Lesetja Kganyago: South Africa - "Fit for the Future"
Address by Mr Lesetja Kganyago, Governor of the South African Reserve Bank, at the
Agricultural Business Chamber Congress 2016, Cape Town, 1 June 2016.
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Introduction
Good morning, Ladies and Gentlemen.
I am honoured to be here with you today, on this 70th anniversary of the Agriculture Business
Chamber. Congratulations on this milestone, Agbiz!
The theme of this Congress is "Fit for the Future", and to my mind, this is an excellent
encapsulation of South Africa's monetary policy framework. Inflation targeting, the cornerstone
of this framework, is fundamentally medium- to long-term orientated.
As you all know, economic activity in South Africa is currently weak. Drought has contributed
much to this weakness, but it has considerably deeper roots.
Structural reforms are urgently needed to improve capital and labour use, which will boost
productivity in the medium term. We have also seen rising inflationary pressures for some time,
which prompted the current monetary tightening cycle. Headline inflation is above the upper
end of the target range of 3 to 6 per cent, and this breach is expected to persist until late next
year, driven especially by food price increases.1
The South African Reserve Bank is certain that an environment of consistently low and stable
inflation is the best contribution it can make to balanced and sustainable growth in South Africa.
However, inflation shocks such as the current food price spike can compromise the credibility
of the Bank and thereby permanently accelerate inflation.
I will focus my remarks today on explaining how the Bank views these shocks and when it
deems a monetary policy response necessary.
Economic conditions and the drought
South Africa's short-term prospects do not look encouraging. While growth has declined since
2011, underlying inflation1 has increased. At the same time, the economy continues to suffer
spillovers from low global growth as well as idiosyncratic shocks, of which drought is the most
recent.
Rainfall in 2015 was 20 per cent below its long-run average.2 Parliament recently adopted a
motion that drought should be declared a national disaster.3
After a particularly large maize harvest in the 2014/15 season, of 14,3 million tonnes,
commercial maize production dropped last season and is estimated even lower for 2016/17,
at just 7,2 million tonnes. We are thus likely to need up to 4 million tonnes of imported maize
this year.
The agriculture, forestry and fisheries sector contracted in every quarter of last year, losing
8,4 per cent of its total value over the course of 2015.4 Associated sectors such as
manufacturing (via agro-processing) as well as banks and insurance companies that are
heavily invested in the agricultural sector have felt the impact of this contraction - as everyone
here will know.
In addition to the issue of access to food, we continue to see enormous human suffering from
water shortages affecting people's quality of life. These shortages also endanger businesses;
this, in turn, threatens the livelihood of the communities dependent on those businesses for
employment.
More specifically, we in the Bank have been revising our estimates of potential growth
downwards. In other words, the estimated rate at which the economy can sustainably grow
before inflation rises has declined. As a result, South Africa today faces a high-inflation,
lowgrowth situation similar to many other commodity-exporting emerging markets. The response
to this problem is to push potential growth back up while ensuring that inflation does not rise.
Currency depreciation, while uncomfortable, is an important part of the adjustment to broader
economic weaknesses, in particular coming from falling commodity prices. But it also tends to
lift inflation as firms increase producer prices in response to higher imported input costs and
as consumers demand higher wages to re-establish living standards relative to the cost of
imported goods.
With a drought and a weaker currency, food prices are playing an unusually strong role in
complicating the inflation outlook. I will turn to this relationship in more detail shortly. For now,
from a policy vantage point, preventing an inflation response is critical to keeping our overall
cost of borrowing low for investment and to maintaining the competitive advantage we have
gained with depreciation.
In the past two years, National Treasury has embarked on a fiscal consolidation programme
and the South African Reserve Bank has entered a monetary policy tightening cycle. These
actions help to reduce inflation and will foster economic stability, consistent with our respective
policy frameworks. In the long run, this is good for everyone. In the short run, however, we are
providing less economic stimulus while the economy remains far from the hoped-for recovery.
Structural reforms to improve opportunities for small businesses and job seekers would
increase investment and productivity, and should therefore complement the current
macroeconomic policy stance of the Bank.
Food price inflation and the exchange rate
In 2015, due to favourable oil price shocks, inflation averaged 4,6 per cent. In contrast, inflation
outcomes have exceeded 6 per cent this year because of food and petrol prices. The Bank
expects headline inflation to average 6,7 per cent in 2016 and 6,2 per cent next year. Food
prices are increasing due to the drought, whereas petrol prices are increasing because oil
prices have risen off the extremely low levels prevailing at the start of 2015 and a weaker
exchange rate. The drought, like oil price movements, is a supply-side shock to inflation.
Domestic price increases in maize, South Africa's staple food, have been extreme. Since
1 January 2015, yellow maize prices have increased by almost 70 per cent while white maize
prices have increased by more than 130 per cent over the same period.5 In total, food prices
make up 14 per cent of the consumer price index, and this measure increased by 11,3 per cent
in April 2016, up from 4,3 per cent ten months earlier. Food inflation is forecast to peak at
12 per cent in the final quarter of this year.
Dry conditions since 2015 have caused a long period of herd culling, which increased the
shortterm supply of meat and temporarily suppressed meat price inflation - thus, although grains
inflation has accelerated since June 2015, meat price inflation accelerated this year.
Meat price dynamics were an important reason why food inflation rose at a
slower-thanexpected pace last year. However, this trend has reversed in 2016, as food inflation rose faster
than we had anticipated in the first four months of the year. Furthermore, the rising cost of
meat inputs and the lower supply of animals to the market are likely to push meat prices
significantly higher over the course of 2016.
Food prices are not solely determined by domestic supply and demand; they are increasingly
influenced by international food prices and therefore by the exchange rate.6 This is not
necessarily negative. Although South Africa is a net food exporter, we do not have a
comparative advantage in all food production. Thus we rely on international prices, which are
predominantly US dollar-denominated, in markets where we are price takers. During a drought,
international food prices and the currency play a greater role, as food imports are larger than
in "normal" years and more food commodities trade at import parity prices. Exchange rate
depreciation is thus often discussed as a disadvantage as it drives up food costs.
Yet there are advantages to depreciation that are easy to overlook. For South African
commodity producers, rand depreciation has mitigated the impact of international price
changes: food price indices from the UN's Food and Agriculture Organization, measured in US
dollars, show international food prices deflating for the past three years. When calculated in
rand terms, these prices have continued to rise. Thus, domestic producers (or at least those
who have harvested during the drought) have been protected from global agricultural price
deflation.
In general, currency movements assist the domestic economy in adjusting to changing
international conditions by signalling an appropriate allocation of resources for production. I
have been talking about food prices in particular, but broader commodity prices have been
declining since 2011. This has resulted in rand depreciation, making our manufacturing and
services exports more competitive at a time when mining exports have become less profitable.
For the agri-sectors, this implies scope for agro-processing expansion, as we have a relative
advantage while the currency is depreciating. Of course, this can only happen once harvests
recover from the drought. The extent to which we can lock in these benefits will depend on
ensuring that future price increases are contained so as not to erode competitiveness.
The rationale for inflation targeting in South Africa
Before discussing the way in which the South African Reserve Bank thinks about food prices
and its framework, let me briefly reiterate the inflation-targeting rationale.
Inflation targeting is global best practice in monetary policy because it is transparent while also
recognising that there is no long-run, or even medium-run, trade-off between inflation and
growth. Instead, in the long run, price stability is a precondition for significant sustainable
growth. This is also true of financial stability, which has been added to the mandate of the Bank
in the aftermath of the global financial crisis.
Inflation targeting is a framework that helps to create the conditions for a stable and
investment-friendly business environment. Volatile or higher inflation outcomes increase
business costs in several ways. They can push employees into demanding above-inflation
wage increases, which pressure business margins. More variable inflation also increases
uncertainty about the costs of business operation, which can delay investment decisions.
Finally, investors require higher returns for increased uncertainty, which means elevated
longterm real interest rates.
In addition, higher inflation can negatively impact on competitiveness. If inflation in South Africa
is above that of our trading partners or export rivals, then the production costs of our exports
will be relatively greater, and as a result we will be less competitive in global markets. This can
be corrected by rand depreciation but the rand is especially volatile and, furthermore, domestic
inflation can easily erode these gains. Inflation targeting helps to address these problems by
guiding policymakers to respond to temporary supply shocks when they may permanently
accelerate inflation, as well as by ensuring that demand-side inflation is controlled.
These advantages are generic; they apply to everyone. Yet inflation targeting is also
particularly suited to the structure of the South African economy. The recent increase in the
unemployment rate is a reminder of the large number of people locked out of the real economy.
Fundamentally, inflation targeting is a policy framework that protects the vulnerable groups in
society, such as the unemployed, the poor and the elderly - basically those with a fixed or no
income. Higher headline inflation affects these groups most severely as they are not able to
negotiate income increases commensurate with inflation, nor are they able to access financial
markets to acquire assets to protect themselves against inflation.
The South African economy is characterised by strong pricing rigidities and resilient barriers
to entry in many industries. Because of the high concentration of the economy as well as the
shortage of skilled employees, "insiders" - meaning price and wage setters - are in a position
to mark prices and wages in line with their expectations. When these price and wage setters
expect higher inflation in the future, their actions make the expectations self-fulfilling: inflation
duly rises and the risk of a wage-price spiral increases.
Inflation targeting, once credible, has the capacity to break this cycle as it provides an external
anchor for the "insiders." They focus instead on the Bank's inflation forecast and its
communication and on how and when it will achieve the inflation target. This then protects
those groups that do not have the same market power as price and wage setters, such as the
unemployed, non-unionised employees and small firms. Greater certainty and lower inflation
rates remove a significant constraint that these groups face in accessing the real economy. Of
course, this is only the case as long as the Bank can convince price and wage setters of its
commitment to the inflation target range -as long as the Bank keeps their inflation expectations
anchored.
Food prices and second-round effects
Food prices hold a particular interest for the Bank. In part, this is because we are aware of the
regressive nature of food price increases. More crucially, from an inflation-targeting
perspective, if those who do have negotiating power use it in response to food price shocks,
this can lead to second-round effects. By second-round effects I mean a reaction in inflation
expectations or wages to higher headline inflation, which would cause a further increase in
headline inflation after the initial effect of the shock would have dissipated. This occurred after
the previous peak in food prices; in 2008, food price inflation averaged 15,8 per cent. In four
of the five subsequent years, wage inflation exceeded both food and headline inflation.
The current tightening cycle began in January 2014. Since then the Bank has hiked the repo
rate by a cumulative 200 basis points to 7 per cent currently. This year, the Bank has hiked the
repo rate by 75 basis points. From a historical perspective, the 7 real interest rate remains low,
following a prolonged period of monetary accommodation. Furthermore, this is one of the most
gradual hiking cycles on record.
Let me emphasise that interest rate increases are not aimed at decreasing food inflation; the
Bank understands that the food inflation we are seeing is a market-based response to a
temporary shock. Typically, a flexible inflation-targeting regime will look through supply shocks
that shift headline inflation away from the target range, provided that the shift is clearly
temporary and will not create second-round effects. The Bank applied this approach for a
number of shocks occurring between 2009 and 2013. Headline inflation spent 18 months
above the upper end of the target range over that period. Yet the Bank could afford to look
through those shocks; underlying inflationary pressure, as measured by core inflation, was
contained, and this, alongside anchored inflation expectations, meant that there was space for
temporary breaches.
However, the Bank is of the view that, since January 2014, it has not been appropriate for it to
look through supply shocks that drive inflation above 6 per cent. At that time, the Bank
forecasted an extended breach of the target if it did not act. The risks around its forecast implied
that second-round effects would manifest if it did not act to prevent them. In the run-up to the
hiking cycle, the Bank noted with concern persistently above-inflation wage settlements
despite weak growth and the clustering of inflation expectations around the upper end of the
target range. These were signals that inflation could permanently accelerate if further shocks
occurred.
The problem is not that inflation may exceed 6 per cent; the problem is that people may come
to believe that the South African Reserve Bank does not target 3 to 6 per cent but instead
targets 6 per cent plus a "supply shock premium". Such a perception would compromise the
credibility that the Bank has earned since inflation targeting was introduced in 2000. As I've
mentioned, price and wage setters have enormous discretion if they believe that the true target
is above the set range. The Bank wants to avoid such a situation.
"Fit for the Future" and the agribusiness and agro-processing sectors
The environment that I have described today may feel discouraging to you. I would not want
that to be my overarching message. I think that the actions South Africa takes now, to reinforce
our framework, will protect economic competitiveness in the global arena and encourage future
growth.
The National Development Plan has highlighted the potential of the agriculture and
agroprocessing sectors, particularly for increasing employment but also growth. Although South
Africa is a leading exporter of certain food commodities - including maize, sugar and fruit -
there is great scope for expansion of the agro-processing sector. Even a cursory glance at the
manufacturing production statistics makes them look encouraging, as the weight of the food
and beverages category has increased from 11 per cent in 2000 to 24 per cent currently.
However, the contribution from manufacturing production to GDP has been shrinking over this
period, so agro-processing volumes have merely grown in line with real GDP. I am sure that
this observation will be a key focus of your conference over the next two days, so I will not say
more on the subject.
There are multiple advantages to expansion. Agriculture is relatively labour-intensive, and it is
a crucial source of employment for rural communities. Increasing agricultural output would also
strengthen food security, not just in South Africa but in sub-Saharan Africa. Furthermore,
expanding manufacturing production is key to creating stable jobs suitable for our
underemployed workforce. The International Monetary Fund has recommended expansion of
agro-processing in sub-Saharan Africa as the region has a comparative advantage in
agriculture and countries such as Ethiopia have enhanced their integration into global value
chains through agro-processing.7 Research has shown that this value chain integration is key
to productivity growth for small open economies in particular, as they learn from countries
further along in the value chain. Overall, then, expansion would assist in South Africa's great
need for export growth and give it a productivity boost and additional employment.
Conclusion
This Chamber is well suited to tackling challenges related to expansion. As a forum of
stakeholders from different stages of the agricultural process, Agbiz is in a unique position to
facilitate communication and action. It is encouraging that your strategy and objectives
highlight competitive performance, transformation, inclusivity and technology - all necessary
for a thriving and sustainable agriculture sector, and for managing the challenges of
globalisation and climate change.
Although periods of underperformance are often the most difficult times to make changes, they
also provide valuable time to evaluate and strengthen frameworks with a view to sustainable
growth. The many recent shocks to growth and inflation have created a great deal of
uncertainty. In this context, you can at least be certain that the South African Reserve Bank is
committed to containing inflation. This preserves your competitive advantage for exporting and
contains long-run investment costs, creating the foundation for your expansion. You can count
on the Bank to do its part. In turn, I look forward to watching you build a productive and
integrated sector that is able to contribute ever more meaningfully to domestic growth and
employment.
Thank you