2. WHAT IS A NET OPEN FORWARD POSITION?

3. The market for foreign currency South African firms require foreign currency to –pay for goods imported from abroad –settle foreign currency debt –Find it prudent to hedge –Made it possible for SA entities to fund off-shore –Bridged failure of govt. to enter foreign markets Across the economy as a whole, this creates a demand for foreign currency –Private markets supply the majority of the currency demand (March: Private $116 bn, SARB $14bn) –The South African Reserve Bank (SARB) supplied the remainder The SARB, therefore, provided forex contracts with SA banks and firms to provide foreign currency in exchange for rand

4. The Forward Book The total value of all contracts to provide foreign currency in the future The contracts are agreements for the SARB to provide a certain amount of foreign currency (Typically US dollars) for a certain amount of rand at some point in the future -- at a specific exchange rate The contracts enable firms with commitments to hedge against possible fluctuations in the rand exchange rate

5. The NOFP The Net open forward position (NOFP) is equal to the value of contracts for foreign currency minus net reserves Net reserves = Gross reserves - foreign loans received In other words… NOFP = Net Reserves - Forward Book >Thus the NOFP is that part of the forward book not covered by net reserves Represents currency risk that the SARB takes on behalf of government

6. Change in the size of the NOFP Since, NOFP = Net Reserves - Forward Book The NOFP increases in size when… –The Forward book increases and net reserves remain unchanged –The SARB sells forex to the market or government The NOFP declines in size when… –The Forward book declines in size and net reserves remain unchanged –The SARB buys forex to the market or government

7. Quantified example NB: This is a highly simplified example, only for illustration!

8. The state’s liability The liability of the state is equal to the loss (-100) reflected on the last column on the illustration Neither the NOFP nor the Forward Book is a liability of the state

9. Reducing the NOFP The NOFP is reduced through the purchanse of forex from the market Sources of foreign currency: market related capital flows, privatisation, borrowing foreign listings

10. Status of the NOFP At the end of January, the NOFP stood at $9,5 billion, comprised of net reserves of about $5 billion and a forward position of $14,5 billion  The NOFP was reduced at a rate of +/- $900 million per month between August 1999 and March 2000, made possible mainly by inflows of portfolio investment  (mainly government borrowings)  Since April 2000, however, the pace of forward book reduction has slowed  From June onwards, the SARB has been able to continue the path of NOFP reduction, but at a significantly slower pace of around $100-$200 million per month  (emerging market volatility)

11. Change in the NOFP 1996 to 2001

12. Forward contracts & the rand Forward contracts have been used to ensure that SA firms have access to foreign currency for their international transactions In the past, forward contracts were also used to support the value of the rand The demand for forward cover has been fundamentally driven by expectations of rand depreciation (driven by importers)

13. Inflation targeting & the NOFP Whereas in the past the NOFP was used to support the rand In the current dispensation, the SARB targets inflation and not the exchange rate

14. Broader impact of Forward Book Anticipated losses on the Forward book as a result of currency depreciation represent a contingent liability In other words, accrued losses are a potential charge on the fiscus Therefore, international investors view the Forward book as a risk to the budget and to the debt profile of South Africa And, therefore, demand a somewhat higher premium to hold rand-denominated assets In short, South African interest rates are higher than they otherwise would be without the Forward book

15. Accountability Reserve management accountability: Joint policy decision of National Treasury and the Reserve Bank to eliminate the NOFP A consistent improvement in the NOFP appears to be as important, if not more so, than the actual level of the NOFP itself

16. Policy implications Important to continue lowering the size of the Forward Book and NOFP Possible through several channels... –Increased govt borrowing in foreign currency: Increase maturity profile of liabilities Increased debt service costs as against contingent risks Higher risk premium on foreign debt Higher cost when exchange rate depreciation is larger than interest rate differential –Continued reduction on the back of capital flows: State asset restructuring and better economic growth will lead to continued capital flows