South African Reserve Bank

PRESS STATEMENT
EMBARGO DELIVERY
25 May 2017


STATEMENT OF THE MONETARY POLICY COMMITTEE

Issued by Lesetja Kganyago, Governor of the South African Reserve Bank
Headline inflation has now returned to within the target range as expected, with
outcomes in March and April surprising on the downside. While the inflation outlook
has improved over the near term, the longer-term forecast trajectory is unchanged
and uncomfortably close to the upper end of the target range. The rand exchange
rate and domestic bond yields benefited from increased global capital inflows to
emerging markets which largely offset the impact of the sovereign credit ratings
downgrade. With further ratings decisions imminent, risks remain for a further
depreciation against the backdrop of continued global and domestic political
uncertainty.

Domestic economic growth prospects have deteriorated, as the impact of the ratings
downgrade is expected to weigh on domestic investment and consumer sentiment
over the forecast period. The output gap is estimated to have widened, and
consumer demand has weakened. However, the trajectory of the growth forecast is
still positive, and the growth rate for this year is expected to exceed that recorded in
2016.
The year-on-year inflation rate as measured by the consumer price index (CPI) for all
urban areas moderated to 6.1% and 5.3% in March and April. Food price inflation
was the main contributor to the downside surprise in April when it measured 6.6%.
The contribution of the category of food and non-alcoholic beverages to the overall
inflation outcome declined from 1.5 percentage points in March to 1.1 percentage
points. The Bank’s measure of core inflation, which excludes food, fuel and
electricity, measured 4.8%, down from 4.9%.
Producer price inflation for final manufactured goods also surprised on the downside
at 4.6% in April compared with 5.2% in March. The further moderation in food prices
was also reflected in the PPI with the category of food products, beverages and
tobacco products decelerating for the sixth consecutive month to 6.4%.
The inflation forecast of the Bank has improved over the near term, but is unchanged
in the outer quarters. In line with the previous forecast, headline consumer price
inflation is expected to remain within the range for the rest of the forecast period.
Inflation is expected to average 5.7% this year compared with 5.9% previously, while
the forecast for 2018 has moderated by 0.1 percentage point to 5.3%. The forecast
average for 2019 is unchanged at 5.5%.

The improvement is driven by downward revisions to international oil price and
domestic electricity tariff assumptions. In the latter case, a tariff increase of 4.0%
with effect from July 2017 is assumed, down from 8.0%. These revisions have been
offset to some extent by a less appreciated exchange rate assumption, and a slower
decline in food price inflation. A continued moderation of food prices is expected over
the medium term given the favourable agricultural outlook and significant upward
revisions to the maize crop estimates. Food price inflation is expected to average
7.7% and 5.4% in 2017 and 2018, compared with 7.4% and 5.2% previously, and
unchanged at 5.5% in 2019.

The forecast for core inflation in 2017 is 0.4 percentage points lower at 5.0%, partly
due to the lower starting point of 0.2 percentage points following the sizeable
downside surprise in March. The forecast for 2018 declined by 0.1 percentage point
to 5.1%, and is unchanged at 5.3% in 2019.

Market-based inflation expectations are largely unchanged since the previous
meeting of the MPC, with the median forecasts in the latest Reuters Econometer
survey similar to those of the Bank. The median expectation for 2017 declined
marginally to 5.7%, and is unchanged at 5.5% and 5.4% for the next two years.
Expectations implicit in the break-even inflation rates in the bond market have also
moderated since the previous meeting. Break-even inflation rates for shorter-dated
maturities are below 6% but higher than this level for longer-dated maturities.

The global growth outlook continues to show signs of sustained recovery amid rising
world trade volumes. Nevertheless, the trend growth rate is expected to be lower
than that experienced before the global financial crisis. The current recovery is
characterised by downward revisions to potential output growth in numerous
countries, and generally low levels of productivity and wage growth. Despite a weak
first quarter, US growth is expected to average above 2.0% this year, although
further policy uncertainty could undermine investor and consumer confidence.
Growth rates in the euro area and Japan are expected to be sustained at around
2016 levels, supported by accommodative monetary policies.

The outlook for emerging markets is also generally positive. Concerns about
Chinese growth have dissipated somewhat following policy intervention, but high
leverage in the financial sector remains a risk. While Russia has emerged from
recession, the expected recovery in Brazil may be undermined by current political
uncertainty. The outlook for commodity producers may be tempered by recent
weaker commodity price trends, particularly those of iron ore and coal.

Global inflation remains relatively benign although country experiences differ.
Inflation is below target in most of the advanced economies, apart from the UK, and
the risk of deflation is low except in Japan. Where high inflation rates are being
experienced in a number of emerging markets, these are generally driven by
exchange rate shocks rather than underlying global price pressures.

Monetary policies are also likely to remain divergent. The US Fed is expected to
maintain its moderate pace of tightening, dependent to some degree on the size and
nature of possible fiscal reforms. Policy rates are expected to remain low in most
other advanced economies, but a reduction in quantitative easing is possible in the
near future in the euro area. In general, emerging market economies have displayed
a loosening bias, particularly in those countries where previous policy tightening had
resulted in improved inflation prospects. The high yield differentials of emerging
markets have persisted, sustaining capital flows to these economies.

At the time of the previous meeting of the MPC, the rand was trading at around
R13.00 against the US dollar. It then depreciated following the domestic cabinet
reshuffle and the consequent sovereign credit ratings downgrades by two ratings
agencies. Having reached a weak point of almost R14.00 against the US dollar in
April, the rand subsequently recovered some of these losses in line with improved
sentiment towards emerging markets in general. Some of these gains were reversed
by spill-over effects of recent political uncertainty in Brazil. Since the previous
meeting the rand has appreciated by 0.4% against the US dollar and depreciated by
1.6% on a trade-weighted basis. At current levels the rand is still more appreciated
relative to rates prevailing at this time last year.

Despite the recent weakening, the rand has been supported by a more favourable
current account outlook, following a significant narrowing of the deficit in the final
quarter of last year. A further positive trade balance was recorded in the first quarter
of this year, but a moderately wider current account deficit is expected over the
forecast period, due in part to a recent deterioration in the terms of trade.

Non-residents remained net buyers of domestic government bonds in April and May
to date, to the value of R23.2 billion, despite the recent ratings downgrades. This
may change should further downgrades occur, particularly with respect to domestic
currency ratings. The rand therefore remains vulnerable to this prospect, as well as
to changes in global risk sentiment towards emerging markets.

The domestic growth outlook has deteriorated amid weak business and consumer
confidence. The Bank’s forecast for GDP growth has been revised down for the
entire forecast period, by 0.2 percentage points for 2017 and 2018, and by 0.3
percentage points in 2019. Annual growth rates of 1.0%, 1.5% and 1.7% for the
forecast years are now expected. This downward revision is due in part to the
expected impact of the sovereign credit ratings downgrade on domestic private
sector gross fixed capital formation in particular. The downgrade is also likely to
weigh on public sector investment through higher funding costs and more difficult
access to funding.

At the sectoral level, a strong near-term improvement is expected in the agricultural
sector, and mining output has also rebounded. By contrast, the manufacturing sector
outlook remains constrained, with a third consecutive quarterly contraction expected
in the first quarter of this year. In line with this, the latest ABSA Purchasing
Managers Index showed a sharp decline. Growth in the trade sector also appears to
have moderated somewhat.

A slower but positive pace of household consumption expenditure growth is forecast
for this year. Real retail and wholesale trade sales contracted in the first quarter of
this year. While domestic sales of passenger motor vehicles improved, the outlook
for the sector remains subdued. Factors such as low consumer confidence, higher
tax burdens, the absence of significant wealth effects and stagnant employment
growth have contributed to these weaker consumption trends.

In addition to these factors, credit extension to the household sector in particular
remains weak, and is reflected in further household deleveraging. Although credit
extension to the corporate sector is still relatively robust, the downward growth trend
has persisted. There may, however, be some relief to consumers from moderating
inflation, while increases in real disposable income over the forecast period are also
expected to provide some support to consumption, but to a lesser extent than
previously.

Nominal salary and wage increases have continued to show signs of moderation, but
are still at levels that contribute to the persistence of inflation at higher levels. While
continued moderation of nominal unit labour costs are expected over most of the
forecast period, the trajectory has been revised slightly upwards largely due to the
weaker economic growth projections.

International oil prices have firmed since the previous meeting, having declined to
levels below US$50 per barrel at one stage. The recovery was a response to
indications that the OPEC agreement to curtail output would be extended for a
further six months. However, the fragility of this agreement, and the increase in shale

production in the US is expected to cap increases going forward. The international oil
price assumption has been revised down by US$2 per barrel for each forecast year,
but the moderate upward trend has been maintained. Domestic petrol prices
increased by around 50 cents per litre in May, due to the weaker exchange rate and
higher international product prices. The current over-recovery on the petrol price
indicates that a reduction of around 20 cents per litre is likely in June, mainly due to
international price movements.

The short-term inflation outlook has improved further since the previous meeting of
the Monetary Policy Committee. Headline inflation in April was lower than expected,
largely related to the pace of food disinflation. The MPC notes, however, that there
have been broad-based downside surprises in core inflation as well. The current
forecast does not incorporate the most recent outcomes, and further downside
surprises in the coming months could impact of the starting point of the forecast and
lower the entire trajectory. However, in the absence of such revisions, the MPC
remains concerned about the persistence of the longer-term forecast trend at
elevated levels within the target. This gives very little headroom to absorb the impact
of possible adverse shocks.

The rand remains a key upside risk to the forecast. The rand has, however, been
surprisingly resilient in the face of recent domestic developments. This is partly due
to offsetting factors, particularly positive sentiment towards emerging markets and
the improved current account balance. The current level of the exchange rate, at
below R13.00 against the dollar, is slightly stronger than at the time of the last

meeting and stronger than that implicit in the starting point for the real exchange rate
assumption.

The outlook for the rand, and therefore the risks to the inflation outlook, will be highly
sensitive to unfolding domestic political uncertainty, as well as decisions by the credit
ratings agencies. The rand could weaken significantly in the event of a worst-case
ratings downgrade scenario that could result in South African government bonds
falling out of the global bond indices.

A downside risk may come from electricity tariffs. The increases from July may be
lower than the 4.0% now assumed, given the 1.8% guideline for municipalities
published by Nersa. However, there is a great deal of uncertainty with regard to this
assumption for next year, when a new application from Eskom is likely. Currently an
8.0% increase is assumed from July next year.

The MPC assesses the risks to the inflation outlook to be more or less balanced.
Domestic demand pressures remain subdued, and, given the continued negative
consumer and business sentiment, the risks to the growth outlook are assessed to
be on the downside.

In light of these developments the MPC has decided to keep the repurchase rate
unchanged at 7.0% per annum. Five members preferred an unchanged stance while
one member preferred a 25 basis point reduction.

The MPC remains of the view that the current level of the repo rate is appropriate for
now and that we are likely at the end of the tightening cycle. A reduction in rates
would be possible should inflation continue to surprise on the downside and the
forecast over the policy horizon be sustainably within the target range. However, in
the current environment of high levels of uncertainty, the risks to the outlook could
easily deteriorate, and derail the current favourable assessment.

Lesetja Kganyago
GOVERNOR

Contact person:
Zamandlovu Ndlovu
012 399 7118