1. Capital flows, exchange control
regulations and exchange
rate policy: the South
African experience
``
25 March 2004

2. 1 Introduction
The relationship between capital flows,
exchange control regulations and
exchange rate arrangements has long
occupied policymakers
This paper reviews the SA experience

3. Figure 1 The South African financial account

4. 1 Introduction
The relationship between capital flows,
exchange control regulations and
exchange rate arrangements has long
occupied policymakers
This paper reviews the SA experience
Presentation proceeds chronologically:
• Evolution of controls prior to 1983
• The 1985 debt crisis and the re-
imposition of controls on non-residents
• The liberalisation of controls in the post-
1994 period
Some issues for the future

5. 2 Evolution of controls prior to 1983
The British influence
The relationship between controls and
parallel foreign exchange markets

6. 2 Evolution of controls prior to 1983
We never thought at the time that we
were instituting a dual exchange rate
system. We thought we were simply
applying exchange control, blocking
funds of non-residents ... there were
some suggestions that we should, in
fact, institute a formal dual exchange rate
system. But we decided against this,
partly because the extended exchange
control was considered to be a
temporary crisis measure (emphasis in
the original). De Kock (1979)

7. 2 Evolution of controls prior to 1983
The British influence
The relationship between controls and
parallel foreign exchange markets
Evolution of the parallel exchange rate
system:
• the Blocked Rand
• the Securities Rand
• the Financial Rand

8. The Financial Rand system 1979-83:
Located in Johannesburg and London
Operated via 2 linked channels:
• the ‘cash’ market
• the stock exchanges
Some implications of the system
• Implications for the BOP

9. Implications for the BOP:
A non-resident seller of South African assets
had to be matched by a non-resident buyer, with
the exchange rate adjusting to clear the market.
Therefore, non-resident disinvestment had no
impact on the country’s balance of payments.
However, there could be no net investment via
the financial rand either.
To quote Stals (1980) “investments in South
Africa by non-residents with financial rand do
not benefit the balance of payments. The
mechanism only enables non-residents as a
group to shift existing investments in South
Africa from one application to another”

10. The Financial Rand system 1979-83:
Located in Johannesburg and London
Operated via 2 linked channels:
• the ‘cash’ market
• the stock exchanges
Some implications of the system
• Implications for the BOP
• Inherent uncertainty regarding duration
Abolished February 1983

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Figure 2b The financial rand: 1979-83 and 1985-95

12. 2 Evolution of controls prior to 1983
“… with the wisdom of hindsight it is clear that
in 1982/3 the monetary authorities were too
optimistic about the financial strength of the
rand and certainly insufficiently sensitive to the
international market perceptions of the basic
weaknesses of the rand, the high liquidity of the
country’s foreign debt, the downside prospects
for the country’s foreign terms of trade, the
doubts concerning its internal monetary
stability as measured by the increase in the
domestic money supply, the low level of real
interest rates, and the low level of fiscal
discipline.” Lombard (1994)

13. 3 The 1985 Debt crisis and the re-imposition
of controls on non-residents
The 1985 debt crisis: the backdrop
• Between the end of 1980 and the end of
1984, South Africa’s total foreign debt
increased from R12,6 billion to R48,2
billion (US $16,7 billion to $25,5 billion)
• of this, short-term debt increased from
49,1 per cent to 68,0 per cent
• largest share of this was private sector
debt.
Deteriorating economic fundamentals
and a political catalyst

14. 3 The 1985 Debt crisis and the re-imposition
of controls on non-residents (cont.)
The deterioration of economic
fundamentals
• Gold price declined from over US$500
per fine ounce in February 1983 to
US$299 per fine ounce in February 1985
• Exchange rate depreciated by 53 per cent
against the USD between September
1983 and January 1985 (44 per cent vs
NEER)
• Weak world commodity markets, 3 years
of drought, excessive money creation in
1983-84

15. 3 The 1985 Debt crisis and the re-imposition
of controls on non-residents (cont.)
The political catalyst
• Declaration of State of Emergency 20
July 1985, and subsequent capital
outflows
• Rumours banks wouldn’t renew loans
• Rubicon speech 15 August 1995
• Large-scale outflows until 27 August
when government suspended trading on
the JSE and foreign exchanges
• 1 September 1985: emergency package
announced including moratorium on debt
repayments and re-imposition of the
financial rand

16. Was the financial rand system
‘effective’?
It depends
Very little empirical work done
Can perhaps say something about
insulation provided to interest rates and
exchange rates but this has to be
weighed against the costs of the system

17. Source: Kahn (2001: 238)

18. Tests for volatility shifts in nominal
exchange rates:
Compared various exchange rates for
first unified (1983-85), financial rand
(1985-95) and re-unified periods (March
1995 – October 1998)
Conditional variance proxies for
exchange rate volatility in each of the
three time periods obtained from ARCH-
type models
The conditional variance proxies for
exchange rate volatility were then
compared for the various periods

19. Sample period Sign of Mean Variance
st
change ratio test ratio test
1 unified Finrand
Rand/US$
mean 2,287 0,723 - 3,163** -
standard deviation 3,322 2,805 - - 1,403**
Rand/British ?
mean 1,778 0,786 - 2,262** -
standard deviation 2,757 1,656 - - 2,772**
Rand/German mark
mean 1,810 0,602 - 3,007** -
standard deviation 2,971 1,311 - - 5,136**
Rand/Japanese ¥
mean 2,453 0,734 - 3,342** -
standard deviation 3,069 1,342 - - 5,230**
NEER
mean 2,352 0,605 - 3,888** -
standard deviation 4,923 2,866 - - 2,951**

20. Sample period
Sign of Mean ratio Variance
Finrand 2nd unified change test ratio test
Rand/US$
mean 0,723 0,531 - 1,362** -
standard deviation 2,805 1,320 - - 4,516**
Rand/British ,
mean 0,786 0,800 + 1,018 -
standard deviation 1,656 1,495 - - 1,227**
Rand/German mark
mean 0,602 0,823 + 1,367** -
standard deviation 1,311 1,103 - - 1,413**
Rand/Japanese ¥
mean 0,734 1,092 + 1,488** -
standard deviation 1,342 1,244 - - 1,164**
NEER
mean 0,605 0,696 + 1,150** -
standard deviation 2,866 1,879 - - 2,326**

21. Some further evidence
The Engle-Kozicki common feature test
• No evidence was found of a common volatility
(ARCH) process in the dual foreign exchange
rates using the ‘common features’ methodology
Tests for volatility spillovers
• Hamao et al (1990) approach used
• estimated volatility shock for finrand included as
explanatory variable in the conditional variance
equation for comrand, and reverse
• results revealed volatility spillovers from the
commercial rand exchange rate to the financial
rand, but not in reverse direction

22. 4 The post-1994 liberalisation
The debate on exchange control
liberalisation
The ‘big bang’ approach
• controls provide a disincentive to foreign
investment
• immediate abolition as a signalling device
The gradualist approach
• sequencing of financial liberalisation (McKinnon
1973 and 1979, Edwards 1984)
• risks involved in ‘big bang’ approach
Abolition of financial rand March 1995
Further relaxation of controls

23. 4 The post-1994 liberalisation (cont.)
Resident institutional investors
• asset swap mechanism introduced July 1995
• involved proposals to swap part of existing
portfolios for the foreign assets of foreign
investors (incorporating measures to “lock-in” the
reciprocal foreign investment)
• some problems, but “… even so they achieved
their basic objective of greater diversification
without capital flight” Vittas (2003)
• 2003: as an interim step towards prudential
regulation, institutional investors allowed to
invest on approval up to the foreign asset limits
Resident companies and private
individuals

24. The foreign exchange and tax amnesty
Dangers associated with amnesties
Motivation: repatriation of capital vs
regularisation of affairs
Emigrants ‘blocked’ funds to be released

25. Some issues for the future
Volatile capital flows are a fact of life
Revival of debate on controls with each
crisis
Softening of attitudes towards controls?
• earlier positions may have overstated
benefits and not emphasised enough the
dangers of liberalisation
• current state of the debate

26. Some issues for the future
Implications for SA
• Gradual approach seems to be consistent
with the direction debate has taken
• obvious that further liberalisation should
seek to maximise benefits and minimise
costs
• How is perhaps less straightforward?
• Shift away from managing flows directly
and toward limiting the vulnerability of the
economy via prudential regulation is
important, but it would seem there are still
important policy decisions to take

27. SA cents per US dollar
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Financial rand/US$
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Commercial rand/US$
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Figure 2a The financial rand: 1979-83 and 1985-95
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