Month: October 2023

We all know that market determined prices reconcile supply and demand. Higher prices discourage demand and encourage supply. What is true of an individual price is true of all prices on average, as represented by a Consumer Price Index(CPI) That prices generally tend to rise with increased demands or reduced supplies and vice versa seems obvious enough.

Higher prices discourage demand and encourage supply. That prices generally tend to rise with increased demands or reduced supplies and vice versa seems obvious enough. But the supply and demand for all goods and services are not determined independently of each other. The supply of all goods and services produced in an economy over a year is equivalent to all the incomes earned producing the goods and services that year. The value added by all producers (GDP) is equal to all the incomes earned supplying the inputs that produce output. Incomes are received as wages, rents, interest, dividends, taxes on production and what is left over, the profits or losses for the owners after all input costs have been incurred.

Produce more, earn more and you are very likely to spend more. The economic problem, not enough of everything, too little income, is surely not the result of any reluctance to spend on the necessities or luxuries of life. The problem is we do not produce enough, earn enough income to spend really more.

Extra demands can be funded with debt. Yet for every borrower spending more than their incomes, there must be a lender saving as much. Matching financial deficits with financial surpluses, is the essential task of financial markets and financial institutions, and may not happen automatically or seamlessly. There may be times when the demand for credit and the spending associated with it may run faster or slower than the supply of savings. If so incomes and output may increase temporarily above or below long-term trends. We call that the business cycle. Interest rates (yet another price) may be temporarily too low or too high to perfectly much the supply of and demand for savings. But such imbalances must sooner or later will run up against the supply side realities, the lack of income.

There is a further complication. The supply of goods and service is augmented by imports. And demand includes demand for exports. In South Africa both imports and exports are each equivalent to about 30% of the economy, making a large difference to supply and demand. But the prices of these imports and exports are not set in South Africa. They are set in US dollars and translated into rands at highly unpredictable and generally weaker exchange rates. The prices paid for imports and exports affect average prices. And they mostly push the averages higher. It has been the case in SA of a weaker exchange rate leading, equivalent to a supply side shock, and prices following.

And the rand is still expected to depreciate against the dollar by more than the difference between SA and US inflation. The bond market expects the rand to weaken against the USD by an average 7.3% p.a. over the next ten years, being the spread between RSA bond yields (12%) and the US yield(4.7%) While the difference in inflation expected in SA (7.2% p.a.) and in the US (3.2% p.a) over the next ten years is much less, only 4.8% p.a. according to the break-even gap between vanilla bond and inflation protected bond yields.

Lenders to the SA government remain suspicious of SA’s ability to grow fast enough to raise the taxes  that could sustain fiscally responsible policies. That is the government will not avoid resorting to funding expenditure with money supplied by the central and private banks. A sure source of extra demands without extra supply that leads to ever higher prices as it does persistently in most African countries.

There is little monetary policy and short-term interest rates can do to strengthen the rand and bring inflation down further against this backdrop. That is without resulting in too little demanded and even less supplied than would be feasible. That in turn bringing  still slower growth more fiscal strain, higher borrowing costs and a still weaker rand- and higher prices.  The call is not to inhibit already depressed demand but for economic policy reforms that would stimulate the growth in SA output and incomes enough to change the outlook for fiscal policy, the exchange rate and inflation.

The group of countries that will make up the enlarged BRICS, Argentina, Egypt, Ethiopia, Iran, Suadi Arabia and the UAE have little in common other than a deep suspicion of the motives of the US and its close allies. A state of mind also shared by left wing opinion everywhere including in the US itself. If the unlikely combination of kingdoms, autocracies and genuine democracies is to become more than a another talking shop with an anti-West bias, then it should take an important lesson from the economic development of the US and Europe.

What has been of great benefit to the US and to Europe, since it established a common European market and Euro are their highly significant common currency areas.  The same money is used everywhere in the US and Europe as a medium of exchange and a unit of account. Thus unpredictable rates of exchange when buying or selling goods and services across frontiers are avoided, as are the direct costs of converting one currency into another- usually converting US dollars -into the domestic money.

Trade and financial flows between the states of the US and now of Europe is greatly encouraged by what is a fixed exchange rate regime within a common market, also free of protective of domestic industry tariffs or discrimination against foreign suppliers, by regulation. As it does incidentally when transactions of one kind or another take place within any country. The important trade between Gauteng and the Western Cape for example is facilitated by prices set in the rand common to both.

In the nineteenth century when which international trade and finance first flourished and economies came to benefit from wider markets for their goods and labour, and the ability to realise productivity and income enhancing economies of scale, currencies were mostly linked by fixed rates of exchange.  The link was the ability to convert the different monies, if necessary, into gold at a fixed rate. And the issuers of different monies made sure to maintain convertibility by protecting their balance of payments through adjusting domestic interest rates. If gold generally flowed out interest rates could be raised to conserve and attract gold reserves and vice versa. Provided the commitment to currency convertibility was fully credible, the extra interest received would balance the payments by attracting or retaining capital.

A modified fixed exchange rate system was re-established after the second world war with the US dollar as the reserve currency- but dollars that could be converted into gold at the request of other central banks. This commitment was abandoned unilaterally by the US in 1971 and market determined exchange rates, with the still dominant US dollar, became the norm. Highly variable rather than predictably fixed exchange rates have become the unsatisfactory order of the day. The rates of exchange of other currencies with the dollar, both in money of the day terms and when adjusted for differences in inflation of different currencies have varied very significantly – and unpredictably- damaging volumes of international trade and real investments.

US Dollar Exchange Rate Index. Market Determined and Inflation Adjusted

Source; Bloomberg, Federal Reserve Bank of St.Louis and Investec Wealth and Investment

It has not been a case of exchange rate moves levelling the playing field for traders in goods and services- so maintaining purchasing power parity in the face of differences in inflation rates across trading partners. Rather the exchange rates have adjusted to equilibrate independent flows of capital – large and reversible flows – in search of better risk adjusted rates of return- to which inflation then responds. Weaker exchange rates lead to more inflation and vice versa. Without stable exchange rates, controlling inflation in the face of capital withdrawals and a suddenly weaker exchange rate with the US dollar can become a severe interest rate burden on the domestic economy – as South Africa demonstrates.

The enlarged BRICS could establish fixed exchange rates between each other to promote trade and investment. They might usefully adopt a Chinese standard- that is offer convertibility of their own currencies into Renminbi at fixed rates. And rely on the Bank of China to manage the float of the crucial rate of exchange of Renminbi into US dollars, as it now does.