Can some of South Africa's Recent Exchange Rate Volatility be Attributed to Contagion?

South Africa has experienced considerable currency volatility during the past few years, despite strong economic fundamentals. Recently this resulted in the appointment of the Myburgh Commission of inquiry into the depreciation of the rand. From January 1, 1996 to May 29, 2002, the value of the rand depreciated from R3.64 per US$ to R9.85, reaching an all-time low of R13.002 on December 20, 2001. Policymakers and academics have increasingly wondered about the nature of these crises, the factors responsible for their spread and particularly whether a country with seemingly appropriate domestic and external fundamentals can suffer a crisis because of contagion. More specifically, why should a country like South Africa be affected if there are problems in Brazil, as these countries are hardly related? Or why do events in Zimbabwe continually "haunt" the rand? The answer to this question requires an examination of the channels through which disturbances are transmitted from one country to another (Hernandez and Valdes 2001:3).

Isolating the relevant contagion channels is key from a policy perspective, for appropriate prescriptions may vary substantially depending on what drives contagion. For instance, if trade linkages were to drive contagion, countries would have few alternatives other than to diversify their trade base or to fix irrevocably their foreign exchange rate. On the other hand, if financial links were to be blamed for contagion, countries should attempt other measures such as imposing prudential capital account regulations. Alternatively policymakers can attempt to protect foreign reserves with a policy of high interest rates. This can have detrimental consequences for the domestic economy.

The purpose of this paper is to analyse empirically the existence and extent of contagion in explaining volatility of the South African rand. Misfortunes in Zimbabwe and other emerging-markets countries (like Argentina) have often been blamed for the recent volatility. This implies the possible presence of financial contagion. On the other hand, declining economic activity in Zimbabwe can also result in contagion through trade linkages. We investigate two alternative contagion channels: (i) real interdependence (trade links) through bilateral trade and trade competition in third markets, and (ii) financial contagion.

Empirical results confirm the presence of contagion. This suggests that no open emerging-market country, even with relatively sound fundamentals and policies, is capable of insulating itself from events in the rest of the world. The difficult challenge still faced by emerging markets is how best to reap the benefits of a more open economy while minimizing the risk of becoming the victim of a potentially devastating financial crisis inherent in the liberalization process.