T T Mboweni: The outlook for the South African Economy in a period of
uncertainty
Address by Mr T T Mboweni, Governor of the South African Reserve Bank, at the London Capital
Club, London, 27 June 2006.
* * *
Ladies and Gentlemen,
1. Introduction
I was very pleased to have received this invitation to address the members of the London Capital Club
today for two reasons. Firstly, I suspect that this club might contain within its history the first seeds of
central banking. I believe this Club builds on the proud foundations of the Gresham Club, named after
Sir Thomas Gresham. And I was interested to learn that Sir Thomas was an advisor to King Edward VI
in 1551 on the financial difficulties facing the country at the time. Sir Thomas implemented a set of
plans to overcome these difficulties, which raised the external value of the pound. In his management
of these problems, one can perhaps conclude that Sir Thomas was one of the first-ever central
bankers. Indeed, Sir Thomas might have had an easier task if England had already followed a policy
of inflation targeting at the time as both South Africa and England do today.
The second reason why I am delighted to be here today is that the South African Reserve Bank has a
direct association with the London Capital Club. One of our former Deputy Governors, Ian
Plenderleith, CBE, serves on the Board of Advisors of the Club. I am therefore indeed honoured today
to make a contribution to your deliberations but, more importantly, to enjoy lunch with you.
Recent upheavals in the international markets have placed the spotlight again on emerging markets.
There is disagreement in the markets as to what this burst of global volatility actually reflects, with
answers ranging from inflation concerns, to global liquidity and to the growth outlook. South Africa has
in the past few weeks experienced significant movements in the rand exchange rate and stock market
prices. These developments may be seen by some as a threat to South Africa's recent strong growth
performance, as well as to the growth strategy of the government. But that should not necessarily be
the case.
2. Recent international developments
Emerging markets have enjoyed an extended period of investor exuberance and search for higher
yield over recent years, which, combined with a generally supportive environment of strong global
growth and high commodity prices, have caused their currencies to appreciate, equity prices to
increase and bond spreads to narrow. Recently, we have experienced the effects of greater
uncertainty about future inflation, interest rates and growth in the major economies. These concerns,
combined with a state of general nervousness about the fairly sharp increases recently in the prices of
riskier assets such as equities and commodities, caused many investors to pause, take profits, square
positions and generally adopt a lower-risk investment strategy.
The increased risk aversion of global investors was reflected in a number of indicators: The volatility
index of the Chicago Board of Exchange (or the VIX), which gives a general reflection of risk aversion
in equity markets, doubled from just below 12 on 10 May to almost 24 on 13 June. Prices of
foreigncurrency denominated bonds of emerging markets also fell, contributing to an increase in the spread
of these bond yields over US Treasuries. The JPMorgan EMBI Plus spread widened from 176 on 10
May to 232 on 13 June. The widening in spreads occurred across all the sub-indices of the EMBI plus,
with Latin America the most affected. South Africa's spread widened relatively less, from around 80 in
mid-May to around 90 in mid June.
The initial sell-off of higher-risk assets commenced in the US equity markets on 11 May following
increased market uncertainty regarding the outlook for global interest rates. A marked decline in the
S&P 500 index was followed by similar trends in the equity markets of Europe, Japan and the UK. By
mid-June, all the year-to-date gains in most of the major equity markets had been wiped out. Equity
prices in some emerging markets were even more affected. The South African equity market, which is
dominated by the resources sector, declined by over 16 per cent from its peak reached in mid-May.
A number of emerging-market currencies depreciated markedly. Since 11 May until mid-June, the
Turkish lira depreciated by over 16 per cent and the Brazilian real by almost 11 per cent. The rand has
not fared any better, having depreciated by almost 13 per cent over the same period. As is normally
the case whenever investors cut their emerging-market exposures, the liquid South African market has
been more severely affected than most of its peers.
The rand exchange rate is strongly influenced by commodity prices, which in turn are dependent on
global growth and also by the deteriorated sentiment towards emerging markets. Commodity markets
also felt the effects of the sell-off of riskier assets. The price of gold declined from around US$725 per
fine ounce in mid-May to around US$570 a month later. Similarly, platinum declined from a high of
US$1331 per ounce in May to a low of US$1125 in June. It should be noted however that these
changes are exaggerated by particularly strong upward price movements in the previous month. For
example, the gold price averaged around US$550 per fine ounce in each of the first three months of
this year, whilst the platinum price averaged around US$1040 per ounce in these months. This
suggests that there had been some overshooting and that the current trends may be an inevitable
correction, rather than a generalised collapse in commodity prices. However, the degree of volatility in
commodity markets creates an uneasy environment for commodity-based currencies.
Interestingly, despite the "sell-off" in emerging market assets since May, non-residents have remained
net buyers of South African financial assets and there have been significant investment flows into
South Africa over the past year. Non-resident investors bought a net R13 billion worth of South African
equities during May 2006, and R460 million in the first half of June 2006. Despite generally negative
sentiment towards emerging-market assets, they continued to buy R768 million worth of bonds in May,
and R4,5 billion in June. These purchases brought the net amount of South African bonds and equities
bought in the year to mid-June to R68 billion, compared with R41 billion in the whole of last year.
Similarly, Britain's Vodafone Group paid R21 billion earlier this year to take over VenFin's stake in the
local cellular operator, Vodacom. And towards the middle of last year, British bank Barclays bought a
majority stake in local bank, Absa, for an amount of about R33 billion, making this most likely the
single largest foreign investment in South Africa to date.
While the market outlook has become more uncertain against the backdrop of a withdrawal of liquidity
as well as geopolitical developments which have impacted on the international oil markets, the
macroeconomic landscape still appears to be generally favourable, although not without risks. Inflation
pressures seem to be building up across emerging markets whilst trade and industrial production
trends look robust. High levels of international reserves and current account surpluses in a number of
emerging market countries, together with reductions in external debt, have radically improved solvency
ratios so that existing volatility, although very large, is unlikely to precipitate any systemic credit events
in emerging markets. This is in contrast to the Asian crisis in 1997/98, which was generated by
imbalances originating in emerging markets. These recent trends have also left their mark on the
South African financial markets. However, not much has changed fundamentally in the domestic
economy, and there still seems to be significant appetite for South African financial assets, albeit with
a somewhat higher risk premium being priced in. Although South Africa is not a current account
surplus country, our low level of foreign indebtedness, both public and private, and improved
international reserves position, in conjunction with upgrades from credit rating agencies in the past two
years, means that we are likely to be less vulnerable to balance sheet effects that have characterised
previous emerging market crises.
3. The growth outlook
From a broader perspective, the above suggests that although a period of heightened volatility and
uncertainty may ensue, there should be no undue negative impact on South Africa's growth prospects.
In 2005 and 2005 the South African economy grew at a robust pace of 4,5 per cent and 4,9 per cent
respectively. Growth in 2006 is expected to be moderately lower than that achieved last year following
the 4,2 per cent measured in the first quarter of this year. This is in sharp contrast to the 3 per cent
average annual growth experienced between 1994 and 2003.
The recent strong growth performance has been underpinned by strong consumer demand which
grew at annual rates of 6,5 per cent in 2004 and 6,9 per cent in 2005. Sustaining growth at higher
levels will require significant structural reforms and an increase in investment relative to consumption
as a contributor to the growth process. Gross fixed capital formation has been growing at annual rates
of over 8 per cent for the past three years, driven mainly by private sector investment. In recent years,
however, parastatal and public sector investment growth has been extremely low, which accounts for
the relatively modest ratio of gross fixed capital formation to GDP of 16,8 per cent in 2005. This ratio
has however been on a rising trend since 2002.
As you may be aware, the South African government has embarked on the Accelerated and Shared
Growth Initiative of South Africa (ASGISA), with the intention of raising the GDP growth rate to around
4,5 per cent until 2009 and 6 per cent thereafter. Central to this strategy is a strong focus on
infrastructural investment. As indicated in the Medium Term Budget Policy Statement in late 2005,
government and public enterprise investment expenditure for the period April 2006 to March 2009 is
planned to be about R370bn. This investment should not only raise current growth, but will also allow
for sustained future growth through improved transport, communication and electricity provision.
Estimating potential output of a country is a notoriously difficult thing. The problems of estimation are
compounded when a country has been experiencing significant structural changes, as has been the
case in South Africa. There is no doubt that over the past few years such changes have raised the
efficiency and the potential output of the economy. Previous estimates by the IMF and others had put
the potential rate of output growth at around 3 per cent per annum or lower. Preliminary research at
the Bank estimates current potential output growth to be in the region of between 4 and 4,5 per cent,
assuming no significant changes in the underlying economy. Other scenarios in this study show that if
the investment initiatives contained in the government's strategy come to fruition, a potential output
growth rate of over 6 per cent can indeed be achieved and sustained.
An important component of the future growth scenario is the availability of finance. South Africa has
been running current account deficits in the recent past, and will therefore continue to be reliant on
non-resident inflows to finance the investment-savings gap. In the past few years, these deficits have
been more than financed by capital inflows which, in turn, are being attracted by the improved growth
prospects in the economy. These inflows enabled the Bank to further increase its holdings of foreign
exchange reserves. By the end of May, official gross gold and other foreign exchange reserves had
increased to US$24,1 billion, while the international liquidity position had increased to US$20,4 billion.
This is a significant improvement on the negative average international liquidity position of almost
US$10 billion in 2000.
The stronger reserves position is expected to contribute to greater stability in the foreign exchange
market and reduce South Africa's vulnerability to external shocks. The recent inflows have been
mainly equity or FDI inflows, reflecting the fact that favourable growth prospects have been key, and
will be critical for future inflows. The sustainability of these flows will depend in part on the evolution of
the current bout of volatility in international markets and investor perceptions towards emerging
markets in general, and South Africa in particular. An important element in the growth outlook is
macroeconomic stability, which is where monetary policy makes its contribution.
4. The role of monetary policy
The mandate of the Bank is to achieve low inflation in the interest of sustainable economic growth and
development. A low inflation environment contributes to growth and development by providing a more
certain basis for investment decisions in the economy, and lowering overall risk.
The inflation-targeting framework adopted in February 2000 has contributed to the reduction of
inflation to low levels. For the past 32 months, CPIX inflation (i.e. headline inflation excluding mortgage
interest cost) has remained within the target range of 3-6 per cent, despite strong output and
expenditure growth in the economy, and significantly higher international oil prices. Furthermore, there
is evidence that inflation expectations have become entrenched at levels consistent with the target.
These developments have allowed for nominal interest rates to fall to levels last seen in the late
1970s. Between June 2003 and April 2005, the repo rate was reduced by a total of 650 basis points,
although at the most recent Monetary Policy Committee meeting earlier this month, the repo rate was
raised by 50 basis points to 7,5 per cent per annum. Real interest rates have also come down
somewhat and have become less variable.
The recent repo rate increase, the first since September 2002, was motivated by the deteriorating risks
to the inflation outlook. Apart from adverse oil price developments, the concerns of the Committee also
centred around the continuing high levels of consumer demand, which have been reflected in rising
levels of credit extension to the private sector and also the larger-than-usual current account deficit
on/of the balance of payments. Twelve-month growth in bank loans and advances extended to the
private sector measured 23,1 per cent in April compared to 24,3 per cent in March, while asset-backed
credit extended to the private sector continued to grow strongly at a year-on-year rate of 27,2 per cent
in April. Although there were few signs of inflationary consequences at that stage, the impact was
being felt in the deficit on the current account of the balance of payments which had expanded to 6,4
per cent of GDP by the first quarter of this year.
As we observed in our latest Monetary Policy Review, current account deficits are a reflection of
higher domestic expenditure and are not in themselves inflationary. There is however a possible risk to
the exchange rate if the deficits are perceived to be unsustainable, particularly if the deficits reflect
higher consumption expenditure. This is particularly the case where the international markets are
rerating emerging market risk. Under these circumstances, there is the risk of a significant exchange
rate adjustment which could threaten the longer-term attainment of the inflation target. The recent
events in international markets, particularly with respect to New Zealand and Iceland, show how
sensitive market perceptions can be to large current account deficits. Moderately higher interest rates
therefore should not be seen to be undermining growth. Failure to respond to inflation risks could,
however, be inimical to growth.
5. Conclusion
Despite the recent turbulence in international markets, we are of the view that growth prospects
remain sound both in South Africa and in the rest of the world. The inflation threats are likely to
subside given the resolute determination of central banks around the world to tighten policy. Although
the global interest rate environment may need further tightening and the results of which might be a
moderation in global growth, it is unlikely to lead to a significant downturn in global growth. Combined
with continued strong growth in China and other Asian countries, this should underpin commodity
prices. Nevertheless serious risks remain, particularly those posed by geopolitical events which could
have an impact on international oil prices. Domestically, the Bank will continue to play its part by
contributing to the favourable growth environment. This we do through ensuring that inflation remains
within the target band of 3-6 per cent.
Thank you.