South African Reserve Bank

PRESS STATEMENT
EMBARGO DELIVERY
18 July 2013


STATEMENT OF THE MONETARY POLICY COMMITTEE

Issued by Gill Marcus, Governor of the South African Reserve Bank

The period since the previous meeting of the Monetary Policy Committee (MPC)
has been dominated by the reaction of the global financial markets to statements
by the US Federal Reserve that a slowdown in quantitative easing may begin
sooner than previously anticipated. The news impacted on capital flows to
emerging markets, with outflows from bond markets in particular, but yields on
long term bonds of advanced economies were also affected. While some of the
initial fears have been addressed by further guidance from the Fed, this episode
gives some insight into the difficulties that could be faced in fine-tuning exit
strategies from highly accommodative monetary policies, particularly at a time
when global growth remains weak.

These events had a significant impact on the exchange rate of the rand, creating
further upside risks to the inflation outlook at a time when the domestic economy
has shown increased signs of vulnerability. There has consequently been no letup in the policy dilemma faced by monetary policy: that of a widening output gap
in a worsening inflation environment.

The year-on-year inflation rate as measured by the consumer price index (CPI)
for all urban areas surprised on the downside at 5,6 per cent in May 2013, having
measured 5,9 per cent for the previous three consecutive months. However, this
decline is likely to have been temporary as it was due in part to a 73 cent per litre
decrease in the petrol price in May, which has since been reversed by an 84 cent
per litre increase in July. Food price inflation increased further from 6,3 per cent
in April to 6,7 per cent, and accounted for 1,0 percentage point of CPI inflation.
The other main contributors to the inflation outcome were housing and utilities
and miscellaneous goods and services which contributed 1,4 and 1,1 percentage
points respectively. Administered price inflation declined to 6,3 percent from 8,9
per cent in April due to the petrol price decline. Excluding petrol, administered
price inflation was unchanged at 7,8 per cent. Core inflation, which excludes
food, petrol and electricity, measured 5,3 per cent, marginally up from 5,2 per
cent in April. The headline producer price inflation for final manufactured goods
measured 4,9 per cent in May, compared with 5,4 per cent in April.

Despite the lower starting point, the inflation forecast of the Bank has
deteriorated since the previous meeting of the MPC. Inflation is now expected to
average 0,1 and 0,3 percentage points higher in 2013 and 2014 at 5,9 per cent
and 5,5 per cent respectively, while the forecast for 2015 has been raised from
5,0 per cent to 5,2 per cent. A temporary breach of the upper end of the target
range is still expected in the third quarter of 2013, but at a higher average level of
6,3 per cent (6,1 per cent previously), followed by a return to within the target
range by the final quarter of the year. The deterioration is mainly due to
continued currency weakness and higher-than-expected petrol price increases.

The forecast for core inflation for 2013 is unchanged at an average of 5,3 per
cent in 2013 and is now expected to peak at 5,5 per cent in the fourth quarter.
This measure is then expected to moderate and to average 5,2 per cent and 5,0
per cent in the coming two years, compared with the previous forecasts of 5,0 per
cent and 4,6 per cent respectively. This upward drift in the forecast in the
absence of obvious excess demand pressures suggests that there may be
emerging underlying pressures, possibly due to the lagged effects of the
depreciation of the rand exchange rate.

Inflation expectations appear to have remained anchored around the upper end
of the inflation target range. According to the survey conducted by the Bureau for
Economic Research at Stellenbosch University during the second quarter of
2013, inflation expectations of all the categories of respondents remained almost

unchanged compared with those of the previous quarter. Overall, the survey
found that inflation is expected to average 6,0 per cent in 2013 and 6,1 per cent
in the next two years, with financial analysts’ expectations below those of the
business executives and trade union officials over the whole forecast period and
within the target range. The former category is consistent with the Reuters survey
which reflects expectations of an average of 5,9 per cent in 2013, and
moderating to 5,6 per cent and 5,4 per cent in the following two years,
respectively.

The global economic growth outlook has remained fragile due to the continuing
deeper recession in the Eurozone and a slowdown in a number of systemically
important emerging market economies. Several forecasters, including the IMF,
have downgraded Eurozone growth forecasts against the backdrop of a
slowdown in Germany, and continued risks emanating from Portugal, Italy and
Spain. In its recent World Economic Outlook update, the IMF reduced its 2013
forecast for Eurozone growth by 0,2 percentage points to -0,6 per cent, with a
weaker recovery than previously forecast in 2014. Although the US economic
recovery appears to be gaining some traction, headwinds from the fiscal
contraction remain, and first quarter economic growth, at an annualised 1,8 per
cent, was weaker than the initial estimate of 2,5 per cent. The sustainability of the
recovery is also at risk from rising long-term bond and mortgage interest rates in
response to expectations of a tapering off of asset purchases by the Fed. There

are tentative signs of stronger growth in Japan, but the sustainability of the
recovery remains uncertain.

The slowing growth in various emerging market economies including China,
Brazil and Russia illustrate the difficulties of decoupling from the advanced
economies, with the IMF revising its forecasts for 2013 for China from 7,8 per
cent to 7,5 per cent; Russia from 3,4 per cent to 2,5 per cent; and Brazil from 3,0
per cent to 2,5 per cent. The deteriorating outlook for emerging markets has
been compounded by the recent capital flow reversals that impacted adversely
on domestic bond and currency markets in particular. While financial markets
have stabilised somewhat, the risks posed to emerging economies in general,
including South Africa, by normalisation of monetary policy in the US in the
future, are evident.

The combination of slower growth in China and the stronger US dollar has also
impacted negatively on commodity prices, although oil prices have been
underpinned by risks related to recent events in Egypt. Global inflation remains
benign and monetary policy is expected to remain accommodative in the
advanced economies for some time, as indicated in the forward guidance
provided by the ECB, the Bank of England and the Fed, notwithstanding a
possible slower pace of quantitative easing in the US. By contrast, a general
tightening bias is evident in a number of emerging markets in response to recent
capital flow and exchange rate developments.

Movements in the exchange rate of the rand continue to pose the main upside
risk to the inflation outlook. Since the previous meeting of the MPC exchange
rate volatility has increased and the rand generally traded in a range between
R9,60 and R10,36 against the US dollar. Since the beginning of the year the rand
has depreciated by 14,2 per cent against the US dollar and by 11,1 per cent on a
trade weighted basis. Much of the recent volatility and weakness has been in line
with the reaction of a number of other emerging market currencies to fears of US
monetary policy tightening. The rand has also been negatively impacted by lower
commodity prices.

Domestic bond yields increased significantly in response to capital outflows and
higher bond yields in the advanced economies. The yield on the 10-year
government bond, for example, increased by more than 100 basis points since
the financial market turbulence in late May. Net sales of domestic government
bonds by non-residents amounted to R17,4 bn in May and June. In July nonresidents became net buyers again with net purchases of R3,0 bn, bringing the
year-to-date net total to R5,2 bn. Having been net sellers of South African
equities in both 2011 and 2012, non-residents have returned to the market, with
year-to-date net purchases of R23,3 bn.

Despite a 15,5 per cent nominal effective depreciation of the rand exchange rate
since January 2012, the pass-through to inflation has been relatively muted,

particularly when compared with previous episodes of currency weakness. This is
probably a reflection of the weak pricing power in some sectors of the economy
in a low growth environment. Nevertheless the risk remains that these pricing
pressures may intensify at some stage, particularly if the exchange rate
depreciates further from current levels.

Market expectations are for a moderate appreciation of the rand in the coming
months, although these expectations have been tempered in recent surveys.
According to the Reuters Econometer survey conducted in June, analysts on
average expect a rand/dollar exchange rate of R9,70 at the end of 2013, and
R9,40 at the end of 2014. There is, however, a wide dispersion between the
forecasters, reflecting a high degree of uncertainty. Despite a slight narrowing of
the current account deficit in the first quarter of 2013 to 5,8 per cent of GDP, the
depreciated currency reflects this deficit against a backdrop of declining terms of
trade and more uncertain global capital flows.

The outlook for domestic economic growth has weakened further, following the
first quarter annualised growth rate of 0,9 per cent. While more favourable
outcomes can be expected in the subsequent quarters of this year, overall annual
growth is likely to be lower than the 2,5 per cent growth rate recorded in 2012.
The Bank’s growth forecast for 2013 has again been revised down from 2,4 per
cent to 2,0 per cent, and from 3,5 per cent to 3,3 per cent for 2014. Growth is
expected to accelerate to 3,6 per cent in 2015, compared with 3,8 per cent

previously. The risks to the outlook are still assessed to be on the downside,
particularly in the face of further delays in overcoming electricity supply
constraints. In line with these subdued growth prospects, the RMB/BER Business
Confidence Index declined from 52 in the first quarter of 2013 to 48 in the second
quarter, consistent with the continued sideways movement of the Bank’s leading
indicator of economic activity.

The outlook for the mining sector remains bleak following a 0,7 per cent year-onyear contraction in May. Although production showed positive month-to-month
growth for the first time in four months, on a three-month-to-three-month basis
the sector contracted by 1,4 per cent. There are indications that the
manufacturing sector will make a positive contribution to growth in the second
quarter following the annualised 7,9 per cent contraction in the first quarter. In
May the sector expanded by 2,2 per cent on a year-on-year basis, and by 0,9 per
cent on a three-month-to-three-month basis. This more positive trend is also
indicated in the Kagiso PMI which increased by 1,2 index points to 52,6 in July,

The real value of building plans passed remains on a moderately upward trend
despite a decline in May. The FNB construction confidence index reflects some
improvement, having increased by 4 points to 41 in the second quarter of 2013,
although the civil construction index declined somewhat over the same period.

Underlying the sluggish economic growth outlook is the low growth in real gross
fixed capital formation, which moderated from an annualised 4,3 per cent in the
fourth quarter of 2012 to 2,5 per cent in the first quarter of 2013. Private sector
fixed investment growth slowed from 3,8 per cent to 2,8 per cent over this period,
and reflected lower outlays in all sectors apart from agriculture, construction and
finance. Work stoppages at Eskom’s Medupi plant also impacted negatively on
investment by state-owned enterprises in the quarter. Fixed investment
expenditure is likely to remain affected by low business confidence and
prolonged electricity supply constraints.

Employment growth remains subdued, particularly in the private sector. In the
year from March 2012 to March 2013, employment grew by 1,0 per cent, or
80,000 workers, of which 65,000 were in the public sector, although this number
was inflated by temporary appointments relating to municipal by-elections in the
first quarter of the year. Employment contracted in the mining and manufacturing
sectors during this period. The official unemployment rate increased from 24,9
per cent in the fourth quarter of 2012 to 25,2 per cent in the first quarter of 2013.
Of particular concern is the increase in the youth unemployment rate to 52,9 per
cent in the first quarter.

Slower growth in real consumption expenditure by households is indicative of
declining consumer confidence and the relative lack of excessive demand
pressures in the economy. Household Consumption expenditure growth

moderated to 2,3 per cent in the first quarter of 2013, driven mainly by more
subdued demand for durable goods, particularly motor vehicles. Real retail trade
sales surprised on the upside in May with year-on-year growth of 6,2 per cent.
Nevertheless, retail trade sales increased by 0,5 per cent in the three months
ending May compared with the previous three months, suggesting a continuation
of the moderate growth in sales.

Consumption expenditure is expected to be constrained by high petrol and
electricity costs, high consumer debt levels and declining growth in credit
extension to households. Despite a moderation in the growth of household debt
in the first quarter of 2013, the ratio of household debt to disposable income was
unchanged at 75,4 per cent, as growth in real disposable income also slowed.

Twelve-month growth in total loans and advances extended to the private sector
increased by 9,3 per cent in May, but excluding mortgage advances the increase
was 16,8 per cent. In the first five months of 2013, general loans (mainly
unsecured lending) continued to account for the bulk of the increase in credit
extension, but at a slower pace, particularly to households. Twelve-month growth
in general loans to households declined from a recent peak of 35,4 per cent in
September 2012 to 24,4 per cent in May 2013. The slowdown is more
pronounced when measured over three months. In the three months to the end of
May 2013, annualised growth was 11,3 per cent, compared with rates of increase
in excess of 30 per cent during 2012.

One of the upside risks to inflation remains wage and salary increases. In the first
quarter of 2013, a stronger upward trend was observed with growth in nominal
remuneration per worker increasing from 6,6 per cent in the fourth quarter of
2012 to 7,5 per cent. With slower productivity growth, this implied an increase in
unit labour cost growth from 5,2 per cent to 6,7 per cent. These increases are
consistent with the overall average wage settlement rate in collective bargaining
agreements published by Andrew Levy Employment Publications, which
increased from 7,6 per cent in 2012 to 7,9 per cent in the first quarter of 2013.

Other upside risks to the inflation outlook emanate from food prices, which have
been accelerating over the past few months following a low of 4,6 per cent in
September 2012. Food price pressures are intensifying at the producer price
level, with manufactured food product prices increasing by 6,9 per cent in May.
Although agricultural product inflation remained subdued at 2,6 per cent, this was
mainly due to the 13,0 per cent decline in live animal prices which offset the 10,4
per cent increase in cereal and other crop prices. More favourably, global food
prices have declined as a result of expectations of bumper crops in some of the
main grain producing countries. The FAO international cereals price index
decreased by 10,1 per cent since September 2012.

Global oil prices have broken out of their recent trading range of between
US$100 and US$105, mainly due to political developments in the Middle East.

However, the relatively subdued global growth outlook, particularly in China, is
likely to restrain these price increases. The current under-recovery of around 36
cents per litre on the domestic petrol price is mainly due to international price
developments, and indicates that a further petrol price increase can be expected
in August.

The MPC continues to face conflicting policy choices relating to rising inflation
and slowing growth. Inflation is expected to resume its upward trajectory
following the brief respite in May. However, despite the upward trend in core
inflation, there are no strong signs of excess demand pressures and the forecast
for headline inflation suggests that the breach of the target may be short-lived.
The main upside risk to the inflation outlook is the exchange rate and much will
depend on the strength of the pass-through to inflation, which to date has been
relatively muted. However, the risk remains that these pressures could be
mounting, particularly if further currency weakness occurs and affects inflation
expectations, which are currently anchored at the upper end of the target range.
In addition, the outcome of the present round of wage bargaining will be critical in
determining the extent of wage pressure on the inflation outlook.

The output gap has widened, and is only anticipated to begin to narrow during
2015, when growth is expected to be more or less in line with potential. The
downside risk to growth has already resulted in the Bank being more tolerant of

inflation at the upper end of the target range than would normally have been the
case, an approach that is consistent with a flexible inflation targeting framework.

While the upside risks to the inflation outlook reduce the scope for further
accommodation, a tightening of the monetary policy stance does not
automatically follow. This will be highly dependent on how we see the inflation
trajectory unfolding in this very uncertain environment. In other words, it has
become even more data dependent. At this stage a sustained breach of the
inflation target is not our central forecast. However, we are concerned about the
revised higher trajectory of core inflation and macroeconomic vulnerabilities that
are increasingly evident. The MPC is mindful of these conflicting pressures and
the challenging domestic and global environment, and will continue to monitor
developments closely and act appropriately to achieve its mandate. The MPC
has decided to keep the repurchase rate unchanged at 5,0 per cent per annum.

Gill Marcus
GOVERNOR

Contact person:
Candice Jeffreys
+27 12 313 4209