François Groepe: The changing role of central banks
Address by Mr François Groepe, Deputy Governor of the South African Reserve Bank, at the
University of the Free State, Bloemfontein, 12 August 2016.
* * *
Good morning - and thank you for the opportunity to address you.
The past few years have been extremely challenging, both domestically and internationally.
The aftershocks of the global financial crisis of 2008-09 have persisted. The advanced
economies are still struggling to recover on a sustained basis, while the emerging markets,
initially the main engine for the recovery, have fallen out of favour in the past four years, as
the Chinese economy has slowed and brought commodity prices down with it.
Low growth is not the only issue. We are seeing increasingly widespread discontent about
rising income and wealth disparities in many countries, where the fruits of growth have not
been equitably shared and have been aggravated by persistently low growth.
The initial responses to the financial crisis involved both monetary and fiscal policy
loosening. But fiscal space was eroded very soon as debt ratios rose to unsustainable levels.
This placed a near impossible burden on monetary policy, which persists to this day.
Referring to the post-crisis focus on central banks, Mohamed El-Erian appropriately titled his
most recent book The only game in town.1 Today, I would like to highlight the role that central
banks can play in the economy and, perhaps more importantly, point out the limits to what
central banks can do. It is important to understand these limits because, I would argue, the
biggest risk to central bank independence is the possible backlash from being unable to
deliver on unreasonable expectations. Central bank mandates have expanded - perhaps
appropriately so - but there are limits to what monetary policy was designed to achieve.
Central banks cannot be, and should not be regarded as, "the only game in town".
The role of central banks has changed over time. The first central bank was established in
Sweden in 1668 and had a chequered early history, from providing commercial banking
services to financing a war against Denmark. Most of the early central banks were in fact
initially private banks, and for this reason, a number of them (including the South African
Reserve Bank) have private shareholders to this day. Over time, however, these banks
evolved into official institutions, with various roles.
It is not my intention to give a historical account of the evolution of the role of central banks
through the ages. Rather, I will fast-forward to the modern period and highlight the current
thinking about central banks and their appropriate mandates and policies. Important to note
is that the role of central banks is still evolving, so what is conventional wisdom today could
well be supplanted tomorrow. Although central banks are no longer in the business of
financing wars, the cost of maintaining peace and stability during periods of crisis is perhaps
far higher!
Prior to the financial crisis, there were a number of generally accepted views about the role
of central banks. Besides their exclusive responsibility for printing and issuing banknotes and
coins, the almost unquestionable view was that a principal role of central banks should be to
maintain price stability. While this opinion was generally accepted, the choice of framework
was not. Before the 1990s, the focus was on intermediate targets for monetary policy, for
instance money supply targets. More recently, the trend has shifted towards targeting
inflation directly, generally through using an official interest rate as the policy tool. The
inflation-targeting framework evolved, with the objective of monetary policy clearly specified
and quantified. It is worth pointing out that the choice of framework is constrained by the
nature of the exchange rate regime: in a fixed exchange rate environment, the focus is on
maintaining the peg, and monetary policy is determined by the policies of the currency to
which it is pegged.
It may be rightfully asked why price stability should be elevated to a policy objective. There
are a number of reasons why we want to pursue stable prices. First, it makes planning
investment for the future so much easier. The more unpredictable future prices are, the
higher the risk premium that investors are likely to price into their decisions. Although price
stability is not in itself a generator of economic growth, it is an important prerequisite for
providing a sound macroeconomic basis within which growth can be achieved. Second, it is
generally the case that it is the poor who are most vulnerable to the ravages of high inflation,
as they are the least able to hedge against this. The only people who benefit from high
inflation are those who have fixed-interest nominal debt, as the real value of the debt
declines during inflationary periods. However, under these conditions, lenders are reluctant
to lend at fixed rates and demand higher interest rates to be compensated for higher
expected inflation. Therefore, high-inflation countries tend to have high nominal interest
rates.
The more contentious issue is the impact that monetary policy can have on economic growth
and employment. It is generally accepted that monetary policy can play a role in stabilising
the business cycle. The concept of 'the potential rate of output growth' is central to this view.
This concept refers to the maximum growth rate which an economy can sustain without
generating inflationary pressures and consistent with employment at the natural rate.
Potential output is determined by structural factors in the economy, such as the availability of
capital and labour, infrastructure, technology, skills levels, and trade policies. Changes to
potential output are determined by changes in these factors. It follows then that if growth is
above potential, there will be inflationary pressures and the role of monetary policy will be to
moderate these pressures by reducing demand pressures to be consistent with price
stability. We do this through raising interest rates.
The converse also holds true. When the economy is growing at levels below potential,
demand is weak, as are inflation pressures, and monetary policy has room to stimulate the
economy by reducing interest rates. In other words, under normal conditions, monetary
policy should be conducted contra-cyclically, by boosting growth in a downturn and cooling
down an overheating economy during a cyclical upturn.
The central point here is that monetary policy has little role in determining potential output. Its
impact on output is cyclical. The challenge is that potential output is not observed but
estimated. Although there are a number of techniques with varying levels of sophistication,
these estimates are subject to a great deal of uncertainty and often vary quite considerably
from one to another. This means that, while we can observe how current output changes, it is
difficult to be certain at any point in time whether the potential itself has changed. This is
critically important for policy purposes. For example: if cyclical growth falls below potential,
then countercyclical monetary and/or fiscal policies are appropriate, but what if the current
observed growth slowdown is also a reflection of a decline in potential output? This could
mean that countercyclical policies would not necessarily be effective.
This issue is at the heart of the current debates about the persistence of low growth in the
global economy. Some have argued that below-potential growth is a cyclical phenomenon
that can be resolved through contra-cyclical macroeconomic policies by stimulating demand.
However, others have warned that we are experiencing a period of secular stagnation,
associated with a prolonged period of low growth and declining potential output. If this is
indeed the case, it follows that the effectiveness of monetary policy in stimulating the
economy will be limited. What is required under such circumstances is structural change in
the economy, in order to stimulate supply.
Monetary policy may help to prevent deflation by underpinning demand to some extent, but it
is unlikely to be the primary source of growth.
Recently, many countries have revised down their estimates of potential output growth.
However, it is unclear whether these are short-term estimates or whether a prolonged period
of secular stagnation is with us. Domestically, we at the South African Reserve Bank have
also successively revised down our estimates of potential output, from around 3,5 per cent in
2010 to the current levels of around 1,4 per cent. We see these as an estimate of short-term
potential output; our longer-term estimate is higher, when, for example, the electricity supply
constraint is expected to be relieved. But the longer-term estimates remain lower than
previous ones. This constrains the ability of monetary policy to stimulate cyclical growth, as
the output gap - which is the difference between actual output and potential output - is not
as wide as would be the case with a higher potential output. Thus, if the growth problem is
structural in nature, the scope for successful monetary stimulus is limited.
When the global financial crisis struck, it was viewed as a cyclical downturn, and there was
almost universal agreement on the need for stimulatory monetary and fiscal policies. While
fiscal space was quickly eroded, monetary policies in the advanced economies remain highly
expansionary and 'unconventional'. It used to be assumed that once interest rates reached
the zero lower bound,2 then monetary policy would become ineffective.3 But the post-crisis
period saw attempts at monetary stimulus through quantitative easing (or QE) which took
various forms but in essence entailed central banks buying government or corporate bonds,
thereby injecting liquidity into the system. While the US ceased its QE programme in 2014,
the Bank of Japan and the European Central Bank have maintained theirs while the Bank of
England recently resumed its QE programme in the wake of the UK's decision to leave the
European Union. Interest rates in the advanced economies remain extremely low and in
some instances in fact negative. In early 2015, both the US and the UK were expected to be
the first of the advanced economies to begin raising interest rates. The US tightened policy in
December 2015 but it has remained on hold since then, while the UK has recently reduced
rates further. Unfortunately, this highly expansionary monetary policy environment has not
generated the growth that was hoped for, but it can be argued that it prevented the
immediate situation from getting worse.
I should note that there are potential negative effects from very low or indeed negative
interest rates, not least of which is that they create problems for defined-benefit pension
funds which have to provide cover for ageing populations while many of these funds face the
risk of underfunding. The amount of government debt trading at negative yields has
increased significantly since the beginning of the year. Pension funds are therefore forced to
search for higher yields and, almost by definition, they move their funds to more risky
investment categories and jurisdictions. This is a potential time bomb waiting to explode, far
more serious than the concerns over the potential inflation risks of ultra-loose monetary
policy. In fact, inflation is not currently a concern in the advanced economies, and in some
instances the concern is that inflation is too low.
The situation in emerging markets and developing economies is more complicated,
particularly in those that are currently facing rising inflation and slowing or low growth. These
inflation pressures have typically been driven by weakening exchange rates in response to
declining commodity prices - and not by excess demand where monetary policy is most
effective. This is the case in South Africa at the moment. Our economic growth outlook is
weak following the contraction in the first quarter of this year. The South African Reserve
Bank forecasts 0 per cent growth this year and below-trend growth of just 1,1 per cent and
1,5 per cent in 2017 and 2018, respectively. At the same time, inflation is outside our target
range of 3 - 6 per cent and is expected to remain outside the range until the third quarter of
2017. However, demand pressures are weak while inflation is driven primarily by supply-side
factors, including drought-induced food price increases, a relatively depreciated currency,
and administered prices.
None of this means that monetary policy should not be used under such circumstances. We
know there is nothing we can do about the impact or first-round effects of these supply-side
shocks. We try to look through these effects and focus on the second-round effects, where
higher prices feed into higher generalised inflation and higher wage settlements. If we ignore
these pressures, inflation expectations are likely to rise. And if wage negotiators and price
setters believe that inflation will accelerate, they will adjust wages and prices accordingly,
and in so doing bring about a self-fulfilling prophecy.
This scenario of high inflation and low growth creates a dilemma for monetary policy. The
tightening of monetary policy could have a negative impact on the already weak economy,
but failure to act could cause inflation expectations to become unhinged and ultimately
undermine inflation. It is a difficult balancing act. Since January 2014, we have been in a
gradual tightening cycle, with a cumulative increase of 200 basis points since then, the most
recent a 25 basis point increase in March. The moderate nature of the tightening cycle is due
to our concern over the growth outlook; the tightening would have been more aggressive had
the economy been more buoyant. Furthermore, real interest rates remain relatively low,
implying an accommodative monetary policy stance despite the tightening.
But central banking is not only about monetary policy. Since the global financial crisis, the
mandates of central banks have expanded, particularly with respect to financial stability. Prior
to the crisis, many central banks had an implicit mandate, or no mandate at all, in this regard.
In South Africa, for example, although the South African Reserve Bank had explicit
responsibility for regulating and supervising individual banks (micro-prudential policy), it did
not have an explicit mandate to ensure the stability of the financial system as a whole. By
way of an example, excessive price increases or bubbles in asset markets, including the
housing market - particularly if financed by excessive leverage or borrowing against these
assets - could pose a risk to the financial system at large should the prices of these assets
collapse.
Prior to the global financial crisis, conventional wisdom dictated that there was not much that
central banks could do to cool down overheating asset markets. Indeed, many - including
Federal Reserve Bank Chairman Alan Greenspan - argued that there was no reason why
central banks were better placed to recognise asset price bubbles - and that the best they
could do was to clean up after things had already fallen apart. The predominant view at the
time was that things were unlikely to fall apart.
There were, of course, dissenting voices, notably at the Bank for International Settlements,
who argued that central banks should not have a narrow focus on inflation only and should
rather lean against this excessive leverage with higher interest rates, focusing on the
financial cycle, which is usually longer than the business cycle. This would have implied
higher interest rates than those prevailing before the crisis, despite the low inflation
environment.
History shows that these dissenting voices were correct; current conventional wisdom
prescribes that financial stability should be an explicit focus of central bank policy. There are
disagreements, however, about where this responsibility should lie and what instruments
should be used. Some argue that it should be part of monetary policy and that interest rate
settings should take the financial cycle into consideration. Others argue that monetary policy
should remain focused on inflation and that the task of financial stability should be given to a
separate committee, although it is not self-evident whether this separate committee should
be housed within the central bank or outside the central bank in a separate institution, as is
the case in Sweden.
In South Africa, we have adopted a position similar to that of the Bank of England, where the
responsibility for financial stability is given to the central bank overseen by a financial stability
committee. This committee considers the stability of the financial system more broadly,
rather than regulating and supervising individual banks. The latter remains the job of the
Bank Supervision Department at the South African Reserve Bank, which is transforming into
a Prudential Authority in terms of the Financial Sector Regulation Bill (FSR Bill) currently
before Parliament.
The promulgation of the FSR Bill will make the Bank's responsibility for financial stability
explicit. The Bill sets the provisions that will give effect to the Bank's financial stability
mandate. The Bank will be responsible for protecting and enhancing financial stability, and
for maintaining or restoring financial stability if a systemic event has occurred or is imminent.
In monitoring the strengths and weaknesses of the financial system, as well as any risks to
financial stability, the Bank will be expected to advise the financial sector regulators and
other agencies of the steps required to mitigate risks to financial stability. The FSR Bill also
requires the Bank to publish its assessment of the stability of the financial system at least
every six months in the Financial Stability Review, which is to be submitted to the Minister of
Finance and the Financial Stability Oversight Committee.
Once the FSR Bill is promulgated, the Prudential Authority will regulate individual banks and
insurance companies while the Financial Services Board, previously responsible for
overseeing the entire insurance sector and other non-banks, will assume responsibility for
market conduct within the banking and wider financial sector. So while monetary policy,
macro-prudential policy and micro-prudential policy are all separate functions of the Bank,
their coordination is facilitated by them being housed within the same institution, with some
degree of overlapping membership.
But we could ask whether the central bank has a wider role to play in the economy,
particularly within emerging markets. We are often asked why the South African Reserve
Bank does not get involved with direct lending or development finance, be it to industry or the
agricultural sector, and whether we should not be more involved in promoting financial
inclusion.
Theoretically, there is no reason why central banks cannot perform wider functions.
Generally, apart from the functions I have outlined above, central banks have the important
role of being responsible for issuing currency. Furthermore, in South Africa, the banking
sector plays a prominent role in the national payment system, which facilitates the settlement
of millions of transactions every day; the total value of transactions settled in the 12 months
to March through the Bank's SAMOS4 system amounted to R123,9 trillion. We take for
granted simple things like credit card or other card transactions that are settled immediately.
This requires a significant infrastructure, and the South African Reserve Bank ensures that
the rules are applied. At a regional level, we have played an important role in extending this
infrastructure and expertise to a number of countries in sub-Saharan Africa, which in turn
helps to facilitate intra-regional trade and promotes financial inclusion by helping
communities access financial services.
In some countries, central banks play a prominent role in the allocation of credit to various
sectors. For example, the Nigerian central bank plays an important role in directing credit to
the agricultural sector, and in South Korea the central bank decides how much credit banks
should extend to small and medium enterprises. Whether such functions should indeed be
performed by a central bank is often dependent on the nature of the financial system, its level
of sophistication, and the existence of other institutions that are focused on extending credit
to other sectors.
In South Africa, we have a number of public sector institutions that are focused on extending
credit to different sectors. These include the Industrial Development Corporation, the
Development Bank of Southern Africa, the Land Bank, and a number of institutions that
specialise in lending to small businesses. These functions could theoretically be performed
by the central bank as a separate function, but there is no clear advantage to this - unless
there were scarce skills in the economy and/or a lack of resources that would make a good
operational argument for this. In many developing economies, there may be a lack of skills,
and combining these diverse functions into one institution may be helpful from the
perspective of achieving economies of scale.
But even if it were the case that the South African Reserve Bank granted loans to the
agricultural sector or small businesses, these loans would not be financed by 'printing
money'. Rather, such an arrangement would disburse funds raised in the money and capital
markets at competitive rates, or it would be funded by grants from government and/or
multilateral organisations. There is no reason why the Bank would necessarily have the
advantage of assessing the needs of these sectors, as opposed to the specialised
institutions that focus on these sectors, or have the necessary expertise to do so.
In developing economies, central banks often have a role in promoting financial inclusion.
This is, however, a particularly challenging area of policy formulation and one that means
different things to different people. At a superficial level, financial inclusion is often simply
seen as having access to a bank account and consequently to the national payment system.
Mobile banking has brought banking services to the rural areas in a number of African
countries. In South Africa, the low-cost Mzansi accounts have given easy and cheap access
to rudimentary banking services to a broader segment of the population.
I would, however, argue that financial inclusion entails much more than this and that, from a
political economy perspective, it is a complex matter, particularly due to the broad range of
opinions on how best to achieve this policy objective. There is, however, broad consensus
that financial inclusion should extend to include access to loans, transactional banking, and
risk products and services.5
Financial inclusion should not mean irresponsible or reckless lending to people who cannot
afford it. After all, it was the unfettered provision of cheap loans to people who could not
afford them, or the so-called sub-prime lending, that largely triggered the global financial
crisis.
Typically, banks grant loans on the basis of some security provided by the borrower. Often,
this entails fixed property. But in a country like South Africa, with a highly skewed distribution
of income and wealth, the ability to provide such security is beyond the reach of a significant
proportion of the population. It becomes even more complicated when we consider rural
communities and communal forms of land ownership which is not conducive for providing
surety for loans.
As the sub-prime crisis in the US has illustrated: while lending to disadvantaged communities
may be a noble cause, there are dangers to excessive lending, particularly when such
lending is simply financing consumption. In South Africa, we experienced extremely strong
growth in unsecured lending between 2009 and 2013, some of which was to lower-income
groups previously excluded from formal sector borrowing and some of which may yet come
to manifest itself in higher levels of non-performing loans - although it is the view of the
South African Reserve Bank that our banks have sufficient capital buffers to absorb any such
increases.
Access to unsecured loans has meant that lower-income groups could avoid having to
borrow from ruthless informal money-lenders at exorbitant rates of interest. But it has not
solved the problem of over-indebtedness of the poor and its social consequences. In
numerous instances, large portions of earnings were paid over to lenders (both formal and
informal), often in terms of court orders, leaving wage earners with very little to live on.
There were also concerns that this form of lending and its rapid expansion posed a systemic
risk to the financial sector and broader financial system. However, unsecured lending was a
fairly small portion of total bank lending. Nevertheless, at a micro-prudential level, the Bank
Supervision Department of the South African Reserve Bank kept a close eye on these forms
of loans - and although one significant player in the field, African Bank, did collapse, its
failure cannot be solely attributed to its provision of unsecured lending. The role of the central
bank in this instance was not to decide who the beneficiaries of bank loans should be or how
much should be lent; the role of the central bank was to ensure that commercial banks in
general maintained adequate capital and made appropriate provisioning for risk.
The African Bank episode did illustrate the danger of talking about the need for financial
inclusion in a glibly manner. Banks have often been criticised for not extending lending to the
poorer segments of society, but when they did, they were criticised in some quarters for
"reckless lending" and for facilitating the accumulation of excessive debt. While increasing
financial inclusion is a laudable and important goal, a fine balance needs to be struck
between protecting consumers from exploitation and extending credit in such a manner that
the stability and soundness of the financial system as a whole is not undermined. The market
conduct regulators, including the National Credit Regulator and the Financial Services Board,
are responsible for preventing reckless lending, and the role of the South African Reserve
Bank in the context of promoting financial inclusion is to ensure the stability of banks and the
financial system.
There is a view that giving too much discretion to central banks in some of the areas I have
highlighted could politicise the central bank unduly. This brings us to the issue of central
bank independence. The main argument for independence is that it minimises the
politicisation of monetary policy decision-making and avoids what is known as the "political
interest rate cycle". This refers to the incentive of politicians to lower interest rates in advance
of elections. The argument is that an operationally independent central bank does not have
to bow to such pressures.
That is not to say that central banks are not pressurised by political and other elements in
society to act in a particular way, and monetary policy in South Africa has not been without
its domestic critics and political economy challenges. The monetary policy framework has
been criticised, and, not surprisingly, opposition has tended to intensify during the upward
phases of the interest rate cycle. But the South African Reserve Bank has been able to resist
such pressures, as its operational independence is entrenched in the Constitution. The
inflation-targeting framework lends itself well to the separation of goal and instrument
independence: generally, central banks do not have goal independence as the target is
usually, but not always, set by government, but, in order to prevent the so-called "political
interest rate cycle", central banks do have instrument and operational independence to
pursue the mandate given to them.
However, the global crisis has created challenges for central banks that could undermine this
seemingly comfortable insulation from the political arena. The expanded mandate of financial
stability in itself may have implications for their independence, while the other possible
objectives - such as financial inclusion and direct finance - imply political decisions being
made by unelected officials.
Compared to financial stability decisions, decisions on monetary policy, while not easy, are
more straightforward and better understood by the public. They usually involve the use of
one tool, namely the interest rate, and there is a clear objective. The financial stability
mandate is more complicated, as it is a shared responsibility. It generally involves
government in crisis resolution, particularly when public funds are involved, and the policy
tools are more directed at particular sectors; it may therefore be more politically sensitive as
the distributional impacts are more apparent than in the case of monetary policy.
Furthermore, as has been argued in a paper published by the International Monetary Fund,
financial stability is difficult to measure but financial stability crises are evident, so policy
failures are observable, unlike successes. As has been noted in the IMF paper, "central
banks would find it difficult (even ex post facto) to defend potentially unpopular measures,
precisely because they succeeded in maintaining financial stability".6 Whichever failures may
be perceived on the financial stability front have the potential to undermine monetary policy
independence through a general loss of credibility of the central bank.
In conclusion, we are living in challenging times. Central banks are called on to do more and
more, and are still called on to provide solutions to the low-growth environment we find
ourselves in. But, as I have argued, although central banks play an important role in the
economy and society at large, there are limits to what they can do - and these limits are not
always well understood. Mohamed El-Erian argues that while we should give central banks
due credit, their effectiveness is waning given the limited number of tools available to them.
He argues that the world has come to a critical junction, and faces a choice of two roads.
One road "involves a restoration of high-inclusive growth that creates jobs, reduces the risk
of financial instability, and counters excessive inequality. It is a path that also lowers political
tensions, eases corporate governance dysfunction, and holds the hope of defusing some of
the world's geopolitical threats. The other road is one of even lower growth, persistently high
unemployment, and still worsening inequality. It is a road that involves renewed global
financial instability, fuels political extremism, and erodes social cohesion as well as
integrity".7
This is a sombre warning - and relevant both domestically and at the global level. It is clear
what the preferred road is. Taking it requires political leadership and political will. This is not
a responsibility that can be abdicated to central banks.
Thank you