Lesetja Kganyago: South African monetary policy and the path to
normalisation
Address by Mr Lesetja Kganyago, Deputy Governor of the South African Reserve Bank, at
the RMB Morgan Stanley 2014 Big Five Investor Conference, Cape Town, 30 September
2014.
* * *
1. Introduction and context
Global economic rhythms remain disturbed and economic policies of major advanced
economies are moving in different directions. Much of the emerging market universe is
experiencing weak economic growth and higher than comfortable inflation. US policy is
slowly normalising, while Europe is taking strong remedial action in an attempt to address
extremely low inflation and a protracted recession. These developments, and others, will
continue to affect South Africa and test our policies.
This has already been a challenging year for the Reserve Bank. We have seen a sustained
breach of the inflation target. We have raised policy rates for the first time since 2008. Output
contracted for the first time since the crisis. In August, African Bank was placed under
curatorship.
Confidence in the economy is currently weak, and all else equal, will tend to put upward
pressure on inflation rates as households and firms seek price increases as a way to improve
their finances. Stubborn inflation persists in South Africa in part because of this, and we need
to be clear as a society that a spiral of wage-price inflation cannot substitute for productivity
growth as a way to improve our incomes. We need low inflation, as a protection of the living
standards of the poorest among us, to support access to finance, for financial stability - and
as a means of safeguarding our competitiveness and encouraging investment and job
creation.
At present it is important to conserve and move to rebuild policy space, and facilitate
macroeconomic adjustment away from our persistent and large current account deficit. This
should be achieved by increasing exports, investment and saving, and more moderate
consumption of imported goods as spending rises. Higher inflation and large twin deficits are
undesirable and unsustainable. A moderation in imbalances will support sustainable
longterm investment by reducing long-term costs of capital and improving confidence, enabling
the economy to grow and create the jobs we need.
Policy normalisation in the US will occur in a global environment that is slowly improving and
which will require higher global interest rates. Our monetary policy stance will need to evolve
in line with domestic priorities and take into account pressures exerted by international policy
normalisation. A normalisation cycle will support the moderation in inflation that we seek to
achieve and to assist in correcting macroeconomic imbalances. We can also expect,
however, that normalisation will generate volatility in the short-term. Our policy framework
allows for most of the volatility to remain in the foreign currency market, thereby enhancing
stability in the real economy.
Further dampening of volatility can be achieved by ensuring effective policy communication
across monetary and fiscal domains.
We have in place the right kind of macroeconomic policy framework to facilitate the
adjustment to external and internal shocks, both those hitting us now and those we will
experience in future. This policy framework enables policy makers and investors to see
through near term volatility, keeping policy rates and adjustments minimal and efficient, and
economic fundamentals more stable. This is critical to enabling public and private sector
actors to keep their eyes on the real economy backdrop - the improvement in global
conditions - and seek ways to strengthen our ability to take advantage of it through rising
investment.
Before I discuss SA policy normalisation, let me first say a few words about the global
economy and its effects on South African conditions.
2. US policy normalisation
The US economy has achieved critically important gains over the past year. Unemployment
has fallen faster than expected and is now approaching its natural level. The budget deficit
has fallen steeply since the crisis and fiscal policy has also become more predictable. New
estimates of future health care costs from the CBO (US Congressional Budget Office)
suggest long run fiscal prospects are much rosier than previously thought. Technology and
resources, particularly the shale boom, have provided new sources of economic growth,
perhaps enabling a further permanent improvement in the US trade deficit and balance of
payments.
Inflation to accelerate
Certainly, we stand at the beginning of a long path to normalisation of US policy. But the
pace of normalisation is less certain and will depend on data and how the Federal Reserve
interprets inflationary pressures and the economic recovery.
The productivity enhancing effects of shale oil developments will tend to weigh against rising
inflation in the US. But this structural downward force on inflation may be offset by the
decline in the US labour force participation rate. So far, we have seen unemployment fall
sharply without generating sustained inflationary pressures. If the decline in the labour force
participation rate is permanent, then, as GDP rises, there will be greater pressure on wages
and prices - with falling participation the labour market tightens more quickly. Other longer
term factors, like less immigration and the on-going re-pricing of labour costs in China, will
also tend to give impetus to global and US inflation.
It is also possible however that substantial slack remains in the US labour market. As GDP
rises many discouraged workers will return to work, and part-time workers will get more
hours, before we see wages and inflation rise. This is one crucial problem for the US
policymakers. Another is how much inflation to accept before feeling secure enough in the
recovery to raise rates. Understandably, the Fed will be reluctant to throttle an infant
recovery with premature tightening.
The US policy response
We might conclude that it seems unlikely that the US Fed will allow inflation to rise too
strongly as the real economy recovers. After all, the success of counter-cyclical fiscal and
monetary efforts has depended in large part on the willingness of domestic and foreign
economic agents to finance the US deficit and rise in public debt. Allowing inflation to erode
the value of the debt and the income payments associated with it would undermine the
effectiveness of future counter-cyclical policy efforts.
These thoughts suggest that a reasonable baseline view is that as the US recovery
continues, on balance inflationary pressures should creep up. Policy will respond, via a
commensurate tightening from the zero lower bound over the medium term, and also through
sustained fiscal deficit reduction. Smaller fiscal deficits, higher interest rates, and strong
economic growth should generate a sustained rise in the US dollar against other currencies -
including the rand. All things equal, US normalisation will require corresponding policy shifts
in South Africa, including higher local interest rates.
These predictions are reliable, but specifying just when they will be validated is harder. Will
the first rate increase in the US come in mid-2015? A few months later? Will policy tighten at
every meeting, and in what increments? Will markets understand the signals sent by the
Fed? These uncertainties will probably generate bouts of volatility, which in turn might be
misread as a trend reversal or strengthening. One possibility is of a further gradual
weakening in the rand as clarity about US normalisation emerges incrementally. Another
possibility is of step changes, in which markets react most strongly to occasional clear policy
signals and adjust expectations of forward values for the rand and interest rates in larger
discrete movements.
3. Baseline complexities
This baseline for the US economy, which promises economic recovery and policy
normalisation, is clouded by developments in Europe, Japan, China and much of the rest of
the emerging market universe.
Japan
In Japan, the sustainability of the effort to push up inflation and re-ignite growth seems to be
in question, in large part because of the futility of trying to use macroeconomic policy alone to
address structural features of a complicated socio-economy. The three arrows strategy is
currently a one arrow strategy, with structural reforms still missing and the second quarter tax
hike lowering growth. The pre-tax consumption boom was more than cancelled out by the
post-tax slump, leaving the Japanese economy at mid-year smaller than it was at the end of
2013. The world's third largest economy continues to struggle for the kind of sustained
growth rates that have eluded it for almost a generation.
Emerging markets
Emerging market economies bounced back quickly from the Great Recession, prompting
much talk of decoupling from the advanced economies. Since 2010, however, growth has
trended persistently lower, to the point where we now sit with a generalised EM slowdown.
Meanwhile, China aside, the average large EM has experienced rising inflation and an
expanding current account deficit, with monetary policy moving in the direction of tightening.
The lesson is that EMs have not decoupled; instead, many of the biggest emerging markets
have been contributing to global demand, using up policy space, and slowing for a lack of
world growth. Now they must rebalance and restructure to ensure economic stability.
What role will China play in our fortunes? We know that policymakers are trying to find a path
between keeping growth strong and rebalancing away from investments and exports. We
really don't know how this process will affect us. South Africa's terms of trade have softened
by just over 6% since 2011 as commodity prices have weakened, but they remain at
historically elevated levels.1 How much further could they fall, and what impact will softer
prices have on volumes demanded?
Evidence suggests that iron ore, coal and other exporters cannot rely on high prices to keep
profits up, but this doesn't mean a collapse in volumes. To take one example, production of
iron ore increased 114%, in volume terms, between 2005 to 2014.2 It is hard to imagine a
scenario in which these volumes collapse, although it is easy to see that firms will need to
restructure to remain profitable with lower prices. The price effects of commodity prices
falling in USD terms have been offset in rand terms by currency depreciation, but we should
be careful about extrapolating further when structural factors supporting high volumes remain
intact.
It is also worth noting that South Africa's export markets continue to shift. In particular, the
African market is becoming much more important for us.3
Europe
The trajectory of Europe remains an important determinant of global macroeconomic
conditions and for South African outcomes. In recent years, weakness in the European
economy has meant that there have been few real benefits to SA despite major rand
depreciation against the Euro.4 As with the United States, we appear to be witnessing a
seachange in European policy - although this could not possibly be described as normalisation.
The question for South African monetary policy is whether these changes will offset US
normalisation, fully, partially, or not at all.
From a real economy perspective, a sustainably growing Europe is crucial, but this may take
considerable time to materialise. It is very hard to imagine Europe returning to growth with its
current institutional configuration and policy settings. The contradictions are too
overwhelming.
Household consumption and investment across Euro Area has and will remain weak so long
as banks remain in financial distress and property values and the housing markets are
depressed. Europe's financial sector needs a clearing out of bad debt.
The emphasis on fiscal austerity - clearly correct for over-indebted sovereigns - would,
cumulated across Europe, weigh too heavily on growth in the absence of any other demand
stimulus and an exuberantly strong currency.
Germany has stood out for its strong growth in the midst of stagnation by its neighbours, but
its longer-term interests cannot be served by endless stagnation in the euro area. The
country seems too integral to the rest of Europe, via positive and negative spillovers, to
continue indefinitely on a real depreciation-based economic strategy. It cannot declare
independence from Europe.
Rather, Europeans probably need to think of themselves less like we do these days - less as
small open economies subjected to the vagaries of currency fluctuations and capital flows -
and more like a continental super-economy if the region as a whole is to prosper.
It is, perhaps, out of recognition that the old "normal" cannot go on that the ECB has moved
resolutely in the direction of encouraging more coherence in Euro Area macroeconomic
policy. As Europe's inflation rate has declined, the ECB has begun urging governments to
consider some easing of budget consolidation while expanding its own monetary easing
programme. And the President of the ECB has emphasised that this must be accompanied
by structural reforms, which would pay off now as well as later if they could be locked in
alongside policy easing. This may create confidence that European governments understand
their challenges and have the will to address them.
The impact of ECB policy easing should be to sustain a depreciation of the Euro against the
USD, both nominal and real. Cees Bruggemans has reminded us recently that when the US
dollar and Euro change directions, they do so much more than analysts tend to realise and
over significant time frames.5
As the Fed's purchases of mortgage backed securities dwindle to nothing, the ECB will buy
about 1 trillion Euros, returning its balance sheet to 2012 levels.6 It will also buy asset backed
securities. The impact of this on the rand will be to encourage depreciation against the US
dollar and some appreciation against the Euro, but the net effect on the Rand's nominal
effective exchange rate will also be affected by commodity price trends. We don't expect that
the ECB's easing programme will offset normalisation on a one for one basis. It may delay or
slow the process, drawing out the global normalisation process.
4. South African monetary policy
Fortunately, the direct implications of normalisation for South African policy settings at this
point in time are reasonably straight-forward. Rising global interest rates will put downward
pressure on the value of the currency, at least in the short term, and push up interest rates.
The less responsive short term rates are to this upward pressure, and the stronger the
buildup of inflationary pressures in the wake of depreciation, the steeper the yield curve is likely to
get. Long-term borrowing costs will take the burden of slow policy responses to a widening
interest differential and currency weakness.
The real economy effects of being behind the curve with short rates will be relatively small in
the near term, but working against the longer term direction I think we want to go. Lower
short rates might generate somewhat more near term consumption growth for less
investment growth in the longer-run. But this is a poor trade-off for us to make and one we
cannot exploit. With rising inflation, more policy accommodation would significantly increase
the risk of a sell-off of rand assets and pre-emptively push market interest rates across the
yield curve higher than they should be given our fundamentals.
Economic growth
Certainly our growth and employment outcomes have been poor. After 3.0% growth in 2011
and 2.5% in 2012, the outcome for 2013 was desultory and 2014 is proving as bad.
Protracted strikes have had serious economic consequences; the platinum strike is
estimated to have directly and indirectly reduced annualised quarterly GDP growth by
1.6 percentage points.
Up to 2011, South Africa has benefited from a sustained positive demand shock caused by a
rising terms of trade. As China's economy has cooled, the deflating commodity price bubble
has generated a significant negative demand shock as the terms of trade declined by 6.7%
since 2011 (and 9.4% since Q4 2010).
But can we say this has much to do with monetary policy settings? Our real interest rates
have averaged around -0.5% since 2009, reflecting accommodative monetary conditions.
Meanwhile, household spending has slowed amid7
greater emphasis on working down
household debt levels. Lower nominal interest rates have increased cash flow to households
and this is going in part to debt service and debt reduction rather than consumption and
taking on new debt. This makes sense - future expected real growth in income is low relative
to future potential interest payments on new debt. Improving household balance sheets will
create space for future consumption growth.8 But there are limits here too - low rates don't
encourage households to reduce debt levels faster neither do they impose a penalty on
government borrowing, to speed up the process of shedding excess debt.
More broadly, this debt constraint continues to have implications for economic growth. With
the stock of household and public debt remaining high relative to historic norms, there is
insufficient domestic investment or productivity growth, or exports, to offset the slower
consumption growth attributable to our weaker terms of trade and over indebted
households.9
Low rates are also not doing much for investment in fixed capital, with gross fixed capital
formation growing by just under half the pace of the 2000s and a third of the rate achieved in
the six years before the crisis.10 Of course the stronger rise in loans and advances to firms
seen in 2014 so far is welcome. But we have some distance to go before we move beyond
the minimal investment in productive capacity we have seen in recent years. This suggests
that future growth in the economy will be handicapped unless investment becomes much
stronger.
For many years we took the view that the economy's potential growth rate hovered
somewhere around 4 percent. This was optimistic. Our current estimates suggest that it
could be considerably lower, in part because we overestimated historical growth and in part
because of the effects of the economic slowdown.
Negative supply shocks explain some good part of our lower potential growth. One recent
shock was the strikes I referred to earlier. Another more distant shock was the sharp rise in
unit labour costs that occurred in 2008 and 2009 just as the global crisis hit. These factors
have also dragged down confidence.
Reversing negative supply shocks will be an important part of achieving better growth rates
and reducing macroeconomic imbalances. But the role of monetary policy is limited - for
instance, having no impact on building additional electricity production capacity.
However, inflation differentials and cost differentials with the rest of the world continue to
weigh heavily on South African competitiveness. The exchange rate has supported domestic
producers, with the nominal effective rate falling 36% from the end of 2010 and the real
effective rate falling 20%. But if we measure our competitiveness by unit labour costs, say
against the US dollar, SA has about 20% more real depreciation to claw back.11
Monetary policy can - by being credible and focused on the right target - reduce the extent
to which domestic inflation appreciates the real exchange rate and erodes competitiveness.
When a domestic real cost shock hits, the currency needs to adjust to offset the real impact,
but we don't want the currency reaction to set off an inflation spiral or entrench higher
inflation expectations. With this in mind, the Monetary Policy Committee has closely
monitored the trend rise in core inflation, unit labour costs, and producer prices and how rand
movements interact with them. It is important that real depreciation is not offset by future
upward spikes in unit labour costs or a sustained upward trend in core and consumer price
inflation.
Currency weakness has contributed to the sustained rise in inflation since mid-2013.
Headline consumer price inflation has led this rise, drifting up from 5.0% in 2011 to 6.6% in
June this year before moderating to 6.3% for July. Core consumer price inflation, excluding
food, NAB, and petrol, has risen from 4.0% in 2011 to 5.3% in 2013 and 5.7% as of July
2014.
Other factors have weighed against the rise in consumer prices and core inflation, in
particular the sharp fall in international food prices through the latter half of 2013 and the
renewed deceleration in food prices we are seeing at present. But these exogenously-driven
movements in food prices are only slowly impacting on core and headline inflation. We
expect headline CPI to average 6.2% in the fourth quarter of 2014. The forecast for 2015 is
5.7%; for 2016 it is 5.8%. This is much higher than our main trading partners. China is 3%,
the US at 1.4%, the euro area at 0.9%, the UK at 1.9%.12
This suggests reasons for the buoyancy of our current account deficit despite what appears
to be significant real exchange rate depreciation since 2011. The deficit, in turn, heightens
our vulnerability to shocks, as we saw in May 2013 and again this month, when we published
the information that the current account deficit for the second quarter was 6.2% of GDP.
South Africa needs rebalancing, and this will be aided both by the moderation of policy
stimulus, which often generates import-intensive demand, and the weaker currency, which
makes foreign goods and services less attractive relative to locally-produced ones.
Financial stability
Finally, we should consider the implications of monetary policy developments for financial
stability.
The decision to put African Bank under curatorship was not a signal of concern with a weak
banking system. It was a specific intervention targeted at idiosyncratic risks emanating from
a small bank (which accounts for about 1.2% of total banking sector assets) emanating from
its unique, undiversified and as such unsustainable business model.
Critically, the terms of the curatorship as announced by the Governor on 10 August are
designed to ensure that the bank remains open for business, preventing an abrupt halt to
credit extension to the important segment of the market (low income earners) which African
Bank serves. Such credit extension, however, is now done on much sustainable terms, given
the need to improve asset quality in the banking book of the "good bank".
Given the isolated nature of the intervention, and the uniqueness of African Bank's previous
business model, the concern that higher rates will impose an unbearable burden on
borrowers, with dire consequences for lenders in general is overstated. Most clients of
African Bank had fixed rate loans. For the rest of South African borrowers, interest rates are
rising slowly from very low levels, giving borrowers and lenders plenty of warning and space,
as well as incentives, to improve their balance sheets.
5. Conclusion
In 2003, the Nobel-prize winning economist Robert Lucas published an article in the
American Economic Review entitled "Macroeconomic Priorities". It was elegant, compelling,
and a terrible prophecy. He argued that further attempts to smooth out the business cycle
weren't much use, because fluctuations in economic activity just didn't cost much. Instead,
the priority should be growth, because over the longer run that meant vastly more wealth.
Naturally, the Great Recession devastated this argument. Lucas was not entirely right: there
was still an awful lot to be learnt about depression-fighting and high costs to getting it wrong.
And yet, we may perhaps have learnt the lesson too well, and focussed too much on demand
management and smoothing economic fluctuations. Today, there is little policy space left to
boost demand, and it is surprisingly hard even to specify where we are in the business cycle.
We should take this as an invitation to shift our focus. The greater problem is not getting the
output gap to zero, it is raising the economy's growth rate. We used to think potential growth
was close to 4%, and more with brave reforms. The IMF suggests it is about 2 to 2.5% and
we fall short of that. We need to reorient households, firms and investors on longer-term
targets, and to be clear about the policy settings needed to achieve them. The contribution
from monetary policy is threefold:
First, sensible and sustainable monetary policies (as well as fiscal policies) support the
availability of capital for growth in South Africa, which is crucial to ameliorate our chronic lack
of savings. Global financing conditions have remained benign since 2010, but as part of
normalisation we should expect rising global yields ratcheting up our own borrowing costs. It
is important that we seek to minimise this where possible. The more money we spend on
schools and roads, and the less on paying interest, the better. It is also important that we
avoid taking an overly-mechanical or short-term view of the impact of rising rates. Ultra-low
world rates were the right policy response to a global economic catastrophe; rising rates are
a sign of a healthier world economy, which will help to realign investment decisions around
long-term growth prospects.
Second, we need the exchange rate to play its part as a dependable buffer for the real
economy in the face of international financial and economic shocks. With our terms of trade
easing, a large current account deficit, and the global recovery firming up only incrementally,
currency depreciation helps improve the balance of payments in a market-friendly way,
sending the right incentives to exporters, importers and import-competing industries.
Macroeconomic adjustment should and needs to occur in the direction of more exports,
investment and saving, and less consumption. Meanwhile, credible monetary policy - moving
back within the inflation target - will help moderate volatility and facilitate SA's adjustment to
US policy normalisation.
Third, we need to be competitive, which in part means ensuring inflation does not price South
African goods and services out of world markets. Monetary policy must retain and strengthen
its focus on inflation. In doing so, we will push the envelope of transparency and clarity
wherever possible; to help ensure that inflation expectations do not drift from the target.
My concluding message to you is that we must keep our eyes on our goal: to get South
Africa growing again, to create jobs, to restore our macroeconomic balances, and deliver
meaningful transformation.
Thank you.