Lesetja Kganyago: South Africa and the normalisation of world monetary
policies
Address by Mr Lesetja Kganyago, Deputy Governor of the South African Reserve Bank, at
the Merrill Lynch 2nd Annual Fixed Income Investor Conference, Sandton, 27 November
2013.
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Introduction
Since the onset of the world economic crisis, monetary policy in the major advanced
economies has been extremely loose. This has been helpful in supporting economic
recovery in those economies, which has had positive spillover effects for developing
countries, including South Africa. In line with other emerging markets, we have also
benefitted from capital inflows which have boosted growth, lowered our borrowing costs and
reduced inflation, through a stronger currency. However, these trends have started to
reverse following signals from the US Federal Reserve that it plans to reduce the pace of
bond purchases and ultimately tightening monetary policy. Today, I will discuss what this
change means for South Africa.
The unmoved mover: US monetary policy
The prospect of Fed tapering moved to centre stage in world financial markets on the 22nd of
May, when Chairman Ben Bernanke told the US Congress that he envisioned slowing or
tapering the Fed's quantitative easing programme this year. The result was a worldwide
increase in medium and longer term interest rates and outflows of capital from emerging
markets, as investors responded to better rates of return in advanced economies. For
emerging markets, the shock appeared most visibly through weakening exchange rates,
especially in the countries with large current account and fiscal deficits.
de facto
By September, this strong market reaction had achieved a world monetary
tightening which had only to be validated by an actual Fed decision to taper. Yet this, to the
surprise of many, was not forthcoming. The reasons the Fed declined to fulfill expectations
were really quite persuasive. The Federal Open Market Committee had attempted to provide
forward guidance on interest rates using unemployment as its main indicator, with 7%
unemployment as the guideline for ending QE and 6.5% the threshold for raising rates. By
September, unemployment had fallen to 7.3%, suggesting that tapering would need to
happen rather quickly if QE were to be finished when unemployment reached 7%. However,
unemployment was actually an unreliable indicator of the health of the US economy. This
was because most of the improvement was being achieved not through people finding jobs
but through people leaving the labour force. When unemployment hit 7.3% the labour force
participation rate fell to 63.2%, the lowest level since 1978. The Fed therefore seemed
unwilling to reduce its stimulus when so many people remained without jobs. Furthermore,
the US economy was threatened by a fiscal shock from the budget and debt ceiling
standoffs, to which the Fed was reluctant to add a monetary shock.
For emerging markets, delayed tapering offered some respite from currency depreciation.
However, it remains inevitable that advanced economy monetary policy will start to
normalize, beginning in the United States. South Africa is in some ways vulnerable to this
process, and I will detail our main weaknesses and the ways in which we might be affected,
before discussing the proper policy responses.
Vulnerabilities
Our most important vulnerabilities are the twin deficits: the fiscal deficit and the current
account deficit. We are also concerned about household indebtedness and therefore
exposure to higher interest rates.
At the moment, South Africa is running a current account deficit worth more than 6% of
GDP. In comparison with other emerging market deficit countries, our deficit is the product of
both weak export and strong import performance. In Brazil and Indonesia, current account
deficits have come mainly from falling prices of commodity exports, whereas in India and
Turkey deficits have grown mainly because of rising imports, with exports little changed. In
South Africa, export performance has been disappointing and imports have been growing at
a brisk pace.
To fund the current account deficit we rely on capital inflows, and as they become scarcer
the deficit will have to narrow. If this is to be achieved mainly through reduced imports the
consequences for growth will be severe, especially as these imports include capital goods
that are crucial to investment. It is therefore urgent that we improve on the country's export
performance. Furthermore, rising import penetration in the context of an output gap suggests
that the tradeable sector as a whole has lost competitiveness, not just exporters.
Regarding the SARB's repo rate stands at 5%, a more than three-decade low.
fiscal policy,
Although we do not provide forward guidance on rates, should the rates rise, that will add to
the cost of government borrowing. National Treasury has signaled smaller deficits in the
future, as fiscal policy shifts from stimulus to consolidation, but smaller deficits will still add to
SA's debt. QE made borrowing much cheaper, with SA Government bond yields unusually
closely correlated with US Treasury bonds. It was appropriate to capitalize on record low
rates and provide stimulus during the crisis, but these conditions are now passing. As rates
rise, interest costs will consume a greater portion of GDP. Our attempts to estimate this
effect point to an extra R11 to R30 billion in interest payments annually, averaged over the
next four years and depending on the interest rate path. It is therefore important that fiscal
policy adjust appropriately to more normal interest rates. National Treasury's most-recent
MTBPS shows that this exigency has been well-understood by the fiscal authorities, and we
are confident that it charts a sustainable course for South Africa.
In addition to the fiscal and current account deficits, South African consumers are also likely
vulnerable to higher interest rates. As the SARB's September 2013 Financial Stability
Review shows, households have used low rates to increase their debts, driving the ratio of
debt to disposable income to almost 76%. The number of consumers with impaired credit
records has climbed steadily since 2008, to nearly half the total. Although South Africa's
banks are well-capitalised and therefore capable of withstanding higher default rates, this
raises concerns both for consumer demand, an important driver of GDP growth, and the
wellbeing of these financially vulnerable households.
Will South Africa experience a "sudden stop"?
Given South Africa's vulnerabilities, the question is not if world monetary normalization will
affect us but rather how quickly and dramatically it will do so. The worst-case scenario is that
we suffer a sudden stop, meaning inflows abruptly cease.
One helpful definition of a sudden stop offered in the literature specifies a year-on-year fall in
the financial account greater than two standard deviations from the mean. Other scholars
have expanded this to a fall greater than one standard deviation, with the added requirement
that the decline in inflows must exceed 5% of GDP, to exclude cases where low volatility
produces small standard deviations.1 By either definition, this has never happened in
democratic South Africa. Indeed, some of these writers pick out South Africa as a special
case, a country which has experienced large currency swings but no sudden stops.
By contrast, other emerging markets have a long history of "sudden stops", and these have
often been growth disasters; Indonesia, for instance, took about a decade to recover the
GDP levels it had attained before the Asian Crisis of 1998. Sudden stops have also affected
advanced economies - although some of them stopped being advanced economies after
suffering sudden stops. As Olivier Accominotti and Barry Eichengreen have recently argued,
the economic crises in Europe after 1929 and 2009 should both be treated as sudden stops.
In 1927, Austria, Germany and Hungary were running current account deficits of around 5%
of GDP. In 2008, Greece, Portugal, Italy, Ireland and Spain had an average current account
deficit of
6.7%.2. When foreign funders suddenly refused to finance these deficits, crises
resulted.
Could a sudden stop happen here? We consider it unlikely. Partly, this is because world
monetary policies are likely to normalize slowly, with very low rates likely to persist for
several years in the United States, the Euro Area and Japan. Perhaps more importantly,
South Africa's vulnerabilities are manageable. The literature flags three main domestic
drivers of sudden stops: and
current account deficits, fixed exchange rates foreign
currency denominated debt. I will discuss each of these in turn.
The main reason current account deficits help precipitate sudden stops is that they exert
downward pressure on the currency. Additionally, as a matter of economic identities the
Current Account is equal to Aggregate Demand less gross national product (GNP). If the
current account deficit closes suddenly demand has to fall as quickly, unless GNP expands
enough to cover the gap, which it is unlikely to do in the short term. South Africa has a large
current account deficit, but this is mitigated by our currency and debt policies.
When a country with a fixed exchange rate experiences capital outflows, the peg comes
under pressure and needs to be defended. This normally entails raising rates sharply and
selling reserves, which suppresses output, exacerbates local debt problems and often fails
anyway, especially when speculators bet against the fixed exchange rate. Furthermore, an
overvalued exchange rate in the context of a current account deficit just exacerbates the
problem, because imports are unrealistically cheap and exports are penalized. The rand,
however, is a free-floating currency. This liberates us from vain or harmful attempts to
manage its value, and ensures that there is liquidity in the foreign currency market at all
times. Depreciation also provides the right incentives to producers and consumers of
tradeables. The floating rand acts as a shock-absorber for the South African economy and is
one of our best defences against a sudden stop.
Foreign currency denominated debt, from the public or private sectors, may be an even more
serious problem. Ricardo Hausmann has described it as the "Original Sin" of emerging
markets, by which he meant that EMs are unable to borrow long-term in local currency,
leading to debt profiles riven with currency and maturity mismatches. The problem with
foreign currency debt is that if the exchange rate falls, the debt burden rises. The results can
be likened to a bank run, with rising debt burdens deterring foreign lenders, weakening the
currency and pushing debt burdens even higher, deterring more lenders, and so forth. South
Africa's debt, however, is mostly rand-denominated, so investors bear the currency risk. We
do not suffer much Original Sin.
South Africa is therefore equipped to handle a shock like the end of QE without suffering a
sudden stop. Although the current account deficit should prompt depreciation, a flexible
currency and rand-denominated debt protect SA.
This confidence that we can avoid a sudden stop is also supported by independent
measures of country vulnerability. Nomura Global Economics has recently compiled an index
meant to show vulnerability to a currency crisis, meaning a shift of three standard deviations
from the two year average. South Africa is comfortably within the safer group of countries,
ahead even of countries like China, Israel and Chile. In September 2013 The Economist
magazine produced a similar index, measuring the likelihood of a capital freeze. This showed
a much more disturbing result: South Africa was revealed as the third-most vulnerable
country, after Turkey and Colombia. But this bad news, it turned out, was thanks to a
spreadsheet error. When corrected, South Africa suddenly moved to 16th out of 26, a much
less precarious position.
Thinking through the likely outcomes
For these reasons, we feel reassured that a sudden stop is unlikely. This clears the way for
us to think about the more plausible outcomes as world monetary policies normalise. To
assist with this task, we have modeled a range of scenarios, from growth in the advanced
economies to renewed recession. The headline finding for this exercise is that the end of QE
is neither good nor bad, in itself. What matters are the circumstances surrounding the exit.
Advanced economy central banks are most likely to end QE and raise rates as growth
improves - indeed, this is the whole point of monetary stimulus and the basis for forward
guidance. This outcome is good for SA as faster world growth translates into higher domestic
growth. Stronger exports plus depreciation would also narrow the current account deficit.
It is possible exit from unconventional monetary policies could occur with world growth still
disappointing. After all, this remains uncharted territory for central banks, and we cannot
assume they will definitely get the timing right, or that they will not be compelled to tighten
monetary policy earlier than they would like by unacceptable increases in asset prices or
inflation. In this case, growth would be weaker but a depreciating rand would still boost
inflation, requiring higher interest rates (although the effect is muted by the larger output
gap). A weaker currency would also shift the current account towards balance.
Getting policy right
How should policymakers respond to the end of QE and fast-depreciating currencies? There
is a danger, during currency sell-offs, of losing focus. One mistake is to treat the exchange
rate as a crucial indicator of prestige. Another may be to look back on previous exchange
rate crises (such as India's in 1991, Indonesia's in 1997/1998 or Brazil's in 1998), and worry
about losing the last war again. It may even be that currency rates, which change throughout
the working day, are reported on so intensively that they assume outsize importance.
Nonetheless, the exchange rate should not dominate our thinking.
For the Reserve Bank, our policy stance is clear. As flexible inflation targeters, the proper
response to a weakening currency isn't to defend its value, as the priority, but rather to target
the pass-through from the exchange rate to inflation. The Bank's normal estimate of this is
20%, meaning about a fifth of the change in the currency's value shows up in the CPI. The
scale of the pass-through varies from time to time, however, and at present it appears to be
lower, probably as a consequence of reduced pricing power in a subdued economy.
Although inflation moved outside the target during the third quarter it has since returned to
the target band, as forecast, registering 6% in September and 5.5% in October. We have
therefore not changed rates so far this year, nor have we introduced other policy measures
to influence the exchange rate.
This contrasts with the responses seen elsewhere. Brazil has raised rates by 225 points this
year, Indonesia by 150 and India by 50 points. Central banks have also resorted to less
orthodox policies including tightening overnight rates, implementing some capital controls
and creating new swap auctions - essentially, opening forward books.
Comparing the performance of the rand with the currencies of these other countries, we see
little evidence that a more activist and experimental approach would have changed the
rand's direction in a meaningful way. Furthermore, there are advantages to our approach, not
the least of which is a less volatile output, inflation and interest rates.
Conclusion
In essence, South Africa is not a fragile country. Rather, our system is anti-fragile, like a
welldesigned building in an earthquake zone: it moves with the shocks so it doesn't collapse.
- Our monetary policy stance is clear and appropriate;
- Fiscal policy is vigilant in anticipation of the normalization of interest rates;
- A sudden stop is relatively unlikely for South Africa;
- The end of QE is not plainly bad for SA, and could be a good thing if it heralds a
return to growth in the advanced economies.
Thank you.