Daniel Mminele: Policy implications of some key market developments
Address by Mr Daniel Mminele, Deputy Governor of the South African Reserve Bank, at the
Financial Markets Department's Annual Cocktail Function, Pretoria, 3 March 2015.
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Introduction
Ladies and gentlemen, good evening.
Thank you for attending this year's Financial Markets Department cocktail function.
It has almost become tradition for me to take stock of major global and domestic market
developments that occurred during the past year, and to briefly reflect on their implications
for South Africa. In the past, we also used this event to brief you, our partners in financial
markets and other stakeholders, on key projects undertaken, changes and innovations
introduced in the Financial Markets Department.
This year, though, I would like to take a slightly different approach. Rather than providing a
detailed review of operations over the past year, I will look at what I think are potential
challenges that market participants and policymakers are likely to be confronted with in the
period ahead. Given the time constraints, I will focus on the policy implications of some key
market developments.
You will, however, not be deprived of information about recent developments and activities of
our Financial Markets Department. I have the pleasure of announcing the launch of the
newsletter called FMD update, copies of which will be available tonight. The newsletter will
also be available on the Bank's website.
What has not changed and will not change is the importance of central bank interaction and
communication with the markets, especially in light of the new views on the role of forward
guidance in its various forms. Forward guidance, in more formal or less formal ways, appears
to have graduated from what was essentially a crisis-fighting instrument to now being
advocated by some as part of the standard toolkit of central bankers, even in normal times.
Recent experience has shown how sensitive financial asset prices have become to changes
in signals over future policy. We therefore continue to value our ongoing interaction with
yourselves as market participants, as you are in essence part of our transmission
mechanism of monetary policy.
Monetary policy divergence, the stronger US dollar, and global imbalances
But let me get back to market issues and policy.
One of the key trends observed over the last few quarters has been the steady appreciation
of the US dollar against the backdrop of divergent monetary policies in advanced economies.
At first glance, such a recovery in the US currency seems consistent with the improvement in
US economic prospects. US GDP growth continues to outpace that of the eurozone and
Japan, and most economists agree that 'the healing process' of balance sheets in the private
and public sectors, a necessary adjustment following the global financial crisis, is more
advanced in the US than in some of the other advanced economies. In view of these
improvements, and of perceptions that the US economy is likely to prove fairly resilient to
foreign-exchange appreciation, market participants have discounted earlier rate hikes in the
US than in other major blocs, and widening yield and forward rate differentials have favoured
the US dollar. As you are aware, the actual timing for a lift-off in US interest rates remains
the subject of much debate and speculation. Conversely, the resulting currency depreciation
in regions like Europe, Japan and Latin America is seen as growth-enhancing and also
assisting, in some cases, with warding off the risk of deflation.
The marked appreciation of the US dollar may, however, revive other concerns. We have
seen a very strong correlation between the stronger dollar and weaker commodity prices.
While this is in part a logical consequence as the US dollar is the currency of denomination
for trading in many commodities, the firming in the US currency appears to have contributed
to an unwinding of long speculative positions in commodity futures, which has possibly
exacerbated the overall price decline. Some have argued that the risk that such an
unwinding of positions could extend to other financial assets through portfolio rebalancing
effects should not be underestimated. Hence, it may not be a coincidence that the stronger
dollar was accompanied by a rise in financial market volatility, a subject I will address in more
detail later. Finally, it may be worth asking whether the stronger dollar and stronger US
growth will not, as has already happened in earlier decades, exacerbate current-account
imbalances or result in widening global imbalances, at a time when external surpluses in the
eurozone and China are rising again and the US trade deficit is drifting wider.
How has this affected South Africa? A corollary to the rising US dollar has been depreciating
emerging market currencies, including the rand. The downward trend of the rand versus the
US dollar continued in 2014. At R11,71 to the US dollar as of 2 March, the bilateral exchange
rate is approximately 7,0 per cent weaker than a year ago and only marginally stronger than
the low of R11,87 reached at the height of the 2008 global financial crisis. However,
compared with other emerging market currencies, the rand was certainly one of the
betterperforming currencies against the US dollar and has regained some of the ground it had lost
in earlier years. Yet, unlike previously, this weakening of the rand against the US dollar has
not resulted in depreciation on a trade-weighted basis. In fact, the effective exchange rate
has been relatively stable since the beginning of 2014. On 2 January 2014, the TWI was at a
level of 68,3 while on 2 March 2015 it was virtually unchanged at 68,4. For 2015, up to and
including 2 March, the rand has appreciated by 2,1 per cent on a trade-weighted basis. This
is explained by the fact that while there has been a marginal depreciation against the US
dollar of close to 2 per cent, the rand has appreciated by 6,3 per cent against the euro.
This reconfiguration in currency markets arising from the stronger US dollar, which happens
to coincide with easing policies in other parts of the world, has led some observers to
highlight the risk of new currency wars. Any currency wars which inhibit international trade
will affect economies highly dependent on exports and will certainly trigger uncertainty, with
an adverse impact on capital flows to emerging market economies. It is for this reason that
the G-20 agenda argues against the use of competitive devaluations as a deliberate policy
measure.
The volatility of domestic bond yields
Another important development over the past year has been the decline in long-term South
African bond yields, even as the rand continued to weaken against the US dollar. For
example, while off its late-January lows, the yield on the R186 bond is still about 130 basis
points below early-2014 levels. The current yields are nevertheless still substantially higher
than the levels that prevailed prior to the 'taper tantrum'. Before bond yields started rising to
the current levels of 7,66 per cent, the R186 bond traded at 7,04 per cent towards the end of
January. The strong bond market rally in January was due to market participants having
scaled down their expectations for interest-rate hikes compared with what they projected in
early 2014 due to the oil price having declined sharply, to the point that domestic inflation
was no longer expected to exceed the upper end of the target range over the forecasting
period, and real domestic GDP growth having also fallen short of earlier expectations.
Furthermore, non-residents were net buyers of domestic bonds to the value of more than
R9,1 billion.
Bond yields reversed course as non-residents started selling domestic bonds (approximately
R13,7 billion in February). There were also rising concerns and uncertainty as to the
sustainability of the low oil price. There were indications that broad measures of longer-term
inflation expectations - as depicted by the BER survey - had not declined significantly, at
least not as much as market measures like break-even inflation expectations, which was a
key factor behind the decline in long-term bond yields in January.
The Bank will continue monitoring the international and domestic factors driving bond market
volatility. Increased volatility would be a source of risk as it could undermine capital inflows
and put pressure on the balance of payments. In that respect, it may be worth reflecting on,
in particular, what the relationship should be between long-term interest rates and the price
of oil. Indeed, a decline in oil prices should depress the inflation rate in the short term but at
the same time provide a boost to real GDP growth, and as a result need not have a big
impact on long-term inflation expectations. A strong rally in longer-term bonds on the back of
lower oil prices may be justified in places like the eurozone, where market participants fear
that even a few months of negative headline inflation readings might entrench deflation; yet
one cannot make a similar case in South Africa. After all, more likely, the decline in long-term
SA bond yields was influenced by the strong correlation between domestic and foreign term
premiums, especially with the US. However, this pattern highlights the vulnerability of
domestic yields to any sudden steepening in global yield curves.
Causes of the recent uptrend in volatility
While global long-term yields are still below the average levels that prevailed in the second
half of last year, most indicators of financial market volatility, especially in the fixed-income
and currency markets, have tended to move higher in recent months. Furthermore, at least
compared to the period of relative stability around mid-2014, these indicators seem prone to
swings that are both more frequent and bigger in magnitude. In a word, volatility seems to be
getting more volatile.
Some commentators argue that this volatility is driven by, among others, geopolitical events,
uncertainties about the timing and pace of US rate rises, tensions arising from needing to
find sustainable solutions for Greece, and doubts about how successful QE will be in the
eurozone. These factors have a significant bearing on this rise in volatility. Rising volatility in
several financial assets seems to have been correlated with higher oil price volatility as a
result of the drop in crude prices, which may sound a bit counterintuitive as lower oil prices
typically bring about a better growth/inflation mix in the world's largest economies. While
demand and supply factors are responsible for the over US$50 per barrel decline in the price
of Brent crude, we do not have a full understanding of the drivers of the oil price decline. In
fact, there are indications that financial factors, while not dominant, did have some bearing
on oil price movements. Or was the oil price decline seen as a harbinger of deflation in some
regions? It could also be a reflection of deeper structural economic weaknesses that will
complicate the task of policymakers, and thereby challenge the valuation of many asset
prices. Only time will tell.
At the same time, the side effects of regulatory changes introduced in recent years, and in
particular limitations on banks' proprietary trading, appear to have reduced the willingness of
established primary dealers to hold sizable inventories of fixed-income securities, and to
continue to make markets in the less liquid issues. As a result, turnover has tended to
decline relative to amounts outstanding in many of these markets. At a time when fund
managers (both private and public) have tended to diversify their portfolios and hold larger
quantities of these less liquid issues, the risk of a sudden plunge in liquidity, and subsequent
sharper price swings, may rise should asset managers be required to substantially reduce
their positions in a relatively short period.
Yet, while these constraints to market liquidity are likely to be a sign that new regulations
could be having unintended and undesired side effects, they should not be used as an
excuse to put on hold the search for greater fairness, transparency and ethics in financial
markets, both internationally and at home. In a world where both the size and the complexity
of financial transactions keep increasing, yet where a growing number of intermediaries and
trading technologies mean a decline in the personal relationship between buyers and sellers,
the need for trust, strong culture and appropriate values becomes even more important.
This requirement is illustrated by recent findings on collusive practices in reference rate
setting and foreign-exchange markets over recent years, which resulted in huge financial
penalties for the institutions involved. In the absence of trust, acceptable norms and values,
market participants would require additional risk premiums to protect against the risk of unfair
pricing, implying, in the long run, restrictions in access to credit, suboptimal returns for
savers, and overall constraints to economic growth and development. In South Africa, the
Bank has spearheaded several initiatives in recent years with respect to strengthening codes
of conduct for Jibar and foreign-exchange markets, and, more recently, a push to enhance
transparency in the broader money market. Yet professional associations and their members
still need to play a key role, at home and abroad, in enforcing greater and more efficient
selfregulation.
Concluding remarks - implications for the Bank's policy
What does this all mean as we go deeper into 2015? The big themes that we saw in the
closing stages of 2014 are still with us. In addition to domestic growth and inflation trends,
the outlook for South African financial markets, similar to other emerging market economies,
will likely be dominated by four factors, namely: the pace of normalisation in US interest
rates, growth and monetary policy dynamics in the eurozone, growth developments in China
(large and to a lesser extent in other emerging market countries), and the outlook for
commodity prices. These developments appear to have set the tone for higher volatility in
global markets and a possibly more challenging environment for emerging market
economies, especially those whose private and public entities have borrowed heavily in US
dollars in recent years and in some instances have invested in oil-related activities. While
shock changes to sentiment seem to affect markets more (as exhibited by this heightened
volatility), the ability of the market to absorb such events still seems to be intact, but spill-over
effects could be more pronounced.
Policymakers will have to deal with the increasingly complex nature of various cross-currents
that characterise the current environment. Such factors of uncertainty require a high degree
of vigilance from monetary authorities, even as inflation falls lower than we expected a few
quarters ago. Although it is clear that policymakers globally have been given some reprieve
as a result of the decline in oil prices, there still exists much uncertainty as to its drivers and
its sustainability, which makes us vulnerable to a correction or reversal in prices from current
levels. In such an environment, it is important to remain vigilant and not to declare early
victories because of what appear to be temporary dynamics around headline inflation
outcomes, but to continue to be guided by a forward-looking approach over the medium
term.
Amid such new developments and uncertainties, the Bank will continue to abide by its
mandates of price and financial stability. The Bank is cognisant of how the oil price decline
has significantly changed the near-term inflation outlook, however, the former's long-term
impact on both growth and inflation will depend on how persistent the decline is.
Consequently, the Bank has made moderate downward revisions to its core inflation
forecast, projecting average rates of 5,5 per cent in 2015 and 5,1 per cent in 2016, versus
rates of 5,7 per cent and 5,3 per cent, respectively, at the time of the November MPC
meeting.
Furthermore, several factors may preclude the normal positive boost that a marked oil price
decline typically provides to a country's growth-inflation mix, highlighting the uncertainties
surrounding these forecasts. The currency remains a major factor of uncertainty, for while the
rand's real effective exchange rate is relatively low by historical standards and showed signs
of stabilising last year, the persistence of a structurally large current-account deficit, coupled
with the uncertainties I mentioned earlier about market liquidity and volatility and asset price
valuations, highlight the risk of reduced portfolio inflows, even outflows, and further currency
depreciation.
At the same time, on the wage front, the continued rigidity in wage demands and
settlements, at a time when labour conflicts have risen and productivity has slowed, raises
doubts as to the extent that a temporary, oil-driven drop in inflation can feed into a more
benign wage-price spiral. Finally, on the real economy side, the country's well-publicised
power supply constraints, while limiting the growth benefits of the oil price drop, raise
questions about the extent to which potential growth, and the output gap, may be trimmed
over the next few years.
Such factors of uncertainty require a high degree of vigilance from monetary authorities,
even as inflation falls lower than we expected a few quarters ago. The more benign projected
inflation path, in an environment where growth in credit and property prices does not signal
any build-up in financial imbalances, gives the Bank some room to pause in its interest rate
normalisation process. Yet, risks related to currency moves, capital flows and overall
financial market volatility will have to be closely monitored in coming quarters.