Problem With Transmission Mechanism Between Consumption and Production
8 Mar 04   

MOST VOLATILE WEEK IN CURRENCY MARKETS
Last week saw some of the most volatile of movements between leading currencies in years. Following the publication of the Institute of Supply Management (ISM) index on Tuesday, the Dollar soared by almost 3% against other leading currencies. Even though the ISM, which is a gauge of confidence in US manufacturing, disappointed slightly, the component incorporating expectations of employment within US manufacturing, rose sharply. This encouraged analysts to believe that the February payrolls data, which were due to be published on Friday, would come out extremely strong and reflect a gain in nonagricultural employment of 125,000 jobs for the month. This in turn would imply that the US economic recovery was now beginning to translate into a gain in jobs, potentially boosting consumption further, thereby potentially putting upward pressure on prices and necessitating a rise in US interest rates sooner rather than later. Given that the existence of lower US interest rates relative to, say, Euro or Sterling interest rates, has been one of the factors driving the Dollar downwards, the potential for American interest rates to rise relative to other interest rates would make the Dollar more attractive in terms of the income investors could earn from the currency. At the same time, however, one felt that the magnitude of the strengthening of the Dollar was related more to technical rather than fundamental factors. Specifically, the fact that previous support for the Euro at around $1.24 was broken, contributed to a sudden and marked sell-off by investors who had held Euros in the expectation that the latter would continue increasing indefinitely because of the existence of the huge American twin deficits. Nevertheless, on Friday, publication of an increase in new payrolls of just 21,000 dashed expectations that the US economic recovery was finally beginning to generate a lot of jobs. As a consequence, the whole rationale for the Dollar's earlier rise was totally reversed and the currency fell back by almost 3% to end the week more or less where it had started, viz. at $1.24.

RAND AN EXAGGERATED BAROMETER OF THE EURO
The interesting feature from the South African perspective was that the Rand/Dollar exchange rate fluctuated by even more than the Dollar/Euro exchange rate, with the South African currency declining by 4.5% vis-à-vis the Dollar in the early part of the week, but then rebounding by almost 6% on Friday. Two conclusions could be drawn from this. Firstly, the lack of confidence in the potential elimination of the US twin deficits, is likely to keep the Dollar under pressure in the longer term. In the short term, there is undoubtedly support for the Dollar due to the relatively strong performance of the US economy relative to other economies and it is possible that the Dollar could continue rallying to around $1.15 to the Euro. However, in the absence of solid evidence of a contraction in the twin deficits, one suspects that the longer term downward pressure on the US currency will ultimately resume. Secondly, last week's currency movements show that the Rand remains more volatile than most other currencies despite the elimination of the oversold forward book. It remains an exaggerated barometer of the Euro.

DIVERGENCE BETWEEN HIGH CONSUMER SPENDING AND LOW INDUSTRIAL PRODUCTION IN US, UK AND AUSTRALIA
Disappointment with the US February employment statistics highlights the growing fear in the US that the buoyancy of

                                

consumer spending and overall economic growth in the country is not translating into more jobs. Various factors have beenadvanced for this, including the increased incidence of overtime and part-time work, as well as enormous gains in productivity, partly as a result of technological improvements over the past decade. It has been noticeable that in the cases of the US, UK and Australia, growth in retail sales recently (7.4%, 4.0% and 7.3% respectively) has been way in excess of growth in industrial production (2.3%, -0.8% and -0.1% respectively). In contrast, in Japan, industrial output is growing at 5.7%, whilst retail sales are reflecting marginally negative growth, of -0.1%. These divergences between high growth in consumer spending and low industrial production in the US, UK and Australia and low consumer spending but high industrial output in Japan, has persisted for some time. In the case of the UK and Australia, one could argue that the high value of the Pound and Australian Dollar have been the principal drivers of this divergence, encouraging Britons and Australians to spend heavily on imported goods. To some extent one could likewise argue that the Dollar remains overvalued and that this too is driving Americans to import goods more cheaply than they are able to produce them within the United States. Either way, one can make a cogent argument for why the Dollar , Pound and Australian Dollar are bound to depreciate and the Yen to appreciate in order to restore some balance between supply and demand. All three of the US , UK and Australia are running huge trade deficits and are reliant on capital inflows to compensate.

INEFFICIENCY OF TRANSMISSION OF HIGH CONSUMPTION EXPENDITURE INTO PRODUCTION AND JOBS
Closer to home, the same divergence between booming consumer spending and weak manufacturing production is even greater than is the case in the US, UK and Australia. The authorities in South Africa are waiting anxiously for the supply side of the economy to respond positively to the boom in consumer spending. However, as in the US, UK and Australia, it appears to be slow in coming. Some of the reasons for this are similar, viz. the growing impact of rapid technological advances and the shift in the structure of the economy towards knowledge intensive services industries and away from manufacturing. Nevertheless, in South Africa, impediments to the transmission mechanism for translating high consumer spending into increased production are exacerbated by the lack of skills of the population and in particular the difficulty with which people who are laid off in one sector can apply their skills in another sector. Whereas growth in GDP in the US, UK and Australia has been able to sustain a very high level despite relative weakness in industrial production, mainly because of continued growth in their services sectors, this has not been the case in South Africa. Indeed, perusal of consensus forecasts for economic growth in the coming year shows that out of all significant economies in the world, only Israel and the Czech Republic are forecast to experience lower economic growth in the coming year than South Africa's projected 2.8% growth rate. The extraordinary stickiness of the transmission mechanism necessary to translate high consumption into production in South Africa and the serious implications thereof, drives one's expectation that the real exchange rate of the Rand is set to depreciate by more than most other currencies over the next year if markets are to play their role appropriately.

 

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econometrix 04-May-04