Gill Marcus: A perspective on the global and domestic economic outlook
and the challenges facing monetary policy in the current environment
Address by Ms Gill Marcus, Governor of the South African Reserve Bank, at the South
African Institute of Chartered Accountants (SAICA) Business Breakfast, Rosebank, 10 June
2014.
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Good morning and thank you for the opportunity to be with you today at this event organised
by the South African Institute of Chartered Accountants. According to the World Economic
Forum, South Africa was again ranked number one globally in strength of auditing and
accounting standards. This ranking is a tribute to SAICA and to all of you here today.
Unfortunately, these rankings while pleasing, are not enough and there is no room for
complacency. While the financial sector generally compares very favourably with the rest of
the world, with deep and liquid markets and our banks ranked number three in the world for
soundness, the broader economy performs less favourably on many of the other measures.
While the accuracy of these measures can be debated, we only need to look at the recent
growth rate of the economy, -0,6 per cent in the first quarter of this year and concerns for
second quarter growth amid unresolved and intensifying labour disputes, to recognise that
we have enormous challenges ahead of us.
While the global backdrop remains difficult as the advanced economies emerge from the
very deep financial crisis of the past seven years, it is no longer the main cause of South
Africa's weak domestic economic performance. The slowdown we have experienced is
domestically driven, largely self-inflicted and we cannot blame external factors alone. This
does mean, however, that the solutions are in our own hands, and as a country instead of
focusing on whether we are entering a recession or not, we should all be striving to restore
the economy to the strong growth path that it is capable of achieving. This morning I will
present a perspective on the global and domestic economic outlook and the challenges
facing monetary policy in the current environment.
The recent global crisis has reminded us that financial crises take a long time to repair
themselves. Such crises are characterised by high levels of leverage and debt, whether
households, firms or the state, and the loss of wealth associated with the start of a crisis
means that it takes a long time to repair these balance sheets. The process of deleveraging
implies low levels of consumption and investment by households and firms, while banks will
be reluctant to lend. There are now encouraging signs that some of the advanced economies
have been through this process are on a path of sustained recovery. The US economic
recovery appears to be taking hold, with a clearer path of fiscal consolidation and stronger
bank and corporate balance sheets. Households deleveraging has also occurred, and the
housing market has shown signs of improvement. However, severe weather conditions
earlier in the year resulted in a contraction in the first quarter, and it will be difficult for the
economy to achieve the 2,8 to 3,0 per cent growth forecast recently by the US Fed.
Nevertheless, the underlying strength appears to be there, and the market consensus is for
an annual growth rate of around 2,5 per cent.
The UK economy also appears to have moved to a sustained recovery path, with growth of
around 3 per cent expected this year. Unfortunately, the outlook for the Eurozone, an
important export market for South Africa, is much less favourable. Although the region has
emerged from recession, growth is expected to be anaemic, with continuing concerns about
deflation, particularly in some of the European periphery. Consequently, the ECB has taken
significant measures in an endeavour to stimulate growth in the region. The German
economy appears to be sound, but France has recently slowed down significantly. Although
the Japanese economy recorded strong first quarter growth of 5,9 per cent in anticipation of
the introduction of consumption taxes, this is not expected to be sustained, and the outlook
remains uncertain with an annual growth rate expected to be around 1,5 per cent.
The mixed signals emanating from the advanced economies have important implications for
emerging markets, including South Africa. The abnormally low interest rate environment in
the advanced economies, coupled with quantitative easing, led to an almost undiscriminating
wall of money flowing into emerging markets. These flows suddenly reversed following the
announcement by the US Fed in May last year that it was considering tapering its
programme of quantitative easing. The initial impact on emerging market bond and foreign
exchange markets was severe, particularly those markets which were relatively open and
liquid, including South Africa. The uncertainty surrounding the timing and speed of tapering
resulted in a highly volatile period for emerging markets. When tapering was eventually
confirmed in December last year, attention then focused on the timing and speed of US
policy normalisation, which is the increase of the policy rate from the zero bound to more
"normal" levels. So while tapering is steadily continuing, and is expected to be completed
later this year, there is a great deal of uncertainty about the outlook for short term interest
rates. Any changes in perception concerning the timing and intensity of the US interest rate
cycle are likely to elicit reactions in global financial markets. Thus while the recovery in the
US is good news for emerging markets in that this breaks the synchronised downturn in
advanced economies and that a growing US economy is critical to global recovery, it does
have implications for emerging market financial markets.
We are therefore in for a bumpy ride, with the prospect of a series of "risk on" and "risk off"
scenarios as global risk perceptions change in response to unfolding developments. We can
expect financial markets, including the rand exchange rate, to remain volatile in response to
these changing perceptions. The outlook is complicated by the fact that a synchronised
normalisation in the advanced economies is not expected. The Bank of England is most
likely to move in line with the US, but the Eurozone and Japan are still in an easing cycle.
Only last week, the ECB cut interest rates again, and announced a range of new measures
to induce banks to increase lending, including measures to expand bank liquidity, and hinted
at the possibility of some form of quantitative easing in the future. The ECB also indicated
that this accommodative stance was likely to remain in place for a protracted period. The
Bank of Japan is also likely to maintain its highly accommodative monetary and fiscal stance
for some time.
The bottom line is that normalisation will happen: it will not be a synchronised event, and the
timing and speed of the cycle is uncertain and will be dependent on the pace of the recovery
in the advanced economies. The more uneven these recoveries, the more volatile capital
flows to emerging markets are likely to remain. But the era of abundant flows to emerging
markets appears to be over: the volume of flows is likely to be lower and more discriminating
than was the case in recent years. And of course this applies more strongly to countries such
as South Africa, where sustainability of current account deficits are perceived to be an issue.
These developments come at a time when emerging markets in general are slowing, and the
previous optimism that emerging markets are the new epicentre of global growth may have
been a bit misplaced. Despite this, emerging markets remain an important driver of global
growth, but the outlook is fragile. The Chinese economy is expecting to slow to levels of
between 7-7,5 per cent, growth rates that would be the envy of many countries. The slowing
growth trajectory has already impacted adversely on South Africa through weaker commodity
prices, and there are concerns the Chinese growth outlook could be undermined further by
developments in the shadow banking sector and the housing market. South Africa's other
BRICS partners, particularly Russia and Brazil, are also facing slowing growth scenarios.
More positively, sub-Saharan Africa, where South Africa's trade and investment links have
expanded, is expected to remain one of the fastest growing regions in the world, although
weaker commodity prices remain a risk to the outlook.
While the global environment shows signs of improvement and there are real opportunities
for South and sub-Saharan Africa, there are also new challenges. It is against this backdrop
that the South African economy contracted by 0,6 per cent in the first quarter of 2014. This
contraction arises largely from the negative growth of 24,7 per cent and 4,4 per cent in the
mining and manufacturing sectors respectively in the first quarter. The rest of the economy,
excluding mining and manufacturing, recorded growth of around two per cent, and while at
least positive, is still inadequate. This follows a disappointing growth outcome of 1,9 per cent
in 2013, following more optimistic expectations earlier on in the year.
There has been much speculation as to whether the country is headed for a recession,
defined as two consecutive quarters of negative growth. To give some perspective of how
bad things will have to be in order to get to this point: if zero growth in each of the remaining
three quarters of the year were to be recorded, the economy would still achieve a positive
growth rate of 0,8 per cent for the year. To get to a negative growth rate in the second
quarter, and assuming the rest of the economy continues to grow at rates of around 2 per
cent, we would have to have significant further contractions off the already low bases in both
the mining and manufacturing sectors, and such contractions would have to be of similar
orders of magnitude as in the first quarter. Given that the platinum strike covered more than
two months of the first quarter, it is unlikely that a further contraction of that order of
magnitude will occur in the second quarter. Therefore, we do not believe that a recession is
the most likely outcome. Should it transpire, it would be a very grim outcome indeed. But
even if a recession is avoided, it will be cold comfort if the growth rate is a weak positive
number. Therefore it behoves all of us - government, business and labour - to rebuild the
confidence and trust that is an imperative to change the negative trajectory that the economy
is presently on.
The Bank's most recent growth forecast, as indicated in the May monetary policy statement
of the MPC, is for growth for this year of 2,1 per cent, but with a downside risk. This follows a
progressive downward revision of these forecasts since November last year when a growth
rate of 3,0 per cent was still forecast. The main downside risks to the growth outlook were
the continuing strike in the platinum sector and electricity supply constraints. The platinum
mines affected by the strike account for about 40 per cent of platinum production in South
Africa. The contraction in platinum output accounted for about 19 percentage points of the
total mining sector contraction of around 25 per cent in the first quarter. In the meantime the
strike is continuing, and even if a settlement were achieved today and workers returned to
work soon thereafter, it would take weeks for normal operations to resume. It is also possible
that a number of shafts will never re-open.
In the meantime the costs to both workers and the mining companies continue to escalate.
According to the Chamber of Mines, workers have lost R9,6 billion in wages foregone, while
the companies have lost R21,5 billion in earnings. The knock-on effects of the loss of
earnings go well beyond the 70,000 workers and their dependents directly affected by the
strike. There are numerous accounts of how the communities and businesses in the
Rustenburg area and parts of the Eastern Cape are being impacted by the loss of earnings.
It also impacts on the upstream and downstream industries that are connected to the sector.
While the strike has already been felt in the economic growth outcome, it has not as yet been
fully reflected in the export data. The mining companies had significant platinum inventories
that they have been able to use to meet their contractual commitments. However, these
inventories are being depleted, and the longer the strike continues, the sooner the adverse
effects on exports will be felt. The deficit on the current account of the balance of payments
is often regarded as the Achilles heel of the South African economy, particularly in the light of
a relatively slow export response to the rand depreciation. Some tentative positive signs in
this respect was evident late last year with the deficit contracting from 6,4 per cent of GDP in
the third quarter of 2013 to 5,1 per cent in the final quarter. Import compression is
constrained by the fact that a large proportion of the country's imports are capital goods
related to the infrastructural expenditure programme of government. We would not want to
see such imports declining as improved infrastructure increases economic efficiencies by
unblocking domestic bottlenecks in the economy, and allows for future exports.
Therefore, a strong export performance is essential. It is difficult enough to achieve this in the
context of weak growth in the Eurozone, one of our main trading partners. But to have a
concurrent decline in platinum exports is an unnecessary self-inflicted wound at a time when
the mining sector should be responding positively to the rand depreciation. The platinum
group metals accounted for about 8 per cent of our total merchandise exports in 2012 and
almost 9 per cent in 2013, so the impact of a total cessation of exports by the three affected
companies is very clear.
A number of looming strikes in other sectors also threaten the growth prospects of the
economy. Nevertheless, unless these stoppages turn out to be far worse than anticipated,
the Bank's base case remains one of positive growth for this year, although it may be difficult
to achieve a better outcome than last year. The growth forecast of 3,1 per cent for 2015 is
predicated on a more stable industrial relations environment and an improvement in the
electricity supply situation, with new generating capacity coming on stream early in 2015.
There are, however, downside risks to this forecast. On the positive side, government
infrastructural expenditure is set to continue, and this should underpin current and future
growth. The recent growth numbers also show that there is life in the construction sector,
which grew by 4,9 per cent in the first quarter of 2014. In March, the real value of building
plans passed increased by 13,6 per cent on the 3-month-to-3-month basis, and by 5,9 per
cent on a year-on-year basis. These positive developments are also consistent with the
improvement in the construction sector business confidence indices. However, the recovery
needs to be more broad-based. In particular, the mining sector needs to get back to work,
and the manufacturing sector needs to stay at work. This is also an imperative to ensure we
retain the jobs we have, and do not have further job losses and increased unemployment.
So what role can monetary policy play in this context? Unfortunately, monetary policy has a
limited role in kick-starting the economy, particularly given the causes of the slowdown.
Notwithstanding the interest rate increase in January, monetary policy is still accommodative
and the repo rate low by historical standards, with the real repo rate being slightly negative.
In effect, the 50 basis point increase simply offset the recent increase in actual and expected
inflation. The problem of low growth and unemployment is therefore not high interest rates.
The recent slowdown is clearly related to a fractious labour relations environment, while the
unemployment rate is primarily structural in nature, and not something that monetary policy
can solve. As we have stressed many times in the past, monetary policy can impact on the
margin on cyclical growth and employment, but it cannot determine the potential real growth
path of the economy. This is the domain of other policies that can directly influence the
structural constraints on the economy.
The primary mandate of the Bank remains the achievement of price stability. Inflation moved
outside the target band in April, in line with the Bank's forecast, and we expect it to remain
outside the target for the next four quarters. We also see an upside risk to this forecast, with
the main risks coming from the exchange rate (for reasons elaborated on above) and food
prices. Other potential risks come from wage settlements should they significantly exceed
productivity growth.
In response to these inflation pressures, combined with the prospect of normalisation of
monetary policy in the US, the MPC embarked on a tightening interest rate cycle in January,
but stressed that the cycle would be moderate given the weak growth outlook. The MPC is
sensitive to the fact that it risks being pro-cyclical, and it could undermine growth at the
margin.
This is the dilemma that monetary policy faces - that of rising inflation and slowing growth.
Monetary policy decision-making in a flexible inflation targeting framework needs to be
sensitive to the general state of the economy. So any given inflation forecast may elicit a
different monetary policy response, depending on the economic outlook. For example, the
current inflation forecast may have produced a much stronger reaction had the economy
been performing much better than it currently is. In other words, in a simple Taylor rule world,
the smaller the negative output gap, the stronger the interest rate response for any given
deviation of inflation from the target.
The monetary policy dilemma is compounded by the fact that the economy is not
experiencing significant demand side inflation. Real growth in consumption expenditure by
households has been steadily declining, from 4,9 per cent in 2011 to 2,6 per cent in 2013.
While a contraction in consumption expenditure is not expected, we believe that it will remain
constrained by a variety of factors, including rising inflation, high household debt levels, and
subdued levels of credit extension to households in particular. The slow growth environment
means that employment opportunities are limited, and job security is reduced. Since the
2009 recession, employment creation in the formal non-agricultural sector of the economy
has been mainly by government. Private sector employment growth is likely to remain muted
as long as investment confidence remains low, and government is constrained by the need
to maintain its fiscal consolidation path, limiting the possibility of further significant
employment creation.
The issue then is, how can monetary policy deal with inflation driven primarily by cost-push
pressures, and under such conditions should we not simply ignore these inflation pressures?
Inflation expectations are central to price formation, and expectations of future monetary
policy actions are an important element in this. If there is a view that the central bank is not
concerned about inflation, it will undermine credibility of monetary policy and impact
adversely on inflation expectations. Inflation expectations, as measured in the quarterly BER
survey, have been relatively well anchored for some time, although at the upper end of the
target range. While we can take some comfort from the fact that they have not deteriorated,
these expectations are uncomfortably high, in line with the precarious level of the actual
inflation rate. We would not want inflation or these expectations to become embedded at the
upper end or worse, at a higher level.
We know that monetary policy cannot prevent the impact effects of supply side shocks. For
example, if international oil prices increase, domestic petrol prices will increase in the
absence of an offsetting appreciation of the rand. But we do need to watch out for possible
second round effects of these increases - that is, the extent to which increases are passed
through to other prices, resulting in more generalised inflation.
A similar example would be the impact of exchange rate changes. We have noted that
despite the significant depreciation since 2011, pass-through to generalised inflation, while
still positive, has been lower than during previous depreciation episodes. We ascribe this to
the weak state of the economy, where retailers find it difficult to pass the full increases on to
consumers for fear of losing market share. But there will always be a temptation on their part
to try and recoup their margins. Under such circumstances, if there is a perception that
monetary policy will accommodate these inflationary pressures they are likely to increase
their prices. However, if there is a tightening bias in monetary policy, firms are more likely to
be constrained in their price setting.
There is a view that is sometimes expressed that inflation may come down more quickly than
we expect, or even if it does not, and if the Bank's forecasts are correct, inflation will be back
inside the target range next year. Under such circumstances, is there not a case for ending
the tightening cycle, or even to consider a cut in interest rates? Although we have been more
tolerant of inflation at the upper end of the target range, given the negative output gap, we do
not see the upper end of the target range as being the inflation target. Currently our
forecasts, and most other forecasts, are for inflation to remain uncomfortably close to the
upper end of the target range in the next two year, and we assess the risks to be on the
upside. While we do not target the mid-point of the band, we would prefer to be more
comfortably and sustainably within the target, as this would provide more room for monetary
policy to act as need be, and better anchor inflation expectations at a lower level.
We also do not believe that the current level of real interest rates is sustainable. As I have
mentioned previously, there is a great deal of uncertainty surrounding the post-crisis new
normal level of interest rates, both domestic and global. But in the same way that it is clear
that the current abnormally low interest rates in the advanced economies cannot be
sustained indefinitely, the same applies to our interest rates. As we have stressed, the timing
and speed of adjustment will be data dependent, in part influenced by monetary policy
developments in the advanced economies. That is not to say that we simply follow US
monetary policy. A flexible exchange rate framework does give us a fair degree of monetary
policy independence, but it is not absolute. This is in contrast to longer term bond yields
which are more highly correlated with those in the US, and over which the Bank has no direct
control. We live in a highly integrated financial world and we cannot ignore these
developments.
To reiterate the MPC position, the interest rate increase in January was not a one-off move.
It is part of a necessary cycle to deal with the inflation risks and to normalise interest rates in
the economy. However, the speed and extent of tightening will be sensitive to domestic
growth considerations, and to the pace of normalisation in the US which is likely to impact on
the South African economy indirectly through the exchange rate. At this point in time, we are
in what we assess to be a moderate extended cycle. That means the interest rates will not
necessarily be adjusted at each meeting, or move by the same amount.
In this context, we are often asked if a 25 basis point adjustment is a possibility. Yes, it is.
When the repo rate was in double digits, a 25 basis point change would make little impact.
But at current levels of the repo rate, it is an option. Can 25 basis points make an impact?
Perhaps not on its own, but seen in the context of a longer cycle, it could be part of a
cumulative increase, particularly should the MPC wish to see a smoother and more gradual
adjustment. The disadvantage of such a strategy, however, is that it could mean that we "fall
behind the curve", which may require even stronger moves later on. A more moderate
approach, on the other hand, could allow for easier adjustment to changing circumstances,
and a less volatile interest rate environment in the short to medium term.
In conclusion, the domestic economy is facing enormous headwinds, many of which are of
our own making, and therefore within our capability to resolve. High on the list is the currently
debilitating labour relations environment, and it is incumbent on all parties to resolve these
issues. All parties need to recognise their own roles in bringing about this toxic environment,
and consider the significant costs to the individual workers, the affected companies and the
country of not resolving these disputes.
Monetary policy cannot resolve these issues, nor can it deal with structural constraints to
longer term growth. Rather, the role of monetary policy is to contribute to a stable
macroeconomic environment conducive to inclusive higher growth. The National
Development Plan is a broad blueprint for dealing with these structural issues and the focus
should remain on implementation of this plan. The South African economy has enormous
potential, but it also faces significant social demands in the context of high unemployment.
Let us all work together so that we get inclusive growth going again and realise the great
potential we have as part of a growing region.
Thank you.