On Tuesday 11 October 2016, South Africa’s National Prosecuting Authority (NPA) issued a formal summons to Finance Minister Pravin Gordhan on charges of fraud. The rand immediately depreciated around 3% against the dollar (We should note that this article presupposes nothing about the validity of these charges).
In December 2015, state president Jacob Zuma fired then finance minister Nhlanhla Nene and replaced him with the almost parodically inexperienced David van Rooyen. The rand immediately suffered a sharp depreciation against foreign currencies. Although Zuma’s decision was reversed a few days later when he relieved van Rooyen of his short-lived duties and re-hired former finance minister Pravin Gordhan, the rand continued to depreciate into January 2016 before staging a partial recovery.
Then, in August 2016, Gordhan’s job came under threat for seemingly political reasons related to his time at the South African Revenue Service. The rand again depreciated sharply.
Why do currencies react to political events? In one sense the answer is fairly obvious. National currencies are nationalised currencies. Their production and use are mandated and controlled by the state and state-regulated banks. Currency credibility, therefore, rests heavily on state credibility.
When the state is so heavily involved in the economy, state credibility and the standards of governance tend to matter a lot for the broader economy, and hence the currency.
Currencies are impacted strongly by the economic health of the companies and households that reside in the geographical area where one is forced to use the nationalised currency. This is because modern fiat currencies are not backed directly by gold but indirectly by credit, and credit rests on the health of the debtors. The health of debtors is their productivity.
While this is easy enough to understand, it doesn’t necessarily help us understand why certain political events matter more than others for the exchange rate. For years the Zuma administration has been making poor decisions, undermining governance standards, and placing favoured, unqualified party ‘cadres’ in positions of power and influence without eliciting such dramatic currency depreciation as experienced in December 2015, August 2016 and October 2016.
What was different about these political events? The key difference was that it was an undermining of governance standards in a critical node of currency credibility, the national treasury. Since the Treasury plays such an overbearing role in the economy – taking in taxes and allocating spending on a massive scale – investors fret when it is at risk of being captured for narrow political ends. Specifically, when market participants believe that the national treasury will be used by politicians to loot the country, it places tremendous strain on currency confidence as financial market participants fret that the national debt will become unsustainably high and geographic productivity will decline as the state levies higher taxes in the future.
The other thing investors worry about regarding national treasury capture for corrupt political ends is that this could quickly lead to the usurpation and corruption of the most critical node of currency credibility: the central bank.
The central bank is vital because it’s the only institution legally authorised to print monetary reserves and regulate the business and lending conditions of commercial banks. The currency supply – how much currency exists in circulation – is critical to currency credibility. If it is printed in enormous quantities, the currency will rapidly lose its value as its availability becomes much less scarce.
Countries in fiscal and economic trouble often turn to the central bank to print money to bail out the government, over-indebted companies and sometimes even cash-strapped households. When this happens rapidly and in large quantities, currencies tend to depreciate precipitously. This is why persistent government budget deficits and treasury capture causes market participants to fret about central bank capture and excessive money printing.
Since currency markets are extremely liquid (extensively and efficiently traded) and try to discount future events, the rising threat of treasury capture – as is allegedly the case in the Nene sacking and legal threats to Gordhan – translates into an increasing threat of central bank capture. This risk, in turn, means currency speculators price in a weaker exchange rate in anticipation of less responsible management of the currency supply in the future. Even though the prospect of central bank capture in South Africa is probably not imminent, a rising risk of capture is quickly discounted in the exchange rate.
Although the reaction in the rand to these events might seem extreme, we should bear in mind that currency speculators are basing their actions on how past experiences of deteriorating governance standards and central bank capture have impacted currency exchange rates. The world is littered with many examples of dramatic currency depreciation once central banks became a state tool to fund government expenditure directly by printing money and once central bank institutional decay led to the corruption of commercial banking. Zimbabwe from the mid-90s until 2009 is a dramatic example of the calamity that can befall a currency once the central bank is grabbed for corrupt political ends. Venezuela is a currently disastrous, though less extreme, example, and there are scores more throughout history.
In short, corruption in various state departments is not equally detrimental. Decrepitude in the department of sport and recreation, for example, is deplorable but not important for the economy or the financial markets. Corruption of the education department is hugely damaging, though in a chronic rather than acute way. Corruption of the fiscal and monetary agencies matters both chronically and acutely for the economy and the currency since these are critical institutions for financial and exchange rate stability in our present monetary system. As long as a dark cloud hangs over the tax collection agency, the national treasury, and the central bank, the rand is likely to remain vulnerable and prone to erratic and sharp depreciation.
Thankfully the South African Reserve Bank presently remains staffed and run by relatively independent technocrats. It’s not that the central bank is a useful institution, but if you must have a central bank as custodian of a fiat currency backed by credit, then it’s far better if that central bank is run by constrained technocrats than by unconstrained regime apparatchiks.
Although there is continually various forms of political pressure placed on the central bank to facilitate more currency creation – and although the central bank is obviously not immune from these pressures – to date South Africa’s central bank still operates in a broadly responsible manner, or at least not worse than most other global central banks. In recent years, the South African Reserve Bank has been relatively restrained in its money printing activities, as have South African commercial banks (commercial banks create new currency out of thin air when they lend currency they do not have).
This all raises a perplexing paradox. On the one hand, South Africa’s general governance structures have deteriorated markedly, notably so in the state’s fiscal arm – given leadership changes at the tax collection agency SARS and political meddling at the treasury. On the other hand, the central bank remains reasonably free of such nefarious influences and is far from operating in ways that could dramatically undermine currency credibility, at least not compared to other central banks around the word.
The rand is presently caught between this strange mix of conflicting forces, which in part explains its extreme volatility in recent years and months. Going forward, the national treasury and, in particular, the central bank are key to currency credibility. While the monetary system is flawed, it could only be made worse by giving partisan politicians the sole right to print money, which is one of the most terrible ideas in history. If the Reserve Bank is usurped for narrow, corrupt political ends, it has the potential to not only spell doom for the rand but could imperil South Africa’s entire social order in unthinkable ways.