Real Exchange Rate Misalignment

By Mariska Krynauw

Exchange rate movements and their deviations from equilibrium bring some challenges at policy level.  Usually, the real exchange rate has not been at the centre for analyses of economic growth. 

The current debate in South Africa is over the effects and how to deal with an appreciating Rand.  There is good reason and plenty of evidence to suggest that the real exchange rate matters for economic growth, unfortunately the nature of this relationship and the policy implications are far from settled. Over- and undervalued exchange rate’s impact on economic growth is an incomplete debate.

For South Africa to improve their economic growth, the real exchange rate should be at equilibrium.  When misalignment in a country’s real exchange rate occurs it will lead to fewer investments as well as instability in the country.  Misalignment in the exchange rate is when the actual exchange rate deviates from the ideal exchange rate. 

For a country’s exchange rate to be over-valued holds many problems.  The result of an overvalued exchange rate can be the undermining of exports because it is much cheaper to import.  Overvaluation can also harm the agricultural sector providing them with less protection which causes lower employment. It also causes higher demand for foreign exchange which put a lot of pressure on reserves and increase borrowing needs.

The Rand strengthened by over 31% between March 2009 and December 2010. This trend becomes alarming because real exchange rate is a measure of how much, on average, South African produced goods and services will cost relative to comparable basket of foreign produced goods and services, and hence their competitiveness across time. 

The impact of the exchange rate misalignment (based on the purchasing power parity measurement) have on growth is that they found evidence that undervaluation is good for growth and overvaluation bad.  However, implications associated with maintaining a particular level of exchange rate, even if undervaluation is good for growth, there are costs of maintaining such exchange value. Undervaluation proved to be good for growth but it has been noted that in such a case problems with large capital inflows will be pending – large capital influx appreciates the currency.

In the last 21 years South Africa has experienced 10 years of overvaluation of their real exchange rate but it caused more damage than good.  Misalignment has a negative impact on economic growth.  Policy makers should take note as it impacts job creation.  South Africa needs to move away from the current consumer driven approach and embark on extensive infrastructure development programmes.

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