Address by Lesetja Kganyago
Governor of the South African Reserve Bank
at the Annual Convention of the South African Chamber of Commerce and
Industry (SACCI)
Emperors Palace, Johannesburg
20 October 2016
Distinguished guests, ladies and gentlemen.
Thank you for the opportunity to address the annual convention of SACCI. The
in today's economic and
theme of institutions and competitiveness is particularly apt
political environment. Strong and sound institutions are essential for the smooth
functioning of society, as they prescribe the behaviour of individuals, and set out the
"rules of the game".
Well-functioning institutions are what investors look for when
making long-term decisions to invest in a country. Institutions and the institutional
framework are generated over time through interactions in society in general, and
are dynamic and endogenous. In other words, they change over time and can be
expected to both affect, and be affected by, the current political and economic
dispensation. Furthermore, institutional arrangements in society are often self-
perpetuating with strong institutions creating incentives for further institutional
improvements and vice versa. But their dynamic nature means that we cannot be
complacent, and we have to resist attempts to undermine strong institutions.
Often people think of competitiveness in terms of the exchange rate. However, this is
only one limited aspect of competitiveness. While relative prices matter, it is the
institutions that underpin the economy that count. The exchange rate, to a certain
extent, simply reflects the strength or weakness of institutions, or changes or threats
to their integrity.
In the recent Global Competitiveness Report, the areas in which South Africa fared
well are those that are underpinned by strong institutions and governance such as
the strength of auditing standards, the protection of minority shareholder interests,
the efficacy of corporate boards and the efficiency of the legal framework and judicial
independence. The soundness of banks is also highly ranked. South Africa was one
of the relatively few countries whose banking system emerged largely unscathed
from the global financial crisis.
In my address today I will reflect on the place of the Reserve Bank within the current
institutional framework, the relationship between the exchange rate, competitiveness
and institutional strength, and make a few comments on the financial stability
mandate.
The Bank's role in South Africa's institutional landscape
has a long and proud history of supporting South Africa's institutional
The Bank
strength. In fact, in June the Bank celebrated its 95th anniversary. The role of the
Reserve Bank and its independence is clearly enshrined in the Constitution. The
South African Reserve Bank, in pursuit of its primary objective, must perform its
functions independently and without fear, favour or prejudice, but there must be
regular consultation between the Bank and the Cabinet member responsible for
matters."
national financial But this notion of the Reserve Bank as an independent
institution is often misunderstood. Independence does not mean that we sit in our
glass and granite tower and make decisions independently of the needs of the
economy or of the overall goals of government policy.
In this respect, it is useful to distinguish between goal independence and operational
independence with respect to monetary policy. Goal independence refers to the
setting of the objectives of monetary policy, while operational independence relates
to the implementation of the mandate that is given to the central bank. Globally it is
generally, although not exclusively, the case that monetary policy objectives are set
by elected representatives of the country. That is how it should be. But these policy
objectives can only be set within the constraints of what monetary policy can
achieve, and not what some people would like it to achieve.
Monetary policy independence usually relates to operational independence, and has
its roots in the need to prevent monetary policy being used for political expedience.
"political interest rate cycle" phenomenon
In particular, to avoid the so-called where
rates are lowered in advance of elections and then raised again thereafter.
This dichotomy is in fact consistent with the Constitution of South Africa, where it is
stated that the primary objective of the Bank is to "protect the value of the currency
in
the interest of balanced and sustainable economic growth. The Constitution
therefore does not give the Bank goal independence, but our operational
independence is explicit. The inflation targeting framework, which is a good example
of an evolving institutional structure, aligns well with this aspect of the Constitution.
The goal of monetary policy, the inflation target, is set by government. The current
target is for us to be within a range of 3-6 per cent. But within that context, the Bank
has full operational independence to implement appropriate policies to achieve that
goal. We are given the responsibility for protecting the value of the currency, but we
are also accountable for this responsibility. Government cannot dictate interest rate
policy to the Bank, and the requirement to consult regularly with the Minister of
Finance does not undermine our independence, but is a mechanism to ensure
effective macroeconomic coordination and information sharing.
To us, protecting the value of the currency means maintaining the purchasing power
of the rand in South Africa by containing inflation. By adjusting monetary policy or
through its communications, the MPC aims to influence both demand conditions in
the economy, as well as the inflation expectations of businesses and consumers.
The commitment to an inflation target acts as a signal to these stakeholders that
broad-based price or unit labour cost increases above the target will influence the
monetary policy stance.
Through this process the SARB is working to build the credibility of the inflation
target to the extent that, during inflation spikes, labour unions and businesses do not
meaningfully raise their expectations for future inflation. Achieving this goal ensures
that the country avoids an inflation spiral wherein wage demands and price
increases persistently ratchet up in response to current inflation outcomes.
Embedding the inflation target within the minds of the general public, through various
communication strategies and initiatives, is a task which the Bank has been working
at for the past sixteen years.
The inflation targeting framework is a good example of an institutional structure
which reduces uncertainty for businesses and households. This increased certainty,
in turn, facilitates long term investment and economic growth and this is the main
contribution that the Bank can make to balance and sustainable growth. At the same
time, maintaining price stability helps to protect the poor in particular, who are most
vulnerable to the ravages of inflation. It also helps to prevent the erosion of our
international competitiveness, a point to which I will return later.
In recent years, the Bank has been confronted with a challenging economic
environment in which GDP growth has been slowing, with a deteriorating inflation
outlook. In order to avoid a persistent breach of the inflation target, the MPC began a
gradual interest rate hiking cycle in January 2014. Since then the repo rate has been
increased by 200 basis points. Part of the challenge has been that inflation has been
driven primarily by supply-side factors, particularly the exchange rate and food
prices. Our approach has been to try and look through these shocks and focus on
second round effects. Given the persistence of inflation expectations at the upper
end of the target range, and wage settlement rates in excess of inflation, it has been
difficult to avoid a tightening cycle.
The Bank's
More recently there has been some improvement to the inflation outlook.
latest inflation forecast is for an average of 6,4 per cent in 2016, 5,8 per cent in 2017
and 5,5 per cent in 2018. The moderating inflation trajectory reflects recent policy
tightening by the Bank, an expected deceleration in food price growth and an
improvement in the exchange rate outlook relative to previous forecasts. The MPC is
of the view that should the forecasts materialise, the hiking cycle may be nearing its
end. However, this does not mean the interest rate reductions are imminent, as we
would like to see inflation more firmly within the target range on a sustainable basis
over the forecast horizon. We are also clear that the bar for any future rate cuts has
been set very high.
Although our mandate is inflation, it does not mean that we ignore growth
considerations. The Constitution states that what we do should be in the interest of
balanced and sustainable growth in the Republic. We have to be clear, however,
about what monetary policy can achieve in this respect. Our view is that long-term
trend growth or potential output is determined by real factors in the economy. These
include infrastructure, education, labour and product market efficiency, productivity
growth, and institutional strength, to name a few. Monetary policy can only impact on
cyclical variations of growth around the growth trend. Monetary policy cannot be an
engine for sustained growth. This requires structural reform, in order to arrest the
declining trend of potential output that we have observed over the past few years.
However, implementing structural reform is difficult and it requires strong institutions
and political management. Some of it requires changes in processes that are
expenditure neutral, for example product market reforms, and changing competition
laws or labour laws, while others could require huge investment layouts, as in the
case of infrastructure. These are political decisions, which are often difficult, and
inevitably involve entrenched interests. It is often difficult to get societal buy-in or to
when the
change expenditure priorities country's requirements are diverse and the
means limited. In South Africa, we do have a structural reform framework in the form
of the National Development Plan, which has been adopted by all parties. It is not
the plan that is lacking, rather its implementation.
It is far easier to look for a quick fix such as monetary policy. This is not a peculiar
South African phenomenon, however. Monetary policies, in conjunction with fiscal
policies, were instrumental in avoiding worse outcomes to the global financial crisis.
But monetary policy is not the appropriate policy to raise potential output. Yet, in the
absence of meaningful structural reforms, the focus globally remains on monetary
policy to provide the solution. This creates a challenge for central banks. As
Mohamed El-Erian has noted in his recent book, central banks are now seen as the
"only game in town"
due to slow progress in the implementation of structural reforms.
This inability to do so creates unreasonable expectations for monetary policy to
achieve objectives that it is not competent to deliver. Ultimately it could lead to an
undermining of central bank credibility and institutional strength, even in those areas
where it is best suited to operate.
The exchange rate and competitiveness
As I mentioned earlier, when people think about global competitiveness, the
exchange rate immediately comes to mind. Central Banks talk about the exchange
rate and global competitiveness, we are referring to the real exchange rate, or the
nominal exchange rate adjusted for inflation differentials between South Africa and
its trading partners. A depreciation only improves competitiveness if it is not eroded
by higher inflation. In other words, if it is a real depreciation. So the Bank's
contribution to keeping inflation low is relevant in this respect.
Our constitutional mandate to protect the value of the currency is often interpreted as
a mandate to keep the nominal exchange rate stable. In the absence of other
shocks, the exchange rate should remain stable if our inflation rate is the same as
that of our trading partners. But assuming our inflation rate is higher and we attempt
to maintain a stable exchange rate (and assuming that we have the means to do
that), our real exchange rate will in fact be appreciating. In other words, we will be
losing competitiveness, as the cost of producing goods domestically will have
increased relative to our competitors. This persistent overvaluation of the currency
will not be sustainable.
Since the beginning of 2011, the real effective exchange rate has depreciated by
26,8 per cent, in contrast to the nominal effective depreciation of 41,9 per cent. So
on this measure we are more competitive, but we have not seen a strong adjustment
to this, as evident in the persistent current account deficit.
There are a number of possible explanations but I will highlight a few points. It is
important to understand what the key drivers of the depreciation have been. While
there are a whole range of factors that impact the rand on a day to day basis, terms
of trade changes and capital flows have been among the key underlying drivers or
determinants. Falling commodity prices since 2011 have been an important factor in
the weakening of the rand. This does not necessarily provide an impetus for
increased production of commodities, but rather it shields the rand value of mining
output. It does make non-mining exports more attractive, and that is how the
adjustment is supposed to work. In other words, a real depreciation is supposed to
be positive for growth.
Capital flows are multidimensional. Some are driven by interest rate differentials, and
the current global low interest rate environment makes emerging markets a desirable
portfolio investment destination. These inflows have given support to the rand over
the past few years. But periodic reversals of these flows, for example during global
risk-off scenarios and risks of interest rate increases in the US have impacted
negatively on the rand. Portfolio inflows into equity markets are growth sensitive, and
this explains why non-residents have been net sellers of South African shares in
recent months.
To some extent, the rand has followed the pattern of commodity-producing emerging
market economies over the past few years in response to changes in terms of trade
and the pattern of global capital flows. However, there have been important
divergences relating to domestic idiosyncratic events which have resulted in
heightened perceived political risk, and reflected in the weaker exchange rate. The
increased risk premium is often associated with falling business confidence. The
resulting exchange rate depreciation is consequently unlikely to be a big boost to
investment and exports. Rather, it will reflect weakening institutions. The adjustment
is then unlikely to come about through increased exports, but through import
compression, in the form lower investment and consumption expenditure. A
weakening currency in the face of heightened political risk is therefore not a sign of
increased global competitiveness, and is unlikely to be accompanied by higher
growth.
Currently, South Africa remains under threat of a possible downgrade from the rating
agencies to sub-investment grade. One of the explicit factors contributing to some of
the agencies maintaining our investment grade rate in the past few months has been
the strength of some of our critical institutions. There is no doubt that should a
downgrade transpire, it will be reflected in the exchange rate (to the extent that it is
not already reflected). This will not be a sign of increased competitiveness, rather an
adjustment to a deterioration in our competitive standing globally as an investment
destination. The impact of strong institutions on our global competitiveness cannot
be underestimated.
The financial stability mandate
Aside from price stability, the Bank has now also been given an explicit mandate to
oversee financial stability as envisaged in the Financial Sector Regulation Bill
(FSRB), which is currently before Parliament. The bill defines financial stability in two
important ways. Firstly, it is the ability of financial institutions to provide products and
services within the confines of the law, without interruption, regardless of changing
economic circumstances. Secondly, it means that the public has confidence in the
financial sector and its ability to function appropriately. The FSRB also provides for
a Twin Peaks approach to financial sector regulation, which, when enacted, will
expand the SARB's scope of prudential regulation beyond banks, to include insurers
the "Financial
and financial market infrastructures, resulting in the establishment of
Sector Conduct Authority"
focusing on the conduct of financial institutions towards
their clients. Whilst South Africa's financial sector is widely seen as globally
competitive and soundly managed, the reforms contained in the FSRB are likely to
add additional institutional strength in this sector. This is because an explicit
separation between the conduct and prudential regulator will allow for improved
oversight.
The responsibility of ensuring financial stability and the soundness of financial
current mandate
institutions and the financial sector is complementary to the Bank's
of price stability. Both objectives are seen as necessary conditions for sustainable
and balanced long-term economic growth. Furthermore, financial stability provides a
platform for the implementation of monetary policy. Without a well-
functioning financial sector, it is impossible to effectively transmit monetary policy
through the economy.
to strengthen the public's confidence in our financial
The Bank constantly strives
sector because it is only through the assurance of financial stability that South
Africans will save and invest for the long term. This institutional strength also
contributes to giving confidence to foreign investors to invest in the country. While
the role of the Bank in regulating and supervising the individual banks has been well
established, (i.e microprudential oversight), we also have an important evolving role
to play in macroprudential oversight. Here the focus is on the financial system as a
whole and our role is to monitor and act against financial excesses that threaten to
undermine the broader economy.
The pre-Crisis approach by central banks was that they did not have the ability to
recognise bubbles and the best they could do was to clean up after the bubble had
popped. Central banks also believed that price stability and micro-prudential
supervision were sufficient to ensure broader financial stability. However, the Global
Financial Crisis taught us that financial excesses can emerge during times of low
inflation and strong individual bank metrics. The current view is that these excesses
should be nipped in the bud by appropriate policies that constrain lending, either
through macroprudential policies directed at the particular market segment, or
through some form of targeted brakes on bank lending or higher interest rates. Our
approach currently is for interest rate policy to be focused on inflation, and for the
Bank's Financial Stability Committee
(FSC) to use other macroprudential policies to
moderate financial stability risks. While our tool-kit is still being refined, we have
implemented the framework of a countercyclical buffer for banks which will be over
and above the capital requirements of individual banks. This provides the FSC with a
tool to change capital requirements in order to protect the banking system from the
boom and bust phases of the financial cycle, and is an integral part of the
internationally agreed standards for risk-based capital requirements. Currently, given
the weak state of bank lending, this buffer is set at zero.
Concluding remarks
In many ways, strong institutions are constraints on the abuse of political and
economic power that society puts in place. As such, there is always the danger that
there are incentives for some to undermine some of these institutions. We must
therefore ensure that strong institutions are supported by society. It is important to
regularly question whether our institutional arrangements are providing the right
incentives to the stakeholders in our society. Furthermore, we must ensure that our
institutions encourage broad-based participation in the economy and do not give rise
to alternative forms of collusion between interest groups. But it is also important to
bear in mind that institutions are not static. We live in a changing world, and
institutional change is inevitable. But we must ensure that change is positive and in
the interest of the broader society.
The Bank will continue to pursue its constitutional mandate within a flexible inflation
targeting framework without fear or favour. We have built a strong reputation as a
respected institution within our young democracy. Together with the National
Treasury we will continue to strive to bring about a stable macroeconomic
environment, conducive to long term growth and development.
Thank you.