Economic Thoughts: The Mystery of Pass-Through

In recent dealings with clients, the usual unease was expressed about the pass-through from a severely weakened Rand to domestic inflation (in other words, imported inflation). The pass-through effect has been weak. This couldn’t possibly continue, with implications for interest rates & much else?


Herewith some speculation.


Regarding imported inflation, one might have to look differently at the pricing mechanism to appreciate the full range of outcomes, and why in recent years this may have been less intense, even in the presence of very large declines in the Rand against the Dollar (and Euro).


In a simpler age, a producer in another country would ship you her product, price her domestic price for convenience sake in Dollar at the going Dollar rate for her currency, and on receipt of her invoice you would pay her the Dollar amount at the going Dollar rate for your currency (Rand).


If her currency had strengthened and your Rand had weakened against the Dollar since your last transaction, you would end up paying (a lot) more in Rand for the same product at the next invoice.


This reality remains applicable, certainly for bulk goods. Imported oil reflects this. The Dollar price of oil may stay the same, yet when the Rand weakens, you pay proportionally more Rand for the same Dollar priced oil next time. Similarly a gold producer exporting in a time of a weakening Rand gets higher Rand income even if the Dollar price stayed unchanged.


This reality also still applies for many one-on-one transactions. You contact an overseas supplier, he quotes you a Dollar or Euro price, and as the Rand fluctuates, you absorb the Rand risk fully nearly every time.


Yet clearly this simple arithmetic does not apply for all imports, as the pass-through from a changing Rand/Dollar exchange rate (and even on trade-weighted) seems to be a whole lot weaker than what it used to be. What could explain it?


One explanation is that much international merchandised trade occurs within global value chains. These source at the cheapest global producers, changing their mixed of suppliers all the time, depending on who can offer the best prices. In the ferocious internecine price competition that results overtime, only the lowest-cost producers offering the best terms (quality & delivery dependability) will win out.


But it probably doesn’t stop there. These global value chains define their businesses in terms of global footprints (market share). They gobble this together in up to 200 country destinations.


The simple reality of pricing a local production price in Dollars and letting the currency risk for the buyer be what it is, letting the implications rest where they fall, has in many instances been overcome by a market share driven model.


In order not to lose market share in any country market due to fluctuating prices reflecting currency swings, or at least seek to moderate this price effect, global value chains tend to price in local currency, absorbing at least a portion of currency risk centrally, possibly recouping some (if not all of it over time) but more likely doing this over various country destinations, where for some the currency swings may have been wilder than for others.


There is, thirdly, the consideration whether your own currency has been singled out for weakness, whatever the reason, or whether you are living in a time of Dollar elevation (or demise), with many currencies possibly sharing the same experiences as you, each though in their own way, of weakening (or firming) against the Dollar, but much less so against each other (trade-weighted), giving rise to much less imported Rand price variation than what the Rand/Dollar exchange rate changes would suggest.


In recent years, we have specifically been subjected to a general Dollar re-rating globally, with many other currencies weakening against the Dollar, but much less so against each other. With global value chains sourcing among the lowest-cost global producers, and ferociously defending market share in a myriad of export markets, not least by pricing locally and going to some length to maintain this, the full effect of currency Dollar fluctuations may not fully register (pass-through to domestic inflation).


This does not prevent global value chains of posting large currency gains or losses in their central command locations, depending on how positioned. But the pass-through phenomenon suggests that any benefit from currency fluctuation doesn’t fully pass to the value chain producers. Some benefits go to the buyers in the defence of market share at a time of major currency swings.


Thus the phenomenon that you may observe in the price of (certain) imported products fluctuating much less in Rand terms than what you would be led to expect by variations in Dollar or Euro exchange rates.


For a fragile currency like the Rand, often subjected to big exchange rate swings against the leading currencies, such local price smoothing is good news, as the currency volatility doesn’t fully transmit through to domestic inflation, inflation expectations, interest rates or growth and asset market pricing as it traditionally would have.