exchange rate simply because, by definition, the monetary shock would have vanished in the steady state.

7

Assuming that Ricardian equivalence does not hold, for example because of uncertainty about the duration of the improvement in the fiscal balance.

8

See De Gregorio, Giovannini and Wolf (1994) for a theoretical and empirical analysis of the impact of government spending on the real exchange rate. The effect of a reduction of government spending, as opposed to the effect of an increase in taxes, may be stronger also if the larger multiplier effect of the former is not neutralized by the optimal saving choices of consumers.

9

The variable definitions and sources are presented in Appendix I.

10

This methodology is preferred over the standard Engle-Granger single-equation method, as the latter has poor small sample properties and has no correction for autocorrelation and simultaneous equation bias.

11

Choosing the degree of smoothing is admittedly arbitrary. The equilibrium real exchange rate in Figure I.2 is derived by applying to the explanatory variables a Hodrick-Prescott filter with a smoothing factor of 10,000. A larger (smaller) factor would generate a smoother (less smooth) equilibrium real exchange rate path. It should be noted that the Hodrick-Prescott filter tend to perform poorly at both ends of the series.

12

After a sizable further overshooting, the real exchange rate returned in May 2002 to levels close to the average for the fourth quarter of 2001.

13

When data for the fourth quarter of 2001 were not available from official sources, staff estimates were constructed on the basis of available information.

14

The role of different commodity prices and other variables is also investigated.

15

The trace-statistic test suggest there may be two cointegrating vectors at the 5 percent significance level.