The South African Reserve Bank’s (Sarb) decision to continue hiking the interest rate at which accommodation is provided to the commercial banking sector (the so-called ʺrepo rateʺ) seems to be out of touch with the reality of a lethargic economy.
In mid-2012, the repo rate was 5% and it now stands at 6%. As a result, the prime overdraft rate has increased by an equivalent of 100 basis points over the last three years, representing an increase in the cost of working capital of 11.8% – hardly what the economy needs at a time when several sectors are facing the prospect of contraction and the leading business cycle indicator is heading south.
Primary sectors seem to be the hardest hit, with mining activity continuing to feel the pinch of a five-year commodity price slump and the lingering effects of exceptionally steep wage increases.
Regular strikes, often accompanied by violence, intimidation and damage to plant and equipment, have also contributed to a decline in investor confidence in the industry. Last year, value added by mining amounted to R287 billion, which is 7.2% less, in real terms, than in 2007.
Agriculture is also confronted by steep declines in a number of producer prices, with the added woes of a serious drought in several regions of the country. Continued uncertainty over land reform has contributed to a marked decline in the ratio of capital formation to value added by agriculture.
The Reserve Bank’s arguments in support of the tightening of monetary policy are flimsy and even contradictory.
The rather lengthy statement by the Monetary Policy Committee (MPC) that accompanied the repo rate announcement implicitly acknowledges the existence of a number of threats to sustained economic growth, while also specifically mentioning the following:
- A weak domestic growth outlook as both the supply and demand sides remain constrained;
- Declining business and consumer confidence;
- Further downward revisions to the global growth outlook, with the initial forecast of around 3% now likely to be closer to the 2%-level (structurally lower growth in China is one cause);
- Low commodity prices, which are exerting a negative effect on the South African trade balance.
Against this background, the logical economic observation is that inflation is not a major problem, especially due to the consistent strong inflows on the financial account of the balance of payments, which have negated the effect of large current account deficits.
In the process, the rand exchange rate has performed better against the US dollar and the euro than the currencies of several trading partners and emerging market peers, particularly over the past year. This point is actually acknowledged by the MPC, which stated that inflation pressures remain benign, reinforced by declining commodity prices, including oil.
It is not surprising, therefore, that the monetary policy stance in most advanced countries and emerging market economies has either remained unchanged or become more accommodative since the beginning of the year.
Arguably the most puzzling statement by the MPC (in relation to the repo rate hike) is the confirmation of an unchanged outlook for headline inflation over the next 30 months. In its discussion of the inflation outlook for South Africa, the MPC is optimistic about headline inflation averaging 5% in 2015 (in line with the forecast of the Economist Intelligence Unit).
Although the Reserve Bank does expect inflation to breach the upper end of the target range (3% to 6%) during the first half of next year, its forecasts for an average of 6.1% in 2016 and 5.7% in 2017 remain unchanged.
Then comes the surprising anomaly – the MPC announces that, despite an apparent sound formulation of arguments in favour of an accommodating monetary policy stance (or neutral at worst), the repo rate is increased. For consumers with mortgage bonds, the rate increase boils down to a combined loss of around R3 billion in consumption expenditure (if the increase is fully translated into higher bond repayments).
Some economists have speculated that the Reserve Bank may have decided to preempt a return to higher money market rates in the US (and possibly Europe as well) later in the year, in an attempt to attract so-called ʺcarry tradeʺ, where speculators borrow in low-interest currencies and invest in higher-yielding currencies.
In theory, however, this should not be a focus of monetary policy. The so-called principle of ʺuncovered interest rate parityʺ states that the difference in interest rates between two countries will equal the expected change in exchange rates between them.
The currency of the country with the higher interest rate will therefore tend to depreciate, which makes imports more expensive. For a country like South Africa, which is highly dependent on oil imports, this would aggravate inflation and run contrary to the objectives of monetary policy. A central bank should also not encourage currency speculation.
Although statistical evidence has often refuted the theoretical relationship between spot interest rates, forward interest rates and exchange rate movements, a currency strengthening would be even more unwelcome for the South African economy, due to its negative effect on international competitiveness.
The Reserve Bank needs to realise that attempts to influence the rand exchange rate via marginal increases in the repo rate are futile. It also needs to revisit its stated intention of balancing the objective of price stability with that of supporting economic growth. The latter is not served well when interest rates are increased at a time of economic frailty.