Downgrade far from death blow
Economics experts Nimisha Naik, Alan Hirsch and Jannie Rossouw interrogate the Reserve Bank’s role in the economy and ability to underpin growth
CENTRAL banks play a critical role in shaping an economy’s direction. The South African Reserve Bank’s mandate is to ensure financial stability and regulate the banking sector. It achieves stability through monetary policy, which involves targeting inflation to prevent a rise in borrowing costs and a deterioration in competitiveness. But it has been criticised for focusing too much on curbing inflation – which it aims to keep in a 3-6% target range – at the expense of economic growth. And the banking regulation arm faces a barrage of questions. The Conversation Africa organised three economics scholars to pose questions to Reserve Bank Governor Lesetja Kganyago.
Nimisha Naik: How should the Reserve Bank respond to the country’s recent credit rating downgrade? What can it do to limit a potential decrease in investment?
A rating downgrade implies higher risk for investing in a country. So a higher return is required to attract the same amount of foreign capital necessary to finance the current account deficit.
As markets shift to reflect this, the currency might weaken. This adjustment could be compounded by foreign funds having to divest if they are not mandated to hold non-investment grade assets.
But a credit rating downgrade need not trigger a reaction from the Reserve Bank unless the impact on capital flows and the exchange rate jeopardises price stability.
Raising the repo rate – at which the central bank lends to commercial banks – alone would do little to attract new investment, because only a small part of the capital flows into the country consist of shortterm money market investments. Most comprise purchases of longer-term bonds and equities.
But a failure to deal with the inflationary consequences of currency depreciation, which pushes up import prices and potentially all prices, would also push up shortand long-term borrowing costs. This could eventually endanger the policy framework.
As the commitment to low inflation weakens, investors will push up expectations of future inflation, which further increases borrowing costs. This would, in turn, worsen capital outflows and push the currency down and inflation up, in a vicious cycle.
The Reserve Bank has tended to think that, over time, such a negative outcome from a downgrade has become less likely. Market expectations of higher borrowing costs had reached levels similar to those of lower-rated, non-investment grade countries even before the April 3 Standard and Poor’s rating event. This implies the market “priced in” the downgrade.
Also, at the moment the global context is unusually supportive of emerging markets. Interest in riskier assets is being sustained by higher commodity prices and better global growth prospects. Given these factors, short-term selling of rand-denominated assets may be relatively muted.
Nonetheless, further downgrades would again lower the prices of assets and raise the costs of financing, which would hit South African borrowers, domestic financial institutions and economic growth in general. mostly
Alan Hirsch: The recent Budget showed the Treasury was tightening fiscal policy. Does this provide scope for loosening monetary policy?
There are two major channels through which fiscal policy tightening can interact with the monetary policy stance. Firstly, curbing private and public sector spending normally dampens demand-driven price pressure. Such pressure builds when the demand for goods and services cannot be easily met by the increased production of goods and services, resulting in higher prices for them. Secondly, reassuring investors about the mediumterm sustainability of debt levels limits the risk of capital outflows – and therefore downward pressure on the rand.
The moderate tightening in South Africa’s fiscal stance over the past three to four years has gradually lowered the amount of annual borrowing from around 4% to about 3% of GDP. This is expected to continue over the next two years.
Some of this fiscal restraint has occurred through tax increases. Expressed as a share of pre-tax disposable income, direct household taxes increased by 1.5 percentage points between 2012 and 2016.
Another part of the fiscal consolidation has happened through a nominal spending ceiling, which is an absolute rand value for spending in a given year.
A sustainable fiscal trajectory for deficits and borrowing is an important influence on the cost of capital in the economy generally. Greater borrowing by the public authorities can put upward pressure on interest rates.
While government spending has contributed to South Africa’s recovery from the global recession of the 2009-2010 period, the impact of the higher cost of borrowing weighs more heavily on economic activity as borrowing continues. This appears to be where the country is now. Spending contributes less than it did earlier to sustained economic growth, in part because the cost is higher.
As a contribution to short-term economic growth, government and private debt has probably become a constraint. Fiscal space is being reopened as government debt levels stabilise and the economy’s growth rate strengthens. Household debt levels have also come down in recent years, especially in 2016. This creates space for stronger consumption growth in the long term.
As the fiscal consolidation progresses and deficits work down, both inflation and interest rates should moderate. This is helpful to monetary policy. It has, and should, continue to facilitate the Reserve Bank’s gradual and flexible approach to getting inflation sustainably down towards the middle of the target band of 3-6%.
Hirsch: As global interest rates rise this year, will the Reserve Bank be able to delay reciprocal increases so as not to stifle SA’s meagre growth. And to allow its currency to continue to favour exporters?
The rise in global interest rates will tend to depreciate other currencies, except those of economies that will get a strong and direct growth benefit from more robust growth in the US.
But domestic conditions are critical. The inflation targeting framework provides room for flexibility, allowing the Monetary Policy Committee to choose what weight to place on external and internal factors in deciding policy.
Policy is not bound to follow the interest rate decisions of major central banks. This is unlike countries that use the exchange rate targeting framework to achieve low inflation. As the committee has noted, domestic economic growth has been weak and this requires policy settings that are supportive. Thus a “de-coupling” of interest rates is a common feature of growth and policy cycles.
This implies some currency depreciation has been expected in recent years. And this has happened. In this context it has been important for policy to focus on whether depreciation will generate future inflation. Up to now we have been fortunate this “pass-through” into domestic prices has been less than would normally be expected.
This may, in part, be because of lower commodity prices and terms of trade and the generally weak economy. The upshot is that we have gained competitiveness as the nominal exchange rate has depreciated, without inflation going up too much. This has helped to keep interest rates at near historically low levels since 2010, which has supported the economy’s recovery while keeping expectations of future inflation within the target band.
Jannie Rossouw: Does the structure of private shareholders still serve the best interests of the Reserve Bank and SA?
The Reserve Bank’s shareholding structure is unusual, but not unheard of in central banking.
Eight of the world’s central banks have a degree of private ownership, including the US Federal Reserve, Bank of Japan and the Swiss National Bank.
Historically, most central banks were privately owned. This changed drastically after the Great Depression of the 1930s. Back then, many governments felt that the conflict between private shareholders’ interests and the public policy mandate of these institutions had in some cases prevented appropriate policy responses.
Several safeguards ensure that the Reserve Bank’s shareholding structure does not pose such risks in SA. The private shareholders have no influence on the Reserve Bank’s key mandates of price and financial stability. The governor and deputies are appointed by the president and the SA Reserve Bank Act can only be amended by Parliament.
Its functional independence is enshrined in the constitution and, in that constitutional spirit, the inflation targeting framework was determined through a consultative process with the Treasury.
The act stipulates no individual shareholder, including associates, can hold more than 10000 of the 2million shares. It also caps the dividend at 10c/share. These measures prevent any attempt by shareholders to extract significant profits from the institution through, for instance, the sale of its assets.
Overall, the private shareholders’ role remains one of oversight and can improve governance. This happens, for example, through the tabling of an annual report and financial statements at the annual general meeting.
While international experience does not suggest the shareholding structure of a central bank affects its performance much, there is no obvious case for changing such a structure.
Rossouw: What needs to happen before there can be a debate about a lower inflation target?
South Africa’s inflation target range is wide and high by international standards, including among emerging countries. When the 3%-6% target was adopted in the early 2000s, South Africa was an economy in transition, having recently faced renewed exposure to global economic volatility.
The economy was thus exposed to shocks, and it was felt that a relatively wide and high target would be more credible in such an environment. The strategy seems to have borne fruit: compliance with the target has improved over time despite greater currency volatility. Inflation, as well as inflation expectations and wage growth, display less volatility than in the early years of targeting. And the policy appears to have gained growing acceptance.
But a wide target can create uncertainty as to monetary policy objectives. In South Africa, this has resulted in an anchoring of inflation expectations at the upper end, which restrains the margin of policy manoeuvre in the event of exogenous shocks.
In addition, the persistence of higher inflation relative to the main trading partners introduces a medium-term depreciation bias to the currency, which will raise the risk premium on domestic interest rates. Achieving a lower inflation rate would help ease these constraints.
Hirsch: What has the Reserve Bank learnt from the Barclays/ Absa saga? Will it be more circumspect in allowing foreign investors to buy thriving South African banks in future?
The Barclays Plc separation from Barclays Africa Group (trading in South Africa as Absa Bank) has renewed the policy debate on foreign ownership of large South African banks. The debate is back because of the regulatory reforms imposed by the Basel Committee and Financial Stability Board on global systemically important banks following the global financial crisis.
These reforms imposed various additional requirements on global systemically important banks. This has filtered down to their significant subsidiaries operating in different jurisdictions, including emerging markets. These subsidiaries then need to compete with other local banks that don’t need to meet such requirements, contributing to an uneven playing field.
The Reserve Bank is supportive of and welcomes foreign ownership of SA’s large banks. But it is cautious of control by a global systemically important bank as this could result in onerous regulatory requirements being imposed on the local operation. Separation is also closely monitored as local banking operations become closely aligned and integrated on IT systems, infrastructure and processes with parents. As such, any separation needs to ensure the local subsidiary remains operationally stable during and after a separation. – The Conversation
Naik is a lecturer in economics, macro-economics and mathematical economics at the University of the Witwatersrand, Hirsch is professor and director of the Graduate School of Development Policy at the University of Cape Town and Rossouw is head of the School of Economic & Business Sciences at the University of the Witwatersrand.