Trade deficit's impact on Rand exchange rate

A serious economic fallacy that is readily accepted as the truth by the mainstream is the notion that a current account balance impacts the foreign exchange rate of a country’s currency.

Listen to currency analysts on popular financial media (FTV) and you’re guaranteed to hear the expected widening of the SA trade deficit or current account deficit being mentioned as a reason for expected future Rand weakness, and vice versa. They are confusing cause and effect.

Luckily this fallacy can be easily dispelled. Let’s say for argument’s sake that South Africans did not produce any goods (for simplicity there are only physical goods in the world), owned a fixed supply of Rands and only consumed imported goods. When a South African buys a foreign good, Rands and goods change ownership. Our focus here lies with the Rands – which can either shift from domestic ownership to foreign ownership, or it can shift from domestic ownership to another domestic owner who clears the transaction. In today’s monetary system, the exchanged Rands end up with a SARB-authorised financial intermediary which acts as a clearing house. Whether the Rands end up being foreign or domestic-owned makes no difference. The fact remains that soon local uber-consumers would not own any Rands with which to pay for imported goods – and – foreigners and financial intermediaries would own the entire Rand money supply. Local consumers would have no choice but to curtail their consumption.

The exchange by a South African of his Rands for a foreign good does not cause the Rand to weaken. In fact, whoever accepted the Rands in exchange (whether a foreigner or a financial intermediary), demanded it over what was given up – which implies the value of the Rand would be bid stronger. Competition in the free market would see to it that the Rand is not bid significantly weaker – if at all. The new owner now has control over the purchasing power of that one unit the Rand can afford him – and in no way does an idle cash balance lose purchasing power or value in exchange only because it is lying idle.

Barring short-term fluctuations, the exchange ratio between the Rand and other currencies or goods will remain the same, unless if there was to be an increase or decrease in the supply of any of these items relative to each other. This is the crux of the matter.

Today, the fallacy dispelled above is exploited on a daily basis by the incumbent administration to create money out of thin air which they use to spend on whatever it is they please [think FIFA 2010, infrastructure programmes, five (or is it six?) first wives]. The reference to fallacious Mercantilist terminologies such as an “unfavourable balance of trade” is continuously made, and the public is told the nation requires a weaker rate of exchange that will eventually bring the deficit on the balance of trade back into balance.

The causal relation that leads to Rand weakness is the creation of new Rands out of thin air, which increases its supply, and leads to a higher rate of exchange relative to other currencies and goods that has increased in supply at a slower rate. The unfavourable balance of trade will never be reversed by a weaker Rand, it can only be solved by going back to the basics, domestic production. Production precedes the need for media of exchange (paper currencies). Those South Africans who have spent all their money on consuming imported goods will not be able to acquire new goods until they produce something that an owner of Rands (or another currency) would be willing to exchange for it.

Weakening the Rand to reverse the “unfavourable balance of trade” will only benefit some at the expense of others – with those others being government employees, government employed contractors (aka the well connected), exporters, and savvy speculators (the financial intermediaries). The rest of the public therefore pay an invisible tax.