Determinants of exchange rate volatility in South Africa

Abstract

The rand is observed to have experienced volatility in recent times, which was particularly pronounced during times of crises such as the East Asian Crisis of 1998 and the global financial crisis of 2008. The purpose of this study is to identify key macroeconomic variables that determine exchange rate volatility in South Africa, and to also determine the contribution of each of these variables to volatility. The study makes use of quarterly data from 1994 to 2014. Volatility is measured by means of a generalized autoregressive conditional heteroscedasticity approach. Estimation techniques employed include the Johansen Co-integration and vector error correction model. Impulse response and variance decomposition analysis revealed that interest rate differentials account for most of the variation in exchange rate volatility (36 percent), followed by inflation rate differentials (31 percent), economic growth (3.5 percent), trade openness (0.45 percent), money supply (0.25 percent) and government spending (0.03 percent). Interest rate differentials and inflation rate differentials thus account for 67 percent of the 71 percent variation in exchange rate volatility in South Africa, with trade openness, money supply and government spending all being of low levels of significance. The large impact that monetary variables have on exchange rate volatility implies that policymakers should maintain sound monetary policies, ensuring that large unwarranted increases in interest rates do not occur in the bid to control inflation.