The behaviour of the real effective exchange rate of South Africa: Is there a misalignment?

Abstract

This paper examines the extent of misalignment of the real effective exchange rate (REER) of South African rand. With South Africa being an open emerging market economy closely linked with global markets, the country’s economy is susceptible to external shocks and changes in global trade patterns. Based on the behavioural equilibrium exchange rate framework of Clark and MacDonald (1998) the study uses a cointegration technique, which caters for endogeneity to estimate the equilibrium value of the REER of the rand. Next, the study uses a Markov regime-switching (MSM) method to determine whether the exchange rate’s departure from the equilibrium level is meaningful enough to be considered as either over- or undervalued. The results show that long-run equilibrium relationship between the rand’s REER and economic variables inclusive of terms of trade, external openness, capital flows and government expenditure. The MSM correctly captures exchange rate misalignment as distinct episodes of exchange rate overvaluation and undervaluation. Most of the exchange rate undervaluation episodes identified in the study have been in response to either idiosyncratic shocks emanating from internal economic/political challenges or systemic global factors transmitted through either the nominal exchange rate or capital flows and not policy-induced behaviour.