Modelling South Africas equilibrium real effective exchange rate A VECM approach

It is not the South African Reserve Banks (SARB) policy to intervene in the financial markets, which essentially means that the external value of the rand is considered to float freely. As a result, the level of the currency is determined by the supply/demand fundamentals governing price behaviour in the financial markets. This paper investigates the various factors that may have an impact on the level of the exchange rate, and estimates a suitable model to measure the level of the equilibrium real effective exchange rate. The results from the model suggest that the equilibrium level may be determined by the effects of key economic fundamentals, including an interest rate differential, a suitable productivity measure, commodity prices, the fiscal balance and capital flows. Deviations of the actual level from this estimated equilibrium level can then be used to indicate whether the prevailing level of the exchange rate is either under or over-valued. On the basis of these fundamentals, it was found that the actual level of the real effective exchange rate was close to its equilibrium in the last quarter of 2011, but that it is currently less than five per cent overvalued (appreciated) relative to its equilibrium in the first quarter of 2012. It should be noted that this model serves only to indicate a possible equilibrium level based on the given economic fundamentals. Although the study provides a clear indication whether the level of the exchange rate is inconsistent with a set of given fundamentals, the estimated equilibrium in this study should nevertheless remain to be considered as an unobservable.