Address by Daniel Mminele,
Deputy Governor of the South African Reserve Bank,
at the Central Banking Seminar of the Federal Reserve Bank of New York
New York
2 October 2018
The impact of a changing global environment on African economies and policy
Introduction
Ladies and gentlemen, good afternoon.
Thank you to the New York Fed for again inviting me to address this prestigious
annual seminar where major topical issues are discussed. This year is no
exception. The theme of 'less accommodative policy amid questions about the global
order' has been a key focus of investors and policymakers alike for quite a while
already, and clear answers are still not forthcoming. Are we just witnessing a
temporary correction of financial markets amid an otherwise benign economic
environment, or are disruptions large enough to challenge global expansion, especially
in emerging economies? If more severe challenges were to occur, would there be
sufficient global cooperation to deal with them in a cohesive manner? I certainly will
not pretend to have clear answers to these questions, but will try to provide some
perspective, looking specifically at how the changing in global environment is affecting
South African Reserve Bank's (SARB) reaction thereto. I will also
South Africa and
pay attention to the challenges facing the rest of Sub-Saharan Africa and what to
possibly expect next.
In some aspects, the global outlook does not appear to have changed fundamentally
from earlier this year. The International Monetary Fund is yet to release its October
2018 World Economic Outlook, but the last time it published an update to its forecasts
in July, its 2018 and 2019 global growth projections were unchanged from the previous
forecasting exercise, at 3.9% for both years. The Bloomberg consensus of economists
delivers a similar message of stability in expectations. The forecast for 2018 gross
domestic product (GDP) growth is presently at 3.8%, unchanged from two quarters
ago. At the same time, the normalisation of monetary policies in advanced economies
from the unusually loose stance that had prevailed since the end of the global financial
crisis has proceeded largely along the pace which policymakers had signalled, and
investors had expected, at the start of the year.
Yet, a closer look at the details of the global environment suggests that the outlook
may be becoming more challenging as some risks previously identified have begun to
materialise. First, economic expansion has become less synchronised than in the
'sweet spot' of 2017, when most economies experienced upside growth surprises
without too much inflation. While GDP growth in the United States (US) is still strong
on the back of a buoyant labour market and fiscal stimulus, activity has slowed since
the start of the year in the eurozone, Japan and China. Second, some policy
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developments have contributed to either increasing such de-synchronisation such
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as fiscal stimulus in the US or raising overall growth uncertainty, as in the case of
rising trade conflicts.
One key consequence of such economic and policy developments has been renewed
upward pressure on the US dollar, which has benefitted from the further rise in interest
rate differentials (nominal and real) between the US and other major advanced
economies, and from the outperformance of US equities.
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The combination of rising growth and policy uncertainties, weaker commodity prices
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with the notable exception of oil from March to August 2018 and a stronger dollar
has hit emerging countries' financial assets particularly hard.
Since it peaked in
February 2018, and despite some recovery in September, the JPMorgan emerging
markets foreign exchange index has declined by 13%. Over the same period, the
MSCI index of emerging market equities has shed 13% and the Emerging Markets
Bond Index Plus (EMBI+) sovereign spread over US Treasuries has widened by 60
basis points.
However, performances across the emerging world have been very disparate, ranging
from severe financial stress to near-stability. Judging by these different reactions, it
appears that the less favourable global backdrop has led investors to refocus on
relative country vulnerabilities, specifically with respect to the rising external liabilities
of governments and large corporations, fiscal trends, exposure to global trade and
value chains and, in some cases, the level of inflation and the degree of anchoring of
inflation expectations.
How the changing environment has affected South Africa
If one excludes the most dramatic sell-offs experienced by the Turkish lira and the
Argentine peso, the South African rand has been among the most affected emerging
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market currencies this year losing 13% on a trade-weighted basis since its 26
February peak. This depreciation, together with the 98 basis point increase in the yield
on the R186 benchmark government bond and the 60 basis point widening in the
country's
five-year credit default swap spread illustrate the vulnerability of South
African financial assets to the changing world environment I have just described.
Why has this happened? In contrast to some of its emerging market peers, South
Africa has managed to keep its foreign currency-denominated external liabilities
relatively under control. While the ratio of external debt to GDP has risen from a low
of 18% in the mid-2000s to 46% as at the first quarter of 2018, the majority (about
55%) of that debt is denominated in rand, and includes government bonds held by
offshore portfolio managers. Importantly too, the short-term component of foreign
currency-denominated external debt did not exceed 8.5% of GDP, and the bulk of
finance or domestic banks'
these liabilities consists of either trade foreign currency
deposits, which in the latter case are more than offset by foreign currency assets.
Inflation patterns do not appear to be the cause of the market sell-off. Over the past
12 months, consumer price readings have been below consensus expectations seven
times (including in the past month), and the average inflation rate (of 4.4%) for the
Reserve Bank's
second quarter also fell short of what the South African (SARB) model
projected 6 or 12 months earlier. The extended period of sub-par growth in demand
appears to be limiting the pass-through to prices of higher input costs, including those
related to exchange rate depreciation. Indeed, recent survey indicators suggest that
companies' pricing power, especially in the retail sector, is increasingly being
eroded.
At the same time, some modest signs of slower wage and unit labour cost growth have
also emerged in the past year or two.
several of South Africa's fundamentals
However, some are fragile enough to keep the
country at risk of portfolio flow reversals in periods of rising risk aversion. Among those
is the persistence of 'twin deficits'. While the current account deficit has declined, on
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average, in recent years it stood at 3.3% of GDP in the second quarter of the year,
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down from a high of 5.8%, on average, in 2013 it nonetheless appears elevated for
an economy with weak demand and a negative output gap. Domestic savings remain
low, illustrating the risk of renewed deficit widening if demand, especially much-
needed investment demand, picks up. At the same time, the budget deficit has
remained in excess of 3% of GDP in the past few years, despite repeated tax
increases, resulting in a continued rise in the debt-to-GDP ratio, compounded by an
increase in contingent liabilities linked to state-owned enterprises.
Real economic growth has also been disappointing. At a year-on-year growth rate of
only 0.5% in the second quarter of 2018, South African GDP growth was one of the
weakest among the large emerging countries. In the second quarter, the South African
economy entered what is commonly called a 'technical recession', as GDP growth
contracted for a second successive quarter. In many ways, hopes that domestic
political developments at the start of the year would translate into a quick boost to
activity proved to be excessive. Business confidence quickly retraced most of its early
2018 gains, and the South African rand, which had rallied at the time on the back of
such hopes, fell back in sympathy with corporate sentiment (but also on account of the
factors already mentioned).
Even as domestic financial markets came under pressure, some assets showed
relative resilience, in particular long-term domestic bonds that sold off by a lesser
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amount relative to the degree of rand depreciation than in previous episodes of
market stress, for example the 2013 'taper tantrum'. Continued and relatively benign
inflation readings probably helped limit the upward drift in bond yields, highlighting the
importance for central banks of keeping price expectations solidly anchored, if the
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impact of market stress is to remain limited in both length and scope.
How the South African Reserve Bank is reacting
The SARB has had to acknowledge the risks that the changing global environment is
posing to the domestic inflation outlook. Earlier this year, a decline in both actual and
- models had been projecting -
forecast inflation relative to what the SARB's had
allowed the Monetary Policy Committee (MPC) to ease policy moderately, by 25 basis
points in March, in an environment of weak domestic demand. However, the outlook
for inflation has since deteriorated, even though actual inflation readings generally
remained benign and the impact of the increase in the value-added tax rate from 14%
to 15%, in particular, seemed relatively muted. Exchange rate depreciation as well as
the rising trend in world oil prices and uncertainties about future electricity tariff
increases pose the main upside risks to the outlook.
While inflation is still expected to remain within the 3-6% target range over the
Quarterly
forecasting period, according to the latest forecasts from the SARB's
Projection Model (QPM), inflation will peak at 5.9% year on year in the second quarter
of 2019, before eventually settling at 5.4% in the last few quarters of 2020. Core
inflation is expected to follow a relatively similar, though smoother, profile, peaking at
5.6% year on year during the course of 2019. Given the volatile environment, the risk
of an overshoot of the target, given the balance of risks, should not be underestimated.
Furthermore, an extended and sizable deviation in inflation from the midpoint of the
target range would raise the risks of medium-term inflation expectations drifting back
to, if not above, the top end of the range.
The SARB's
QPM model projects that in order to bring inflation back towards the target
midpoint in the long run, five interest rate increases of 25 basis points each will be
needed by the end of 2020. It is important to reiterate that the QPM projection is not a
pre-commitment to a future rate path. It is a broad policy guideline that can and will
evolve as economic conditions change. At its most recent meeting about two weeks
ago, the MPC opted to leave the repurchase rate unchanged at 6.50%, cognisant that
downside risks to the growth outlook had partly offset the upside risks to the future
inflation profile. The output gap remains negative and unlikely to close until late 2020,
suggesting that risks of demand-led price pressures should remain low over the
forecasting period. Nonetheless, the MPC will need to remain vigilant and ready to act
against any sign of second-round price effects from the recent rand exchange rate and
oil price shifts.
The exchange rate of the rand has been the subject of much debate recently, given
its depreciation and heightened volatility in reaction to a combination of fundamental
drivers, external risk factors and a general reallocation of capital away from emerging
markets. A number of emerging markets have more recently resorted to intervention
in the foreign exchange market, informed by their own country-specific circumstances.
The SARB has allowed the exchange rate to act as a shock absorber and adjustment
mechanism, and maintained its policy of not intervening in the foreign exchange
market with a view of supporting the currency.
However, as previously stated, this does not mean that we are totally indifferent to
exchange rate movements. It also does not mean that there cannot be circumstances
where the cost of not intervening to dampen excess volatility or abrupt and disorderly
adjustments, could be higher than that of intervening. This suggests that policy
flexibility requires that foreign exchange intervention continues to be part of the
monetary policy toolkit to support economic and financial stability. As previously
stated, our preference has been to deploy this tool if there are signs of the orderly
functioning of markets being threatened, rather than to go against the grain of a
market, which is realigning and repricing on the back of the factors mentioned above.
Recent developments in domestic foreign exchange markets have not been judged to
have been of such magnitude and nature that they required any intervention from the
SARB.
Challenges in the rest of sub-Saharan Africa
A changing global environment is equally as important for the rest of the African
continent. A decade or so ago, the conventional view was that, apart from the demand
for exports and the impact of commodity price fluctuations on the terms of trade,
African countries were relatively insulated from global financial shocks, as their
economies were less integrated into the world financial system and thus less
vulnerable to portfolio outflows or cutbacks in banks'
cross-border loan portfolios. This
proved true, to some extent, in the global financial crisis, when the sub-Saharan
African region experienced a less pronounced growth downturn than other major
regions. However, this too is changing. Greater integration of sub-Saharan Africa into
global financial flows has brought access to new resources for the financing of
investments and economic development. It has also, however, ushered in a greater
vulnerability to potential capital outflows.
So far this year, with a few exceptions, currencies in sub-Saharan Africa have
depreciated by only a moderate amount against the US dollar. The recovery in oil
prices appeared to help energy exporters, while other countries benefitted from
continued, relatively stable economic growth. However, other segments of their
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financial markets have not performed as well. In particular, yields on eurobonds
which have grown in size as a funding instrument in recent years as sovereigns took
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advantage of the global 'search for yield' have increased. In most cases, such yields
are up by 100 to 150 basis points from early 2018 lows, reversing a significant part of
the previous two years' rally.
At the same time, 'frontier' equity markets are displaying
a stronger correlation with larger emerging markets than before, illustrating the
vulnerability of earlier gains in still-small African stock exchanges.
Furthermore, several fundamental economic trends in sub-Saharan Africa are a
growing source of vulnerability. Current account imbalances are rising in a majority of
the continent's countries,
which are largely non-resource exporters, and contributing
to a rising trend in external liabilities relative to GDP. Government budget deficits
remain fairly high, pushing public debt ratios higher. And while economies continue to
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grow in real terms, the experience of the past few years in particular, their abrupt
- highlights the region's vulnerability to external
slowdown in 2015 developments,
prices or a rebalancing of China's growth path towards
such as swings in resource
less commodity-intensive demand. Finally, while inflation in the first half of 2018 was
reasonably benign in the majority of African countries, the sensitivity of consumer price
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trends to prices of oil and food commodities, and to exchange rate swings because
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of the high share of consumer goods that are imported is a strong reminder that such
stability cannot be taken for granted.
What will happen next?
How will the emerging market situation evolve over the next few months and quarters?
In the past couple of weeks, pressure on emerging currencies and other assets has
abated to some extent, helped by signals from several central banks indicating that
they would not tolerate durable upward shifts in inflation. However, it is too early to
predict a stabilisation in emerging market assets, and too early to say with confidence
whether the recent market correction will, or will not, turn into a more severe
adjustment that could severely undermine growth prospects, and possibly strain
corporate and bank finances in emerging countries.
At present, many economists are of the opinion that emerging market assets, and
especially currencies, are more fairly valued than they were at the start of the year.
However, historical experience tells us that 'overshoots' can often happen, following
adjustments similar to what has just been witnessed, and financial assets can face an
extended period of volatility before settling around new 'equilibrium' values.
There are, however, some encouraging factors which should limit the risk of a further,
severe adjustment. First, as I indicated earlier, growth in advanced economies has
remained relatively resilient, much as risks seem tilted to the downside. Even in
emerging markets, with the exception of Argentina, Turkey and South Africa , growth
forecasts have not significantly changed since early 2018; hence, the risk that financial
market stress in emerging countries could negatively 'spill back' into the advanced
economy growth outlook still appears, for now, to be low.
Importantly, too, much as the risk remains, we are not witnessing the kind of inflation
force the world's major central banks into a significantly faster
pressures that might
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pace of policy tightening potentially derailing economic expansion. While both
headline and core inflation are at present higher in the US, eurozone and Japan than,
on average, in the past few years, few economists anticipate a prolonged overshoot
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of inflation targets in the event that these targets are reached in the near future,
which may not always be the case. And, while tighter labour markets are finally
pushing wage growth higher, this is in part offset by some acceleration in productivity,
implying limited upward pressure on prices from unit labour costs.
Equally, just like it has not led to a strong build-up of price pressures in advanced
economies, the prolonged period of stimulative monetary policies has not led to the
kind of broad-based private sector (especially financial sector) leveraging that would
threaten an early and abrupt end to what is now an extended period of economic
expansion. Admittedly, in some large emerging countries, in particular in China, private
sector liabilities have risen sharply in the past decade as a share of GDP, raising the
risk of a future adjustment that may, at some stage, have adverse consequences on
not just local but also global economic growth. However, in the short term, the steps
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recently taken by Chinese authorities including some mild loosening of their
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monetary, fiscal and regulatory stance indicate that they do not see the deleveraging
of specific segments of the economy as incompatible with a relatively stable pace of
economic expansion.
This said, several factors of uncertainty are likely to persist in coming quarters,
implying an ongoing strong need for vigilance by central banks, especially in emerging
countries such as South Africa that enjoy open and liquid capital markets.
The first factor to mention is the recent escalation in trade conflicts between the US
and China, with both nations announcing an increase in tariffs on a broader range of
goods than initially targeted. While earlier tariff announcements in the second quarter
of 2018 appear to have not yet had major negative effects on economic activity,
concerns remain that a broader, longer conflict could undermine global trade flows,
corporate investment and, ultimately, economic growth.
More generally, a move away from the multilateral approach to international relations
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followed in recent decades not only in trade but also in financial, regulatory and even
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military matters could create a more complex environment for emerging countries
relying on open markets and stable external relationships for economic development.
Turning to financial matters, one factor of uncertainty is the future path of risk-free,
'neutral' real interest rates in coming years, and how this will continue to affect global
investors' appetite for risk
and, in turn, the cost and accessibility of foreign funds for
emerging economies. In the decade following the global financial crisis, several factors
tended to depress these risk-free rates, including low productivity growth, higher
precautionary savings, and continued reserve accumulation by emerging countries
with large current account surpluses. However, these factors have started to fade,
albeit gradually.
Finally, geopolitical issues remain a concern. In the past few years, commentators and
investors have mostly focused on growing voter frustration of low growth and rising
job insecurity in advanced economies. However, one should not forget that such
challenges persist in emerging economies too, in particular in Africa. Failure to
address issues of persistent inequality and poverty, insufficient job and skills
development opportunities, and poorly planned urbanisation could easily increase
social unrest and reverse earlier gains towards a more stable, rules-based policy
environment. And while most of the policy responses fall outside the remit of central
banks' mandates, their contribution to price and financial stability remain essential if
development goals are to be achieved.
Conclusion
Acknowledging the impact of the downside risks, especially the escalating of trade
tensions and the tightening of global financial conditions, to global growth and inflation,
it goes without saying that global coordination and cooperation to deal with these
challenges is necessary. In part this would mean that authorities should consciously
implement policies and reforms that will weather the financial markets volatility as well
as protect global expansion. This kind of coordination and cooperation has served the
global economy well during the last global financial crisis and we should work hard to
improve on that.
Thank you.