Bank’s dreadful mistake
The Reserve Bank is fooling itself if it thinks it can have a positive impact on the rand in any easily predictable way
Reserve Bank governor Lesetja Kganyago accepts that the economy is in dire straits. However, in seeming disregard for the severity of the problem, the monetary policy committee on May 25 unanimously ordered a further 50 basis point increase in short-term borrowing costs for mortgages and overdrafts.
The governor justifies raising interest rates in a distressed economy as part of a “no pain, no gain” regimen. He argues that though increasing interest rates may have a negative impact on the growth rate of the economy in the short term, in the longer term his actions will lead to low and stable inflation rates; these will, in turn, embed expectations of continuing low and stable inflation rates into the future. His implicit assumption is clearly that the latter will outweigh the former.
The problem with this theory of monetary policy is that it is not particularly applicable to the South African case. South Africa is a small economy and open to foreign trade and capital flows. This means the foreign exchange value of the rand, which is a primary driver of the inflation rate, can change abruptly for reasons that have little to do with interest rate settings, the actions or beliefs of the Bank, or expectations of its actions.
In an infamous piece of South African economic history, Chris Stals, the Bank’s governor during the emerging-market crisis of 1998, repeatedly raised the repo rate in an attempt to reverse a sharply weakening rand. By mid-1998 he had raised the repo rate to a record 22%, resulting in the commercial bank prime overdraft rate rising to 25.5%. This ill-considered move to defend a falling rand cost the country $20bn in lost forex reserves and ended in failure.
Sadly, the South African economy has not changed fundamentally in the past 25 years. It remains a small, open, commodity-exporting economy subject to supplyside shocks from the outside world, including the commodity price cycle, and wars and world events that have nothing to do with us.
However, the governor still seems to disregard these lessons of history. Kganyago should realise that the behaviour of the rand is the primary determinant of the inflation rate, but that he has little power to positively influence its value in any easily predictable way.
This was borne out yet again last week. After the unexpectedly harsh announcement, the rand lurched from R19.35/$ to R19.70/$. This plunge happened because the rate rise further weakens South African expenditure levels and growth prospects, and raises sovereign risk. Debt repayments increase and consumers are squeezed even harder. Sovereign risk increases because external perceptions of South African growth deteriorate further and the government, which is dependent on the PAYE tax receipts collected by private sector enterprise, is put under further fiscal pressure.
By raising the interest rate by 50 basis points, Kganyago has done little except inflict damage on an already weak economy. He has clearly hurt, not helped, the exchange value of the rand by directly depressing any growth prospects for the economy, achieving precisely the opposite of what one assumes he intended.
It’s worth noting that the Bank governor has a constitutional mandate to protect the value of the currency, but to do so (in the words of the constitution) in the interests of balanced and sustainable economic growth. What’s more, the Bank also has a constitutional obligation to enhance and protect financial stability. It is hard to see how that imperative is concordant with inflicting financial pain on South African households and firms in the form of higher interest rates. In fact, the threat of serious domestic instability through low growth and high unemployment is both real and dangerous.
In Kganyago’s defence, the overwhelming problem for South Africa is a poorly functioning government. It is primarily the actions of the government which have led to a high sovereign risk and low investment rates from outside the country, as well as from private enterprise inside our borders. Kganyago can do little about this. But he must accept that he cannot fundamentally influence the exchange rate and thus the rate of inflation. Instead, he now needs to take a more passive, growthpromoting role.