An address by Lesetja Kganyago,
Governor of the South African Reserve Bank,
at the 5th SA Tomorrow Investor Conference
New York
9 November 2017
Good morning, ladies and gentlemen.
Thank you for the opportunity to address this important conference today.
As many of you will know, the South African economy faces some major challenges.
Economic growth is weak and unemployment remains high despite favourable terms
of trade and a robust global recovery. We have good ideas for addressing these
problems, but regulatory and policy uncertainty as well as corruption and a lack of
direction in some areas have all sapped consumer and investor confidence and
weakened private-sector investment. It should not be a difficult task to turn things
around. Setting out some investment-friendly ambitions for the economy and reducing
political uncertainty would go a long way towards boosting confidence. As is often said,
raising confidence is the cheapest form of stimulus.
Given the economy's poor performance, there is an understandable focus on the
negatives - but we should not forget that there are also positives. I will touch on these
during my address today, particularly on those that impact directly on the work of the
South African Reserve Bank (or SARB). These include a much smaller current account
deficit, which has made the rand more resilient to risks. There has also been some
moderation in inflation, which has eased the near-term pressure on monetary policy.
Given our enhanced focus on keeping inflation expectations low, this could extend
well into the future.
Current account rebalancing
Four years ago, South Africa was counted as one of the Fragile Five, along with Brazil,
India, Indonesia, and Turkey. These were all countries with weak external positions,
which seemed vulnerable to shifting capital flows. In particular, all five experienced
sharp currency depreciations after the Fed1 signalled that it could tighten policy faster
than the market then expected - provoking the so-called 'taper tantrum'.
The impact of this shock was that South Africa focused on the need for rebalancing.
At the time, the fiscal deficit (for 2012/13) was 4.3% of GDP2 while the current account
deficit was unsustainable at nearly 6% of GDP (-5.88% in 2013). The combined twin
deficits were just over 10%. Monetary policy was fairly loose: with a repo rate3 of 5%
and an inflation rate close to 6%, our real interest rate was negative and also lower
than real interest rates in the major advanced economies. This couldn't go on, and
thankfully it didn't.
By 2014, most of the high-deficit countries had begun to adjust their imbalances, even
though the capital-flow reversal was more modest than expected. The start of
normalization in the advanced economies kept on being delayed, and when it did begin
in the US4, the pace was much slower than initially expected. Today, these 'fragile'
countries have adjusted significantly, in response to increased macroeconomic policy
discipline. They are now in a better position to deal with the possible consequences of
higher interest rates in the advanced economies.
Although the speed of South Africa's current account adjustment was slow, the extent
of the adjustment was significant. Over a three-year period, the deficit went from a
quarterly trough of 6.8% of GDP to just 1.7% of GDP in the fourth quarter of 2016, and
then to 2.0% and 2.4% in the first two quarters of 2017. This correction was facilitated
by a more depreciated exchange rate, the tighter monetary policy stance from January
2014, as well as a degree of fiscal consolidation.
The adjustment has come mainly through the trade account, which turned positive in
the second quarter of 2016 and has since been roughly balanced. This reflects better
net exports, partly through more favourable terms of trade but also because weak
investment expenditure has led to lower imports. The overall current account remains
in deficit, however, due to services, transfers, and income payments to foreign
investors - which are the inevitable consequence of attracting large quantities of
foreign savings on a sustained basis.
Before the global financial crisis, the current account was financed predominantly
through equity purchases by non-residents while bond flows were comparatively small
on a net basis. Since the crisis, with interest rates in the advanced economies close
to 0%, the search for yield has resulted in large-scale net purchases of rand-
denominated government bonds by non-residents. This trend intensified following the
inclusion of South Africa in the Citibank World Government Bond Index. Whereas
before the crisis non-residents held about 7% of domestic currency government debt,
this ratio increased to current levels of around 40%. This is a positive development; it
reflects South Africa's deep and liquid domestic bond market and an absence of
'original sin'. There are, however, concerns that the increased holdings may make us
more vulnerable to changes in non-resident sentiment.
In the context of concerns about the impact of possible sovereign ratings downgrades,
the narrower current account deficit implies a lower financing requirement. It puts us
in a better position to cope with a possible portfolio capital outflow or reduced inflows.
Furthermore, the fact that South Africa has a positive international investment position
also means that we do not have a 'fear of floating' as is the case in a number of other
emerging markets, where foreign-currency liabilities are relatively high. Under those
circumstances, currency depreciations have significant negative balance-sheet
effects. The floating rand remains a key shock absorber for the economy, assisting in
the correct direction of economic adjustment and making a market in rand assets.
That is not to say that we will emerge unscathed should our local-currency debt be
downgraded to sub-investment grade. There is little doubt that such a move would
impact negatively on the rand, government bond yields, and confidence. Short-term
overshooting of the currency is likely, with some longer-term level change and pass-
through into inflation expectations. But the exact long-term impact is uncertain.
Estimates of the possible extent of selling by index-tracker funds range between R100
billion and R180 billion. The short-term impact will also depend on how much is already
priced into the markets, the extent to which exposures have already been reduced,
and whether the buyers of these bonds are residents or non-residents. While South
Africa's risk premiums have increased in line with those of countries that are sub-
investment grade, the possibility of an additional deterioration is high as the broader
downgrade shock is felt in medium-term decisions of households and firms.
From a monetary policy perspective, a central objective is to reduce the impact that
currency volatility and level shifts have on the inflation trajectory. And while pass-
through, as in other economies, has been weaker in the post-crisis period, we saw
greater price responsiveness to rand strength early this year. We should be cautious
in inferring too much from this for our pass-through estimates, but with renewed
currency weakness in recent months it does warn us against complacency. Various
factors beyond a credit rating review present themselves as risks to the currency, and
there are even some, like slower normalization in the advanced economies, that push
risk towards a stronger currency. Indeed, conditions in the global economy have
generally played a strong role in reducing downside risk to the rand in recent years.
The inflation outlook and monetary policy
The outlook for the exchange rate is an important, although not the only, consideration
when making monetary policy decisions. The current environment has created
challenges for monetary policy, but the positive news is that inflation has moderated
and has been sitting fairly comfortably within the target range for the past few months.
However, the expected inflation trajectory is still higher than we would prefer, with the
risks tilted to the upside. At the same time, we have to take cognisance of the growth
outlook and provide whatever support we can. This is exactly what we did at the
Monetary Policy Committee (MPC) meeting in July. However, we must be clear about
the limits of monetary policy, and what it can and cannot do. We cannot expect
monetary policy to solve what are essentially structural problems in the economy.
Year-on-year headline CPI5 inflation returned to within the inflation target range in April
this year, having declined steadily from 6.6% in January. It reached a low of 4.6% in
July before rising to 4.8% in August and to 5.1% in September, in line with our
forecasts. At the September MPC meeting, the headline CPI inflation forecast was
5.3% for 2017 and 5.0% and 5.3% for 2018 and 2019 respectively. A lower turning
point of 4.6% was still expected in the first quarter of 2018. The forecast for core
inflation - which strips out the volatile components of food, petrol, and electricity - and
which is a reflection of underlying price pressures, was 4.8% for 2017, rising marginally
to 4.9% and 5.0% in the next two years.
These forecasts are markedly lower than those from earlier in the year. We remain
concerned, however, that inflation expectations, as reflected in the survey conducted
by the Bureau for Economic Research, remain anchored at the upper end of the target
range. This is particularly the case for the price-setters in the economy, i.e. business
and labour respondents. We would prefer to see these expectations anchored at the
midpoint of the target band. Inflation at this level would bring our inflation rate closer
to, though still remaining somewhat above, those of our peer emerging-market
economies. It would also give us more headroom within the target range to absorb
adverse supply-side shocks without breaching the upper end of the range.
Getting inflation expectations to converge on the midpoint of the target band would
help to ensure that inflation actually gravitates towards that level. Yet inflation
expectations are unlikely to moderate much, unless price-setters believe that lower
inflation can be sustained. This requires improving monetary policy credibility by
bringing inflation closer to the 4.5% midpoint of the inflation target range.
Bringing inflation to the midpoint and ultimately anchoring expectations there, instead
of at 6%, is one of the SARB's most important medium-term strategic goals. Yet we
are well aware that the economy is undergoing one of its worst growth phases in
several decades, and although most of the growth problem is structural, there is some
scope to provide countercyclical stimulus. We therefore aim for a policy stance that
5
consumer price index
balances short-term growth support with long-term disinflation, and all its
accompanying benefits.
It is difficult to calibrate the exact repo rate this requires. In July, the combination of
better-than-expected inflation outcomes and worse-than-expected-growth prompted
us to reduce the repo rate by 25 basis points to 6.75%. This adjustment also flattened
out a spike in the real interest rate, keeping the policy stance fairly expansionary. At
that stage, we assessed the risks to the inflation forecast to be broadly balanced.
There was a widely held view in the markets that a further cut would transpire in
September. In the event, the MPC decided to keep the monetary policy stance
unchanged as the inflation forecast shifted marginally while our assessment of the
risks to the inflation outlook deteriorated significantly. Events have since vindicated
that September decision; in particular, the rand has depreciated quite sharply recently,
not
demonstrating that some of the risks we had in mind were already priced in by
asset markets.
It is, perhaps, unfortunate that some market players were surprised by our decisions.
Nonetheless, at times of heightened uncertainty, monetary policy becomes highly
data-dependent and also more sensitive to our assessment of the risks to the forecast.
We have tried to communicate this data dependence and its implications. We also
include, in our MPC statements, the preferences of the different MPC members, which
should help analysts to understand which decisions are finely poised and which are
more straightforward. With a four-two spilt in July and a three-three divide in
September, it should have been reasonably clear to observers that monetary policy
was not on a predetermined course.
Although it may be comfortable for markets to have certainty around the short-term
repo rate path, the real priority for the larger economy is fostering confidence that
inflation will be well behaved over the medium and long terms. To this end, we
implement monetary policy through flexible inflation targeting. This provides a
framework both for interpreting economic news and for communicating our policy
stance to our stakeholders so that it is more predictable over time. How, then, does
the outlook appear through this lens?
As outlined earlier, the exchange rate and its long-term impact on price and wage
determination remains the single biggest risk to inflation. In analysing these risks, we
would want to look through short-term volatility and focus on the longer-term trend.
This is often easier said than done, given the tendency of the rand to overshoot (in
both directions) and the conflicting factors weighing on it.
Apart from the exchange rate, the main risks to the inflation outlook emanate from the
supply side. The application by Eskom for a 20% tariff increase from mid-2018 poses
a significant risk. An increase of this magnitude could increase the inflation trajectory
by 0.2-0.3 percentage points, relative to the current assumption of an 8% tariff
increase. The National Energy Regulator of South Africa is currently conducting public
hearings into Eskom's request, but at this stage we have not adjusted our assumption
and will await the outcome of that determination. However, to the extent that there is
an upside surprise, our reaction will be guided by the extent to which we assess the
second-round effects. In general, we would not automatically react to the first-round
effects of a supply-side shock.
International oil prices have increased significantly since their lows of below US$45
per barrel in June. They are currently trading at over US$60 per barrel, above our
current assumptions of US$55 and US$56 in the next two years. Increased global
demand, coupled with output restrictions by some producers, has contributed to the
higher trend. The prices may, however, be ultimately capped by increased output by
US shale producers, who have now become the main swing supplier in the
international oil market. While we still expect a moderate increase over the forecast
period, there may be some upside risk to this. At this stage, we see the main risk to
the domestic petrol price coming from the exchange rate and higher fuel levies.
Demand pressures are expected to remain relatively muted. They may have
contributed to the more moderate trend of core inflation in 2017. This is also reflected
in the persistence of a negative output gap despite potential output growth of only
1.1% for this year rising to only 1.3% by 2019. We do not see inflation pressures
coming from the demand side for some time, although global growth is expected to
close the global output gap in 2018 - and this will also further narrow our own gap.
Household consumption expenditure growth is expected to remain relatively muted, at
around 1% per annum, over the forecast period. This is against a backdrop of weak
growth in credit extension to households, low levels of consumer confidence, higher
tax burdens, and the absence of significant wealth effects.
By contrast, some support to consumption expenditure is expected to come from lower
inflation and real, albeit modest, wage growth. Wage pressures remain a concern, as
nominal wage settlements continue to contribute to the persistence of inflation at
higher levels.
Overall, we remain concerned about the weak economic growth outlook. The SARB's
forecast for GDP growth for 2017 has been revised upwards, albeit marginally, from
0.5% to 0.6% in September, while the forecasts for 2018 and 2019 have remained
unchanged at 1.2% and 1.5% respectively. The risks were assessed to be slightly on
the downside. Of major concern is the negative growth in gross fixed capital formation,
particularly by the private sector. Growth in private-sector fixed capital formation has
been negative for six consecutive quarters. As I mentioned earlier, restoring
confidence will go a long way in getting us on a recovery path. Without growth, we will
not be able to make any inroads into our most pressing problem of high
unemployment, currently at over 27%.
can
So, what monetary policy do to help in this situation? It is clear that the problems
the economy faces are mostly of a structural nature - not something that can be solved
by monetary policy alone. In addition, recent surveys conducted by the Bureau for
Economic Research also indicate that the uncertain political environment is the single
biggest factor weighing on business confidence, and therefore on investment.
Research conducted at the SARB indicates that the confidence factor shaved off at
least one percentage point from growth in 2016.
Nonetheless, we do not believe that low growth is a non-issue for monetary policy.
The moderate nature of the tightening cycle in 2014-16, when we raised interest rates
by a cumulative 200 basis points, attests to our sensitivity to growth and the output
gap. Furthermore, as we noted in the July MPC statement, we saw the reduction of
the repo rate as having a positive impact on growth at the margin, providing a measure
of support to the economy.
Conclusion
The SARB will continue to focus on its constitutional mandate to pursue price stability.
This is the best contribution we can make to the economy because it creates the
conditions for long-term investment decisions that generate jobs. However, this will be
done within a flexible inflation-targeting framework, always mindful of the trade-offs
and the impact we may have on growth in the short run. This balancing is important.
It implies that, while our bi-monthly monetary policy deliberations have become
intensely data-dependent and are likely to remain so with uncertainty and risk high,
we will continue to see through the noise and focus on long-run outcomes.
This stability in our approach to monetary policy can contribute to better long-term
inflation outcomes and therefore a more favourable environment for investment. In
conjunction with appropriate structural and confidence-boosting policies, there is no
reason why we cannot get investment and growth going again and make South Africa
an investment destination of choice once more.
Thank you.