Monetary policy in South Africa

1. An Empirical Analysis of Exchange
Rate Pass-Through on Prices in South
Africa (2002-2015)
By
H Madhuku, T Contogiannis
And
I Kaseeram

2. Introduction
• Exchange rate pass through(ERPT) is the transmission or consideration of
the exchange rate changes into tradable prices Kabundi and Schaling,
(2013) ; Choudhri and Hakura (2015) and Aron et al., (2014).
• When exchange rate changes are all transmitted to prices (complete) and
when a portion is passed on (partial).
• The study targets only the inflation targeting period
• When imports control a bigger part of the domestic market, the ERPT is
expected to be very high since imports are more responsive to changes in
the exchange rate.
• intermediate goods imported into the country is a headache to IT

3. Background
• The South African Reserve Bank (SARB) adopted an inflation targeting
monetary policy in 2000 in a bid to achieve price stability.
• The band is that of 3% to 6%.
• Monthly inflation and other provincial inflation rates that are sometimes outside
the upper band of the target
• exchange rate channel is of paramount importance mostly for small and open
countries
• The country was hit by a series of rand depreciations mainly from around 2009
• Also the country witnessed a series of changes in the finance ministry and the
shuffles took place more than 3 times for the duration covered by the study
• the rand losing value through loss of confidence in the country’s policies and
leadership
• The conventional wisdom assumes that depreciation of a currency makes the
imports to be more expensive and the opposite happens to exports.
• However, the country could not benefit from depreciations on trade terms

4. Background cont…
• ERPT can be divided in two stages
• the first stage which is the transmission form exchange rate to import
prices
• second stage pass through which comes from the import prices to other
prices down the pricing chain
• Finding the duration taken by the price indices responding to exchange
rate fluctuations took a central role to this research
• Also the magnitude of pass through

5. Findings by previous studies in SA
• Aron et al.(2012) estimates a Johansen Co-integration model and single
equations for short-run Exchange Rate Pass-Through (ERPT) using monthly
data of import price indices for 1980:1 to 2009:12
• ERPT was found to be incomplete and it was 50% after a year and 30 % in 6
months
• Edwards and Garlick, (2008) focused on an analysis of trade flows and
exchange rate pass-through in South Africa basically the relationship between
the nominal effective exchange rate (NEER) and trade flows and they also used
a Johansen co-integration approach in investigating that.
• The study used quarterly data from 1980 to 2005
• ERPT to export prices had an estimation of 0.85 (85%) and that of import
prices was at 0.89 (89%).
• Karoro et., al. (2009) in a way to also investigate longrun-pass through in the
republic of South Africa, employed the VECM.
• Findings about the equilibrium pass-through to import prices appeared to be
higher for depreciations at 0.72 (72%) than that of appreciations 0.64 (64%).

6. Findings cont…
• Parsley (2012) did a research on which he estimated the effects of
exchange rate changes to import prices and services in the republic of
South Africa using panel data of goods and services at the dock using
disaggregated homogenous import units.
• The study finds low pass through to the final consumer goods prices and it
was between 14-27% in two years after an exchange rate change.
• Razafimahefa, (2012) investigated on the asymmetries of the pass through
in South Africa using exchange rate data.
• The study investigated the effects of the rand depreciation for 4 quarters
and 8 quarters.
• The study used a sign restricted VAR
• The study finds that pass through is less asymmetric after 4 quarters (13%)
than after 8 quarters (16%).

7. Methodology issues
• use monthly data for both the Structural VAR and the Recursive VAR
• Ouliaris et al., (2016) as they argued that SVAR is better specified using
disaggregated
• period of the inflation targeting regime
• Output gap- world demand shocks
• Petrol prices- supply shocks in the model
• NEER, IMP, PPI, CPI

8. Recursive VAR identification
• 𝐴 =
1 0 ⋯ 0
𝑎21 1
⋮ ⋱ ⋮
𝑎 𝑛1 𝑎 𝑛2 ⋯ 1
, 𝐵 =
𝑏11 ⋯ 0
0 𝑏22 0
⋮ ⋱ 0
0 0 0 𝑏 𝑛𝑛

9. SVAR identification
• A =
1 0 0 0 0 0 0
𝑎21 1 0 0 0 0 0
𝑎31 𝑎32 1 𝑎34 𝑎35 𝑎36 𝑎37
𝑎41 𝑎42 0 1 0 0 0
𝑎51 𝑎52 0 0 1 0 0
0 0 0 𝑎64 0 1 0
0 0 𝑎73 𝑎74 𝑎75 𝑎76 1
𝜀𝑡 =
𝜀𝑡
𝑔𝑎𝑝
𝜀𝑡
𝑝𝑡𝑟
𝜀𝑡
𝑛𝑒𝑟
𝜀𝑡
𝑐𝑝𝑖
𝜀𝑡
𝑖𝑚𝑝
𝜀𝑡
𝑝𝑝𝑖
𝜀𝑡
𝑒𝑥𝑝01
• 𝐵 =
𝑏11 0 0 0 0 0 0
0 𝑏22 0 0 0 0 0
0 0 𝑏33 0 0 0 0
0 0 0 𝑏44 0 0 0
0 0 0 0 𝑏55 0 0
0 0 0 0 0 𝑏66 0
0 0 0 0 0 0 𝑏77
𝜇 𝑡 =
𝜀𝑡
𝑔𝑎𝑝
𝜀𝑡
𝑝𝑡𝑟
𝜀𝑡
𝑛𝑒𝑟
𝜀𝑡
𝑐𝑝𝑖
𝜀𝑡
𝑖𝑚𝑝
𝜀𝑡
𝑝𝑝𝑖
𝜀𝑡
𝑒𝑥𝑝01

10. Findings of the study

11. -1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
-1.5 -1.0 -0.5 0.0 0.5 1.0 1.5
Inverse Roots of AR Characteristic Polynomial

12. Unit root tests
• Each and every variable was tested for stationarity using the ADF test
• All variables are non-stationary in levels and get stationary after the first
difference I(1)

13. Cointegration tests results
• The Johansen test results show that the variables have a long-run
relationship
• there are 2 cointegrating equations according to the Trace statistic results
and one cointegrating equation using the Max Eigen results.
• This paper is adopts the results from the Trace statistic since it is assumed
to be the most powerful compared to the Max Eigen.

14. Impulse response functions
(Recursive VAR)
• Direct pass though import prices respond by 37% within 4 months and
41% after 12 months
• Producer prices respond by 20% after 4 months and 28% after 12 months
• Cpi respond by 2% after one month and 7% after 12 months
• On second stage: producer prices respond by 18% after 3 months and 32%
after 1 year
• Consumer prices respond by 4% after 3 months of the shock and 9% after
1 year
• Consumer prices also respond sluggishly to the import price shock

15. Variance decompositions
Recursive
• shock to the exchange rate, the import prices respond by 17.27% within 6
months, 27.54% after 12 months
• Results confirm previous studies by Parsley (2010) and (Aron et al., 2014).
• A shock to import prices accounts for 31.47% fluctuations in the producer
prices only one month after the shock
• On direct pass through, exchange rate accounts for a 5.49% fluctuation in
the consumer prices within 6 months then by 11.55% after a period of 12
months
• The low ERPT on consumer prices can be explained by the low demand in
the country.
• High unemployment of 27%

16. Non recursive VAR (IRF)
• The impulse responses of the import prices do not look much different
from those of the recursive
• only difference being that, the impact is more faster as compared to that
of a recursive.
• This is maybe the restrictions are too tight as compared to the later

17. Variance decompositions

18. conclusion
• This paper has found pass through not complete in South Africa
• The impact is felt after a lag
• First stage pass through is found to be 2% after one month and 7% a year
• Second stage pass through to consumer prices is 4% after 1 month 9%
after one year
• It suggests that IT has somehow worked in stabilising second stage
inflation has been kept in the band mostly although at the neck of the
upper band.
• Inflation expectations need to be handled: More confidence is needed in
the economy.