Mr. Stals discusses 'The many facets of interest rates'  (Central Bank Articles and Speeches, 2 Sep 98)
Central bank: sarb | Type: speech | Date: 1998-09-02

Mr. Stals discusses 'The many facets of interest rates' Address by Governor of the South African Reserve Bank, Dr. Chris Stals, at a Breakfast Meeting of the I Brokers Council of South Africa, on 2/9/98.

## 1.

IntroductionNobody will deny it that South Africa has extremely high interest rates stage.

In the context of South Africa's own historical record and measured against a c of inflation of about 6½ per cent, nominal interest rates are extremely high.

In the c world environment, and particularly within the group of emerging market economies, the South African interest rates lies in the upper quartile, but is still beaten by a nu comparable countries.

Six of the 24 emerging markets listed in the weekly publicatio Economist, for example, have higher short-term interest rates than South Africa at thisNobody will deny it that the high level of interest rates is bad for t African economy, particularly at the current stage of the business cycle and a rather domestic economic situation.

It is only the few savers we still have in the countr old-aged people who live off their interest income, who may benefit from these high rates.

On the other hand, the high interest rates will most probably reduce consumption with borrowed funds, and also investment in fixed capital, equipment and inventories.

T production capacity of the economy is therefore constrained by the present adverse conditions.

In terms of domestic needs, South Africa now requires a stimulation of the and would prefer lower interest rates to encourage economic development.There is also a fairly general consensus of opinion that the present high rates were recently forced on South Africa by the international financial situation.

T East Asian crisis that started to surface in Thailand more than a year ago spilled o economies of many other countries.

Even countries with more stable economies suc Australia, New Zealand and Canada were adversely affected by these developments.

Emer countries far away from the East Asian epicentre such as Mexico, Colombia, Brazi Venezuela have been infected by the problem.

Countries with economies in transformatio as the Czech Republic and Poland also suffered and the recent catastrophic developm Russia cannot be completely divorced from the East Asian crisis.

In the end, South Af could not escape from the turmoil.There are major differences of opinion among economists inside and outsid South Africa on what the reaction of the official macroeconomic policymakers in South should be to soften the blows for the economy.

At the one extreme there is the Inte Monetary Fund that believes that much more restrictive monetary and fiscal policies sho been applied in South Africa in recent months to fend off the attacks of international and short-term profiteers.At the other extreme we find economists in South Africa with major private interests who believe that the Reserve Bank should have kept interest rates artificiall complete disregard of the consequences this would have had for the exchange rate of t and subsequent inflation.

There are those who believe that the Reserve Bank should ha more to keep the exchange rate stable, even if it should have required the reintro tightening of exchange controls.There are many naive critics in South Africa who believe that the Reserve B fully responsible for the high interest rates and that the Reserve Bank indeed used i powers to force interest rates to these destructively high levels.

In their ignorance that the Reserve Bank can even at this stage pull the rabbit from the hat and insta bring interest rates down again.

Unfortunately, in the real world such miracles ar possible.

## 2.

What caused interest rates to go upTo avoid confusion in this debate, the real causes for the recent sharp interest rates should be revisited.

It will be recalled that in the first quarter of t wide-spread optimism that interest rates in South Africa could decline further during of 1998.

The Reserve Bank had already reduced its Bank rate from 17 to 16 per cent in 1997, and to 15 per cent on 9 March 1998.

Inflation was declining, foreign portfolio in flowed into the country, the foreign reserves were rising and the exchange rate of th under pressure to appreciate.However, the situation changed dramatically in May 1998 when non-residen reviewed their investment strategy and started to withdraw some of the funds they had p invested in South African bonds.

During the four months January to April 1998, non-r investors increased their holdings of South African bonds by approximately R16 billio the next four months, that is from May to August 1998, they reduced their holdings o African bonds by about R19 billion.This dramatic change of strategy had an almost immediate negative effect o overall demand and supply conditions in the South African financial markets.

The yi long-term government bonds rose from just below 13 per cent at the beginning of May to of over 21 per cent last week.

Other interest rates followed the upward trend and esta extremely high levels we now have for the Reserve Bank's rate for repurchase transacti prime overdraft rate, and the mortgage lending rate of banking institutions.In this process, triggered by a decline of investors confidence in the e markets of the world, little concern was shown for the depressed conditions in the Sout economy.

No consideration was given to the needs, desires or expectations of the pe South Africa.

Neither the Minister of Finance nor the Governor of the Reserve Ban consulted by the markets before interest rates were forced to higher levels.

The whol was driven by external factors that swept across many of the smaller economies of the w a huge tidal wave.

The switch from a R16 billion inflow of capital for investment African bonds in the first four months of 1998 to an outflow of an almost similar amou next four months dramatically changed the demand versus supply conditions in the African financial markets.

In the situation, it would have required a massive creation by the Reserve Bank to prevent interest rates from rising to the extent they did.

Such a money in turn would have added fuel to the inflationary pressures that were already stim the depreciation of the rand.

## 3.

What can now be done to bring interest rates down?It is amazing to read in the financial press in South Africa almost every accusation that the high interest rates in South Africa at this stage are a reflectionBank's deliberate 'high-interest-rate-policy'.

The present level of interest rates is o as being 'artificially' high because of Reserve Bank intervention in the market.

The overlook the fact that the Reserve Bank indeed raised the amount of accommodation available to banking institutions at the daily repurchase tender for central bank R4.1 billion early in May to R9.8 billion at this stage.

This action by the Reserve Ban prevented interest rates from rising even further and, if anything, created an artifici of interest rates in the country.

Perhaps with some justification, this policy of t recently criticised by the International Monetary Fund.The Reserve Bank also made a huge amount of forward cover available to Sou African residents with outstanding commitments in foreign currency, and to non-re investors with open rand positions in South Africa with the objective of discouraging t sending more funds out of the country.

This policy undoubtedly contributed towards main interest rates at a lower level as the IMF quite correctly pointed out.

In South Africa widely criticised for having provided this forward cover, but at the same time also bla 'high' interest rates.After four months of heavy pummelling by the markets, South Africa now fi itself in a situation where:- the exchange rate of the rand has depreciated by about 25 per cent;- interest rates have risen to a level where borrowing from the banking sec the financing of additional economic activity has become almost prohibitiv- the banking sector has lost a lot of liquidity;There is therefore an understandable pressure on the Reserve Bank to something that will bring interest rates down immediately and effectively for all borro South African market.

Can the Reserve bank do anything to salvage this situation?A simplistic view is that the Bank should reduce the rate for its rep transactions and therefore provide accommodation to banking institutions at a lower c view overlooks the fact that the repo rate of the Reserve Bank is determined on a d through a tender system, and is no longer fixed by the Bank.

Should the Reserve Bank t want to reduce the repo rate, it will have to offer more central bank funds ('high money) to the banking institutions.In deciding on its policy, the Reserve Bank must, however, take into account- the recent large outflows of funds through the Bond Exchange.

An expansion domestic liquidity in this situation could facilitate the outflow of funds;- existing relationships between interest rate margins, spot exchange rat forward rates.

A disruption of these relationships can easily lead t speculative transactions against the rand;- the continuing high rates of growth in bank credit extension and in the supply; and- the need to keep inflation in check in the aftermath of a depreciation of t more than 20 per cent since May this year.In this situation, it will be irresponsible for the Bank to create more mo effort to force interest rates down.

Advantages, if any, to be gained from such a pol very short-lived.A solution in the short-term for the South African dilemma can only come the original source of the problem, that is, from the international financial markets. must return to the many international fund managers who have decided in recent mont withdraw substantial amounts of portfolio investments from the bond markets of the economies around the world.

These fund withdrawals not only forced interest rates to levels, but also created turmoil in the foreign exchange markets.

A return of stabil markets will pave the way for lower interest rates in South Africa, and in many othe countries of the world.

For any individual country such as South Africa to try to br these shackles at this stage will be almost impossible, unless impenetrable brick wa constructed around the South African economy to isolate it from the rest of the world.

## 4.

Can South Africa survive with these high interest rates?As already mentioned, the high level of interest rates at this stage is not with the current needs of the South African economy.

There is, however, very little we get ourselves out of the dilemma in the very short-term.The present unsatisfactory situation emphasises the long identified need fo Africans to save a greater percentage of our income or, to put it in more sensible language, to consume less.

We must remember that, in terms of the macro-econo consumption financed with borrowed funds counts as negative saving.

By borrowing from b to finance current expenditure, we actually use up tomorrow's income today.The situation also emphasises once again that the South African total prod machinery must become more competitive.

We must make ourselves not only more self-sufficient in the provision of finance for our own economic development, but al production of the goods and services we need for domestic consumption and real investm other words, we must reduce our dependence on the rest of the world and eliminat vulnerability for recurrent balance of payments crises.As long as these high interest rates are forced on us by the international over which we have no control, a slow-down in total economic activity will be unavo Sensible adjustment to the realities of the situation will, however, avoid a major rece already predicted in some quarters, and feared by many.

To delay a spending decision tod not mean a permanent abolition of a justifiable need, but realistic deference to th disciplines and constraints of an adverse global situation, until international condit again.In the meantime, we should not lose confidence in the resilience of the African economy, and in its ability to weather the current storm.

Looking around th today, we still have, even in the present adverse climate, many reasons for remaining about the medium and longer-term prospects for the South African economy.

Our bank system remains sound, our financial markets operate with great efficiency, and a huge demand for goods and services needs but little encouragement to re-stimulate the econom