Has the Exchange Rate Pass‐Through changed in South Africa?

• Date: 01 September 2018
• Author: Alain Kabundi,Asi Mbelu
• DOI: http://doi.org/10.1111/saje.12197
• Published date: 01 September 2018

© 2018 Economic Society of Sout h Africa .

South African Journal of Economics Vol. 86:3 September 2018

doi : 10.1111/ saje .12197

HAS THE EXCHANGE RATE PASS-THROUGH CHANGED IN

SOUTH AFRICA?

ALA IN KABUN DI* AND ASI MBELU†

Abstract

This paper uses the two-stage exchange rate pass-through (ERPT) framework instead of the direct

pass-through (PT) from the exchange rate to consumer inflation to assess the variation in the

ERPT for South Africa from 1994 to 2014. The paper uses rolling-window estimation to examine

the possibility of change in the ERPT over time. In addition, it investigates the asymmetric

behaviour of the ERPT over the business cycle. The results indicate that the ERPT for South

Africa is complete in the first stage but incomplete in the second stage. It implies that retailers do

not pass all the cost to consumers. The first-stage ERPT has declined slightly since the Global

Financial Crisis. Weak domestic demand and possibly the concentration of firms in the

manufacturing sector are the main forces behind this low PT. Moreover, there is evidence of

asymmetry in the first-stage ERPT in that it tends to rise in the upturn phase of the economy

compared to the downturn. The second-stage ERPT shows a considerable decline since the

adoption of the inflation-targeting regime. Similar to the first-stage case, the PT is muted in the

downturn but rises in the expansionary phase by about 10%.

JEL Classificati on: C51, E52, E58

Keywords: Exchan ge rate pass-through, rolling-window regre ssion, asymmetric exchange rate

pass-through

1. INTRODUC TION

Since the adoption of the inflation-targeti ng (IT) framework, the South African Re serve

Bank (SARB) has largely left the domestic currency f loating freely. The rand has been

responsive to both domestic and external shocks a nd in some regards also acts as a shock

absorber. Like in most emerging market economies (EMEs), the exchange rate is one

of the key drivers of inflation in South Africa. The transmission mechanism operates

through import prices. Hence, the magnitude and the speed of the transmission de-

pends largely on first-stage a nd second-stage pass-through (PT ). First-stage PT refers to

the impact of exchange rate movement on import prices, while second-stage PT points

subsequently to the effects of the latter prices on overall consu mer prices. Recently, the

exchange rate pass-throug h (ERPT) in South Africa has been less reactive to exchange

rate movement. Massive depreciation of the rand has not translated into higher inf lation.

The question arises on how to explain this conundrum. This paper attempts to an-

swer this puzzle using a t wo-stage framework, proposed by Chew et al. (2011), instead

of the direct PT from the exchange rate to consumer inflation. The advanta ge of this

*Corresponding author: The World Bank Group, Washington, DC 20 433, USA. E-mail:

akabun di@worldban k.org

†Trinity College Dublin, Dublin, Irela nd.

This paper was w ritten while Ala in Kabundi was aff iliated with the South Africa n Reserve Bank

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of Economics

© 2018 Economic Society of Sout h Africa . doi : 10.1111/ saje .12197

South African Journal of Economics Vol. 86:3 September 2018340

framework is that it quantif ies separately the two stages through which the nominal

exchange rate affects domestic consumer prices. Moreover, the analysis based on the

entire sample might be misleading as t he ERPT may be affected by policy and shocks

prevailing at specif ic points in time. The current study takes th is into account by al-

lowing for the possibility of a change in the PT over time using the rolling-window

regression. Finally, there is evidence that retailers pass the costs incurred from exchange

rate depreciation to consumers more rapidly when the economy is expanding relative to

periods when the economy is extremely weak. In addition to the rolling-window ana lysis,

this paper exami nes the asymmetry i n the PT.

The literature on ERPT provides evidence of the decline in PT which coincides with

the adoption of the IT framework. The rationale is that P T is muted when the central

bank anchors inf lation expectations in a way that is consistent with its objective. To test

this hypothesis, the analysis includes quarterly data from 1994Q1 to 2015Q2, which

comprises the country's first democratic elections, the opening of the capital account to

non-residents, and the adoption of the IT regime. Furthermore, the sample size is long

enough to include the Global Financial Crisis (GFC).

The results show evidence of complete PT in the first st age and incomplete PT in the

second stage. In addition, the first-stage E RPT seems rapid where 50% of deviation from

the long-run equilibrium is recovered in the first t wo quarters, while second-stage ERPT

is weak and very slow. Moreover, first-stage ERPT declines towards the end of the sam-

ple, which coincides with the GFC, from 80 to 63% in 2011, before rebounding to 68%

in 2014. Second-stage ERPT also portrays a decline which coincides with the adoption

of the IT framework. It suggests t hat the perception of the public in general is that the

central bank will act to keep inflation anchored when the economy is affected by nega-

tive shocks. Finally, there is evidence of asymmetry in both first- and the second-stage

ERPTs. Both the first- and second-stage ERPTs tend to rise in the upturn phase of the

economy compared to the downturn.

The rest of the paper is organised as follows. Section 2 includes the review of litera-

ture. Section 3 discusse s the theoretical models used in the estimation of the first- and

second-stage ERPT. It includes the specification of long-run models, error-correction

models and models which are suitable to deal with a symmetry in the ERP T. We describe

the data and data tra nsformation in Section 4. Section 5 discusses the empirical results of

the first- and second-stage ER PT using long-run estimations, rolling-window regressions

and asymmetric specifications. Section 6 concludes the paper.

2. LITER ATURE REV IEW

The ERPT is c omplete if the full extent of the exchang e rate movement is transferred to domestic

prices. Conversely, a partial t ransmission of exchang e rate movement to domestic prices implies

an incomplete ERPT. The Law of One Price (LOP), which equates t he domestic price of traded

goods to the foreign price of identica l goods at the exchange rate level, is pre valent in a world with

perfect competition and no ba rriers to entry. Put differently, the LOP postulates a one-to-one re-

lationship between t he domestic price of traded goods and the foreign price of identica l goods. It

means that exch ange rate movements are expected to have a noticeable effe ct on domestic prices.

In practice, thoug h, this relationship is seldom observed . Domestic and foreign goods are ra rely

identical, trade bar riers such as tarif fs and taxes exi st, and importers often incur t ransportation,