An address by Lesetja Kganyago,
Governor of the South African Reserve Bank,
at the World Bank Reserves Advisory and Management Program
Washington, D.C.
15 April 2019
Building resilience
Distinguished guests, ladies and gentlemen. It is a great pleasure to be
here.
The recent World Economic Outlook highlights that although global
economic conditions remain benign, in recent months growth in both
emerging and advanced economies has begun to decelerate. At the same
time, risks to the global economy are tilted to the downside, linked to both
political and financial developments. An important element of managing
risk in such an uncertain environment is to focus on building
macroeconomic resilience.
My comments today will be centred around that theme. In particular, I'd
like to share some thoughts around how emerging market central banks
can contribute to economic resilience.
I will begin by outlining a broad definition of resilience in the
macroeconomic context. In addition, I will put forward some principles that
can underpin a policy framework aimed at supporting resilience. I will then
discuss the experience of emerging markets and finally South Africa in
addressing vulnerabilities and building macroeconomic resilience.
Resilience conceptualised
When thinking about economic resilience, it is important to focus on two
distinct issues. The first is about how an economy responds to adverse
shocks.
The other relates to an economy's propensity to avoid these shocks. As
such, resilience can be defined as minimising both the depth and the
frequency of economic downturns.
Resilience is important because the incidence of a downturn may
influence the future growth potential of an economy. Indeed, there is a
growing body of scholarly evidence indicating that recessions are
associated with permanent output losses.1 In particular, the longer output
remains below its pre-crisis trend, the less likely it is to return to that trend.
Containing shocks and minimising their frequency could, therefore,
produce lasting benefits.
Another important justification for striving to achieve macroeconomic
resilience is that it can shield the most vulnerable in society from adverse
outcomes. We know that lower-income families and smaller firms are less
able to smooth consumption during downturns. As a result, negative
shocks can have severe and lasting effects on the economically
vulnerable, even if the aggregate output loss is relatively small.
In thinking about resilience, we do, however, need to be guided by some
broad principles.
Resilience principles
Since the global financial crisis, many central banks have seen an
expansion of their mandates. The South African Reserve Bank (SARB)
has been no exception, as we have recently been given the significant,
but shared, responsibility for promoting financial stability.
The expanded mandate comes with a larger policy toolkit. Consequently,
central bankers face a distinct challenge in coordinating their monetary,
exchange rate and financial stability policies.
One useful way of achieving coordination is by assessing whether a
particular policy mix is supportive of macroeconomic resilience. To
facilitate this, I would like to suggest four key principles, which should
underpin any policy framework aimed at promoting and sustaining
macroeconomic resilience.
In short, policy should aim to increase the flexibility of an economy in
response to shocks, to be countercyclical as far as possible, to be
consistent, and attempt to contain negative externalities.
Let me expand on each principle briefly.
On the topic of flexibility, various policies can be undertaken to ensure that
an economy is able to adjust to changing conditions in a way that
minimises disruptions. Within the realm of central banking, this calls for a
focus on the way in which financial shocks propagate through an
economy. For example, ensuring that the banking sector is liquid and well
capitalised improves the ability of banks to finance projects through the
cycle. Having buffers in place to reduce shock amplification also frees up
policy space.
This leads me to the second principle, which is countercyclicality. The
scope to support an economy during a downturn, and curb exuberance
during a boom, is a key element of resilience. The Keynesian revolution
in economics popularised monetary and fiscal stimulus during recessions.
Now, central banks are increasingly introducing countercyclical
macroprudential policies. Although the theory clearly supports this
approach, there are significant challenges in achieving countercyclical
policy outcomes. I will elaborate on some of these challenges later in this
speech.
Next, let me briefly expand on the principle of consistency. It is very
important to regulate same activities in a similar way. This reduces
opportunities for regulatory arbitrage and avoids the inefficiencies
associated with gaming regulation. Similarly, in monetary and
macroprudential policy, a consistent and predictable reaction function
ensures that policy itself is not a source of significant uncertainty.
The final principle is that of addressing negative externalities. Economic
downturns are often caused by exuberance in prior periods, be those
strong capital inflows or rapid increases in private credit. What such
episodes often have in common is the tendency for private actors to
expose the broader economy to undue risk. This is a so-called negative
externality because the persons taking the risk do not bear the full
economic cost, should the risk materialise. As a result, more risk than is
socially optimal is undertaken in the absence of regulation. It is therefore
necessary to have a policy framework that incentivises, the alignment of
private and social interests as far as possible. There are a number of
areas in which this principle is currently being explored. For example,
some jurisdictions regulate the variable pay of bank CEOs2, to limit their
incentive for risk taking.3
I think that, by applying these four principles, central bankers can craft a
set of policies that appropriately reinforce resilience.
Let me turn now to a discussion of resilience within emerging markets and
South Africa specifically.
Resilience in emerging markets
Reforms
Since the crises of the 1990s, emerging market policymakers have
undertaken a number of key reforms to reduce external vulnerabilities and
build macroeconomic resilience, many of which have been in the spirit of
the principles I have just outlined.
A particularly important policy choice has been to reduce the risks
associated with foreign currency-denominated debt. One strategy has
involved building foreign exchange reserve buffers and working with
international organisations to strengthen the global financial safety net.
Indeed, over the past 20 years, global foreign exchange reserve assets
have grown more than sixfold,4 with the bulk of the growth driven by
emerging market economies. Meanwhile, bilateral swap lines and regional
financing arrangements have grown in prominence, complemented by
increased International Monetary Fund (IMF) resources.
A supporting strategy has involved structural reforms to limit reliance on
foreign currency debt. This broadly includes the development and
deepening of domestic capital markets, as well as legal and institutional
reforms to address frictions impeding bank credit growth. The shift
towards local-currency borrowing in emerging markets has provided an
important layer of resilience against external shocks.
There has also been a concerted effort to enhance monetary policy
frameworks and stabilise inflation at lower levels. Many countries,
including South Africa, have opted for an inflation-targeting framework in
order to shift the public's focus away from the exchange rate as a nominal
anchor. By moving the focus to a stable inflation anchor, it has become
easier and less costly to contain inflation shocks. Reduced inflation risk
has also helped to support credit growth, particularly at longer durations.
All of which has been positive for resilience.
Linked to the change in monetary policy frameworks has been an increase
in exchange rate flexibility. Such flexibility has introduced greater scope
for monetary policy countercyclicality and has allowed the exchange rate
to play a role in absorbing shocks.
Meanwhile, most emerging market economies have undertaken some
form of financial sector liberalisation, be it increasing private involvement
in the sector, reducing controls on capital flows, or increasing the extent
to which markets determine the price of credit.
We, however, must acknowledge that while these reforms have provided
important benefits, in some cases an excessive pace of capital account
liberalisation has been associated with heightened volatility and even
crisis. But, generally, the research on this topic shows that the adverse
effects associated with capital flow liberalisations have tended to be
concentrated in those countries where financial development is relatively
low.5 This indicates that the sequencing of reforms is also an important
consideration.
Challenges
Despite significant improvements over the past 20 years, emerging
market central banks continue to face challenges in building and
sustaining macroeconomic resilience.
As I've alluded to earlier, procyclicality has been difficult to avoid in some
countries. Indeed, we continue to see central banks give in to the
temptation of providing stimulus, even when an economy is operating near
full capacity. This is particularly prevalent in countries that lack central
bank independence.
However, other challenges related to procyclicality are also present. For
example, there are significant difficulties in measuring business and
financial cycles in real time. This has been compounded by substantial
changes in potential growth across various parts of the world in recent
years.
A further source of procyclicality is that many emerging market central
banks have not had the luxury of considering only domestic conditions
when setting policy. The widespread emerging market currency sell-off in
2013 was a prime example of an exogenous shock that forced procyclical
tightening in some countries. Nevertheless, that episode also provided an
important lesson. Those economies that had created policy space by
anchoring inflation expectations were under less pressure to act in a
procyclical fashion.6
An associated challenge with respect to policymaking is that of data gaps.
These preclude regulators from accurately monitoring risk and making
cross-country comparisons. Such gaps may also be exploited by firms
seeking to avoid regulation. Policy challenges in this area are exacerbated
by developments in cybersecurity and financial technology, which pose
new types of risk.
But, the familiar problem of elevated debt level poses the greatest risk to
resilience. Since 2008, private non-financial sector debt in emerging
markets has more than tripled to almost US$40 trillion.7 While China has
played a significant role in this outcome, the trend of rising private debt
has been broad-based. Furthermore, benign financing conditions have
supported substantial foreign currency borrowing in a number of key
economies, increasing debt risks. This is a real challenge to resilience
because a large debt overhang can amplify adverse shocks and weaken
recovery.
Let me now turn to the resilience of the South African economy.
Resilience in the South African context
I believe that South Africa's macroeconomic framework has contributed to
significant resilience in spite of various challenges. In particular, the
combination of a floating exchange rate, inflation targeting and sound
prudential regulations has helped to contain externalities and has
provided for significant flexibility to macroeconomic shocks.
South Africa has been an exception to the trend seen in other emerging
economies of late. It is one of only a few countries that have experienced
a decline in private sector debt over the past decade. Despite receiving
strong capital inflows after the global financial crisis, bank credit extension
has remained relatively muted. Instead, capital inflows have largely found
their way into listed assets and bonds. Indeed, foreign ownership of
domestic government bonds has increased significantly, from 22% in early
2011 to approximately 38% today.
Flows into the bond market have supported substantial public sector
borrowing. General government debt, as a share of GDP8, has more than
doubled over the past decade. At 56% of GDP, gross public debt is
relatively high by emerging market standards. The trajectory and size of
this debt implies a lack of fiscal space. However, the National Treasury
has taken a number of steps to contain the negative externalities
associated with the debt. For example, the average maturity of the
outstanding debt stock has been increased to about 15 years, reducing
rollover risk, while almost 90% of the debt is denominated in rand.
Similarly, South Africa's private debt is mostly in domestic currency. The
economy's large banking sector, alongside deep capital markets, has
provided a stable source of local-currency funding, allowing the corporate
sector to keep its foreign currency liabilities low.9 Furthermore, in the spirit
of containing externalities, the SARB has in place a number of prudential
limits on the banking sector with respect to foreign currency risk. For
example, domestic banks are required to keep their net open foreign
currency position below 10% of their capital.
As a result, South Africa's foreign liabilities are largely in local currency,
while its foreign assets are nearly all foreign currency-denominated. This
structure makes the flexible exchange rate a powerful shock absorber. In
addition, full exchange rate flexibility reinforces the structure of the
economy's liabilities by disincentivising foreign currency borrowing.
Given the make-up of South Africa's assets and liabilities, periods of
exchange rate weakness have been associated with an improving net
international investment position (IIP). The IIP itself has been further
supported by strong growth in domestic equity investments abroad.
Consequently, South Africa belongs to a small group of emerging market
economies with a positive IIP.10
As a result of the shock-absorbing capacity of the exchange rate, the
SARB has not had to actively utilise its international reserves since
adopting inflation targeting in the year 2000. Instead, we have opted to
gradually rebuild the country's reserve buffers, having faced substantial
losses while defending the currency during the 1990s. The SARB
currently holds approximately US$50 billion in gross international
reserves, largely as a precaution against severe market dysfunction.
This level is regarded as being well below the IMF's assessed reserve
adequacy. However, at about 15% of GDP, the SARB holds a similar level
of reserves (relative to the size of the economy) as various other large
emerging markets do - a level which for many countries exceeds the
IMF's assessed reserve adequacy. Furthermore, as I have mentioned,
South Africa's foreign currency debt levels and IIP are better than many
of its peers.
Indeed, a key driver of South Africa's assessed reserve shortfall is the
large share of portfolio liabilities. The extent to which we should hold
reserves against these liabilities is a subject of debate, particularly
because the SARB does not actively intervene in the exchange rate.
Nevertheless, we remain committed to reserve accumulation and will
continue to grow our reserve assets on a measured basis.
The fact that capital inflows have been directed largely towards listed,
local-currency investments has both positive and negative dimensions for
resilience. On the negative side, portfolio investment is believed to be a
more volatile source of funding, potentially exposing the economy to the
risk of rapid capital flow reversals. Furthermore, the disproportionate
demand for financial assets has, in the past, reflected relatively weak
domestic GDP growth and a perceived lack of direct investment
opportunities.
On the positive side, however, foreign procurement of listed assets means
that asset prices adjust rapidly to changing demand. Fast price discovery
is key for ensuring that capital flow volumes remain intact even as global
conditions fluctuate. Indeed, we often observe counterbalancing
behaviour by domestic residents during periods in which foreign investors
are selling assets. This is usually prompted by sizable asset price
changes, which encourage domestic investors to repatriate capital from
abroad.
Moreover, the international demand for South Africa's financial assets is
an indication of the relative strength of our financial markets. Daily foreign
exchange turnover, for example, is among the largest of any emerging
market economy (when measured as a share of GDP).11 This ensures a
high level of liquidity for portfolio investors.
Improving the depth and sophistication of the domestic financial markets
has been a joint effort between the authorities and the private sector. One
of the most important outcomes associated with more complete markets
is enhanced sharing and allocation of risk. For example, there are
relatively liquid currency hedging opportunities in South Africa, which
means that foreign investors can acquire local-currency assets even if
they do not wish to have exposure to the rand.
Now let me turn to the banking sector, which we believe to be a key pillar
of macroeconomic resilience. The sector is well capitalised, with ample
liquidity. It was strong enough to withstand the global financial crisis
without any bank failures or recapitalisations required. Presently, South
Africa's regulations are broadly compliant with Basel III.
To further build on the resilience of the financial sector, the SARB,
alongside other regulators, is currently introducing deposit insurance and
a resolution framework for banks and other systemically important
financial institutions. Deposit insurance is expected to reduce the risk of
retail bank runs, while the resolution framework will formally introduce the
possibility of private creditor bail-in. Both regulations will limit the public
cost of bank failures. This is particularly important for preserving fiscal
space.
Moving to monetary policy, the introduction of inflation targeting in 2000
has steadily improved the anchoring of inflation expectations and has
reduced the level of inflation. In recent years, the SARB has been
attempting to steer inflation expectations closer to the midpoint of the 3-
6% inflation target range. We believe that this will improve policy flexibility
and increase the scope for countercyclicality.
However, while much has been done to boost domestic resilience, a
number of challenges remain. Rising public debt and the threat of further
sovereign credit rating downgrades pose risks to both the financial sector
and the real economy. In particular, these developments have already
lifted longer-term borrowing costs and adversely affected private
investment. Furthermore, should a crisis materialise, the scope for fiscal
stimulus will be very limited - a fact which further underscores the
importance of creating monetary policy space.
Perhaps the biggest threat to the economy's resilience is the presence of
various binding structural constraints. These have given rise to
persistently low GDP growth. The SARB estimates that South Africa's
growth potential is a little over 1% at present. This pace of growth is
insufficient to address the high level of inequality and joblessness in the
country. Aside from eroding growth potential, structural challenges are a
real threat to resilience because they reflect a substantial degree of
inflexibility in the economy. Various reforms are therefore required if South
Africa is to grow faster and become more resilient. However, these are
beyond the remit of the SARB.
Concluding remarks
To recap: I believe that central banks can play an integral role in building
economic resilience. In particular, this can be achieved by operating in a
countercyclical fashion, ensuring policy consistency, addressing financial
sector externalities, and putting in place policies that increase the flexibility
of an economy in response to shocks. Of course, the central bank's
contribution is necessary, but not sufficient, to ensure broader economic
resilience. Well-functioning product and labour markets as well as sound
fiscal management are also key.
Thank you.