Daniel Mminele: The South African Reserve Bank's activities in financial
markets
Address by Mr Daniel Mminele, Deputy Governor of the South African Reserve Bank, at the
Financial Market Department's Annual Cocktail function, Pretoria, 3 June 2010.
* * *
Introduction
Good evening ladies and gentlemen and welcome to the fourth annual cocktail function of
the Financial Markets Department (FMD). It is our privilege to host this event. Thank you for
accepting our invitation.
You are all familiar with recent economic and financial market developments, but please
allow me to just briefly touch on these events from the perspective of the central bank. I will
then discuss the Bank's activities in the financial markets given that, in some form or another
you are all counterparties to our operations and activities in the financial markets, or are
affected by what we do.
International developments
Since the previous FMD Cocktail at the end of July 2009, there have been a number of
economic developments, which have had a significant impact on global risk appetite and
trends in financial markets. For much of 2009, the EUR was relatively strong, appreciating to
USD 1,51 in early December 2009. Speculative currency positioning, as represented by
weekly data from the Commodity Futures Trading Commission (CFTC), showed aversion
towards the USD in this period. The USD showed a net short position of over 280 000
contracts. The VIX index, a popular measure of expected volatility, and often referred to as
the "fear index", hovered around its long-term average of 20 index points, while advanced
and emerging market equity markets were recording double digit gains. In developed bond
markets, short dated yields were declining owing to the still lax monetary policy, while
long-term yields were rising in reaction to increased government debt issuance. Emerging
market bond spreads as measured by the Emerging Market Bond Index (EMBI) plus spread,
had come off their high levels of almost 900 basis points in October 2008 to 280 basis points
in December 2009. Credit Default Swap (CDS) spreads for the advanced economies and for
certain European countries recently in the spotlight were also stable over this period,
indicating little concern about sovereign default risks. Money markets were also relatively
stress-free, as reflected by the continued narrowing in Overnight Index Swap (OIS) spreads
at the time.
The global economy emerged from recession in the latter half of 2009, much
sooner-thanexpected and at a pace that was stronger than even the most optimistic forecasts. This
development proved to be the catalyst for the rally in financial markets. Furthermore, the
pace and speed of the recovery, differed vastly across countries and regions, with emerging
markets proving to be the engine for global growth. Together with record-low interest rates in
advanced economies, risk aversion having dissipated and abundant liquidity, emerging
market countries started to attract significant capital inflows.
However, towards the end of 2009, some headwinds emerged, which more recently
intensified with the sovereign debt crisis in southern Europe and with markets becoming
particularly concerned about a possible default by Greece and the contagion effects thereof.
Was this to be the start of a new crisis? Was the nascent global economic recovery now at
risk? Was the confidence we saw in financial markets misplaced and needed to be replaced
by renewed risk aversion? The initial comfort provided by the EUR750 billion rescue package
announced in early May by the European Union (EU), IMF and European Central Bank
(ECB), soon gave way to concerns and uncertainty as to whether the measures taken would
be sufficient to resolve the underlying solvency problems and whether the required fiscal
consolidations would be politically and socially feasible.
Budget cuts imposed across the euro zone spurred debate about the sustainability of the
euro, the ramifications of fiscal tightening on European economic growth and the impact of a
slowdown in the euro zone demand on the overall global recovery. Speculative currency
positioning now showed aversion towards the EUR instead of the USD. The net long
EUR contracts changed to net short positions of almost 120 000 contracts. Over the same
period, the EUR depreciated to USD1,21 in mid-May. Risk aversion subsequently increased
and the VIX index spiked to over 40 points in May 2010. Equity markets lost ground and
CDS spreads, most particularly for Portugal, Ireland, Greece and Spain, increased. Strains in
the money market came to the fore once more and the US OIS spread ticked up from around
10 basis points to approximately 30 basis points. Central banks that had been slowly and
carefully embarking on exit strategies from unconventional policies, found themselves
pondering about and indeed implementing re-entry strategies.
It is clear that there is an urgent need for countries to consolidate their fiscal positions and
bring their public debt ratios and fiscal deficits back to within more sustainable parameters.
Domestic financial markets
These developments are important for South Africa, being a small and open economy with
deep and liquid financial markets. Against the backdrop of the stronger global and domestic
economic environment, domestic financial markets also rallied in the latter part of 2009. The
ZAR appreciated by almost 23% per cent on a trade-weighted basis in 2009, reversing the
23.5% decline recorded in 2008. This appreciating trend continued until mid-May 2010,
supported by stronger commodity prices, the search for yield, liquid domestic markets, a
relatively favourable economic and fiscal backdrop and the reduction in risk aversion. The All
share index, as well as the Morgan Stanley Capital International index (MSCI) for South
Africa, registered double digit gains, P/E ratios improved and domestic government bond
yields declined. The fixed income market was supported by the easing in monetary policy
and healthy appetite for domestic bonds by non-residents. Non-residents purchased a net
R24 billion worth of domestic bonds in the fourth quarter of 2009 and purchased over
R 30 billion in the first four months of 2010. The international bond issues of the South
African Government in 2009 and 2010 were also well received, as confirmed by the latest
USD 2,0 billion issue in March 2010, which realised the lowest coupon ever achieved on a
USD bond issue.
Nonetheless, the recent bout of risk aversion caused the rally in domestic financial markets
to also run out of steam, while the appreciation in the ZAR dissipated and volatility increased
from 13 per cent in April to almost 18 per cent in May.
Market development initiatives
An important milestone was reached in February 2010, when South Africa's multibillion rand
money market industry officially commenced the electronic issuing, trading and settlement of
securities in place of the manual paper based system.
As the largest issuer of money market securities (on our own behalf and on behalf of
Government), the Bank welcomed the implementation of a fully-dematerialised money
market. All SARB debentures and Treasury bills are now being processed in the new
electronic format, representing not only a milestone for the South African financial markets,
but also being the very first fully automated dematerialised settlement environment globally.
Many of the people here tonight were involved in this project, and I want to sincerely thank
you for your contributions to this very important project.
As part of the FMD's own contribution to market development and to enhance our exchange
of information with market participants, a platform known as the Money Market Liaison Group
(MMLG) was initiated in 2005, mainly to consult with banks on the modifications to the
Bank's refinancing system at the time. Earlier discussions were dominated by issues such as
the extension of the pool of eligible collateral for the Bank's refinancing operations and
improvements to the benchmark overnight interbank rate. More recently, the need to reform
this body to make its scope wider became apparent. A review of the MMLG was undertaken,
resulting in the reconfiguration of its membership to cover the broader spectrum of financial
markets, and the change of its name to the Financial Markets Liaison Group (FMLG).
To meet the objectives of this consultative body, the FMLG will have four subcommittees that
are in the process of being finalised. The Money Market subcommittee will focus on issues
impacting the functioning of the money market, the Financial Market Infrastructure
subcommittee replaces the former Money Market Association and will discuss ways of
strengthening and improving market infrastructure. The FMLG will also have a Foreign
Exchange and Fixed Income and Derivative Market subcommittee, which will engage on the
safe and efficient functioning of these underlying markets, as well as derivative-related
developments.
Open market operations
Managing the overall liquidity in the money market is of the utmost importance to the
successful implementation of monetary policy. Having not had any difficulties previously,
since December 2009 the Bank began to encounter some challenges in conducting its
open-market operations in order to manage overall liquidity. In the process, the money
market shortage at times declined to quite low levels. This was mainly due to dwindling
demand for SARB debentures, owing to a slowdown in the growth of banks' balance sheets,
which resulted in lower demand for liquid assets that banks have to hold for prudential
purposes. The National Treasury's increased funding in Treasury bills and government
bonds similarly impacted demand, while the longer-term reverse repos (LTRRs) were
constrained by the ample availability of government bonds in the secondary market, in
addition to traditionally limited participation in this instrument.
The Bank consulted market participants not only to obtain a better understanding of reduced
participation in the debenture auctions , but also to explain why the participation of banks in
central bank open-market operations is essential for the effective implementation of
monetary policy. An effective monetary policy implementation framework contributes towards
financial stability, which is in the interest of all banks and the system as a whole.
In light of the aforementioned challenges, we are considering some changes to the way in
which the Bank conducts its open-market operations and we will be in a position to make
announcements soon. For example, the measures being considered relate to modifications
in the operation of standing facilities offered by the Bank as well as the use of longer-term
foreign exchange swaps. The Bank conducts money market swaps in foreign exchange as a
fine-tuning tool to manage money market liquidity.
Foreign exchange market
The size of the South African foreign exchange market, measured in terms of average daily
turnover in USD, has fluctuated between USD10bn and USD15.2 since the time of the last
FMD cocktail, with the composition in terms of spot, forward and swap transactions
remaining relatively unchanged. Very much like in other parts of the world, conditions in the
foreign exchange market continued to be volatile.
The Bank has continued its involvement in the foreign exchange market mainly for reserves
accumulation purposes. As a result of the appreciation in the rand exchange rate in 2009 and
earlier this year, there were heightened calls for the Bank to intervene aggressively in the
foreign exchange market or to even peg the rand to the US dollar. As indicated before, the
Bank remains committed to a flexible exchange rate regime, with the exchange rate
determined primarily by the market.
The commitment to a flexible exchange rate should, however, not be misunderstood as an
indifference towards the exchange rate. The rand is one of the most volatile currencies and
the Bank is cognisant of the impact that this can have on business, and the uncertain
operating environment it creates. Extended periods of misalignment can lead to a
misallocation of resources between sectors within the economy and lead to an uneven and
unbalanced economic recovery.
Having acknowledged that certain sectors of the economy have been affected by what may
be perceived to be a relatively strong exchange rate, it is also crucial to again highlight the
importance of inflation management. One must bear in mind that a depreciation in the
nominal exchange rate together with an increase in inflation would not lead to an
improvement in the level of competitiveness of the rand. Any consideration for more
aggressive participation in the foreign exchange markets would also have to be carefully
assessed against, among others, the prospects of success given the factors that may be
driving the exchange rate in any particular direction at any given point in time.
More aggressive intervention or pegging the rand to the US dollar would be a very costly
exercise. Firstly, how much foreign exchange reserves would be required to artificially peg
the rand to the US dollar and to maintain this peg in the event of pressure to depreciate?
South Africa's reserves, at just over USD42 billion, are relatively low for that type of exercise.
Furthermore, pegging the rand to the US dollar would not imply an automatic peg to other
currencies, such as the EUR, which is the currency of our biggest trading partner bloc.
Pegging also has the problem that if prices and wages are increasing, any competitive
advantage will soon be eroded and there will be calls for changing the peg. Aggressive
reserves accumulation either in the context of a peg or to prevent or moderate appreciation
also carries significant costs, given the wide interest rate differential between the interest
paid on sterilization and the interest earned on reserves. This results in a negative cost of
carry and places the Bank's income position at risk. The Bank recorded a loss of
approximately R1,0 billion during the 2009/10 financial year. It is however important to point
out that this loss was incurred as a direct result of the bank executing its public policy
responsibilities rather than owing to any inappropriate risk taking or wasteful expenditure.
Over the past year, the Bank continued to purchase foreign exchange as part of its strategy
to steadily increase the level of foreign exchange reserves. Gross reserves increased by
approximately USD8,0 billion from April 2009 to USD42,3 billion in April 2010. The
international liquidity position increased by USD5,0 billion to USD38,5 billion over the same
period. Apart from foreign exchange purchases by the Bank, this increase in official reserves
was also due to foreign currency deposits from government, the allocation by the IMF of
SDRs to South Africa and valuation adjustments. Although valuation adjustments contributed
positively to reported USD official reserves over the financial year, there were periods where
the Bank published substantial declines in the level of reserves due to valuation losses
stemming from the diversified nature of reserves in terms of currencies.
The Financial Markets Department continued to enhance reserves management policies in
order to adjust and streamline our investment strategies.
The Investment Policy, which provides a strategic and operational framework for reserves
management, was reviewed during 2009/2010. The Investment Policy is reviewed every
three years for governance purposes and also to ensure that it is responsive to and keeps
pace with changes in the reserves management activities of the Bank and the external
environment. The recent global financial crisis provided an ideal opportunity to incorporate
into the policy the lessons learned, while also aligning the policy with refinements to
international best practice.
Conclusion
The turmoil experienced in the euro zone with regard to sovereign debt risks highlights the
importance of fiscal sustainability. Markets have become increasingly sensitive towards
sovereign risks and therefore policymakers need to recognise the urgency of reducing
excessive public debt. Fortunately, in this regard South Africa is on a solid footing when
compared to challenges faced elsewhere.
South African financial markets are an integral part of global markets and will continue to be
subjected to global developments. As one of my colleagues recently said: "the best defence
is to stick to sensible policies".
But we must now turn our focus to successfully hosting the 2010 FIFA Soccer World cup
starting in about a week's time, for the first time ever on the African continent. South Africa
has again shown its mettle, and has overcome all scepticism, and we are now ready to
welcome the world!
In closing, I would like to convey my appreciation to the management and staff of the
Financial Markets Department, not only for paying the bill tonight, but for the sterling work
that they do for the Bank and our markets. Thank you also to the staff of the
SARB Conference Centre for taking care of us tonight.
Thank you and enjoy the evening.