T T Mboweni: Fasten your seatbelts! Monetary policy challenges in
turbulent times
Remarks by Mr T T Mboweni, Governor of the South African Reserve Bank, at the 13th
Chintaman Deshmukh Memorial Lecture, organised by the Reserve Bank of India, Mumbai,
2 November 2007.
* * *
Governor Reddy,
Deputy Governors of the Reserve Bank of India
Honoured Guests
The Consul General of the Republic of South Africa Members of the India-South Africa
Business Forum
Ladies and Gentleman
1. Introduction
Thank you for your kind invitation. I am delighted to be in India for the first time at this
juncture as you celebrate the 60th anniversary of your independence and enjoy the
international spotlight as the result of your splendid economic performance.
It is a great pleasure and privilege to deliver this address today for two main reasons. Firstly,
this lecture is in honour of a truly great person, Mr Chintaman Deshmukh. The contribution of
Mr Deshmukh to the Indian economy cannot be exaggerated as is borne out by his long
service to this country as Governor of the Reserve Bank of India, member of the Planning
Commission of the Government of India, Minister of Finance, Vice-Chancellor of the
University of Delhi and as President of the Indian Statistical Institute from 1945 to 1964,
amongst others. Secondly, I understand that this lecture series has been graced with the
presence of some truly remarkable speakers. I am indeed very grateful to be accorded the
privilege to deliver this the 13th lecture in this series.
The relationship between South Africa and India is a very strong one today. This relationship,
however, goes back a long way in history. President Nelson Mandela, the former President
of the Republic of South Africa encapsulated this quite well when he said that "India and
South Africa are two countries held so closely by bonds of sentiment, common values and
shared experience, by affinity of cultures and traditions and by geography"1. The contribution
of one of your and our favourite sons, Mohandas Karamchand (Mahatma) Gandhi, and the
support received from the Indian authorities during the liberation struggle went a long way
towards assisting South Africa to achieve democracy in 1994. The important role that India
played in South Africa's transition to democracy is without question and highly appreciated
back home.
Currently, strategic relationships on the bilateral and multilateral fronts hold promising
opportunities of mutual benefit for both our countries. Already, bilateral trade between India
and South Africa has increased by well over 100 per cent in the past four years and a
Preferential Trade Agreement between South Africa and India aims to treble trade by 2010.
In addition, South Africa has been benefiting from India's rich entrepreneurial and
educational skills base, with many teachers and other skilled personnel being employed in
various institutions in our country.
South Africa is currently India's biggest investment partner in sub-Saharan Africa, serving as
an important entry point into the rest of Africa. Indian investments in our country have grown
significantly over the years, and have become more diverse, ranging from vehicles (Tata,
Mahindra), steel (Arcelor Mittal), telecommunications (Neotel) and pharmaceutical
companies such as Ranbaxy. Investments from South Africa to India are also growing. South
African Breweries acquired stakes in various Indian breweries. Other areas in which South
African companies have invested include insurance, diamond exploration and infrastructure.
In February 2006, Airports Company of South Africa (ACSA) won the contract for upgrading
the Mumbai Airport. I also gather that SASOL is interested in a coal-to-synthetic automotive
fuel project in India and many other South African companies have signed up marketing
contracts with Indian companies in the pharmaceutical sector.
On the multilateral front, initiatives such as that involving India, Brazil and South Africa
(IBSA) and Brazil, Russia, India, China and South Africa (BRICSA) provide useful platforms
for the strengthening of ties between our two countries and the South-South economic
relations in general. In addition, over the last few years India, South Africa, Brazil and China
have been recognised as systematically important countries to the extent that they have
been regularly invited to the G-7 meetings in order to contribute to the discussion on global
economic and financial matters. On the one hand, this participation has taken place usually
on the fringes of the main G-7 meetings, thus raising the question about the seriousness with
which the G-7 countries give to these meetings. On the other hand, these four countries have
started to meet on a regular basis in order to strengthen co-operation on issues of common
interest.
As you may well be aware, one of the burning issues at the moment relates to increasing the
"voice" or representation of emerging market economies in the international financial
institutions such as the IMF and World Bank. This issue, together with other matters relating
to the reform of the Bretton Woods Institutions have also been key agenda items addressed
this year during the preparatory meetings for the G-20 meeting of Ministers of Finance and
Central Bank Governors. As we know, South Africa currently chairs the G-20 Forum and it
will be our pleasure and privilege to welcome the Indian G20 delegation in South Africa
during November. There are many issues which are the centre of focus to the G-20 this year,
but most prominently are the fiscal elements of growth and development and the impact of
commodity prices on member countries. South Africa and India do not only share common
policy positions on many of these issues, but have also been very active in advocating the
interests of emerging market economies in this new world order.
Both countries have benefited from the economic reforms implemented over the last decade
or so. However, both countries have similar economic challenges which in the main relate to,
inequality, poverty alleviation and the reduction of unemployment. As a central banker, I wish
to dwell on some issues and challenges facing monetary policy in emerging markets.
2. The Great Moderation
One of the defining characteristics of global economic developments over the last three
decades has been termed the "Great Moderation" - the sustained decline in the volatility of
output and inflation. This development has been due to the structural changes that many
economies have undergone. Some have attributed these changes to the implementation of
better policy options and others to simply good luck. Professor Kenneth Rogoff of Harvard
University has argued on many occasions that improved competitiveness as a result of
increased globalisation coupled with better policies has had a major positive impact on
inflationary trends in many countries. The declining trend in inflation since 1990 is clearly
evident in India and South Africa. Inflation in India has declined steadily from an average of
10,3 per cent between 1990 - 1994, to 8,9 per cent between 1995-1999 and to 4,3 per cent
in this decade. Similarly in South Africa, inflation has declined from an average of 12,5 per
cent, to 7,3 per cent and to 5,1 per cent over the same time periods.
The economic growth performance of both countries has also been quite impressive. Since
1990, India has experienced average growth rates of around 6 per cent per annum,
increasing to an impressive 9 per cent in the last two years. It is now widely expected that the
Indian economic growth rate trajectory would be very close to, if not, in double digit territory
in the short to medium term. South Africa has not been performing badly either, with an
average economic growth rate of about 3,4 per cent per year since the advent of democracy
in 1994, compared to an average of below 1 per cent in the previous decade. Over the last
three years, however, growth has averaged about 5 per cent and the current trend in the
economic growth rate is the longest experienced in the country's recorded history.
3. Improved macroeconomic performance: some side-effects
A side-effect of strong economic growth in many emerging market countries is the growing
middle class. This has been particularly true for both India and South Africa. The rapid
emergence of this middle class brings opportunities that will have a significant impact on
future prosperity but also poses a rather unique set of challenges for policymakers. With
increasing affluence, there is bound to be a change in consumption levels and patterns.
Related policy concerns centre on the implication of these changes on the demand for credit,
the level of imports and the effect on asset markets.
Then, there is the added concern that the unequal distribution of wealth brings with it a
tension between the haves and the have-nots. Under these circumstances, the broadening of
access to financial services becomes an important policy objective. It is well recognised that
the financial inclusion of the lower echelons of society into the financial sector is a powerful
contributory factor to poverty alleviation through, for example, the provision of microfinance.
As the demand for consumer finance increases, a greater range of financial instruments are
needed and the financial sector will need to adapt.
Over the past few decades, alongside financial deepening, household debt levels have been
on the rise across a number of countries, both in developing and advanced countries. Rapid
increases in household indebtedness have been associated with increases in asset prices,
mainly house prices. These developments have indeed increased the probability of defaults,
stemming in the main from adverse external shocks and rising interest rates.
Whilst household debt ratios in emerging market countries like South Africa are low in
comparison to developed countries, the rapid rise in household debt and credit levels has
raised some concerns. In addition, high levels of inequality could mean that some groups are
more affected than others. Hence, the close monitoring of lending practices and detailed
reviews of credit standards can contribute towards the integrity and stability of the financial
system. In the case of South Africa, an Act of Parliament (the National Credit Act) was
introduced to address this issue. It is still too early to ascertain the impact that this Act has
had on borrowing and lending practices in South Africa. There is little doubt that positive
outcomes may be realised.
4. The role of monetary policy
Central Bankers have more often than not found that the role of monetary policy in the
economic growth process is not fully understood or appreciated by all stakeholders. Let me
use the South African case to illustrate this difficulty. Monetary policy in South Africa is
implemented within an inflation targeting framework - the target range being an inflation rate,
namely CPIX (headline inflation less mortgage interest costs) of between 3 and 6 per cent.
CPIX inflation in South Africa has been outside the upper end of the target range for the past
six months. In addition, there has been a deterioration in the inflation outlook. This has
mainly been (initially) as a result of higher international food and fuel prices as well as robust
consumer spending. However, underlying pressures have also become more broad-based.
Although credit growth has slowed somewhat in response to previous monetary policy
tightening, persistently high food and fuel costs have meant that the risks to the outlook are
on the upside. Inflation expectations have consequently risen to the top end of the target
range, with possible adverse implications for wage and price-setting decisions.
These risks to the outlook have necessitated the tightening of monetary policy from 7 per
cent in May 2006 to 10,5 per cent currently. The tightening of monetary policy has not gone
down well in all parts of society. Not everyone appreciates that sacrifices - albeit short term
sacrifices - are sometimes needed to secure medium to long term benefits. In general, due
recognition is not always accorded to the role that price stability plays in securing sustainable
economic activity. In our modern world where remote controls and microwave ovens are the
order of the day, not everyone - market participants included - always comprehend or
appreciate that monetary policy operates with a relatively long lag. So in essence, one of our
primary challenges as Central Bankers relates to the issue of regular and consistent
communication.
Communicating monetary policy has become complicated because the transmission
channels have become somewhat clouded. Structural changes in the economy have had an
impact on functional relationships, with the result that the transmission mechanism of
monetary policy has become more complex. Advances in econometrics and economic theory
have facilitated the construction of sophisticated structural models incorporating complex
behavioural relationships.
However, as Professor David Hendry argues, forecast errors are very often the result of
unanticipated large changes or shocks within the forecast period2. Hence, anecdotal
evidence that provides a better understanding of the risks to the inflation outlook is essential
to monetary policy-making. As the Chairman of the Federal Reserve Board, Mr Ben
Bernanke recently remarked, good economic forecasts "involve art as well as science"3.
The recent South African experience has shown that some of the conventional observations
do not always hold in practice. For example, the South African currency (the Rand) has on
more than one occasion weakened when interest rates were increased or appreciated when
interest rates were lowered or when they remained unchanged.
Furthermore, emerging market currencies in general are subject to extreme volatility resulting
from shifts such as was the case with the USD recently, having an impact on domestic
monetary conditions. An added challenge relates to the fact that many emerging market
countries have a relatively short track record of credible monetary policy. Credibility is earned
over time and yet it is central to the anchoring of inflation expectations.
Communication is further complicated by the global context in which inflationary pressures
occur. On the one hand, there are downward inflationary pressures as a result of
lowerpriced goods due to globalisation. On the other hand, increased trade protectionism, coupled
with rising commodity prices due to robust world growth, pose risks to price stability.
China and India play a significant role in the global economy today. This assertion to many is
without question. The disinflationary benefits of globalisation have been manifested in
China's contribution to lower global inflation over the last decade, through lower import prices
of manufactured goods, more specifically clothing and footwear. India has also played an
important role through the supply of low-cost knowledge based services such as in the field
of information and communications technology (ICT). However, the utopia of strong
economic growth with low inflation may be reversed as China and India, because of their
appetite for commodities, contribute to the surge in commodity prices, notably in base metals
and minerals, especially oil prices. China and India have been the world's fastest growing
energy markets with oil demand currently increasing at around 6 per cent for China and 5 per
cent for India. As is not foreign to this gathering, oil prices have reached nominal high levels
recently, thus placing upward pressure on inflation and complicating the task of monetary
policy, specifically in the anchoring of inflation expectations.
Regarding the commodity boom, South Africa is faced with a double-edged sword. Whilst the
demand for commodities boosts export revenues, surging energy price increases have had a
significant upward pressure on import costs and inflation in South Africa.
5. Global financial market integration
Global financial market integration has increased significantly in recent years, posing further
challenges to the conduct of monetary policy. There are divided opinions on the advantages
and disadvantages of global financial market integration, but to a large extent most would
agree that globalisation has been positive insofar as it has imposed market discipline on
policymakers. There are many who think that globalisation increases economic growth
prospects and reduces volatility. In some respects, globalisation and financial market
integration also make policymakers aware of the importance of independent central banks.
Market participants are more comfortable in situations where central banks are see (and
actually are) going about their primary objectives without fear, favour or interference from not
only the political executive but all other stakeholders.
One of the main challenges of this new global environment relates to the so-called
"contagion effect". The 1997/1998 global financial crisis is one example. Another more recent
example relates to developments in the US sub-prime market. To begin with the 1997/1998
crisis, economies with relatively weak macroeconomic fundamentals were punished the
most. South Africa, in particular, at the time suffered from capital outflows, a depreciation of
the currency and subsequently inflationary pressures. As a result, monetary policy had to
flow with the tide, and interest rates were increased by a full 7 percentage points between
April and September 1998. However, as painful as the process was, not only for South Africa
but most emerging markets, lessons have been learnt and major reform of existing financial
structures and adjustment in macroeconomic policies emerged.
The 1997/1998 crisis highlighted concerns surrounding debt sustainability. As a
consequence, many emerging market countries reduced their domestic and external debt,
and in the process, reduced currency mismatches which in some respects rendered these
emerging markets less vulnerable to currency depreciation. There have also been efforts to
reduce the external vulnerability through debt buybacks, while reserves accumulation has
also been gathering pace over the past few years. India's reserves are the world's seventh
largest at over USD250 billion. While South Africa's are but a fraction of this, one needs to
bear in mind that we have moved from a position of a negative net open forward position of
almost USD26 billion at the end of 1998, to positive net reserves of US$28 billion, the result
of which means that today the country boasts an investment grade rating.
Furthermore, central banks have shifted towards market-based instruments which enhance
their ability to respond to shocks. India is one such example, with the increased use of repo
and reverse repo operations since the early 2000s, increasing the role of interest rates in the
transmission mechanism of monetary policy. In South Africa's case, we have come a long
way in terms of the development of our own bond market, a process in which the South
African Reserve Bank played a major role for a very long time. Today, we have a very deep
and liquid bond market, if not the most liquid bond market in the emerging market
economies.
The positive impact of these financial market and macroeconomic developments have been
put to the test on numerous occasions since the 1997/1998 crisis. The most recent event has
been that of the US sub-prime mortgage market. This episode has been well documented
and I shall therefore not spend time on its detail. As you are aware, it was a liquidity and
credit crisis, emanating from financial institutions having exposure to the sub-prime market
and thereby incurring huge losses as delinquencies and foreclosures increased in the wake
of tighter monetary policy. Although the sub-prime mortgage market was an issue related to
the US, the adverse developments were transmitted to other developed and emerging
markets without much relation to domestic developments.
At the height of the crisis, developed and emerging market equities were sold. Foreign
exchange markets witnessed a significant increase in volatility as carry trades were rapidly
unwound and emerging market spreads rose significantly between late July and mid-August.
However, the rise in emerging market debt spreads was not quite as pronounced as that of
credit markets in developed economies. Spread movements also reflected higher risk credits
moving the market in either direction.
Although South African financial markets were affected by the events surrounding the
subprime crisis, our money markets were relatively unaffected. Our banking system had very
little exposure to the sub-prime market and liquidity conditions domestically remained
healthy. As such, there was no need for the South African Reserve Bank to provide extra
liquidity to markets. Throughout this turmoil, the principal challenge for the Monetary Policy
Committee has been to address inflation concerns. Inflation developments in South Africa
have been such that at a time when global monetary policy seems generally to have turned
from a tightening bias to an easier or neutral stance, our MPC has had to tighten monetary
policy.
Since the recent turmoil experienced in financial markets, money market conditions have
eased considerably, most notably in the US, following the Fed's decision to cut interest rates
by a cumulative 75 basis points. Money market conditions in Europe, however, remain a little
more strained, probably partly due to the fact that a significant amount of the structured
investment products were in fact purchased by European and other overseas investors. Up
until the end of October, financial markets recovered, with equity markets in particular
bouncing back to levels higher than at the time of the turmoil. However, experience has
taught us that financial market gains could easily be reversed in times of uncertainty.
Emerging markets could still feel the impact of an abrupt and sustained change in global
financial conditions and international investor appetite for risk. Such a scenario could play out
in the event of a significant slowing in global growth and rapid reversal of capital inflows in
spite of better macroeconomic fundamentals. In a more globalised world, emerging market
economies may be more vulnerable to shocks originating in developed economies than was
the case previously. Under these circumstances, extreme vigilance on the part of
policymakers remains the order of the day. The current uncertainties in global financial
markets will remain fixed on the radar screens of policymakers for some time to come.
6. Conclusion
In an interdependent world, the effects of uncertainties will not only be exaggerated but could
also affect innocent third parties. We have to remain vigilant to global and domestic
developments in order to ensure that prosperous outcomes are not unduly threatened. Under
these circumstances, policymakers have to ensure that strong economic fundamentals are
maintained. The role of monetary policy in this process should not be underestimated. For
emerging economies, like India and South Africa, the challenge remains to reinforce and
build on the achievements of the last decade or so.
Thank you very much, once again dear colleagues and Governor Reddy for inviting me to
deliver this address. I will leave this remarkable country truly inspired and I am certain that
this is not my last visit to this beautiful country.
Thank you for your attention.