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Working Paper 157 - How are the US Financial Shocks Transmitted into South Africa? Structural VAR Evidence
08/10/2012 14:23
Working Paper 157 - How are the US Financial Shocks Transmitted into South Africa? Structural VAR Evidence
This paper investigates the transmission of unanticipated US bond yield increases, monetary policy stimulus and the federal funds rate tightening shocks into South Africa using small open economy structural VAR models. We intend to inform policy-makers about the channels impacted on by external developments, which may make policies designed and targeted at dealing with domestic macroeconomic issues, ineffective. First, the US monetary stimulus shock leads to low inflation, rand-dollar appreciation, revaluation in stock prices, depressed bond yields, a decline in monetary aggregates and real interest rates in South Africa. Despite a weaker trade channel result, all other findings are consistent with the predictions of the Mundell-Fleming model of a small open-economy. Second, an unexpected increase in US medium-term bond yields leads to depreciation in the rand-dollar exchange rates and a rise in bond yields, in line with the portfolio balance approach. In addition, a significant stock price decline occurs after two quarters and supports the idea of portfolio re-allocation or rebalancing driven by a change in the return from bonds. Third, we find that the unexpected US federal funds rate tightening leads to a significant increase in SA bond yields, depreciation in the rand-US dollar exchange rate and a delayed response in consumer price inflation. Overall these findings suggest that the South African economy is highly responsive to external shocks, which may destabilise the economy and limit the effectiveness of policies designed to deal with domestic macroeconomic problems. In the absence of regional and bilateral trade agreements, the policies impacted by the exchange rate encompass those directed at enhancing export performance and achieving higher levels of and sustainable growth. An exchange rate appreciation will reduce exports through a decline in  competitiveness. In the absence of good hedging strategies, a strong exchange rate makes manufactured goods expensive and reduces receipts of key exporters such as the mining sector, in turn, this may lead to increased production costs and job losses. The elevated stock prices are possibly not reflecting economic fundamentals and may indicate instead that capital is being misallocated and the levels may not be sustainable. This implies an imminent threat to the soundness of the economy and with finacial stability consequences. While an unexpected rise in bond yields due to unexpected foreign developments indicates possibly unexpected increases in debt service costs, this may require the re-allocation of resources to alternative projects and, therefore, different outcomes relative to initial projections. In addition the repayment costs driven by high debt servicing costs may be compounded by the depreciation in the exchange rate.  The latter also has an impact on the South African Reserve Bank’s (SARB’s) foreign reserve accumulation strategy and can reduce foreign reserve accumulation and therefore impact on its ability to adequately cover external foreign short-term debt and imports.Read more
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