Lesetja Kganyago: African economic and financial development in
challenging times
Keynote address by Mr Lesetja Kganyago, Governor of the South African Reserve Bank, at
the Institute of International Finance (IIF)-First National Bank (FNB) Africa Financial Summit,
Johannesburg, 4 November 2015.
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Introduction
Ladies and gentlemen, good afternoon.
Allow me to first thank both the Institute of International Finance and First National Bank, our
hosts, for inviting me to address this latest instalment of the IIF-FNB Africa Financial Summit.
I am particularly honoured to join the impressive list of speakers and panellists.
I have been asked to deliver the keynote address yet I do not want to pre-empt the debates
that will follow. So, I will first try to summarise some of the challenges that our continent is
facing. And, looking at the Reserve Bank's own experience in the South African context, I will
speak about implications for how Africa's financial systems and its developing capital
markets can best address these challenges and sustain progress in developing the
continent.
New global challenges for the African continent
There is no denying that Africa is facing a more challenging global backdrop than in recent
years; my colleague from the Bank of Tanzania, Governor Ndulu, as well as this morning's
panellists have already discussed some of these challenges. I will not dwell on them in detail,
but would like to emphasise three key points.
First, global growth again is disappointing. We heard last month how forecasters at the
International Monetary Fund, or IMF, again downgraded their outlook for world economic
growth: it is expected to reach 3,1 per cent this year, down from the 3,8 per cent expected a
year ago. This decrease in expected growth is in keeping with the times, but it raises the
concern about whether the weak growth is structural. Earlier this year, the IMF highlighted
how medium-term growth expectations (five years ahead) had been steadily revised down
since 2010, in both advanced and emerging economies.1
The fact that potential growth rates are falling makes explicit our global problem and the
apparent inability of the world's economy to fully recover from the global financial crisis of
2008. Rather, over the years, the crisis seems to have "morphed" from one of real-estate
bubbles and lax underwriting standards, mostly in the US, to one of unsustainable debt
burdens in the periphery of the eurozone, and now to one of excess corporate leverage and
deteriorating macroeconomic conditions in several regions of the emerging world. Policy
responses appear uncoordinated between regions, addressing some immediate problems
but also fuelling imbalances and exposing policy contradictions elsewhere.
Looking at the mix of slowing growth and high private-sector leverage in emerging Asia, in
particular China, some observers wonder whether the world may face a repeat of the
1997-98 Asian crisis. Such concerns may prove excessive: in contrast to 1997, Asian
sovereigns are financially more solid, with stronger reserve buffers and - a point I will return
to later - more flexible exchange rates, which have limited the build-up of external
imbalances. Nonetheless, the era of lofty growth rates in Asia, driven by the fast expansion
of China's industrial sector, is most probably over - and this is a factor that African countries
will have to take into account as their terms of trade weaken and export volumes decline.
My second key point relates to the first, insofar as it deals with the outlook for commodity
prices. When expressed in inflation-adjusted terms, the composite indices of commodity
prices (like the Reuters-CRB index) are back to levels seen in the early 2000s, providing
evidence - in case there was still doubt over the matter - that the commodity "super-cycle" of
the last decade has by now truly reversed.
It is likely true that other factors have exacerbated the decline in commodity prices: the rise in
supply and financial factors, including the strength of the US dollar. However, a central driver
of that decline has been the slowdown in demand from key marginal importers, the largest
being China. It seems sensible to me to take at face value the Chinese authorities' aim to
rebalance their economy away from investment, and for that reason it would be unwise for
African commodity exporters to bank on a strong price rebound in coming years.
Finally, I would like to emphasise the potential challenges arising from the eventual
normalization of monetary policy in the US. We know the debate remains open as to when
this normalization will actually start and that the forecasts are for a gradual normalization.
However, I fear we have been lulled into complacency by the years of abundant liquidity and
a "search for yield". Even a gradual unwinding of easy financing conditions will create greater
competition for funds globally. The timing is not good. Sub-Saharan African countries have
increased their funding needs by and large, and the potential for needs to increase is high as
countries try to sustain spending even as growth, terms of trade and financing costs
deteriorate.
South Africa has not been immune to these challenges. With world demand sluggish and
commodity prices declining, we have seen a loss of 9 per cent in our terms of trade between
the third quarter of 2011 and the second quarter of 2015. The current-account deficit
widened to as high as 5,8 per cent of GDP in 2013. And, while we saw a significant
narrowing since (to as low as 3,1 per cent of GDP in the second quarter of this year), the
Reserve Bank still expects a fairly large external shortfall in the next two years, worth close
to 4,5 per cent of GDP. Net direct investment flows not far from zero, the country remains
highly reliant on net portfolio inflows for the smooth financing of that deficit. Our statistics
show a continued solid net portfolio inflow in the first half of the year, but JSE data paint a
more challenging picture in the past two or three months, coinciding with renewed downward
pressure on the currency.
Currency implications and how to deal with them
Downward pressure on the rand, as on many other emerging and African currencies, should
not come as a surprise. When portfolio flows dry up (or reverse), the ex ante financing of
large current-account deficits becomes problematic. What is more of a debating point,
however, is how to deal with such currency depreciation.
Back in the 1990s, many emerging countries opted for more or less stringent systems of
fixed exchange rates (crawling pegs, hard pegs, currency boards), generally in the hope that
such systems would help to get rid of perennial high inflation, bolster international policy
credibility, and provide a strong basis for increased foreign investment flows. At first, fixed
exchange rate systems did bring about some decline in inflation. However, they equally
allowed the build-up of imbalances as they prevented the adjustment of relative prices to
terms of trade, external demand shocks, and different productivity growth rates. In addition,
they encouraged speculative, "hot money" inflows which aimed to benefit from positive
interest rate differentials while the fixed exchange rate held. Eventually, as the experience of
the 1997-98 Asian crisis or the 2001 Argentinian default showed, most peg regimes had to
be abandoned before policy credibility was restored - though not without a significant
rundown of official reserves, a severe inflationary shock, and a need for painful austerity
measures.
While we never had a formal fixed exchange rate regime, South Africa experienced some
version of these problems in the early years of our new democratic dispensation. As South
Africa reintegrated into the world economy, with import tariffs and capital controls significantly
reduced, the prices of our major commodity exports declined, resulting in intense downward
pressure on the real exchange rate of the rand. With inflation volatile and still high, the
Reserve Bank intervened to stem the depreciation of the currency. But these attempts
resulted in the country running a large net open forward position in US dollars - the same
development that had triggered large-scale economic and financial turmoil in some Asian
countries in 1997. It was only when South Africa moved to an inflation-targeting regime in
2000 and let the market determine the value of the currency relative to macroeconomic
fundamentals that the sustained downward pressure on the currency eased. The
contradiction between policy effort and macroeconomic fundamentals was removed, and
slowly these also started to improve. Gradually but steadily, inflation moved downwards.
Inflation expectations became more stable. And the Reserve Bank was able to wind down its
forward position and rebuild a proper reserve buffer.
Currency depreciation has always been trickier for economies that are more dependent on
few export lines and require greater currency stability to keep inflation in check. For this
reason, historically, many economies in Africa used currency pegs of one sort or another.
Many have now moved away from that approach, opening up a channel that might help to
address external shocks. With commodity prices falling, sub-Saharan African economies
face a potential worsening of their internal relative price balance between tradables and
nontradables.2 Assuming that inflation falls with declining export prices, moderate currency
depreciation will help economies to rebalance and resume growth. Where inflation is
persistent and economic growth weak, however, currency depreciation can exacerbate the
stagflation and has less clear policy implications. It seems sensible to allow floating
currencies to absorb external shocks, to maintain policy stances that do not worsen
imbalances, and to move towards the microeconomic reforms and network infrastructures
needed to help export diversification and sustain investment by the private sector generally.
The experience of the Reserve Bank and reserves management
The depreciation of South Africa's currency has been in line with that of commodity exporters
and other emerging markets, and substantial. So far this year, the rand has depreciated by
16 per cent against the US dollar. While the pass-through of such depreciation has been
more muted than in previous cycles due to weak economic growth and moderate food price
inflation, the Reserve Bank has nonetheless been closely monitoring any second-round
effects from that depreciation. Aware of the risk that already-high inflation expectations are
moving higher and of the overall loose stance of monetary policy, the Bank has raised
interest rates by a cumulative 100 basis points since January 2014. The stance supports the
economy while mitigating the risk of higher inflation. This represents a welcome contrast to
the pre-inflation-targeting era when policy was tightened (by 690 basis points) and large
US-dollar liabilities built up in an effort to more directly target a sharply weaker exchange
rate.
Our approach to the currency has been qualitatively different. In agreement with National
Treasury, we unwound US-dollar liabilities and built a positive reserve position over time,
with the objective of bolstering the national balance sheet and ex ante reducing the risk of
financial and/or liquidity crises. Our official reserves remain rather low by most metrics and
by overall emerging-market standards.
For African countries now facing lower commodity prices and a more challenging global
financial environment, the quality of a nation's external balance sheet seems of paramount
importance. African central banks have slowly rebuilt reserve buffers over the last few years,
but they remain relatively low by overall emerging-market standards. And as the global
environment continues to worsen, policymakers need to focus more on the prudent
management of external liabilities in order to maintain investor confidence.
The growing role of financial stability
Let me now say a few words about the role of financial stability and about the growing
importance of stable, healthy and well-capitalised banking systems - as my colleague, René
van Wyk, will no doubt discuss in greater detail in the next session. It was partly thanks to the
prudent management of banks' external exposure, on both the asset and the liability side,
that South Africa was able to weather the shock from the 2008-09 global financial crisis
without suffering severe domestic banking stains and, consequently, limit the duration and
depth of its recession.
Similarly, it was in part thanks to our prudent supervision of South Africa's banks and their
prudent management of risks that we weathered the global financial crisis as well as we did.
In the recent past, South African banks have taken active steps to comply with the pending
Basel III regulations, increasing in particular their ratio of liquid assets to short-term liabilities
as the liquidity coverage ratio, or LCR, was phased in from 1 January 2015.
For sub-Saharan Africa as a whole, issues of financial stability were mostly subsumed by the
extension of financial services, reflecting in part the lack of depth in the credit markets in
many countries of the region and hence the limited role that bank lending has played as a
policy transmission mechanism and driver of inflation. However, things have been changing
in that domain too. Credit growth has been particularly strong in several countries of the
region in recent years, and while credit deepening is a welcome development, it also, if
unchecked, carries risks. The IMF, in its Regional Economic Outlook for sub-Saharan Africa
released on 27 October, points out that episodes of unusually high credit expansion tend to
be associated with increases in financial risk and that phases of falling commodity prices are
often linked with a deterioration in banks' financial heath, such as a higher rate of
nonperforming loans or a decline in the returns on banks' equity.3
Chances and pitfalls from growing capital markets
Admittedly, the financing of the economy, including in the emerging world, has long ceased
to rely solely on banks, and capital markets have grown in the sub-Saharan African region in
the past decade or so. In an environment of ample central bank liquidity and low returns on
financial assets in the developed world, governments in the region have been able to take
advantage of greater investor appetite for "frontier" markets. From negligible levels prior to
2009, sovereign bond issues in sub-Saharan Africa rose to more than US$6,0 billion in
2014.4 Similarly, the number of countries rated by the major agencies rose from only 4 in
2003 to 17 in 2014. By 2014, the stock of outstanding sovereign bonds in the region had
risen to around US$18 billion, though it is still small at 1,1 per cent of regional GDP.
Furthermore, development in African capital markets has not been limited to sovereign
bonds. Global flows into the region's equity markets, while still very small compared to other
regions, nonetheless grew in importance relative to the size of the recipient economies.
The flow of capital into Africa is critical to its ongoing development. Access to capital has
been greatly enhanced and a more competitively priced supply is currently offered, moving
away from a reliance on official-sector financing. However, to ensure that benefits to
borrowers are maximised, it is important that financing be transparent and that risk be fairly
priced. Furthermore, where lending is overly risk-averse, the development of corporate bond,
equity or even venture capital markets can facilitate the expansion of a private,
mediumsized business sector. Finally, over time, as financial markets grow across the continent, one
can equally expect to see increased cross-border portfolio and direct investment flows within
sub-Saharan Africa, helping to facilitate regional economic and financial integration.
These gains in hand, we need to be mindful of the risks associated with external portfolio
financing. A tightening of financial conditions in the developed world can easily prompt
international fund managers to reduce their exposure to frontier markets. What is then a
small portfolio adjustment for a large US- or Europe-based fund, however, can result in
significant price action on a small and relatively illiquid sovereign debt market. Rising
foreigncurrency external liabilities equally expose a sovereign's balance sheet to currency
depreciation, limiting the benefits I described earlier of foreign-exchange adjustment as a
"shock absorber".
In that respect, an increased focus on developing local-currency bond markets and on equity
financing may present a solution to the risk of excessive foreign-currency leveraging. In
South Africa, the existence of a large and liquid domestic government bond market, with
long-maturity instruments, has limited the rise in foreign currency-denominated debt, even as
our country has experienced large current-account deficits. The ratio of foreign-exchange
debt to GDP stood at 26,8 per cent by the first quarter of 2015, up from 12,2 per cent in
2010. Had South Africa not been able to attract foreign capital inflows into rand-denominated
bonds and equities, this ratio would have risen further.
In sub-Saharan Africa, however, growth in local-currency bond markets has been stymied by
the absence of a large and diversified domestic investor base, undeveloped secondary
markets, and the lack of liquidity of many instruments.5 In most cases, moreover, the
issuance of local-currency bonds has been limited to the sovereign. Where local bond
financing consists mostly of domestic banks, the buying of government securities will tend to
crowd out finance for a large number of private businesses and/or for much-needed
infrastructure projects.
In this respect, it would be desirable to see the growth in domestic securities markets occur
alongside an expansion of the domestic investor base through incentives for longer-term
savings via life insurance products, pension and provident schemes, and mutual fund
investments. A deep domestic investor base can also act as a 'buffer' when non-resident
investors reduce their investments. In South Africa, for example, yields on ten-year rand
government bonds have increased by only 30 basis points since the start of 2014, even as
(according to data from the JSE) non-residents sold domestic bonds to the tune of R60 billion
over the period.
If sub-Saharan Africa is to see a healthy expansion of both international and domestic
investments in its securities markets, the region requires a strong governance structure,
proper regulation and supervision, and adequate reporting and auditing standards in these
markets. We should not underestimate, for instance, the impact on South Africa's ability to
attract and retain foreign investments from our strong performance in this respect. Indeed, in
the 2015 Global Competitiveness Report published this September by the World Economic
Forum, South Africa continued to score first, among 140 countries, on criteria such as
"financing through local equity market" and "strength of auditing and reporting standards".
We came second in the regulation of our securities exchanges and third in the protection of
minority shareholders' interests.
Conclusion
In conclusion, let me emphasise that the new challenges which our continent is facing, while
real, are not insurmountable and, if properly handled, need not preclude continued solid
economic growth in the years ahead. Major progress has been made in a range of areas that
are critical to long-term economic development, not least of which was attaining a much
more sustained level of macroeconomic stability across much of the region. This has been
built on steady improvement in policy formulation and institutional development, but also on
some favourable trade winds. These are now changing direction as commodity prices fall, so
it is essential that policymakers double their efforts to sustain foreign interest in our
economies and encourage diversification. Central to this effort, it seems to me, must be
supporting financial and capital market development, deepening what we already have, and
building robust regional linkages between our markets.
Thank you.