x p guma : low domestic inflation in an environment of high oil prices, vigorous household spending and credit demand and a widening current account deficit ; and the outlook for interest rates in south africa luncheon address by dr x p guma, deputy governor of the south african reserve bank, at investec, pretoria, 4 july 2006. * * * inflation in the world economy has declined significantly in recent years and has remained relatively subdued over the past few years despite a significant rise in commodity prices and strong economic growth. chart 1, based on world bank data illustrates the trend in world inflation, clearly showing the peak that occurred at a rate in excess of 35 percent per annum in the early 1990s and the rapid deceleration to rates around 5 per cent per annum thereafter. south africa ’ s inflation performance began to improve during the 1990s, as the next chart indicates ; and subsequent to the adoption of the inflation targeting framework, inflation as measured by cpix entered and has remained within the target range since september 2003. oil prices have risen sharply since 2003 ( as the next chart indicates ), on account of various determinants. during this year, the spot price of brent crude oil has increased dramatically from approximately us $ 59. 9 per barrel in february to levels around us $ 70. 5 per barrel towards the end of april and an average of us $ 68. 15 per barrel in june. continued brisk expansion in final consumption expenditure by households has been underpinned by a steady increase in household disposable income, continued buoyancy in the real estate and securities markets and what some describe as an accommodative interest rate environment. overall household debt as a percentage of annualised disposable income increased to a record level of 68 percent in the first quarter of 2006. robust growth in gross domestic expenditure and a concomitant strong increase in the value of merchandise imports resulted in a sizeable deficit on the trade account of the balance of payments in the first quarter of 2006. given the larger shortfall on the services and income account with the rest of the world and the somewhat subdued performance of south africa ’ s exports – notwithstanding the buoyancy of international commodity prices, the current account of the balance of payments registered a deficit equivalent to 6. 4 percent in the first quarter of 2006. interestingly, as others have observed, despite the sell - off in emerging markets since may, nonresidents have remained net buyers of south african financial assets and there have

credit derivatives, in their portfolios. this contributes to the compression of risk premia. this can continue as long as long - term interest rates stay low. but there is some circularity in the situation. on the one hand, institutional investors are “ victims ” of low long - term interest rates. on the other hand, they help to maintain this situation as they continue to look for even longer - dated bonds. therefore, if the pricing of long - term government bonds, which is the reference for the pricing of many other assets, remains distorted, credit risk premia may be based on shaky foundations. second, risk transfer mechanisms contribute to a certain opacity in the distribution of risks. most transactions are conducted on otc markets and are not recorded in a centralised manner : there is therefore a “ knowledge gap ” in the financial system as regards crt exposures. more fundamentally, risks are usually transferred by banks, which are regulated and transparent, to entities that are unregulated and are not required to disclose their positions. it is therefore impossible for market participants and regulators to identity the situation of the ultimate risk holders. third, the atomisation of risk has been accompanied by higher leverage embedded in the instruments themselves, making it hard to assess which of these countervailing effects prevails. while atomisation of risk mitigates the impact of a shock, leverage amplifies it. for instance, “ singletranche ” collateralised debt obligations ( cdos ) substantially increase “ embedded ” leverage : a singletranche cdo is generally leveraged 5 to 10 times, meaning that potential losses are 5 to 10 times greater than the losses on the underlying portfolio. this is a type of leverage that does not show up in lending figures. assessing the extent and effect of embedded leverage on a system - wide basis is therefore a real challenge. lastly, market liquidity can be very fragile. indeed, it is now much easier to trade credit exposures thanks to standardised credit derivative indexes. however, liquidity remains very uneven among crt markets and cannot be guaranteed under stressful market conditions. many institutions are also vulnerable to “ runs ”. market liquidity dry - ups therefore constitute one of the risks to be assessed. 3. what are the implications for central bankers and supervisors? i would like to suggest three approaches : first, remind market participants and investors that benign times, such as the current credit environment, should not be the benchmark for assessing risks