Evaluating South Africa's Open Economy

• DOI: http://doi.org/10.1111/saje.12145
• Published date: 01 June 2017
• Date: 01 June 2017
• Author: Kenneth Creamer,Yashvir Algu

EVALUATING SOUTH AFRICA’S OPEN ECONOMY

YASHVIR ALGU

†

AND KENNETH CREAMER*

Abstract

The competing theories of the macroeconomic trilemma and dilemma are empirically tested for

South Africa. The empirical findings show evidence of the trilemma theory being applicable to

South Africa, supporting the country’s ability to maintain monetary independence (MI). An

empirical puzzle, however, emerged as South Africa’s MI index decreased during the country’s

2000–2014 inflation-targeting period. A possible explanation, and subject for further research, is

that the increasing opening of South Africa to international flows since 1995 may have caused

South Africa to be more exposed to international business cycles and shocks, resulting in a reduc-

tion in measured MI.

JEL Classification: F41, E61, F42, E52

Keywords: Macroeconomic trilemma, macroeconomic dilemma, capital flows, financial

liberalisation, exchange rate, monetary policy, foreign reserves

1. INTRODUCTION

According to the field of international economics, an open country faces a trilemma

trade-off when policymakers can simultaneously achieve only two of the following three

policies: (1) free capital flows, (2) an independent monetary policy and (3) exchange rate

stability.

1

Policymakers view all three polices as desirable; however, they cannot be

achieved simultaneously, as increasing the degree of one policy requires a decrease in the

degree of one (or both) of the other policies (Obstfeld et al., 2005; Aizenman, 2013).

In light of new empirical findings, Rey (2013) asserts that the trilemma trade-off may

now have been replaced by a dilemma trade-off, whereby, irrespective of the exchange

rate regime, policymakers can achieve either (1) free capital flows or (2) an independent

monetary policy – but not both. Increasing the degree of one of these polices results in a

decrease in the degree of the other.

Following South Africa’s democratic reform in 1994, the country was able to move

away from international isolation towards greater integration with the world economy,

* Corresponding author: Senior Lecturer, School of Economic and Business Sciences, Univer-

sity of the Witwatersrand, Johannesburg, South Africa. Tel: 011 717 1000, Fax: 127 11 388

2084. E-mail: kenneth.creamer@wits.ac.za

†

University of the Witwatersrand

1

Free capital flows are achieved when the government imposes no restrictions on capital flows in

and out of the country. An independent monetary policy is achieved when the domestic interest

rate responds to domestic factors (such as inflation, aggregate demand and economic growth) as

opposed to foreign/external factors (such as exchange rate movements, foreign interest rates and

shocks affecting foreign countries, unless the shock occurs in the foreign country and the domestic

country). Fixed exchange rates are achieved when a home country pegs its currency to another

country (usually a big economy or an economy that has a high degree of influence over the home

country) (Creamer, 2014).

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C2017 Economic Society of South Africa. doi: 10.1111/saje.12145

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South African Journal of Economics Vol. 85:2 June 2017

South African Journal

of Economics

which meant that the country faced a new set of policy choices (Farrell and Todani,

2004). Once financial sanctions had ended, the country began attracting capital inflows

and, to a lesser extent, began reducing its restrictions on capital outflows.

2

In accordance

with the theory of the macroeconomic trilemma, South Africa has chosen a floating

exchange rate, thereby allowing a combination of free capital inflows and monetary pol-

icy independence. However, in accordance with the theory of the macroeconomic

dilemma and because South Africa lowered its restrictions on capital flows, the degree of

monetary independence (MI) may have been reduced instead.

To test the hypothesis that South Africa has reduced its degree of MI, this paper

evaluates its macroeconomic policy choices to empirically determine whether the

country faces a macroeconomic trilemma or a macroeconomic dilemma. Empirical

studies on the trilemma and dilemma fall short in current literature. This study’s con-

tribution to the literature is twofold: (1) It adds South Africa to the list of limited

country-specific studies conducted on the trilemma using an existing methodology.

This provides comparable results which South Africa can benchmark to studies that have

usedthesamemethodology.(2) This study constructs a novel three-variable VAR methodol-

ogy using a theoretical foundation to test the dilemma. Unlike Rey’s (2013) VAR model

which, by construction, can only be applied in the United States (US), the model built in

this study can be applied to other countries, providing the literature with a baseline theoreti-

cal dilemma methodology which can be expanded on. While this study has a focus on South

Africa, further research will expand the use of the built VAR to empirically test the dilemma

on other countries to obtain comparable results.

The rest of the paper is organised as follows: Section 2.1 and Section 2.2 provide a

discussion of the literature on the macroeconomic trilemma and dilemma, respectively.

Following these theoretical discussions, an empirical investigation is conducted in Section

3, in which Section 3.1 empirically tests the theory of the macroeconomic trilemma and

Section 3.2 empirically tests the theory of the macroeconomic dilemma. The empirical

findings are discussed in Section 3.3, and the paper concludes in Section 4.

2. LITERATURE REVIEW

2.1 Literature on the Macroeconomic Trilemma

To take advantage of globalisation, in the 1990s, many countries began pursuing interna-

tional financial integration by relaxing restrictions on capital flows (Obstfeld and Taylor,

2003). In accordance with the theory of the macroeconomic trilemma, countries there-

fore had to lower either their degree of MI or their degree of exchange rate stability

(Obstfeld et al., 2005; Aizenman et al., 2008). Although some countries decided to trade

off their MI to maintain exchange rate stability during financial integration, other coun-

tries decided to adopt a flexible exchange rate to maintain MI (Obstfeld et al., 2005;

Aizenman et al., 2008). South Africa chose the latter strategy (Mtonga, 2011; Creamer,

2014).

2

While South Africa imposes certain restrictions on capital outflows for its permanent residents,

it currently has no capital flow restrictions for non-residents (SARB, 2014a). The restrictions on

capital outflows for permanent residents do not affect the analysis in this study, as the focus has

been shifted towards the effects of capital inflows, on which South Africa has imposed no restric-

tions (SARB, 2014a).

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C2017 Economic Society of South Africa.