Exploring the relationship between exchange rates and business cycles in South Africa.

Abstract

This dissertation investigates a nonlinear, dynamic relationship between variations in exchange rates and business cycle actions in South Africa, a small open emerging economy with high external vulnerability and substantial financial integration. Although there is strong evidence at the international level for the salience of exchange rates to macroeconomic adjustment, in South Africa, the evidence base is still sparse and mostly consists of linear, time-invariant models with no reference to structural breaks and regime dependence. To close this gap, for the period 1990– 2024, the study employs a hybrid of Time-Varying Parameter Bayesian VAR (TVPBVAR) and Markov- Switching BVAR (MS-BVAR) models to explain evolving transmission mechanisms. The findings indicate that shocks to the exchange rate have time-dependent and asymmetrical (state-dependent) effects on output, inflation, business confidence, and monetary policy. Depreciation episodes are a significant source of contraction during periods of global risk aversion, high uncertainty or domestic weakness, while appreciation during stable periods leads to a weaker expansionary impact. The results show that global financial conditions, and in particular VIX-driven risk sentiment and the U.S. monetary policy, dominate at the domestic level, indicating substantial exposure of South Africa to the Global Financial Cycle. The evidence of regime-switching shows that the relationship between the exchange rate and the cycle is greatly magnified in high-volatility regimes characterised by crises, commodity price collapses, and policy changes. Collectively, the empirical evidence supports the view that, in South Africa, the exchange rate is not a relative price but a pivotal transmission mechanism through which external and domestic shocks create cyclical conditions. The relationship is strong, durable, and highly sensitive to global conditions; therefore, macro stability is associated with policy mechanisms that can mitigate shocks from the external environment.