Mr. Stals discusses monetary policy challenges in South Africa Address by
the Governor of the South African Reserve Bank, Dr. Chris Stals, at a South African Financial
Markets Conference arranged by Standard Bank of South Africa Limited in Cape Town, on
7/11/97.
1. Challenge number one - to find consensus on what the objective of monetary policy should be
in South Africa
In the international community of central bankers, there is widespread consensus
that the primary goal of monetary policy must be domestic price stability. Price stability,
however, is only a means to an end, and not a final goal of overall macroeconomic policy. The
ultimate goal is determined by governments and is normally linked to the objective of maximum
economic growth, development and the creation of more employment opportunities.
Contemporary economic theory supports the view, however, that financial
stability, as measured by a low rate of inflation, is a precondition for the attainment of optimum
economic development. Furthermore, monetary policy, being only one of the sub-elements of
overall macroeconomic policy, is tasked with the responsibility to create and maintain such a
stable financial environment that will be conducive for sustainable economic growth at an
optimum rate in the medium and longer term.
In South Africa, however, confusion remains on what the task and the functions
of the central bank should be. The most important delusion, supported by certain business
people, politicians and even some academics, is linked to the now defunct Phillips curve
approach in terms of which the assumption is made that a higher inflation rate can produce a
sustained lift in growth and employment. World-wide experience, as long back as in the 1970s,
provided sufficient evidence that the assumed trade-off of higher inflation for lower
unemployment could only be exploited over the limited period in which inflation expectations
did not fully adjust to the new higher rate of inflation. With a more effective implementation of
the theory of rational expectations within modern communities, this limited period has indeed
become very short.
Another reason why the conventional theory of demand management through the
application of monetary policy is no longer appropriate is the major shift that took place in
recent years in macroeconomic management, away from conventional Keynesian demand
management to contemporary supply-side economics. The Phillips curve approach is based on
the theory of demand-driven inflationary or deflationary conditions. The world-wide situation in
the 1970s, when there was a simultaneous rise in inflation and in unemployment in many of the
industrial countries, refuted the theory of the trade-off and forced new thinking on particularly
the implementation of monetary policy.
The present universal approach on monetary policy therefore takes account of the
new electronic environment of instant communication leading to a more swift dissection of
policy actions and immediate reaction by markets, and of the more general need in most
countries to raise production capacity, and not to stimulate demand. In this environment, the
appropriate role for monetary policy has been redefined as a responsibility for the creation and
maintenance of stable financial conditions that will be reflected in low inflation. This is what
central banks can do best to support governmental programmes for overall economic growth and
development.
In South Africa, considering the many attacks made on Reserve Bank policy
during this past year, there is still a major lack of consensus on what the prime objective of
monetary policy should be. Unless we can get consensus and support for the almost global
approach of contemporary central bank policy, and unless we can agree to pursue these policies
also in South Africa, the road to the internationalisation of the South African economy will be
rough and difficult.
2. Challenge number two -- deciding on an appropriate framework for monetary policy
Given the objective of price stability, each central bank must design a framework
or a consistent model within which monetary policy can be implemented, taking account of the
structure of the financial system and of the economy of the country. Various models are
available to choose from, but whatever model is preferred, the final objective of monetary policy
should always be the protection of the value of the currency.
In the Bretton Woods system of fixed par values, the main intermediate objective
of monetary policy was the protection of exchange rates, or the external value of the currency.
By linking global exchange rates through fixed gold parities, there was a convergence of
inflation, at a relatively low level, at least for the many countries that succeeded in maintaining
fixed exchange rates over relatively long periods of time. Needless to say, the system broke
down in the late 1960s and early 1970s when more expansionary monetary policies were
followed by some of the major industrial countries, and inflation escalated. Today, some smaller
countries still attach their exchange rates to a selected major international currency, and then
accept the unavoidable consequence that the rate of inflation in the smaller country must
converge with the rate of inflation in the economy of the anchor currency. A good example of
this approach is provided by Argentina with its convertibility law of 1 Peso = 1 US dollar.
A second widely-used model is the one of monetary targeting where an important
monetary aggregate such as the money supply or the amount of bank credit extension is used as
an anchor for monetary policy. Within the context of the prime monetary policy objective of
maintaining low inflation, a monetary target (or exchange rate target) represents but an
intermediate objective of the policy.
South Africa is one of the many countries that introduced money supply targeting
as an anchor for monetary policy during the course of the 1980s. Initially, the policy served the
country well. It made an important contribution to a better understanding of policy decisions,
and also made a major contribution towards the successful reduction in the level of the rate of
inflation from an average of about 15 per cent over the twenty years from 1973 to 1992, to about
81⁄2 per cent over the past four years.
The South African experience with money supply targeting is not very different
from those of other comparable countries such as Canada and Australia -- with the difference
that the process in South Africa is a slower and lagged one, mainly because of the economic
isolation of this country from the rest of the world up to 1993. Australia introduced money
supply targets in 1976, and then abandoned them "with reluctance" in February 1985. At the
time, Australia tendered two reasons for ending the M3-targeting stage:
"The first was the problem of controllability. The fact that targets were often
missed was an indication that close control was either not possible, or would have required
undesirable movements in the policy instruments. The second was the instability of the
relationship between money supply and the ultimate objective of policy such as inflation ...".
(Address by Governor Macfarlane at a Conference of Economists in Hobart, 29 September
1997.)
It was Governor Gerald Bouey of Canada at the time who made the famous
statement: "In Canada, we did not abandon money supply targets, they abandoned us".
In view of the liberalisation of the South African financial markets in recent
years, the integration of the South African economy in the world financial markets and the
increasing importance of large and volatile international capital flows, South Africa may have
reached the same stage now where the usefulness of the M3-money supply as a target for
monetary policy has been diluted to a point where some alternative anchor should be considered.
Following the demise of money supply targeting during the mid 1980s, both
Canada and Australia went through a transitional period which lasted until the early 1990s.
During this transitional period a policy of "monetary pragmatism" was followed. There was
indeed no formal or strictly defined framework to guide monetary policy. A "check-list" of an
ad hoc mixture of intermediate objectives was introduced and the central bank was allowed a
wide degree of discretion in the implementation of monetary policy. After the "rule" of
monetary targeting broke down, the policy was "to look at everything".
Although such a pragmatic approach may have some advantages, particularly in
an environment of major structural changes and volatile international shocks, it has the major
disadvantage of not being transparent. As Charles Goodhart put it:
"Supporters would describe it as sensible pragmatism, detractors as a reversion to
a muddled discretion which, once again, allows the authorities more rope than is good for them,
or us". (The Conduct of Monetary Policy, Economic Journal 1989.)
Both Australia and Canada, and a growing number of other countries, have
recently moved to direct targeting of inflation. In all these countries, however, not only central
banks but also governments commit themselves jointly with the central banks to a predetermined
target for inflation. In the United Kingdom, the Chancellor of the Exchequer indeed sets the
target for inflation in his Annual Budget, and then instructs the Bank of England to pursue the
goal with its monetary policy instruments. Nowhere does the central bank on its own decide on
an inflation target.
For an inflation target to be credible, there must be a commitment at least of the
central bank and the government, and, if possible, also of the business community and labour, to
the achievement of the goal. Furthermore, it will do more harm than good for a country to
introduce a formal inflation target that is much out of line with the rest of the world. Of the
seven countries reported in the BIS Annual Report for 1996 with formal inflation targets, no one
has set a goal for inflation of more than 3 per cent per annum. The central bank must be given
sufficient operational autonomy to pursue the inflation target with vigour and without the fear of
intimidation by politicians or other pressure groups. And, finally, markets must be free, flexible
and responsive to underlying changes. Inflation is often a symptom of malfunctioning markets
and the cure lies not with monetary policy, but with a restructuring of the markets.
It is a big challenge for South Africa to prepare itself for this new age of direct
inflation targeting as an anchor for monetary policy. The proposals made by the Reserve Bank
last week for the introduction in March next year of a more flexible system of providing
accommodation to banking institutions, represents an important further step on this road towards
a more effective monetary policy system that will be compatible with global policies.
3. Challenge number three - establishing an effective institutional framework for monetary
policy
There is a lot of misunderstanding in South Africa about what is meant with the
independence of the Reserve Bank. The Bank can never be made responsible for determining the
overall macroeconomic policy objectives of the country. This is a prerogative of government.
The central bank must, however, be given a clear mandate from government on what its policy
objective should be, but should then be given the necessary autonomy to pursue and achieve this
objective.
Taking account of the powers and influences of central banks, the obvious
directive by government to the monetary authority should be to protect the value of the currency
in the interest of sustainable optimum economic growth and development in the longer term. To
achieve this objective, a central bank must at times apply financial disciplines that are
unpopular, will be opposed by pressure groups and are perceived to be against the interests of
private sector profiteers, and political popularity. It is inter alia for this reason, and only in
respect of the implementation of measures that may at times prove to be unpopular, that central
banks should be given "independence" from governments. To quote once more from what a
former Governor of the Reserve Bank of Australia once said:
"The Reserve Bank must be given all the freedom of the prison exercise yard".
(R.A. Johnston - "Comments on Professor Schedvin - Economic Papers - 1992.)
Although this autonomy has been given to the South African Reserve Bank in
terms of the Constitution of the Republic of South Africa, the disciplinary actions applied by the
Bank in the pursuance of its mandate are often challenged by economists, business people and
politicians whenever they believe their vested interests are impeded by the actions. Many South
Africans must still learn to be more tolerable towards the need of painful financial disciplines,
when justified by adverse macroeconomic situations. These may often be forced on us by
international developments over which we have no control.
Apart from an effective institutional framework for the Reserve Bank, South
Africa also needs well-managed private sector banking institutions, well-functioning financial
markets and an effective clearing, settlement and payment arrangement for inter-bank
transactions. The challenge is therefore not only to liberalise the South African financial sector
further, but also to ensure good and prudent financial regulation, and to provide the country with
a modern electronically-based national payment system. The new system to be introduced by the
Reserve Bank in March 1998 for an improved clearing and settlement system will provide a
further step on the road of preparing for an effective integration of the South African financial
system in the global economy.
The challenge for South Africa is not to isolate itself from the adverse effects of
the globalisation process, but to continue to participate in the programme of gradual
international integration.
4. The overriding challenge for monetary policy is to keep inflation low
Financial stability in South Africa is threatened from time to time by new and
more intensive inflationary pressures. We have not yet succeeded in suppressing the prevailing
inflation psychosis in this country. Expectations at this juncture may have settled around the
8 per cent per annum level, which is about half of what it used to be at the beginning of this
decade. But this is still about three times the amount of actual inflation in the economies of our
major trading partners.
The process of globalisation unavoidably leads to a convergence of the major
financial aggregates such as inflation, real rates of interest and budget deficits. South Africa will
either continue to be part of the globalisation process, together with its inevitable convergence
effects, or will be marginalised and excluded from the advantages of being part of the
world-wide process.
In this period of transition from monetary policy targeting to the introduction of a
national inflation objective, monetary policy must continue to maintain overall financial
stability. This is essential in order to buy time while other policies (as proposed in GEAR) are
put in place to handle the more deep-seated structural deficiencies that must be corrected before
South Africa will be able to experience optimum economic growth with financial stability.
5. Conclusion and summary
The challenges facing monetary policy in South Africa at this stage can be
summarised as follows:
•
We must convince more South Africans that the one and only task for monetary policy
must be to protect the value of the currency.
• We must adapt monetary policy to the changing environment in which we now have to
operate. This may require of us to move away from money supply targeting and to adopt
a more direct focus on inflation developments.
• We must guard against growing pressures in our country for the curtailment of the
autonomy of the central bank.
•
The Reserve Bank must continue to guide the South African financial markets into the
world financial system. This will require further progress in the gradual elimination of
exchange control, the modernisation of the payments system, the encouragement of the
development of more efficient markets and, in the context of Africa, support for
co-operation and integration of financial markets within the Southern Africa
Development Community.
The overriding challenge remains to bring inflation in South Africa to a lower
level that will be more in line with the average rate of inflation of our major trading partners.
This will require a sound monetary policy approach, based on realistic (but not necessarily low)
interest rates; a stable (but not necessarily fixed) exchange rate; a sound (but not necessarily
protected) banking sector, and effective and well-functioning financial markets.