South Africa: Staff Report for the 2003 Article IV Consultation
Author: International Monetary Fund
Publication Date:
01 Jul 2004
eISBN:
9781451841008
Language:
English
Keywords:
ISCR; CR; CPIX inflation; mining output; vehicle sale; exchange rate; price pressure; currency appreciation; U.S. dollar; foreign currency; broad money; Inflation; Africa
Download PDF (2.5 MB)

This 2003 Article IV Consultation highlights that the South African economy performed well in 2002, notwithstanding difficult global economic conditions. Supported by sound macroeconomic management and a highly competitive exchange rate, real GDP growth rose to 3.0 percent in 2002 from 2.8 percent in 2001. However, growth slowed to 1.5 percent in the first quarter of 2003, largely in response to a strong currency appreciation and tight financial conditions. The sharp currency depreciation that occurred in the second half of 2001 provided a major boost to activity during much of 2002.

Abstract

This 2003 Article IV Consultation highlights that the South African economy performed well in 2002, notwithstanding difficult global economic conditions. Supported by sound macroeconomic management and a highly competitive exchange rate, real GDP growth rose to 3.0 percent in 2002 from 2.8 percent in 2001. However, growth slowed to 1.5 percent in the first quarter of 2003, largely in response to a strong currency appreciation and tight financial conditions. The sharp currency depreciation that occurred in the second half of 2001 provided a major boost to activity during much of 2002.

I. Recent Economic Developments

  • The economic recovery continued in 2002, supported by sound macroeconomic management and a highly competitive exchange rate. More recently, however, the recovery appears to have lost some momentum as a result of a strengthening of the rand and weak global economic conditions.

  • Formal sector employment rose in 2002 for the first lime in many years, but labor productivity growth slowed markedly.

  • Monetary policy was tightened in 2002, and inflation has since fallen sharply.

  • The budget overperformed in 2002/03, but it is now set on a mildly expansionary track.

  • External sector performance has generally been good, and substantive progress has been made in strengthening the central bank’s international reserve position.

1. The South African economy has continued to perform well, despite adverse global economic conditions. Supported by sound macroeconomic management and a highly competitive exchange rate, the recovery that began towards the end of 1998 picked up steam in 2002 (Table 1). Real GDP grew by 3.0 percent, which was slightly up from the previous year. For the first time in many years, gains were made in formal sector employment. These developments have been accompanied by an overall strengthening of confidence in the economy, as evidenced by recent upgrades from credit rating agencies.1

Table 1.

South Africa: Selected Economic and Financial Indicators, 1999-2004

article image
Sources: South African Reserve Bank (SARB); IMF, International Financial Statistics; and Fund staff projections.

CPIX is the consumer price index (CPI) less the interest on mortgage bonds.

Excludes individuals who have not token active slips to look for work or start self-employment in the four weeks prior to the interview. September.

In U.S. dollars: annual percent change.

Annual average; Information Notice System (INS) definition.

Contribution (in percentage points) to the growth of broad money.

Calendar-year figures, based on National Treasury data and staffs GDP projections.

Excluding sales of state assets and profit/losses from forward market operations of the SARB.

Excluding rand-denominated debt held by nonresidents; end of period.

Defined as net forward liabilities les net international reserves.

2. More recently, however, there are signs that the pace of the recovery has been losing momentum (Figure 1). Growth slowed to 1.5 percent in the first quarter of 2003, largely in response to a downturn in export demand that was reflected in a contraction in manufacturing output (Figure 2). Domestic demand, nevertheless, remained relatively buoyant and, unlike previous business cycles, South Africa’s growth performance has been stronger than that of its industrial partner countries and many emerging market economies. The slowdown, which has been evident in weakening stock market prices (Figure 3), reflects a combination of factors, notably a strengthening of the rand, rising labor costs, and relatively tight financial policies.

Figure 1.
Figure 1.

Real GDP Growth, 1980-2003 1/

(Annual, in percent)

Citation: IMF Staff Country Reports 2004, 178; 10.5089/9781451841008.002.A001

1/ For 2003, first quarter only.
Figure 2.
Figure 2.

Manufacturing and Mining Production, and Retail Sales, 1994-2003 1/

(Annual change, in percent)

Citation: IMF Staff Country Reports 2004, 178; 10.5089/9781451841008.002.A001

1/ For 2003, first quarter only.
Figure 3.
Figure 3.

Stock Market Indices, 1994-2003

(In log scale)

Citation: IMF Staff Country Reports 2004, 178; 10.5089/9781451841008.002.A001

3. To a significant extent, growth performance has mirrored movements in the exchange rate. The sharp currency depreciation in the second half of 2001 (Figure 4) provided a major boost to economic activity during much of 2002. The rand has subsequently recovered in value, appreciating by about 40 percent on a trade-weighted basis since the end of 2001; in real effective terms, the exchange rate is presently around the level prevailing in the second half of 2000 (Figure 5). The currency has also undergone large swings in value, moving from R 13.8 per U.S. dollar in December 2001 to R 7.1 per U.S. dollar in April 2003, a range of about 50 percent in local currency terms. Much of this appreciation reflects a reversion to long-run equilibrium following the overshooting that took place in 2001, but macroeconomic fundamentals have also contributed to a strengthening of the currency. These include the following:

Figure 4.
Figure 4.

Exchange Rates, 2001-03

Citation: IMF Staff Country Reports 2004, 178; 10.5089/9781451841008.002.A001

Figure 5.
Figure 5.

External Current Account, Trade Balance, and Real Effective Exchange Rate, 1994-2003

Citation: IMF Staff Country Reports 2004, 178; 10.5089/9781451841008.002.A001

  • firmer prices for South Africa’s commodity exports;2

  • tighter domestic credit conditions, accompanied by widening interest-rate differentials vis-à-vis overseas capital markets;

  • a greater appetite by global investors for emerging market bonds since mid-2002; and

  • an improvement in the external current account balance of 0.6 percent of GDP in 2002, resulting in a surplus (albeit small) for the first time since 1994 (Table 2).

Table 2.

South Africa: Balance of Payments, 1998-2004

article image
Sources: South African Reserve Bank (SARB); and Fund staff estimates and projections.

Defined as net forward liabilities less net international reserves.

In response to the currency appreciation, however, the current account subsequently swung back into deficit in the first quarter of 2003.

4. Labor markets conditions have also contributed to the weakening in growth. After a period of sustained decline, real unit labor costs flattened out in the second half of 2002, reflecting stronger wage growth and slowing productivity gains (Figure 6); the rise in productivity in the fourth quarter of 2002 was less than 2 percent, which is the lowest recorded in the past ten years. Although employment in the formal sector increased slightly in 2002, the unemployment rate in September 2002 rose to 30.5 percent, compared with 29.5 percent a year previously.3

Figure 6.
Figure 6.

Real Interest Rate and Unit Labor Costs, 1994-2003 1/

Citation: IMF Staff Country Reports 2004, 178; 10.5089/9781451841008.002.A001

1/ For 2003, Jan-May data only.2/ Prime rate minus CPIX (in percent).3/ Manufacturing sector (in annual percent change).

5. Fiscal policy was relatively tight in 2002/03. The national government budget deficit narrowed slightly to 1.2 percent of GDP, compared with an original target of 2.1 percent (Table 3 and Figure 7). This outturn reflected both strong revenue performance, particularly in the area of company taxation, and higher-than-expected inflation, which led to some compression of expenditures in real terms. Fiscal “overperformance” over the past three years totaled 2.4 percent of GDP.4

Figure 7.
Figure 7.

Government Budget Balance and Public Sector Borrowing Requirement, 1994/95-2002/03

(In percent of GDP)

Citation: IMF Staff Country Reports 2004, 178; 10.5089/9781451841008.002.A001

Table 3.

South Africa: National Government Main Budget, 1999/2000-2004/05 1/

article image
Sources: South African authorities; and Fund staff estimates and projections.

Fiscal year begins April 1.

Projection based on authorities’ medium-term framework.

Southern African Customs Union (SACU) payments are based on a revenue-sharing formula.

Provision of bonds to the South African Reserve Bank in settlement of the Gold and Foreign Exchange Contingency Account.

6. In response to a buildup in inflationary pressures, monetary conditions were tightened during 2002. The South African Reserve Bank (SARB) raised short-term interest rates by 400 basis points in 2002, and monetary growth was sharply curtailed (Figure 8 and Table 5). Rates were subsequently lowered by 150 basis points in mid-June 2003 following an improvement in the inflation outlook (see below). Quasi-fiscal profits made by the SARB on forward market operations contributed to a further dampening of aggregate demand.

Figure 8.
Figure 8.

Broad Money and Inflation, 1994-2003

(Annualized percent change)

Citation: IMF Staff Country Reports 2004, 178; 10.5089/9781451841008.002.A001

Table 4.

South Africa: Nonfinancial Public Sector Operations, 1999/2000-2004/05 1/

article image
Sources: South African authorities- and Fund staff estimates and projections.

Fiscal year begins April 1.

Projection based on authorities’ medium-term framework.

“Other” includes social security funds, other extrabudgetary funds, and privatization receipts.

Table 5.

South Africa: Monetary Survey, 1997-2002

article image
Sources: South African Reserve Bank (SARB); and Fund staff estimates.

Banks are audited using generally accepted international standards; capital adequacy requirements are also imposed on securities trading. The figure for 2000 refers to September.

Including foreign financing in banks’ own name cm-lent to clients.

Including foreign currency deposits and other foreign loans and advances.

Short-term deposits include check and demand deposits.

Includes banks and financial services; insurance services; and investment trusts and private equity funds.

7. Robust private investment has been a particularly positive feature of recent growth performance. Private fixed capital formation grew by 7 percent in 2002, and a further 5½ percent (annualized rate) in the first quarter of 2003. It has been supported by low long-term interest rates, which have fallen by nearly 450 basis points since the end of 2001 as a result of lower inflation expectations, fiscal restraint, and narrower sovereign risk spreads (Figure 9). In the process, the yield curve has become steeply inverted.5

Figure 9.
Figure 9.

Emerging Market Spreads, 2003-03

(In basic points)

Citation: IMF Staff Country Reports 2004, 178; 10.5089/9781451841008.002.A001

8. Inflation surged during 2002, but has declined sharply so far this year. Average inflation rose from 6.6 percent in 2001 to 9.3 percent in 2002, which was well above the SARB’s target range of 3-6 percent under its inflation-targeting strategy.6 The increase in inflation reflected a significant pickup in broad money growth in 2001, the pass-through impact of the currency depreciation, and increases in food costs as a result of serious drought conditions elsewhere in the region. Inflationary pressures subsequently eased appreciably. After peaking at just over 11 percent on a twelve-month basis in November 2002, inflation fell below 8 percent in May 2003. During January-May 2003, inflation was only 3 percent on an annualized basis. In May 2003, Statistics South Africa announced a correction to the consumer price indices for January 2002-March 2003 to reflect more accurate information on housing prices (see Appendix III). The correction implied a lower level of inflation during the period than previously indicated (for example, by 1.6 percentage points in 2002), and confirmed the overall trend of a steady decline in inflation.

9. Continued progress has been made in reducing South Africa’s vulnerability to external shocks. The NOFP, which for many years constituted a major source of vulnerability, was lowered into negative territory in end-May 2003 from US$1.6 billion at the end of 2002 (Figure 10).7 The reduction was achieved through the retention of proceeds from official external borrowing and privatization and through modest intervention in the foreign exchange market. The improved NOFP, together with credit rating upgrades, have contributed to a reduction in sovereign risk spreads of about 100 basis points since the end of 2001.8 The Treasury and SARB have both recently issued debt overseas, the issues were heavily over-subscribed at spreads significantly lower than for previous issues.9

Figure 10.
Figure 10.

Net Open Forward Position, 1997-2003

(In billions of U.S. dollars)

Citation: IMF Staff Country Reports 2004, 178; 10.5089/9781451841008.002.A001

10. South Africa is systemically important in the region by virtue of its relative economic size and position in various monetary and trade groupings.10 The pursuit of sound macroeconomic policies has, therefore, generally had a stabilizing influence on the region, although other members of the Common Monetary Area have shared South Africa’s large currency swings and higher inflation rate over the past two years. South Africa has also been an important force in helping harmonize macroeconomic policies and in liberalizing trade within the region. In recent years, it has been a significant source of fixed investment in Africa.

II. Economic and Social Policy Framework

11. South Africa has accomplished a great deal in recent years in establishing a sound and stable financial environment and in strengthening the economy’s resilience to external shocks and contagion. The removal of international sanctions in the early 1990s and the adoption of structural reforms have opened up the economy to competition, enabling South Africa to gain greater penetration into overseas markets and to realize significant productivity gains. As a result, since 1994 South Africa has enjoyed an average annual growth rate of 2.8 percent, compared with 1.2 percent during 1980-94 (Box 1 and table below).

South Africa: Sources of Growth, 1980-2002

(annual averages, in percentage points)

article image
Source: Staff calculations, based on data from Statistics South Africa.

Potential Output and Long-Run Growth

Staff analysis suggests that, during 1995–2002, the average rate of potential output growth rose to around 3 percent, from 1¼ percent during 1980-94. The estimates are based on a production function approach, and are robust to alternative methodologies.1 They imply a small negative output gap in recent years, that will widen in 2003 as growth slows down (see figure). A more negative output gap is associated with a reduction in inflationary pressures.

uA01fig01

Output Gap and Inflation, 1981-2003 1/

(In percent)

Citation: IMF Staff Country Reports 2004, 178; 10.5089/9781451841008.002.A001

1/ 2003 values are projections.

The substantial increase in real GDP growth after 1994 reflects a turnaround in total factor productivity (TFP) growth, which more than offset the impact of a decline in the growth contribution of capital. The growth rate of employment remained broadly unchanged at 1¼ percent annually, while that of the capital stock declined to l¼ percent during 1995-2002 from 2 percent during 1980-94. The strong TFP performance in part reflects policy and institutional changes, particularly greater trade openness and private sector participation in the economy. It is significant because growth can generally be sustained over longer periods of time when it is based on improvements in technology and efficiency—which are embodied in TFP—rather than on factor accumulation, which is subject to inherent limits based on demographics and diminishing returns.

In the long run, growth prospects depend importantly on policies and institutions that will help to maintain strong TFP growth, reduce unemployment (by increasing labor market flexibility and lowering the cost of labor relative to capital), and improve the investment environment. If recent TFP growth rates (1½ percent) are maintained and the unemployment rate is steadily reduced by 10 percentage points through the end of the decade, annual real GDP growth could reach 5½ percent. This assumes a reduction in labor costs relative to capital costs that encourages investment that absorbs rather than displaces labor.2 However, there are several risks to the long-term outlook. A key risk is that labor force growth may turn out to be slower than currently projected due to HIV/AIDS. If it is only half as rapid as projected, GDP growth could only be in the 3–3½ percent range. Growth could also be much lower than this if policy reversals were to weaken the institutional framework that has supported the strong rates of TFP growth in recent years.

1 The approach is discussed in V. Arora, A. Bhundia, and G. Bagattini, “Potential Output and the Sources of Growth,” South Africa: Selected Issues, IMF Staff Country Report No. 03/18, (Washington: IMF, 2003). In contrast to that paper, the present analysis is based on total employment rather than formal employment.2 The calculation implies a decline in the capital-labor ratio. Investment that simply increases the capital-labor ratio from already high levels would result in temporarily higher GDP growth, but this would be unsustainable in the long run and would not be enough to significantly reduce unemployment.

12. While the improved growth performance is welcome, growth rates of about 3 percent will not be sufficient to make an appreciable dent in South Africa’s acute unemployment problem. To raise growth, private investment must increase well above its present level of about 13 percent of GDP. The scope for funding a significant increase in investment from domestic sources is limited, and South Africa will have to rely substantially on investment from overseas. However, foreign direct investment inflows have been small so far, averaging only 1½ percent of GDP annually during the past five years. While much has been accomplished in establishing a sound and stable macroeconomic environment, foreign investors have been deterred by high rates of crime, inflexible labor market practices, the economic cost of HIV/AIDS, and potential social and political strains associated with wide income, wealth, and land ownership disparities.

13. Higher investment alone, however, will not be enough to raise growth and reduce unemployment. The South African economy has experienced a secular increase in capital intensity that needs to be reversed by raising worker productivity and lowering labor costs. Attracting skilled immigrant labor would help ease South Africa’s chronic skills deficiency, but the long-term solution lies in the education and training of the young and the unemployed. In the meantime, more could be done to address institutional and legal impediments to labor market flexibility. Growth performance would also benefit from further trade liberalization and continued efforts to restructure the parastatal sector.

South Africa: Policy Contributions to Economic Growth

article image

14. The government has further increased budgetary allocations for the social sectors and is taking steps to improve the delivery of social services. Past efforts in this direction have been reflected in improvements in social indicators relating to education and access to basic amenities. The government is focusing particular attention on the HIV/AIDS pandemic, which represents a major social and economic challenge (Appendix V).

15. The Fund’s advice to South Africa in recent years has focused on the central policy challenge of achieving high growth and reducing unemployment. The authorities have been very responsive on macroeconomic issues, and their performance in stabilizing the economy has been commendable. With regard to the labor market and other structural areas critical to more rapid growth of output and employment, the pace of reform has been constrained by the authorities’ commitment to building the broad-based political and social consensus essential to success of the reform effort.

III. Policy Discussions

16. The staff and the authorities broadly agreed on the short-term outlook, with inflation continuing to fall and the growth slowdown being relatively limited. Inflation was expected to decline within the 3—6 percent target range by the end of 2003 and to remain at that level in 2004. The recent declines in interest rates were seen as supporting private investment and the budget for 2003/04 as providing a mildly expansionary impulse to activity. The staff envisaged that real GDP growth would slow to 2¼ percent in 2003 and rebound modestly to 3 percent in 2004. The SARB’s projections were similar, but the Treasury envisaged somewhat higher growth. The risks to the outlook were seen as being largely on the downside, in view of the weak economic state of South Africa’s main European trading partners, the lagged impact of the recovery of the rand, and an anticipated rise in real wages in 2003. However, it was recognized that the economy’s resilience to external shocks had improved and that the debt dynamics were sustainable under a range of scenarios.11

A. Macroeconomic Stabilization

Inflation targeting and interest rate policy

17. The discussions took place against the background of a marked improvement in South Africa’s inflation outlook. Broad money growth had declined significantly since October 2002, the currency appreciation had contributed to a decline in producer prices, and oil prices were lower in the aftermath of the conflict in Iraq. Food prices were dropping with the end of drought conditions in the region. The slowdown in economic activity also suggested some further dissipation of inflationary pressures. Although the decline in inflation and downward revision in the CPI data would help ease wage pressures, the mission and the SARB agreed that an anticipated rise in real wages during 2003, reflecting the backward-looking nature of pay settlements, represented a risk to the inflation outlook.

18. On balance, it was clear to both the authorities and the mission that there was a strong basis for a reduction in short-term interest rates. In June 2003, the SARB’s Monetary Policy Committee (MPC) lowered its key intervention instrument, the repo rate, by 150 basis points to 12.0 percent. Other short-term rates moved in tandem, and the inversion in the yield curve became less pronounced. Since the rate cut was widely anticipated in the market, it did not have any appreciable impact on the exchange rate of the rand the recent movements in the yield curve point to an increase in the credibility of the SARB’s inflation targeting strategy (see Box 2).

19. The frequency of MPC meetings, which has important implications for implementation of the inflation-targeting strategy, was increased in June 2003 from four to six meetings per year. The MPC had met once a quarter to coincide with the availability of key economic data. But this timing did not allow the SARB to respond sufficiently quickly to changing conditions unless unscheduled meetings were convened, which risked being construed as emergency events. The greater frequency of meetings also makes it easier for the SARB to maintain a smooth and continuous flow of information to the market, thereby reducing the risk of creating surprises and adding to asset price volatility.

20. The inflation-targeting framework includes explicit escape clauses to be invoked in the event that the targets are missed. These clauses cover higher inflation arising from spurts in oil and food prices and from the impact of currency changes “unrelated to domestic economic fundamentals and domestic monetary policy.” The clauses were not invoked when the inflation target for 2002 was exceeded. However, the staff considered that the presence of escape clauses risked weakening public confidence in the resolve of the SARB to meet its targets, and that this had important macroeconomic implications. The mission suggested, therefore, that the clauses be dropped. If the inflation targets were missed, the SARB should, of course, provide a full explanation as to the reasons for the slippage and also indicate when it expected inflation to be brought back on track. This approach would be more in line with the practice of most other inflation-targeting central banks.

External vulnerability and exchange-rate policy

21. The mission commended the authorities on having brought down the NOFP to below zero. This was a major accomplishment. The mission, nevertheless, suggested that there were benefits in further strengthening the SARB’s net international reserve position:

  • a stronger reserve position, in conjunction with the implementation of stable financial policies, would help reduce currency volatility (Box 3);

  • South Africa’s gross reserves were still equivalent to only about one-half of total short-term debt, a very low ratio by emerging market standards;

  • the SARB retained an open position in the forward market of about US$5 billion; losses and profits on this exposure could have potentially destabilizing macroeconomic consequences; and

  • higher reserves would contribute to a further reduction in long-term interest rates by strengthening credit ratings and reducing sovereign risk spreads.

Indicators of the SARB’s Credibility on Inflation Targeting

In 2002, average CPIX inflation was 9.3 percent, compared with an official target of 3-6 percent. Despite declining year-on-year inflation rates over the past six months (Figure 1), CPIX inflation at 7.7 percent in May 2003 remained somewhat above the target range. The inflation outlook is encouraging, however, as the repo rate at end-June 2002 was still 250 basis points above its level at the peak of the depreciation in December 2001 and the rand has strengthened beyond the precrisis levels of August 2001.

Figure 1.
Figure 1.

Exchange Rate, CPIX Inflation, and Repo Rate

(In percent, unless otherwise indicated)

Citation: IMF Staff Country Reports 2004, 178; 10.5089/9781451841008.002.A001

A decline in long-term yields and inflation expectations since April 2002 may indicate the growing credibility of the SARB’s inflation targeting. A monetary tightening of 400 basis points between January and September 2002 occurred at a time of declining short-term interest rates in South Africa’s most important trading partners and coincided with additional support for the rand from rising gold and platinum prices. Long-term bond yields fell from above 13 percent at end-March 2002 to below 9 percent at end-May 2003, as inflation expectations declined. Between March 2002 and May 2003, inflation expectations—calculated as the yield difference between regular and inflation-indexed bonds with similar maturities—fell by 3 percent to below 4¾ percent (Figure 2).

Figure 2.
Figure 2.

Inflation Performance and the Difference in Sovereign Risk Spreads

(In percent)

Citation: IMF Staff Country Reports 2004, 178; 10.5089/9781451841008.002.A001

Prospects for a sustained decline in inflation are also reflected in falling sovereign yield spreads. Rising inflation increases the likelihood of a nominal depreciation, which—if inflation does not reflect higher real demand for goods and services—leads to a higher default premium on foreign currency debt. Figure 2 suggests strong comovements of U.S. dollar-denominated South African yield spreads1 and inflation expectations, which are reflected in a positive correlation of 0.6. In consequence, falling inflation expectations result in declining risk premiums, for which sovereign risk spreads are an indicator. Hence, the credibility of the inflation-targeting regime could be an important determinant of the relative strength of the rand against other currencies.

1 Spreads are shown for South Africa vis-à-vis a benchmark that is composed of a group of countries with credit ratings similar to that of South Africa. The benchmark was calculated as an unweighted average of sovereign yield spreads for Chile, Malaysia, Mexico, and Korea.

The Benefits of Holding International Reserves

The net open forward position (NOFP) was eliminated in May 2003. However, there may be a number of benefits to a further buildup in net international reserves, even under a freely floating exchange rate regime (some of these benefits are discussed in the main text):

  • International evidence on early warning indicators suggests that the risk for a currency crisis falls with the ratio of reserves to short-term debt. Larger foreign exchange reserves could reduce the risk for a self-fulfilling collapse in cross-border liquidity in the event that foreign investors refused to roll over short-term foreign exchange obligations.1

  • External and domestic borrowing costs tend to fall with larger reserve holdings. Empirical evidence suggests that there is a positive relationship between the level of reserves and credit ratings and a negative relationship between reserves and sovereign risk.2 Lower sovereign risk spreads will translate into lower long-term domestic interest rates.

  • Larger reserves can contribute to lower exchange rate volatility. Evidence over the past decade suggests that, in emerging market economies with freely or managed floating exchange rates, a higher level of reserves relative to short-term debt is associated with lower volatility of the real effective exchange rate (REER), as indicated in the figure below. While a large set of the observations is clustered at relatively low levels of volatility and reserves, extremely high levels of volatility seem to be much more closely associated with low levels of reserves.

This observation is supported by more rigorous econometric analysis undertaken by the mission. Covering the period 1994-2002, a panel regression with 13 emerging markets.3 indicates a significant nonlinear relationship between the ratio of reserves to short-term debt and the volatility of the REER, even after controlling for other determinants of volatility (see below), as well as country-specific effects. Such a nonlinear relation is shown in the accompanying figure.

The nonlinearity of this relationship is particularly important for South Africa in view of its present low reserve level, as it suggests that small increases in reserves can have a relatively large impact in reducing currency volatility. More precisely, the results for South Africa suggest that an increase of only US$6 billion could reduce the volatility of the exchange rate by about 40 percent. Such a reduction would imply that the probability that the REER would move by less than 4 percent within a month would increase from the level of 75 percent prevailing in 2002 to about 95 percent.

uA01fig02

1990-2002 - 13 emerging markets

Citation: IMF Staff Country Reports 2004, 178; 10.5089/9781451841008.002.A001

In terms of the influence of other determinants of the volatility of the REER, the volatility of broad money, trade openness, and the volatility of terms of trade were also found to have a significant effect, while the fiscal deficit, inflation, and growth proved less important.

1 “Debt- and Reserve-Related Indicators of External Vulnerability,” IMF Board document at http://www.imf.org/external/np/pdr/debtres/index.htm2 C. Christofides, C.B. Mulder, A. J. Tiffin, “The Link Between Adherence to International Standards of Good Practices, Foreign Exchange Spreads, and Ratings,” April 1, 2003, IMF Working Paper WP/03/74 (Washington, IMF, 2001).