Weak domestic growth calls for supportive policy, says Lesetja Kganyago
Central banks everywhere play a critical role in shaping the direction of a country’s economy. The South African Reserve Bank’s main mandates are to ensure financial and economic stability and to regulate the banking sector.
It achieves the first through monetary policy, which involves targeting inflation to prevent borrowing costs from rising and competitiveness of the economy from deteriorating. But the bank has been criticised for focusing too much on curbing inflation — it keeps inflation within a target range of 3%-6% — at the expense of economic growth.
The banking regulation arm is also facing a barrage of questions. The Conversation Africa organised three economic scholars to pose questions to the Reserve Bank governor Lesetja Kganyago.
NIMISHA NAIK: (a lecturer in economics, macroeconomics and mathematical economics at the University of the Witwatersrand): How should the Reserve Bank respond to the country’s recent credit rating downgrade? What approaches can it take to limit the potential decrease in investments to SA?
LESETJA KGANYAGO: A rating downgrade implies higher risk for investing in a country. As such (everything else being equal) a higher return is required to attract the same amount of foreign capital necessary to finance SA’s current account deficit.
As markets shift to reflect the higher return needed, the country’s currency might weaken. This adjustment may be compounded by foreign funds having to divest from SA as their investment mandates prevent them from holding noninvestment grade assets.
But a credit rating downgrade need not trigger a reaction from the Reserve Bank, unless its effect on capital flows and the exchange rate jeopardises price stability.
Raising the repo rate — the rate at which the central bank lends to commercial banks — by itself would do little to attract new investments. This is because only a small part of capital flows into the country consist of short-term money market investments. Most are made up of purchases of longer-term bonds and equities.
But failure to deal with the inflationary consequences of currency depreciation, which pushes up import prices and potentially all prices, would also push up both short- and long-term borrowing costs. This could eventually endanger the policy framework we have in place. As the commitment to low inflation weakens, investors will push up their expectations of future inflation, which further increases borrowing costs. This would, in turn, compound capital outflows and push the currency down and prompt stronger inflation, 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 already reached levels similar to those of lower-rated, noninvestment grade countries even before the April 3 S&P’s rating event. This implies that the market had mostly "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. These factors in turn suggest that short-term selling of rand-denominated assets may be relatively muted.
Nonetheless, further downgrades, in particular to "local currency" ratings, would again lower prices of assets and raise the cost of financing in the economy. This would be clearly negative for South African borrowers, domestic financial institutions and economic growth more generally.
ALAN HIRSCH (a professor and director of the Graduate School of Development Policy at the University of Cape Town): The recent budget showed that the National Treasury is tightening fiscal policy. Does this provide scope for monetary policy loosening?
LK: There are two major channels through which fiscal policy tightening can interact with the monetary policy stance. Firstly, curbing private and public-sector spending growth normally dampens demand-driven price pressures. These are pressures caused when demand for goods and services cannot be easily met by increased production of those goods and services, resulting in higher prices for them. Secondly, reassuring investors about the medium-term sustainability of debt levels limits the risk of capital outflows — and therefore downward pressure on the rand.
The moderate tightening in SA’s fiscal stance over the past three to four years has gradually lowered the amount of annual borrowing from about 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 pretax 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 SA’s recovery from the global recession of the 2009-10 period, the effect of the higher cost of borrowing weighs more heavily on economic activity as borrowing continues year after year. 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 re-opened 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 also creates space for stronger consumption growth over the longer 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%.
AH: As global interest rates rise this year, will the Reserve Bank be able to delay reciprocal increases in order not to stifle SA’s meagre growth. And to allow its currency to continue to favour exporters?
LK: 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 critically important. 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 interest rate decisions of major central banks. This is unlike countries that use the exchange rate targeting framework for achieving low inflation. As the monetary policy committee has noted, domestic economic growth has been weak and this requires policy settings that are supportive. For these reasons, "de-coupling" of interest rates is a common feature of growth and policy cycles.
This implies that some currency depreciation has been expected in recent years. And indeed this has happened. In this context it’s 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 more generally weak economy. The upshot is that we have gained competitiveness as the nominal exchange rate has depreciated, without much stronger growth in domestic inflation. This has helped to keep interest rates at near historically low levels since 2010. This has supported the recovery in the economy, while still keeping expectations of future inflation just within the target band.
JANNIE ROSSOUW (a professor and the head of the School of Economic and Business Sciences, at the University of the Witwatersrand): Does the existing structure of private shareholders still serve the best interest of the Reserve Bank and SA?
LK: The Reserve Bank’s shareholding structure is unusual, yet not unique in the world of central banking. At present, eight central banks in the world have a degree of private ownership. These include the US Federal Reserve, the Bank of Japan and the Swiss National Bank.
Historically, most central banks were privately owned. This pattern 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.
But several safeguards ensure that the Reserve Bank’s shareholding structure does not pose such risks in SA. In fact, the Reserve Bank’s private shareholders have no influence on the Reserve Bank’s key mandates of price and financial stability.
The governor and his or her deputies are appointed by the president of the country. And the South African Reserve Bank Act can only be amended by Parliament. The Reserve Bank’s functional independence is enshrined in the Constitution. Equally, as per the spirit of the Constitution, the inflation targeting framework has been determined through a consultative process between National Treasury and the Reserve Bank.
Provisions of the act further stipulate that no individual shareholder, including his or her associates, can hold more than 10,000 of the existing 2-million shares. It also caps the dividend at 10c per share. These prevent any attempt by shareholders at extracting significant profits from the institution, for instance, through the sale of its assets.
Overall, the role of the Reserve Bank’s private shareholders 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 of shareholders.
While international experience does not suggest that the shareholding structure of a central bank meaningfully affects its performance, there is equally no obvious case for changing such a structure in SA at present.
JR: What needs to happen before there can be a debate about a lower inflation target, say 3%-5%?
LK: SA’s inflation target range is both relatively wide and high by international standards, including among emerging countries. At the time the 3%-6% target was adopted in the early 2000s, SA remained 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 a vulnerable 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 lesser volatility than in the early years of the targeting regime. And the policy appears to have gained growing acceptance, over the years, from respective stakeholders.
But a relatively wide target can create uncertainty as to the actual objectives of monetary policy. In the South African case, this lack of clarity has resulted in an anchoring of inflation expectations at the upper end of the target range, which now restrains the margin of policy manoeuvre in the event of exogenous shocks.
In addition, the persistence of higher inflation in SA relative to its major 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 on the economy. Whether a more efficient target (using a point, a lower target, or being more explicit about where in the band is the best inflation rate) could help achieve such an outcome is an open question for economists to consider.
The target was revised to 3%-5% in 2001 but after the currency depreciation that same year the range was revised back to 3%-6% with the proviso that once inflation is back within the target then the 3%-5% target range will be reinstated. This has not happened yet.
AH: 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 the future?
LK: The Barclays Plc separation from Barclays Africa Group (trading in SA as Absa Bank) has renewed the policy debate on foreign ownership of the large South African banks at the Reserve Bank. The debate is also back because of the regulatory reforms imposed by the Basel Committee and the 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 those global systemically important banks requirements, contributing to an uneven playing field.
The Reserve Bank is supportive of and welcomes foreign ownership of SA’s large banks. But it remains cautious against controlling ownership by a global systemically important bank, as this could result in onerous regulatory requirements being imposed on the local operation.
The actual separation is also closely monitored as the local banking operations have become closely aligned and integrated on IT systems, infrastructure and processes with their parents. As such any separation needs to ensure that the local subsidiary remains operationally stable during and after the separation.
When the banking registrar assesses new investors applying to acquire a stake in any bank, its office conducts a fit-and-proper assessment. This is to establish the strategic intent of these investors. It is to see whether the investment is expected to be long term in nature, how the investment will be funded and how the investors plan to fulfil their fiduciary duties, including in terms of governance.